This is one of many in a series of articles where I reveal the nuts and bolts of investing in unique industries like banks, etc.
Net interest margin = net interest margin (NIM) = net interest income / average interest-earning assets
For a bank without significant capital markets and/or proprietary trading activities, NIM is the key to profitability for the bank.
The key drivers of a bank's net interest margin are:
Mix of interest-earning assets
- Banks with a larger proportion of high yield interest-earning assets, will have a higher net interest margin. Consumer banking is generally more profitable than corporate banking, e.g. credit cards versus corporate loans.
Sources of funds
- Retail deposits entail lower funding costs compared with wholesale deposits, but banks will chalk up higher operating costs though maintaining the distribution network of physical branches, ATMs and bank staff.
- Aggressive price wars for credit cards and mortgage loans waged against competitors will hurt net interest margins. Also, funding costs increase if banks dangle higher interest rates to attract more deposits.
Quality of Loan Portfolio
- Provisions have to be made for non-performing assets.
Investors should understand the drivers for net interest margins and select bank stocks with a history of stable consistent NIMs through different economic cycles.