Question

Discuss three factors that affect net interest income.

Answer 1

The most common determinants of net interest income are inflation rate, credit risk and capital adequacy ratio. The level of importance for these factors varies between developed and developing countries. In developed countries, there is a positive relationship between operating expenses, credit risk, the inflation rate and the level of tax as factors determining greater net interest income. On the other hand, capital adequacy, interest rate risk, the size of banks and GDP growth rate are inversely related to net interest rate margins.

The factors which positively affect the net interest income in developing countries are capital adequacy ratio, the interaction between credit risk and interest rate risk, interest payments, opportunity cost of reserves, and the level of tax. Negative indicators are credit risk, interest rate volatility and the level of efficiency.

Capital adequacy is the measure of capital available in bank. Normally expressed as percentage of banks' risk weighted assets, it is used to stabilise the financial system and provide protection to depositors of banks. Therefore, the higher is the ratio, the higher interest income will be generated net of tax.