Interest Income

Interest IncomePrinciples and practices of banking Management

Banks (Definition)As per Section 5(c) of the Banking Regulation Act, 1949 a "Banking Company" means any company which transacts the business of banking in IndiaAs per Section 5(b) of the Banking Regulation Act, 1949 , "banking" means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise.A commercial bank may be defined as, A financial institution that provides services, such as accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment products like savings accounts and certificates of deposit. The traditional commercial bank is a brick and mortar institution with tellers, safe deposit boxes, vaults and ATMs. However, some commercial banks do not have any physical branches and require consumers to complete all transactions by phone or Internet. In exchange, they generally pay higher interest rates on investments and deposits, and charge lower fees.

Income of BanksConcept (Non-Interest Income)Bank and creditor income derived primarily from fees. Examples of non-interest income include deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly account service charges, inactivity fees, check and deposit slip fees, etc. Institutions charge fees that provide non-interest income as a way of generating revenue and ensuring liquidity in the event of increased default rates.

Concept (Net Interest Income)Net Interest Income may be defined as The difference between the revenue that is generated from a bank's assets and the expenses associated with paying out its liabilities.A typical bank's assets consist of all forms of personal and commercial loans, mortgages and securities. The liabilities are, of course, the customer deposits. The excess revenue that is generated from the spread between interest paid out on deposits and interest earned on assets is the net interest income.Concept (Net Interest rate spread)The difference between the average yield a financial institution receives from loans and other interest-accruing activities and the average rate it pays on deposits and borrowings. The net interest rate spread is a key determinant of a financial institution's profitability (or lack thereof).

Interest and Non-Interest Income (1997-2003)An analysis of the interest and non-interest income of scheduled commercial Banks indicates that since 1997 interest income has fallen from 87% to 81%.On the other hand, non-interest income increased from 12% to approximately 18%.The components of interest income of scheduled commercial banks show that interest on advances and discounts has fallen whereas interest on investments has increased.Major part of these investments was in government securities. This shows that banks are interested in deploying their funds in safe government securities rather than giving loans.

This tendency of banks was evident despite the stipulated statutory liquidity ratio having been reduced.The decline in interest income and the consequent increase in non-interest income may be attributed to liberalization.Also, the heavy investment made by Banks indicate that their earning from advances is less than their earnings from investment.

Bank Behaviour and Financial CrisisBig banks with high deposit concentration could operate with high margin. Banks with higher NPAs have to tolerate lower margins. Margins were dampened by provisions. Therefore, banks with higher NPAs would need to increase provisions, which, in turn, lower their margins. Several studies, both in the Indian context and internationally as well, arrived at similar conclusion.Study on effect of sector-wise NPAs on to banks margin revealed that banks margin came under pressure due to high accumulation of NPAs with foreign banks. Interestingly, during 2001-2005, average NPA of foreign banks was around 18 per cent, whereas all other bank groups registered less than 10 per cent during the same period. In the remaining period also, foreign banks registered higher NPAs as compared to other banks.

Well capitalized banks exhibited higher margins. In particular, the higher the banks capital position over and above the stipulated regulatory levels, higher was its flexibility in extending loans, which translated into higher margins. This has been documented in empirical studiesInefficient banks in terms of cost efficiency have lower margins, as expected.At the industry level, higher levels of deposit concentration and higher foreign bank share steered to improve banks margin. Deposit concentration acts as a measure of market power in the loan market. Therefore, higher market power provided impetus to banks to increase margins. Bank Ownership and Net Interest Margin during financial crisisResults showed that PSBs margin declined substantially in comparison with other bank groups. Hence, it is apparent that the PSBs are more affected by the crisis as compared to othersThis indicated that, as compared to old private banks, NIM of PSBs is 0.6 percentage points lower, on an average, in 2008 and also in 2009, as well. On the contrary, NPBs improved their margins in 2009. What this suggests is that the business philosophy and risk appetite of banks across ownership played an important role in influencing their margins during the crisis.Bank specific variables and effect of crisisThe bank specific variables are size of the Bank, liquidity position of the bank and capital of the bank.

Banks with high liquidity improved their margins during the crisis and also capital rich banks appeared to have exhibited higher margins during the initial period of the crisis.Effect of crisis on small and weak BanksSize of the bank does not have any role to be played in managing banks margin during crisis. No significant impact has been found on the margin determination either for big or small banks.Big banks with high capital and adequate liquidity do not exhibit any impact on their margin during the initial part of the crisis. However, during the second half, well capitalized banks increased their margin.During the initial part of the crisis, small banks with limited capital and liquidity could operate without any pressure on their margin.During the second half of the crisis, small banks could maintain profitability without altering the margin; but banks with low capital and liquidity support could not withstand the hit and were compelled to reduce their margin.

Observations & Suggestions with respect to Interest marginIndian banks are still operating with relatively high interest margin as compared to international benchmark. The study observed that variables such as size, NPA, cost (in) efficiency, capital cushion, deposit concentration and economic growth are important in determining the banks behavior regarding their interest margin.It is, therefore, prudent to seek productivity augmentation by reducing the margin through limiting the intermediation costs. Given the structure of the banking system in India, foreign banks are operating with relatively high margins as compared to other bank groups. However, after the globalization and introduction of several regulatory policy measures by the Central Bank, the overall efficiency increased in terms of other parameters.

Observations & Suggestions with respect to Interest marginChallenges remain in dealing with increasing NPAs for banks in maintaining their margin. Although the NPA level has significantly reduced to around 2 per cent in 2010 from as high as 11 per cent during 2004, banks still maintain provision (in 2010), as high as 40 per cent, for the bad debt in their books of accounts which could be due to changing composition of credit portfolio.Interestingly, the global financial crisis which posed a threat to the banking stability of major economies around the world eventually had some impact on the interest margin of banks in India. The public sector banks (PSBs) appear to be the worst affected as compared to other bank groups. While banks with high capital and liquidity could sustain the margin during the entire period of the crisis, the banks with low capital and liquidity found it difficult to maintain the margin.

Factors affecting loan pricingThe determinants of loan interest rate and spreads are classified into Regulatory and policy variables such as capital adequacy, and the repo rate bank specific variables pertaining to asset quality, managerial efficiency, earnings, liquidity, bank size, loan maturity, cost of funds competition as a market structure variable and macro variables including the rate of growth of GDP and WPI inflation rate.CorrelationThe interaction between policy rate and competition in the banking sector had a negative and highly significant coefficient, which is the impact of competition on interest rate pass-through.An exogenous shock (e.g., deregulation under the Indian banking reform) forces banks to minimize costs, offer services at lower prices, and at the same time forces them to increase profits, e.g. through shifts in outputsit is found that the competition-managerial inefficiency interaction puts a significant downward pressure on loan pricing which leads to increased market share in a competitive loan market, which in turn increases profits and hence the bank soundness by reducing the default rateRegarding the bank specific variables, loan interest rates and their spreads showed statistically significant relationship with operating cost, profitability and capital adequacy, loan maturity, asset quality, bank size and liquidity indicators. Macro variables such as GDP growth and inflation rate also had a positive impact on loan interest rates

VariableDescription Rationale Expected SignNet Interest MarginNet interest income scaled by assetsBank sizeLogarithm of total assetPositive: large banks have market power, credibility and stability. They can mobilize low cost depositNegative: Large banks can operate with relatively low margin due to scale efficienciesPositive/Negative

Interest rate spread and loan rates

Federal Bank reports