What it means
A bank's main business is to take in money and lend it out at a higher rate. The assets that do this lending, loans and investment securities, are the engine of its income.
Branches, computers and idle cash are necessary but do not earn interest, so they are left out of the group. Comparing income with yield-earning assets shows how profitable the engine is.
The yield on earning assets is interest income divided by the average earning assets, and net interest margin is the same idea after subtracting the interest paid to depositors and lenders. A margin of a few percentage points is typical, though it differs by country and business model.
A bank wants as much of its balance sheet as possible working. Too much idle cash lowers the yield, but too little cash risks running short of liquidity when customers withdraw funds.
Management balances those pressures every day. The measure also matters outside banking.
Finance companies, leasing firms and insurers hold large portfolios of investments, and non-financial companies with big cash piles can apply the same thinking. Investors can ask what proportion of a company's assets is generating a return.
Analysts watch the quality as well as the quantity of these assets. A high yield may reflect risky lending, and bad loans that stop earning interest, known as non-performing loans, effectively drop out of the group.
A good analysis looks at both the yield and the level of credit losses. Funding comes into the picture too, because the earning assets are paid for by deposits and borrowings.
A bank that funds loans with cheap customer deposits keeps more of the yield than one that relies on expensive wholesale borrowing. For this reason analysts often view earning assets and interest-bearing liabilities side by side.
In practice
Real-world examples.
Example
A bank analyst compares two lenders and finds one has a net interest margin of 3.8% while the other earns 2.9%. She digs into the balance sheets and learns that the second bank holds a large amount of low-yielding cash and government securities. Management of that bank decides to put more funds into loans.
Example
A leasing company reports that 92% of its total assets are earning assets, with the rest being offices and equipment. The chief financial officer uses the figure to track efficiency. He sets a target of 94% for next year and asks each business unit to report its own ratio monthly. Units that fall short must explain which assets are idle and how they plan to put them to work.
Example
A corporate treasurer notices that a large share of the group's assets is held in non-interest-bearing accounts. She moves the surplus into short-term deposits that earn interest. The change adds $150,000 a year to group income.
Formula
Calculation
Yield on earning assets = interest income / average yield-earning assets
Net interest margin = (interest income - interest expense) / average yield-earning assets
Suppose a bank has average yield-earning assets of $800,000,000, interest income of $44,000,000 and interest expense of $16,000,000. Yield on earning assets = 44,000,000 / 800,000,000 = 5.5%. Net interest income = 44,000,000 - 16,000,000 = $28,000,000. Net interest margin = 28,000,000 / 800,000,000 = 3.5%.Case study
Seen in the real world.
Riverbend Bank is an illustrative, fictional community lender with $1,000,000,000 of total assets. A review by the new chief financial officer showed that only $800,000,000 of the assets were earning interest, because the rest was held in cash, premises and other non-earning items.
She found that $60,000,000 of cash was well above what the bank needed for daily liquidity. By investing $40,000,000 of it in short-term government securities yielding 4%, the bank could earn about 40,000,000 x 0.04 = $1,600,000 a year.
The treasury committee kept a liquidity buffer and invested the rest. The illustrative lesson is that a balance sheet works hardest when most of it is earning, but a bank must always keep enough cash for safety.
Watch out
Common mistakes.
- Counting all assets as earning assets, when cash, premises and equipment do not generate interest.
- Chasing a high yield without checking the credit quality of the loans that produce it.
- Using the year-end balance instead of the average balance, which can distort the ratio if the balance sheet grew or shrank during the year.
Questions
People also ask.
What are yield-earning assets?
They are assets that produce interest or similar income, such as loans and investment securities.
How are they used in analysis?
Analysts divide interest income by average earning assets to measure yield, and net interest income by the same figure to find net interest margin.
Why do banks not invest all assets in earning ones?
They need cash and liquid assets to meet withdrawals and regulatory requirements, so some of the balance sheet must stay idle.
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