Net Interest Income (NII)

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Net Interest Income (NII) is the profit a financial institution makes from its core lending and borrowing activities. Net Interest Income is calculated by subtracting interest expenses (e.g., payments on deposits) from interest revenues (e.g., interest portion of loan revenues).

This metric is essential for evaluating a bank’s core profitability and overall financial performance. It provides information about the spread between the interest paid on liabilities and the interest received on assets.

While Net Interest Income (NII) is useful for assessing a single institution’s profitability, it is less suitable for comparing institutions of different sizes. Since net interest income accounts for dollar values, the size of the company matters a lot in determining the size of the NII. This limitation leads us to a more useful metric for comparison. Net interest margin (NIM) is a better metric for comparing the efficiency of net interest income generated by different financial institutions.

Now that we've seen the NII figures for major Canadian banks, let's examine how these numbers are calculated and what drives them.

Net interest income is easy to calculate as it requires two values commonly found in quarterly financial reports: Interest Revenue and Interest Expenses.

Even though Net Interest Income is easy to calculate, it is important to understand how interest revenue and interest expenses are formed. Understanding asset and liability composition is crucial for two reasons. First, it explains a bank's financial position. Second, it reveals the factors behind NIM fluctuations.

To understand what creates net interest income, we need to break it down into its two main components: interest revenue and interest expenses.

This metric accounts for the non-operating income that comes from the interest received on interest-bearing assets. These assets include issued loans, securities, interbank and institutional lending, and other interest-earning assets.

All interest-bearing assets have a different interest yield structure and may react differently to changing economic conditions. Understanding the composition of interest-bearing assets may provide greater insight into what drives interest revenue.

The loan portfolio consists of loans issued by the financial institution to its customers. These may include Residential, Consumer, and Commercial Lending. The loan portfolio yield is the primary source of revenue for most banks and financial institutions, so it should be watched closely when analyzing an institution's profitability.

The securities portfolio consists of government and corporate bonds, mortgage-backed securities, and other fixed-income instruments. These securities typically provide a stable interest yield, but the return is largely dependent on the credit risk and sensitivity to interest rate changes.

This category accounts for the funds placed at other financial institutions (e.g., overnight deposits) or the central bank (e.g., repurchase agreements). These short-term, low-risk lending activities typically yield slightly above the Bank of Canada’s overnight rate. Because they serve primarily as liquidity management tools, interbank and institutional lending usually represents a negligible share of interest-bearing assets.

All other interest-bearing assets may include cash and cash equivalents, certain receivables, or even margin lending. Similar to the interbank and institutional lending portfolio, these assets usually take a small proportion of the total interest-bearing assets and provide additional liquidity management, but they may carry an elevated credit risk.

All interest-bearing liabilities require certain interest payments, which are the financial institution's interest expenses. This is also a key metric to consider when analyzing net interest income. Similar to interest income, interest expenses may come from multiple sources, the main being the deposit portfolio.

Deposits are the main driver of interest expense and the main source of funding for most financial institutions. These are the money that customers deposit with their bank. Customer deposits come in three main varieties, each with different interest rate structures: demand, notice, and term deposits. Most of these deposits generate a certain amount of interest for the client, so the financial institution is responsible for paying that interest. In almost all cases, interest rates on customer deposits are lower than the interest rate on the bank’s loans.

Demand deposits have the lowest interest rate, but they can be withdrawn at any time. Notice deposits usually have a higher interest rate, but the customer must notify the bank at a predetermined period before withdrawing money. Term deposits pay the highest interest rate among all deposits, but the money is inaccessible to the customer for the predetermined amount of time.

When customer deposits aren't sufficient, banks turn to wholesale funding - borrowing from other financial institutions or issuing bonds. Wholesale funding includes interbank borrowing, repurchase agreements, and the issuance of debt instruments, like bonds. These sources of funds are usually more expensive than customer deposits, or they may not be an optimal source of funding due to regulatory restrictions. Wholesale funding costs also often move with prime rates, which makes this type of borrowing volatile and risky for the financial institution.

Comparing net interest income (NII) for different institutions may be misleading because NII depends heavily on the institution's size. Instead, analysts often use Net Interest Margin (NIM), which incorporates NII relative to interest-earning assets, making it a better ratio for comparing profitability across financial institutions.

NIM shows how efficiently a bank or a financial institution generates income from its income-producing assets. The higher the NIM, the more income they produce per unit of interest-generating assets. This metric allows banks of different sizes to be compared with each other. NIM can be a useful metric, but it has certain limitations that must be considered.

Even though NIM standardizes bank profitability into a simple metric, it still does not account for portfolio risks, financial institutions' size, or business models. For example, a bank with very risky assets may be able to generate a higher NIM, but the potential downside may lead to losses that may not be accounted for before they occur. Smaller and competitive financial institutions also tend to have higher NIM, as it is easier to fill a small portfolio with good deals than to look for the same quality of deals for a larger portfolio. Lastly, some financial institutions, like credit unions, may not seek to maximize their NIM and instead focus on the services they provide to their clients. A risk-adjusted NIM may be able to provide insights into net interest margins from different loan portfolios.

Other metrics can be used to compare different financial institutions' profitability, but they do not require NII in their calculations. These metrics include efficiency ratio, cost of funds, and return on assets (ROA).

Net interest income (NII) consists of interest income and interest expenses, both of which can affect net interest income trends. Depending on the composition of interest-bearing assets and liabilities, different events can affect net interest income.

One of the most significant drivers of net interest income is the interest rates on different financial products. Rising interest rates usually increase net interest income because loan products adjust their interest rates faster than deposit solutions. On the other hand, falling interest rates may compress net interest income. A prolonged flat interest rate environment can narrow the spread between loan yields and deposit costs, reducing net interest income.

The composition of interest-bearing assets and liabilities directly affects net interest income and its margin. Some products may generate more income than others, and some items may be more sensitive to interest rate changes. Depending on the portfolio of all products, the net interest income will be subject to a unique set of risks.

Higher-yield loans usually come with higher credit risk. Although riskier loans can boost net interest income, high default rates and write-offs can significantly reduce profitability over time. A sustainable growth in net interest income requires a balance between loan yields and risk management.

A competitive environment compresses net interest income because financial institutions have to offer better rates to depositors and borrowers to attract their funds. Competition in lending leads to lower interest rates for borrowers, while competition in deposits leads to higher interest rates for depositors. Given that most financial institutions operate by lending out depositors’ funds, when competition increases, the net interest income compresses due to both forces.

Capital and liquidity requirements, as well as leverage ratio requirements, may significantly affect how much income a financial institution can earn from customers’ deposits. Tightening regulatory requirements constrain net interest income growth. Broader economic conditions, such as GDP growth, inflation, and business cycles, may also impact deposit and loan growth via loan demand, deposit supply, and credit quality.