What is net interest margin (NIM)?

What is NIM?

The net interest margin, or NIM, is one of the most common profitability metrics for banks and similar financial institutions. 

Put simply, it measures how much the interest that a bank receives on its loans exceeds the interest it pays to its depositors. The bank pockets this margin, using it to cover its expenses and – hopefully – churn out a profit.

But, to fully understand NIM, you first need to understand the bank's role in the broader economy.

Just what is a bank, anyway?

Despite what financiers might have you believe, a bank's central business model is pretty straightforward. It is simply to connect people who have too much money with those who need more.

Banks (and other financial institutions) entice people to deposit their excess cash with them by offering to pay them interest. The bank then takes these deposits to make loans to individuals, companies, and other entities that need them. This activity helps run the whole economy, and banks expect to make a profit in exchange.

They do this by charging more interest on the loans issued than what they pay out on the deposits they take in. 

Of course, banks now earn revenue from providing all sorts of other financial products and services. But the simple practice of taking in deposits and providing loans is still central to a bank's operations.

Banks that perform these operations more profitably than other banks have a clear competitive advantage. This is why NIM is an important metric to consider if you're thinking of investing in bank shares.

Why is NIM a percentage?

NIM is presented as a percentage of a bank's average interest-earning assets (or AIEA). AIEA mainly comprises the loans a bank has issued to its customers, but it can also include other assets on a bank's balance sheet, like its cash and investments.

This means NIM captures how efficiently (and productively) a bank uses its assets to generate income. Analysts and investors can also use it to compare the relative profitability of any bank, regardless of size.

For example, a small bank may generate little income in dollar terms compared to a larger rival. However, if it makes its income off a relatively lower asset base, it will likely have a higher NIM. This could mean that, despite its smaller size, it may be the more profitable of the two and could make a better investment.

However, be wary. One way a bank can increase its NIM is by selling riskier loans. This might make it seem more profitable, but the bank may struggle to maintain its margin if a recession hits and more borrowers default on their loans.

How do you calculate NIM?

Banks will usually provide their net interest margins in their financial reports, but it is also pretty simple to calculate yourself using the formula below:

Net interest margin = (Net interest income x annualisation factor)/(Average interest-earning assets)

Each of the inputs is readily available in a bank's financial statements. Let's review each one in turn.

Net interest income

This is how much more a bank earns on its loans than it pays on its deposits. Or, put another way, it is a bank's interest income less its interest expenses. Net interest income (or NII) can be found in a bank's income statement.

Annualisation factor

It's important to highlight that a bank's net interest margin is always presented on an annualised basis. If you are trying to calculate a bank's NIM for any period shorter than a full year, you must first annualise the bank's NII.

Luckily, calculating the annualisation factor is easy. You simply divide the number of days in the year by the number of days in the reporting period.

For example, the Commonwealth Bank of Australia (ASX: CBA) reports its half-yearly results every 30 June and 31 December. If you want to calculate CBA's first-half annualisation factor (and it isn't a leap year), you divide 365 by 181 (181 being the number of days between 1 January and 30 June). CBA's second-half annualisation factor would be 365 divided by 184.

Average interest-earning assets

As we touched on earlier, we can calculate a bank's profitability by dividing the net interest income it has received by the amount of interest-earning assets on its balance sheet. A higher percentage implies that the bank is getting a better return on its assets.

A bank's interest-earning assets are mainly its loans and mortgages, but it also includes other assets (like deposits held with other institutions) or just about anything the bank earns interest on. This is averaged over the period being analysed.

What is the average NIM for Australian banks?

Based on their most recent results, the average NIM across the big four Australian banks is about 1.86%.

Considering it has the biggest market share, CBA leads the pack in terms of NIM. In its first-half FY23 results (for the six months ending 31 December 2022), CBA reported a NIM of 2.1%.

Westpac Banking Corp (ASX: WBC) is the next best. It reported a NIM of 1.87% for full-year FY22 (the 12 months ending 30 September 2022).

In its first-quarter FY23 trading update (for the three months ending 31 December 2022), National Australia Bank Ltd (ASX: NAB) reported a NIM of 1.79%.

And rounding out the four is ANZ Group Holdings Ltd (ASX: ANZ), which reported a NIM of 1.68% for the six months ending 30 September 2022. 

What factors impact NIM?

The cash rate: Interest rate change is the main driver for margins, but not in the way you might think. Higher interest rates do tend to increase bank margins. But it's not simply that higher rates allow banks to charge more on their loans because if they also have to pay more on their deposits, their overall NIM remains unchanged.

Bank margins expand when rates rise because banks pass on more of the rate increases on their lending products than on their deposits. This allows them to increase further the difference between their interest income and their interest expenses. Thus, higher margins.

Funding costs: If banks are short on deposits, they can tap wholesale credit markets for the extra capital to finance new lending. When financial markets are more volatile, wholesale credit spreads widen. This means wholesale funding becomes more expensive for banks to account for the additional risk in the economy. These higher funding costs can also eat into banks' margins.

Risk: As we've already touched on, banks can increase their margins by taking on higher-risk clients. Banks have more pricing power in these relationships because the client has fewer competing offers from other institutions.

However, a bank with a higher-risk portfolio may see many clients default if and when a recession hits. It will also likely be burdened with high provisions charges and more onerous capital requirements, which can slow its business.

What's the difference between NIM and the spread?

Net interest margin and net interest spread are similar in concept, but the margin expresses the return as a percentage of interest-earning assets, while the spread does not. This means the spread does not take into account the impact of the mix of lending and deposit volumes.

For example, a bank may (on average) charge 5% on its loans and pay out 2% on its deposits. Its net interest spread would be the difference: 3%. However, if the bank had $500 in loans and $250 in deposits, its NIM would be:

4% =  ((500 × 5%) – ($250 × 2%))/$500

The NIM is higher than the spread because it captures that the bank is leveraged, as it has twice as many loans as deposits.

Why is NIM important to investors?

NIM is one of the most important profitability metrics for a bank. It shows how efficiently and profitably a bank uses its assets to generate income. Given this is a bank's core function, it is a crucial indicator of its overall health.

However, analysts should not use NIM in isolation. A bank can increase its NIM by taking on excessive risk. Therefore, you should combine NIM with other types of analysis before choosing which bank to invest in.