Net interest rate spread refers to the difference between the interest rate paid to depositors and the interest rate they receive from loans. In other words, it is the difference between the borrowing and lending interest rates of the bank. The interest rate spread is a key determinant of the financial institution's profitability and is similar to a profit margin.
To better understand
the net interest rate spread, we first must understand how financial
institutions operate. The financial institutions referred to here are mostly
banks. Banks issue a variety of loans to customers, which include mortgages on
a property, student loans, and auto loans. They charge interest on the loans.
Banks generate income
through deposits in the form of savings and checking accounts, shareholder equity,
or debt issuance and payout interest. Typically, the interest paid out on
deposits is at a lower rate than the interest the bank charges on loans,
meaning that the bank generates income. As such, the larger the interest rate
spread, the higher the income the bank earns.
The interest rates
themselves are a key determinant of the interest rate spread and are affected
by several factors. Government policy plays a key role in determining the
interest rates, as do market transactions in the open market.
Importance of the Net
Interest Rate Spread
The net interest rate
spread is especially important because it is essentially a measure of the
profit margin for the institution. It is because the larger the spread, the
more money the bank earns. Both rates can fluctuate over time, which means that
the bank needs to keep a close eye on them to prevent a substantial decrease in
income.
The net interest rate
spread is reported by hanks and other publicly-traded corporations that are
responsible to shareholders as disclosure in their financial statements for
quarterly and year-end fiscal reports
The spreads of
different banks are closely examined by international organizations, such as
the World Bank, which releases data from different countries around the world
to provide users with information on the average lending and deposit rates
worldwide.
For investments, the
interest rate spread is used to evaluate the rates of investments versus the
benchmark rates in a particular industry. It commonly occurs for securities and
bonds. The spread rates are compared according to the credit rating and enable
bonds of the same rating (such as AA or BB) to be compared against each other
for more accurate results