Net interest margin is a useless concept

There's a lot of talk about banks deriving lower funding costs from depositors than from the wholesale markets. But this perception, which is widespread among bank management teams rests on a misunderstanding.

Systemically important banks benefit from sovereign guarantees to their creditors. For the most part these guarantees are implicit. Customers depositors on the other hand benefit for the most part from formal guarantees through agencies such as the FDIC.

So what the cost of a asset guaranteed by the Government? Well, for formally guaranteed debt like customer deposits. it is the return on the equivalent maturity government debt and, for informally guaranteed debt like wholesale debt, there may also be an additional spread for the uncertainty associated with the likelihood that the Government may not honor the guarantee (think Lehman, Northern Rock, Bradford and Bingley). A functioning market prices this risk daily - the LIBOR market.

So a customer deposit that is formally guaranteed by the Government has the same cost to a bank as its earns on overnight deposits with the central bank. And every customer with a deposit in a bank can access close to the rates earned by banks when they make deposits at the central bank  - if they choose to do so.

A quick survey of rates actually paid by banks throughout the world however suggests that in most places and most times, customers actually earn less that OIS rates and they seem to be content with this.

Why? Quite simply because a customer deposit with a bank gives a customer access to the payment system and providing this service has a cost to banks for which they can charge depositors a fee. That fee is usually in the form of a lower interest rate than OIS but it could equally be an explicit fee or in a few cases a charge based on deposit values (i.e. negative interest rates).

So when the market looks at net interest margins of banks, what is it doing? It is netting off three different things - gross interest receipts, gross interest expenses and fees charged by banks against interest rates for access to the payments system. but if different banks charge for the payments system in different ways (as they do) how useful is the concept of net interest margin in bank analysis?

Frankly not much.