International Comparisons of Bank Margins – August 1994 2. What are Interest Margins?

4. Banks have two main sources of income, namely net interest income and non-interest income. Net interest income is the difference between interest earned on loans and investments and interest paid on deposits and other interest-bearing liabilities. Non-interest income comprises fees and other charges and income from other activities such as trading of securities and foreign exchange. Total income – net interest income plus non-interest income – should over time cover costs and provide a reasonable return on capital if banks are to be viable.

(a) Average interest margins

5. Interest income results from banks charging more on their loans than they pay on their deposits. A number of measures of the average interest margin can be constructed from regular returns submitted by banks in most countries. The dollar value of interest received and interest paid is published in profit and loss reports. The difference between these two items is net interest income. Relating this to a base of interest-earning assets provides a measure of the net interest margin:

   

6. Another measure based on profit and loss and balance sheet information is the interest spread. The interest spread is the difference between the average interest rate earned on interest-earning assets and the average interest rate paid on interest-bearing deposits:

   

7. The net interest margin and interest spread are closely related. They will differ to the extent that banks have liabilities such as equity and non-interest-bearing deposits on which interest is not paid, and which cause interest-bearing deposits to differ from interest-earning assets. Because of the existence of these liabilities, the interest spread will usually be smaller than the net interest margin.^[2] Where the non-interest-bearing liabilities consist mainly of equity, the difference between the measures will be small and the relationship over time will change only to the extent there is a change in banks' gearing ratios. The difference between the measures will be larger if there are substantial non-interest-bearing deposits; in this case the spread will significantly underestimate the true difference between the average interest received and paid. For this reason, it is better to include non-interest-bearing deposits in the denominator of the ratio of interest paid. This ‘adjusted’ interest spread is defined as follows:

   

8. Chart 1 shows the net interest margin and adjusted interest spread for the domestic operations (including non-bank subsidiaries) of the four major banks in Australia. As can be seen, the interest spread is lower than the net interest margin (for reasons noted above) but the two tend to move similarly.
9. The data required to calculate the interest spread are not available in banks' published accounts in most OECD countries, so this measure cannot be used for international comparisons. The data required to calculate net interest margins are more widely available and the international comparisons in this paper are on this basis.
10. The presence of ‘non-accrual’ loans – i.e. those loans on which interest payments have fallen into arrears – also affects measures of interest margins and interest spreads. In order to get a better handle on the margins or spreads that apply on banks' ‘good’ loans – those that are paying interest in full – an adjustment should be made to correct for the interest forgone on non-accrual loans. While this can be done for Australia, data are not available to make accurate adjustments for other countries and so the comparisons in this paper generally do not take this adjustment into account. Where possible, however, the paper provides some indication of what the broad effects of differences in non-accrual loans would be.

(b) ‘Marginal’ measures

11. Sometimes a representative loan rate and a representative deposit rate are compared, such as the gap between the business indicator lending rate and the overnight cash rate, or the gap between the mortgage rate and the rate paid on statement savings accounts. Because they only refer to one line of business, movements in these margins are not a good proxy for trends in overall profitability.
12. A similar approach is to compare a particular lending rate with a measure of the average cost of funds. This can give some idea of the return on a particular type of lending compared with another type, but to be meaningful it needs to be augmented by a measure of the risk associated with the different types of lending. For a given type of loan, e.g. variable rate home mortgage, it is, in principle at least, also possible to make some sort of international comparison in order to gauge the relative profitability of the product.^[3] For the purposes of this paper, however, the aim is not to pursue a product-by-product comparison, but to look at average margins in order to see what they imply about profits, costs and competition.

Footnotes

The position is a little more complicated than this. Banks' assets comprise interest earning assets and non-interest earning assets, with the latter including bills receivable, buildings and property and so on. Their liabilities comprise interest-bearing deposits, non-interest bearing deposits (where deposits include all debt liabilities), bill acceptances, other liabilities and equity. The relationship between interest-earning assets and interest-bearing deposits depends on the relative size of all of the other asset and liability items. [2]

See B.W. Fraser, ‘Some Current Issues in Banking’, Reserve Bank Bulletin, June 1994. [3]