Introduction

In the world of banking and finance, two terms often come up in discussions about a bank’s profitability: Spread and Net Interest Income (NII). At a first glance, it might seem that a higher spread would always lead to a higher NII. However, the relationship between these two is more intricate than it appears. In certain scenarios, even if a bank’s spread is reduced, its NII might increase. Let’s delve deeper into these concepts and explore the circumstances under which this can happen.

Background: What are Spread and NII?

Before diving into the nuances, let’s define the two central terms:

1. Net Interest Income (NII): This is the difference between the interest income a bank earns from its lending activities and the interest it pays on deposits and other borrowings. Essentially, it’s a measure of the profitability of a bank’s core business activities.NII=Interest Income−Interest ExpenseNII=Interest Income−Interest Expense
2. Spread: Spread represents the difference between the average interest rate at which a bank lends money and the average interest rate it pays on deposits. A higher spread typically indicates higher profitability.Spread=Average Interest Rate on Loans−Average Interest Rate on DepositsSpread=Average Interest Rate on Loans−Average Interest Rate on Deposits

Hypothetical Scenario: Everest Bank

For this deep dive, let’s outline a detailed hypothetical scenario for Everest Bank:

Year 1:

• Everest Bank’s lending portfolio primarily comprises corporate loans at an average interest rate of 10%.
• The bank offers deposit accounts at an average rate of 3%.
• The total volume of loans for the year is NPR 100 billion.
• The bank’s deposits amount to NPR 150 billion.

Calculations for Year 1:

• Spread = 10% (lending rate) – 3% (deposit rate) = 7%
• Interest Income = 10% of NPR 100 billion = NPR 10 billion
• Interest Expense = 3% of NPR 150 billion = NPR 4.5 billion
• NII = NPR 10 billion – NPR 4.5 billion = NPR 5.5 billion

Year 2:

• To stimulate borrowing, the bank slightly drops its average lending rate to 9%.
• To attract more depositors, it also reduces the deposit rate to 2.5%.
• This strategy results in the loan volume increasing by 20% to NPR 120 billion.
• Deposits rise to NPR 180 billion.

Calculations for Year 2:

• Spread = 9% – 2.5% = 6.5%
• Interest Income = 9% of NPR 120 billion = NPR 10.8 billion
• Interest Expense = 2.5% of NPR 180 billion = NPR 4.5 billion
• NII = NPR 10.8 billion – NPR 4.5 billion = NPR 6.3 billion

From this detailed breakdown, we see that despite the reduction in spread from 7% to 6.5%, the NII increased from NPR 5.5 billion to NPR 6.3 billion due to increased lending volume and efficient rate adjustments.

Scenarios Where a Reduced Spread Might Lead to Increased NII

1. Higher Volume of Lending: Suppose a bank reduces its lending rates slightly, resulting in a decreased spread. But this reduction attracts a large number of borrowers, leading to a significant increase in the volume of loans disbursed. If the surge in interest income from these loans outweighs the reduced spread, the bank’s NII can rise. As observed with Everest Bank, the 20% increase in lending in Year 2 led to a higher NII despite a narrower spread.
2. Lower Cost of Funds: If a bank manages to attract deposits at a much lower interest rate, its interest expense (cost of funds) will decrease. Even if the lending rate is lowered proportionately, reducing the spread, the overall reduction in interest expense can lead to an increase in NII.
3. Shift in Asset Mix: A bank might shift its portfolio towards safer, less yielding assets, such as government securities, which might reduce its spread. However, if these assets are large in volume and have an almost negligible default rate, the bank can end up with increased NII.
4. Reduction in Non-performing Assets (NPAs): High NPAs mean a significant portion of a bank’s loans aren’t yielding any interest. If the bank manages to reduce its NPAs, more of its loans start yielding interest, potentially increasing the NII, even if the spread on newer loans is lower.Everest Bank had a high proportion of non-performing assets (NPAs) in Year 1 and managed to reduce them by Year 2, the effective interest income would rise, positively impacting NII.
5. Operational Efficiency: Enhanced operational efficiency can ensure that accrued interest is collected promptly and leakages are minimized. Improved collection mechanisms can increase the actual interest income, boosting NII even if the spread is lower.

Important Considerations

• A healthy spread is often seen as an indicator of a bank’s profitability. However, the scenarios above show that it’s not the only determinant of a bank’s financial health.
• Apart from NII, banks also have other revenue streams, such as fee-based services, penalties, and ancillary services. Therefore, while NII is crucial, it’s not the sole metric to gauge a bank’s overall profitability.

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Conclusion

The world of banking is intricate, and simple metrics seldom tell the whole story. While a good spread is desirable, the ultimate goal of a bank is to maximize its Net Interest Income, and there are multiple strategies to achieve that. By understanding the relationship between spread and NII, stakeholders can make more informed decisions about a bank’s operations and profitability.