Net Interest Margin

Net Interest Margin (NIM) is a key profitability metric for financial institutions that measures the difference between the interest income generated from lending activities and the interest paid out to depositors, relative to the bank's interest-earning assets.

Interest income refers to interest earnings from the loan portfolio and other interest-bearing assets. The loan portfolio includes mortgages, business loans, personal loans, credit cards, and other loan instruments.

Other interest-bearing assets include: Securities, Cash and Balances with Central Banks, Interbank Lending, Lease Financing, and Trade Financing.

Interest is also earned in market activities including: Reverse repurchase agreements, Interest rate swaps (net interest received), Trading assets, and Margin loans to brokerage clients.

These include all liabilities that require interest to be paid. These may include:

• customer deposits (e.g., savings accounts, GICs);
• borrowed funds (e.g., interbank borrowing, repurchase agreements);
• other interest-bearing liabilities (e.g., bonds issued by the bank, advances from the central bank, interest rate swaps).

This metric refers to the value of all assets that pay interest, averaged over a period of time. Canadian banks' quarterly reports provide the average interest-earning assets for the applicable quarter.

Types of Interest-Earning Assets

There is a significant connection between NIM and loan portfolio risk. Generally, higher NIMs often correlate with riskier loan portfolios due to several key relationships:

• Risk-Return Tradeoff
• More competitors (traditional banks, fintechs, credit unions) can lead to:
• Lower lending rates as institutions compete for quality borrowers
• Higher deposit rates to attract and retain funding
• Overall NIM compression

Yield Curve Shape

• Steep yield curve (long-term rates much higher than short-term): Favors higher NIMs as banks borrow short and lend long.
• Flat or inverted yield curve: Compresses NIMs by reducing the spread between funding costs and lending rates.

Regulatory Environment

• Capital requirements affect lending capacity and pricing
• Liquidity rules influence funding strategies and costs
• Consumer protection rules can impact fee income and lending practices

How Different business models lead to varying NIMs

Different business models lead to varying NIMs because of their distinct lending, funding, and operations approaches. Here's how it breaks down across various types of financial institutions:

Traditional Banks

• Typically have moderate NIMs (2-4%)
• Benefit from stable, low-cost deposit base
• Higher operating costs from branch networks
• Diversified lending across consumer, commercial, and mortgage loans
• Capital Requirements
• Riskier loan portfolios require banks to hold more capital
• This affects the bank's cost structure and required return
• May influence pricing decisions and, ultimately, NIM

This relationship means that while a higher NIM might indicate better profitability, it could also signal higher risk exposure in the loan portfolio. Metrics such as provision for credit losses (PCL), allowance for credit losses (ACL), and net write-offs allow investors to assess the risk associated with the NIM. Regulators and investors often examine both metrics together for a more complete risk assessment. Note that the banking leverage ratio itself is not a very good indicator of the risk taken on by a bank.

NIM varies significantly based on market and economic conditions due to several key factors:

• When interest rates rise:NIM increases initially as banks can reprice loans faster than deposits, but it normalizes eventually as the competition for deposits reduces the gap between loan and deposit interest rates.
• When interest rates fall: Depending on the reason for the interest rate change, some banks may hold their interest rates steady if they believe it’s a short-term fluctuation. Depending on the bank policies, the interest rates on deposits may come down faster than on loans, which may also create a short-term increase in NIM.
• During prolonged low-rate periods: NIMs tend to compress because there's a practical floor on deposit rates (can't go below zero), loan yields fall with market rates, and competition for quality loans intensifies.

• During Expansion: Higher loan demand leads to a larger interest rate spread, which leads to higher NIMs. The effect of expansion on the NIM depends on the competition for deposits.
• During Recession: Credit quality deteriorates and loan demand weakens, pressuring NIMs to decrease. Banks may also face higher allowance for credit losses (ACL) andprovisions for credit losses (PCL).
• Post-recession: Central banks often keep rates low to stimulate growth, which can compress NIMs while experiencing an increase in earning assets.

More competitors (traditional banks, fintechs, credit unions) can lead to:

• Lower lending rates as institutions compete for quality borrowers
• Higher deposit rates to attract and retain funding
• Overall NIM compression

• Normal Yield Curve: Favors higher NIMs as banks borrow short and lend long.
• Flat Yield Curve: Reduces NIM due to a lower spread between the borrowing and lending rates.
• Inverted Yield Curve: This curve compresses NIMs initially due to the mismatch between funding costs and lending rates, but stabilizes in a prolonged inverted yield curve period. Banks may use other instruments to stabilize income in this environment. This may include a shift to fee-based income, frequent loan repricing, and a focus on shorter-term lending.

A tight regulatory environment rarely increases Net Interest Margin, but it may help stabilize it and avoid unnecessary risk-taking by financial institutions, which may have a large impact on financial markets and the economy. The following policies are often implemented by the regulators that directly affect the NIM:

• Capital requirements affect lending capacity and pricing
• Liquidity rules influence funding strategies and costs
• Consumer protection rules can impact fee income and lending practices

Different business models lead to varying NIMs because of their distinct lending, funding, and operations approaches. Here's how it breaks down across various types of financial institutions:

*Credit unions do not have large trading books, which typically lowers banks NIM. Further their regulation is lighter, so they have a larger portion of their loan portfolio in higher margin consumer loans and less in lower margin mortgages relative to large banks.

The key factors driving these differences are:

• Cost of funding (deposit vs. wholesale funding mix)
• Operating cost structure
• Target customer segments
• Product mix and specialization
• Regulatory requirements
• Competition in their market segment