To understand banking operations let’s start with why we go to banks? We go to banks either to deposit money or to take some loan. So the banking operation consists of two thing one is people deposit money in the banking system to get interest on it and banks give loans to people and charge some interest.
Let’s now understand these two one by one and how bank plans to make profit of it.
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When we deposit money in the bank they are required to pay interest to us. And that interest varies. The interest which they pay varied depending on the deposits. If the deposit is in current account, banks need not to pay any interest. If the deposits is for bulk deposit or fixed deposit they have to pay more interest. For saving deposit account they are paying around 4%. So whatever the way we deposit money in the bank, they are required to pay us interest except current account. As banks are required to pay us interest, thus the deposits with the banks are known as liabilities.
Liabilities: Banks’ legal debts or obligations that arise during the course of banking operations is known as liabilities for banks.
Cost of Funds:
When we deposit money with the banking system, they are required to pay us interest that’s why the deposits are called liability for banks. And banks are required to pay us interest and the average interest on all these deposits put together is known as cost of funds for banks. Thus Average interest requires to be paid across all the types of deposits are known as cost of funds for banks.
Until now we understood how it is important for bank to reduce cost of funds as this may reduce expenses now we need to understand how banks can reduce Cost of Funds?Cost of funds for the banking system should be as low as possible.
Cost of funds can be reduced if banks have more current account and saving account deposits. Because on current accounts banks are not required to pay any interest and on saving accounts the interest rate is very less. It is around 4%. But if banks have more fixed deposits, their cost of funds will be more, that’s why in the banking system banks required more current account and saving account deposits. But the problem here is current account and saving account deposits can be withdrawn at any point of time. They are unstable deposits. Today you may deposit 5 crores rupees and tomorrow you may withdraw all the 5 crores. That’s why they are called unstable deposits or volatile deposits. But fixed deposits are for fixed term. So bank can plan their activity. So the advantages of having more fixed deposits are banks can plan their loans.
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Until now we have seen when we deposit money with the banking system they are required to pay us interest which is known as cost of funds for banks. But when banks are giving loans to us we pay interest to the bank that’s why they are assets for the banking system and the income that they are getting is yield or income. The average interest which banks get on loans is known as yield or income.
In first case banks get deposits from people and give interest on deposits which is known as cost of funds and in second case banks gives loans to people and get interest on loans which is yields or income.
Yield or income should be as high as possible. But because of the competition between various banks they cannot increase the interest rates on loans. If one bank increases, customers will go to second bank. That’s why banks cannot increase the interest rates on loans. Their differences are hardly from 0.25 to 0.5 %.
Banks on one side have to pay us interest on deposits that is cost of funds and on other side they will get interest on loans that is yield, so for successful banking operations the gap between these two that is between cost of funds and yield should be minimum of 3%. Which is known as Net Interest Margin. Net interest margin is the margin between yield and cost of funds. With this gap between yield and cost of funds, banks has to pay salaries, rent on the premises for their operations and they have to get profit also.
For example, suppose average cost of funds is 6.8 % whereas average yield and advances is 9.8%, the gap here is 3%. This is viable banking operation. Bank requires this net interest margin of 3% to ensure profitability.
To make this clear let us assume that bank has got 1000 crores of money. Let us assume cost of funds is 6% means they have to pay 60 crores per annum. If the yield is 9% they will get 90 crores per annum that means the difference 30 crores is the interest they get on the 1000 crores. If the net interest margin is the 3% they will get 3 crores for every 100 crores of deposits and they have to meet all the expenses within this 3% interest margin and have to ensure profitability with this gap only.
In some cases the difference between this average cost of funds and average yields is 2.5% which is not sufficient for ensuring profitability.
Net Interest Margin (NIM) of minimum 3% is met by state bank of India, ICICI Bank, HDFC Bank, Axis bank. For all these banks the net interest margin is either 3% or more. But when you look at the small banks like Andhra bank, united bank of India, state bank of Mysore, the net interest margin is less than 3%, around 2.5%.
Some highlights on Net Interest Margin (NIM):
- Net interest margin (NIM) is the important parameter for the survival of any banking system.
- At present, some new generation private sector banks along with SBI are able to achieve +3%
- NIM, which is the benchmark for profitable banking operations. But most of the public sector banks are struggling with NIMs of 2.2 to 2.7%. Hence thse banks are not able to achieve desired levels of profitability.
