All Eyes on the Margin

By Chris Bledsoe

In my discussions and meetings with bank directors, I’ve found that many don’t really understand what the net interest margin is, how it is calculated and exactly what it means to the bank. Why is it so important? Because the net interest margin is the single, greatest source behind 90 percent of a community bank’s earnings stream. And with today’s volatile rate environment, there’s never been a more important time to stay on top of and track the trend and drivers of the of the bank’s net interest margin in order to help guide your institution. Let’s take a closer look.

Defining Net Interest Margin
The net interest margin is defined as net interest income (annualized) divided by a bank’s average earning assets. Note that tax free income is tax effected in this calculation so it gives a true picture of the impact this source of revenue can have; the number of days in a month also has a bearing on the margin’s calculation. 

The reason why net interest margin drives 90 percent of a community bank’s bottom line is that typically a community bank’s other non-interest sources of revenue only represent 10 percent of its total revenue; in contrast to larger banks where non-interest sources of revenue are often much higher. This is why it is so critical for community bank directors to understand net interest margin, what affects it and the trend. 

A trend graph of net interest margin and cost of funds is simple to create, yet provides directors with powerful insight.

Understanding the Drivers
Every director should be familiar with the primary drivers of the net interest margin:

FOMC Meeting Schedule – the banking industry is one of the few industries where an outside force can change a key driver of an organization’s bottom line—in a bank’s case, the prime rate. Take advantage of it. Every director should know the Federal Open Market Committee (FOMC) calendar and the likely outcome of each meeting based on the Federal Funds Futures Market.

Earning asset yield – primarily comprised of loans and investment securities, both of which are directly affected by changes in interest rates. It is important for senior management to clearly understand loan production and what is helping and hurting the bank in this key area. 

Cost of funds – on the liability side, the margin is impacted by the cost of deposits and wholesale funding sources, as well as the deposit mix.

By knowing and understanding these drivers, you will be in a position to ask senior management more informed questions about what’s affecting the bank’s net interest margin and why.

Tracking the Trend
High performing bank directors pay close attention to the trend of both the bank’s net interest margin and its cost of funds. You must know what the margin is, and the value of one basis point at all times, but even more importantly, how these trends have been tracking over time. Too often I see banks calculate the margin, but then stop short without looking at the trend that has developed in the past six to twelve months. As a result, they are missing an opportunity to view a leading indicator of the institution’s performance.

It is said that a picture is worth a thousand words; a visual presentation of these trends in a simple graphic quickly tells you a lot about the future profitability of the bank (see example). Know whether net interest margin and cost of funds are trending up or down. If trailing down or trending up, ask why.

The reality is that trends will continue until something is done to change them. While there isn’t a whole lot that bankers and directors can do about outside forces such as this year’s FED rate cuts, it’s about knowing what’s coming and doing everything you can collectively do to minimize the impact on the bank’s performance.

The Greatest Source Behind the Bank’s Earnings Stream 
You now know how and why the net interest margin is the single greatest source behind a community bank’s earnings stream. Armed with this knowledge, you can focus your analysis and ask targeted questions that will get to bottom of why the bank is performing as it is and help guide the institution in both unstable and thriving markets.

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