What it means
A bank is a business that borrows money at one price and lends it at a higher one. It pays savers and wholesale lenders an interest rate, and it charges borrowers a higher rate on loans, mortgages and credit cards.
The net interest rate spread measures the gap between the two averages. The calculation uses weighted averages across the whole balance sheet.
The yield on interest-earning assets is total interest income divided by the average value of those assets, and the cost of funds is total interest expense divided by the average interest-bearing liabilities. Subtracting one from the other gives the spread, expressed in percentage points.
Spread is closely related to, but different from, net interest margin. Net interest margin divides net interest income by earning assets, and it therefore reflects the funds a bank has from its own equity and from non-interest-bearing accounts.
Spread looks only at rates, so it shows the pricing advantage and not the total effect of funding mix. Managers watch the spread because it responds to competition and to the interest rate cycle.
If a bank must raise deposit rates to hold customers but cannot lift loan rates by the same amount, its spread shrinks and profit falls. Banks manage this by repricing loans, shifting to cheaper funding and charging fees.
The nuance is that a wide spread is not always desirable. It can reflect lending to riskier borrowers at higher rates, where defaults will eat up the extra income.
Analysts therefore compare the spread with credit losses before deciding that a lender is truly more profitable. Outside banking, the same idea applies to any business that lends or finances customers.
A retailer offering store credit, an equipment leasing firm or a car dealer's finance arm all earn a rate from customers and pay a rate to their own funders. Tracking the spread helps these firms decide whether growth in lending is actually adding profit.
In practice
Real-world examples.
Example
A community bank lends at an average of 7% and pays depositors an average of 3%. Its spread is four percentage points. The chief executive tells the board that every extra $100,000,000 lent adds about $4,000,000 of annual net interest income.
Example
A car finance company borrows from wholesale markets at 4.5% and lends to buyers at 8.0%. The spread is 3.5 percentage points. When its funding cost rises to 5.5% with no change in loan pricing, the spread falls to 2.5 points and profit drops sharply.
Example
A credit union offers high savings rates to attract members, paying 4% on deposits while earning 5.5% on loans. Its spread of 1.5 points is thin. The board raises loan rates slightly and cuts the cost of its fixed-term deposits to restore the margin.
Formula
Calculation
Net interest rate spread = yield on interest-earning assets - cost of interest-bearing liabilities
A bank earns interest income of $62,000,000 on average earning assets of $1,000,000,000, a yield of 6.2%. It pays interest expense of $27,000,000 on average interest-bearing liabilities of $1,000,000,000, a cost of 2.7%. Net interest rate spread = 6.2% - 2.7% = 3.5 percentage points. Net interest income is 62,000,000 - 27,000,000 = $35,000,000.Case study
Seen in the real world.
Lantern Savings is a fictional lender that competed hard for deposits by paying savers 4.2% while its loans earned an average of 6.0%. In this illustrative story, the spread was 1.8 percentage points, and after covering staff and premises the bank barely broke even. The chief financial officer reported the figure each month.
To improve it, Lantern changed its deposit pricing so loyal customers received rates close to the average while only new money received the headline offer. It also began pricing small business loans using risk bands. Within a year the spread rose to 2.6 points, adding about $8,000,000 a year in net interest income on its $1,000,000,000 balance sheet. The board now sets a minimum spread target and reviews it whenever market rates move.
Watch out
Common mistakes.
- Mixing up spread and margin. Spread compares two rates, while margin divides net interest income by earning assets.
- Using ending balances instead of averages. Average balances give a fairer measure because the size of the balance sheet changes during the year.
- Assuming a bigger spread is always better. Higher rates often come with higher credit risk and more loan losses.
Questions
People also ask.
Why do banks care about spread?
Because net interest income is their main source of profit, and the spread drives it.
What causes the spread to shrink?
Competition for deposits, falling loan rates, a flat yield curve and customers moving into more expensive savings products can all squeeze it.
Does it apply outside banks?
Yes, any lender such as a finance company, building society or credit union can measure its spread.
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