HOW BANKING WORKS · INTEREST AND PRICING 26
A bank earns a spread across a balance sheet, not one loan and one deposit
The simplest picture of banking profit says: borrow cheaply, lend at a higher rate, keep the difference. That intuition is useful, but incomplete.
A real bank has many assets earning different yields and many liabilities costing different amounts. Some deposits pay little interest but provide valuable transaction relationships. Some wholesale funding is expensive. Some assets are liquid but low-yielding. Some loans are high-yielding because their expected credit losses are also high.
The bank’s interest margin therefore emerges from the entire balance sheet.
This article continues Batch 07 under How Banking Works.
Start with net interest income
At a high level, net interest income is interest earned on interest-bearing assets minus interest paid on interest-bearing liabilities and funding.
interest income − interest expense = net interest income.
Loans, securities and balances with other institutions can generate interest income. Deposits, wholesale borrowings and issued debt can create interest expense. The exact accounting presentation varies by bank and jurisdiction, but the economic idea is stable.
Net interest margin adds scale to the picture
Net interest margin, often abbreviated NIM, relates net interest income to the bank’s earning assets, usually on an average basis.
net interest margin ≈ net interest income ÷ average interest-earning assets.
The precise reporting definition can vary. The important point is that margin measures how efficiently the bank’s interest-bearing balance sheet converts asset yields and funding costs into net interest income.
A miniature balance sheet
| Item | Balance | Rate | Annual interest effect |
|---|---|---|---|
| Loans | S$80m | 5% | +S$4.0m |
| Securities and liquid assets | S$20m | 3% | +S$0.6m |
| Customer deposits | S$70m | 1.5% | −S$1.05m |
| Wholesale funding | S$20m | 3.5% | −S$0.70m |
Ignoring other items, annual interest income is S$4.6 million and interest expense is S$1.75 million, leaving S$2.85 million of net interest income.
That amount is not profit. The bank still has operating costs, expected credit losses, taxes, technology, fraud losses, capital costs and many other expenses.
Asset yield is a portfolio average
A bank’s loans do not all earn the same rate. Mortgages, credit cards, corporate loans, trade finance, interbank assets and securities each carry different yields, maturities and risks.
The average asset yield changes when the composition of the book changes. If the bank grows low-yielding mortgages faster than higher-yielding unsecured loans, total interest income can rise while average yield falls.
Mix matters as much as headline rates.
Funding cost is also a portfolio average
Customer deposits can include current accounts, savings accounts and term deposits. The bank may also use interbank borrowing, secured funding, bonds or other liabilities.
Each source has a different cost and behavioural profile. Transaction deposits can be relatively low-cost but operationally demanding. Term deposits may be more expensive but provide clearer contractual maturity. Wholesale funding can move quickly with market conditions.
The bank therefore manages not one funding rate but a funding stack.
Why deposit rates often move differently from market rates
Depositors do not all respond instantly to market rates. Some keep money in transaction accounts because payment convenience, salary crediting, direct debits and relationship benefits matter. Others move aggressively toward higher-yielding alternatives.
The degree to which deposit rates respond to market rates is sometimes described through a deposit beta. A low beta means the bank passes through only part of the market-rate movement to depositors; a higher beta means deposit pricing moves more strongly.
Competition can change that behaviour rapidly.
Why rising rates can initially help a bank
If many loans and securities reprice upward faster than deposits, interest income can rise before funding costs catch up. Net interest margin may expand.
This is why some banks benefit from the early phase of a rising-rate cycle.
But the effect is not permanent. Depositors can demand higher rates, move funds, or switch into term products. Borrowers can refinance less. Credit losses can rise as debt service becomes harder. The same rate cycle can help margin first and hurt it later.
Why falling rates can compress margin
If floating-rate loans reprice downward quickly while deposit rates are already near a practical or contractual floor, asset yields can fall faster than funding costs.
That compresses margin even though borrowers may be experiencing lower interest expense.
Low-rate environments can therefore create a different profitability challenge from high-rate environments.
Fixed-rate assets slow the adjustment
A bank holding long-term fixed-rate assets does not immediately earn more when market rates rise. Meanwhile short-term deposits and wholesale funding can reprice upward quickly.
This timing mismatch is repricing risk. The bank’s historical asset book can constrain current profitability even when new loans are being written at attractive rates.
That is why average portfolio yield can lag the rate offered on new lending.
