Net Interest Income (NII)

Net interest income (NII) is the amount by which the interest a bank or other lender receives on its assets exceeds the interest it pays on its liabilities over a period. The assets are mainly loans, bonds and balances with other banks; the liabilities are mainly customer deposits, bonds issued and other borrowing. For most commercial and retail banks NII is the largest single source of revenue, ahead of fees, commissions and trading income, and it is the first line that analysts examine in a bank's results.

NII is an amount of money, not a ratio. Dividing it by average interest-earning assets gives the net interest margin, which allows comparison between banks of different sizes. NII appears at the top of a bank's income statement, before fee income, operating costs and loan impairment charges are taken into account.

The calculation is:

Interest income is what the bank earns on loans, securities and deposits placed with other institutions, and interest expense is what it pays on deposits, wholesale borrowing and debt securities. Both are measured on an accrual basis using the effective interest rate method, so that fees that are part of a loan's return are spread over its life.

Suppose a bank holds 800 million of loans earning 6 per cent and 200 million of bonds earning 3 per cent, funded by 700 million of deposits costing 2 per cent and 200 million of borrowing costing 4 per cent, with the rest funded by equity. Interest income is 48 million plus 6 million, or 54 million. Interest expense is 14 million plus 8 million, or 22 million. NII for the year is 32 million, which on 1,000 million of earning assets is a margin of 3.2 per cent.

Changes in NII from one period to the next can be separated into the effect of volume and the effect of rates. The main influences are:

• Balance sheet size and mix. More lending produces more interest, and a shift towards higher-yielding assets such as unsecured consumer credit raises income, though usually with higher credit losses.
• The level of interest rates. Banks hold some funding that pays little or no interest, including current accounts and equity. When market rates rise, the return on assets funded by these balances rises with no matching increase in cost.
• Deposit pricing. How quickly and how fully a bank passes rate changes to depositors, measured by its deposit beta, largely determines how much of a rate rise it keeps. Movement of customers from cheap accounts into term deposits has the same effect as a higher beta.
• The shape of the yield curve. Banks typically lend for longer periods than they borrow, so a steep yield curve supports income and a flat or inverted one compresses it.
• Competition and funding conditions. Pressure on loan pricing and the cost of wholesale funding both affect the spread.
• Credit quality. Loans on which borrowers have stopped paying cease to contribute interest in full.

Because assets and liabilities reprice at different times, a change in market rates alters NII. A bank whose assets reprice sooner than its liabilities is described as asset-sensitive and gains from rising rates; one in the opposite position is liability-sensitive. The mismatch is measured through the repricing gap and by simulating NII under different rate paths, usually over one to three years.

This earnings view is one of the two standard measures of interest rate risk in the banking book. The other is the change in the economic value of equity, which captures the effect on the present value of all future cash flows. The two can point in opposite directions: holding long-dated fixed-rate bonds stabilises NII in the short term but exposes the bank to large falls in value when rates rise, as several bank failures in the United States in 2023 demonstrated. Supervisors require banks to measure and limit both, and many banks publish the estimated effect on NII of a parallel shift in rates.

Responsibility lies with the treasury and with the asset and liability committee, as part of asset liability management. Banks commonly invest their non-interest-bearing balances and equity in a rolling portfolio of fixed-rate assets or receive-fixed swaps, often called a structural hedge, which smooths income across the rate cycle at the cost of delaying the benefit of rate rises. Internal funds transfer pricing charges lending units for funding and credits deposit-gathering units, so that the margin earned by each business can be measured and the interest rate position is concentrated in the treasury.

NII says nothing about credit losses, so a bank can raise it by lending to riskier borrowers and pay for it later through impairments. It is affected by accounting classification: income from trading assets and from some hedges may be reported elsewhere, which makes comparisons between banks imperfect. It is also not the measure used by Islamic banks, which do not charge interest and report income from financing and investment instead. Analysts therefore read NII together with margin, cost of risk and net income.