Interest Income, Earning Asset Yields and Earning Assets
The interest rates charged by banks typically incorporate a spread over a reference or benchmark rate and reflect their optimization of yields for risk, interest rates, maturities and asset/funding mix, among other factors. Interest income is typically modeled by multiplying the interest yield times an underlying earning asset (daily averages are commonly used). Loans and loan growth are key factors tracked by analysts and are both highly influenced by the macro-economic environment.
Interest Expense, Cost of Funds and Interest Bearing Liabilities
The interest rates paid by banks reflect the mix of funding (demand deposits vs. borrowed funds) and the cost of those funds. Interest expenses are typically modeled by multiplying the cost of funds times an underlying interest-bearing liability (daily averages are commonly used).
Net interest income is the difference between interest income and interest expense. To evaluate and compare the spread business’s strength, analysts will often look at a bank’s net interest margin (NIM), which measures the net profitability of a bank’s investment in earning assets. NIMs are defined as a yield and calculated by dividing net interest income by average earning assets. Differentials in this value between banks can reveal differences in their business focus – retail vs. commercial – and the riskiness of their investment portfolio (e.g., credit cards vs. home mortgages). The ratio of loans-to-deposits will influence the overall margin, while also revealing a bank’s asset/liability mix, along with its source of funding (cheap demand deposits vs. expensive liabilities).
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