New production and back book are different
“New production” refers to loans or deposits currently being originated or repriced. The “back book” contains older contracts still running under previous terms.
A bank may advertise mortgages at 5 per cent today while much of its existing mortgage portfolio still earns 3 per cent. Likewise, new term deposits can cost 4 per cent while older deposits remain cheaper until maturity.
The balance sheet changes gradually because contracts expire on different clocks.
Credit risk sits behind the yield
A high loan rate can look attractive until defaults are recognised. A bank earning 12 per cent on risky unsecured loans may produce less economic value than one earning 5 per cent on safer assets if expected losses are dramatically higher.
Interest margin is therefore only one layer of profitability.
high asset yield − high funding cost − high expected loss can still produce weak economics.
The bank must examine risk-adjusted return rather than celebrating yield in isolation.
Liquidity has a cost even when it looks idle
Banks hold cash, central-bank balances and high-quality liquid assets partly so they can survive payment outflows and stress. These assets can yield less than loans.
That apparent yield sacrifice buys resilience. A bank that maximises margin by holding almost no liquidity can become dangerously fragile.
Good margin management therefore respects liquidity constraints rather than optimising interest income alone.
Capital has an economic cost too
Shareholders provide loss-absorbing capital and expect a return. Riskier assets can require more capital or consume more of the bank’s internal risk capacity.
A loan with an attractive interest spread can therefore be unattractive after the cost of capital is considered.
This is another reason the bank cannot price loans simply by adding a fixed mark-up over deposit rates.
Internal transfer pricing separates customer pricing from balance-sheet economics
Large banks often use internal funds-transfer-pricing systems. A lending business is charged an internal funding price for using balance-sheet resources, while a deposit business can receive internal credit for providing valuable funding.
This prevents a loan officer from appearing highly profitable merely because the bank happens to have cheap deposits elsewhere. It also gives deposit businesses credit for funding value even if the customer account itself earns little fee income.
The exact internal method varies, but the principle is important: customer businesses and treasury share the same balance sheet.
Hedging can stabilise margin at a cost
Interest-rate swaps and other hedges can reduce sensitivity to rate movements. The bank can convert part of a fixed-rate exposure into floating or vice versa.
Hedges have market value, collateral requirements, counterparty exposure and basis risk. Stabilising one part of the margin therefore introduces other costs and controls.
Non-interest income matters because margin is not the whole bank
Banks can earn fees from cards, payments, custody, advisory, trade finance, foreign exchange and other services. A bank with lower net interest margin can still be highly profitable if it has strong non-interest income and disciplined costs.
Conversely, a bank with excellent margin can still perform poorly if credit losses or operating costs are high.
Margin is a diagnostic, not a verdict
| Margin movement | Possible explanation |
|---|---|
| Margin rises | Asset yields repriced faster than funding costs, mix shifted toward higher-yielding assets, deposits remained cheap |
| Margin falls | Funding costs rose faster, asset yields reset lower, competition intensified, liquid-asset share increased |
| Margin stable | Large offsetting changes may still be occurring underneath |
The analyst therefore asks why the margin moved and whether the source is sustainable.
A bank can expand margin by taking more risk
Moving from prime mortgages into high-rate unsecured lending can raise asset yield. Funding more aggressively with short-term wholesale money can appear cheaper in benign markets. Reducing liquidity can lift average asset yield.
Each action can make reported margin look better before the risk arrives.
That is why strong banking asks whether higher margin reflects better franchise economics or merely more hidden risk.
Four misconceptions to remove
| Misconception | Better model |
|---|---|
| “Bank margin is loan rate minus deposit rate.” | It reflects weighted asset yields and many funding sources across the whole balance sheet. |
| “Higher margin always means a healthier bank.” | Margin can rise because the bank took more credit, liquidity or duration risk. |
| “Rising rates always help banks.” | The result depends on how quickly assets and liabilities reprice and how customers behave. |
| “Interest margin is bank profit.” | Operating costs, credit losses, capital, taxes and non-interest items still matter. |
A mastery test
- What is the difference between net interest income and net interest margin?
- Why can average asset yield lag current loan pricing?
- How can deposit behaviour affect margin?
- Why can a higher asset yield still produce worse economics?
- What problem does internal funds transfer pricing try to solve?
If those answers connect, bank interest margin stops looking like a simple markup. It becomes the changing price relationship between two sides of a living balance sheet.