What are the components of net interest income? What must a bank consider in managing each...

What are the components of net interest income? What must a bank consider in managing each part?

Expert Solution

Net Interest Income:

Banks carry interest bearing loan portfolio on asset side such as personal loan, auto loan, mortgage, commercial loan etc. Similarly, banks service interest on their liabilities such as customers deposit. Net interest Income (NII) is difference between interest earned on asset and interest paid on liabilities.
For example, if a bank has loan portfolio of $ 100 million and earns interest rate of 6%. Bank has customer deposit of $ 120 million with interest rate of 4%. Then NII would be ($ 100 * 6%) – ($ 120 *4%) = $ 1.2 millions.

Managing NII:

NII is exposed to interest rate risk and loan portfolio quality.
With change in interest rate by Federal bank, interest applicable on loan portfolio changes as well interest expense on customer’s deposit changes. Banks use to have proportion of fixed interest rate loan and variable interest rate loan, such as to maintain NII. At the same time, loan portfolio composition is spread across various types such as personal loan , mortgage to maintain volatility in NII.
Loan portfolio quality is also an important factor of NII. As default on portfolio increase then , NII can not be realised and portfolio turns into non-performing assets.

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