Meaning of Net Interest Income (NII)
Net Interest Income (NII) is the difference between the revenue generated from a bank's interest-bearing assets and expenses incurred while paying its interest-bearing liabilities. A bank's assets consist of personal and commercial loans, mortgages, and securities. A bank's liabilities consist of customer deposits.
Importance of NII
- It is a fiscal performance measure. When interest rates are growing in the economy, net interest margins become greater and vice versa.
- One can understand the quality of loan portfolio, the effect of interest rate changes on the bank’s profitability etc. with the help of NII.
- Investors who wish to invest in bank stocks can review the financials of the bank by analysing the NII.
- Non Performing Assets (NPAs) have a major impact on the NII of a bank and hence, this measure can be used to estimate the quality of assets of the bank too.
Calculating Interest Revenue, Interest Expenses, Net Interest Income and Net Interest Margin
Interest revenue is generated through interest payments that the bank receives on outstanding loans. It is calculated as,
Interest Revenue = Effective Interest Rate * Financial Asset (valued at its gross carrying amount)
Interest expense is the price that the lender charges the borrower in a financing transaction. More specifically, it is the interest that accumulates on outstanding liabilities. It is calculated as,
Interest Expense = Effective Interest Rate * Financial Liability
Net Interest Income is calculated as, Net Interest Income = Interest Received – Interest Paid
Net Interest Margin difference between the interest income and the amount paid to the lenders. Net Interest Margin = [Interest Revenue – Interest Expense] / Average Earning Assets
Factors Causing Variation in the NII
- Assets and liabilities that have variable rates are more vulnerable to changes in interest rates thereby, impacting causing greater changes in the NII.
- If the spread between rate-sensitive assets and liabilities increases then a rise in interest rate can make interest income rise more than interest expenses pushing the NII value upward. The converse holds true.
- Rise or fall in the NPAs of the bank affects the NII.
