How Banks Make Money: The Net Interest Margin

How banks earn profits from the gap between lending and deposit rates, plus fees, and why interest rate changes affect bank profits.

Banks are businesses, and like any business they need to earn more than they spend. Their main source of income is the difference between the interest they earn on loans and the interest they pay on deposits.

The net interest margin

A bank takes deposits and pays interest on them. It lends money out, charging higher interest. The difference between interest earned and interest paid, relative to the bank’s interest-earning assets, is called the net interest margin.

For example, if a bank earns 9 percent on its loans and pays 5 percent on deposits, its spread is roughly 4 percentage points. After covering costs and losses, what remains is profit.

Other income

Banks also earn fee income from:

Account charges and ATM fees.
Credit card fees and interest.
Loan processing fees.
Selling insurance and investment products.
Foreign exchange and payment services.

Costs and risks

Banks’ costs include staff, branches, technology and regulation. Their biggest risk is credit risk: borrowers who fail to repay. Banks set aside money, called provisions, for expected loan losses. When many loans go bad, as in India’s banking stress in the late 2010s, profits can turn into large losses.

Interest rates and bank profits

When central banks raise interest rates, banks can often raise lending rates faster than deposit rates, widening margins at first. But higher rates can also increase loan defaults and reduce demand for loans. When rates are very low, margins can be squeezed.

A small bank's year

A bank has 1,000 crore rupees in loans earning 10 percent, bringing in 100 crore rupees. It pays 6 percent on 900 crore rupees of deposits, costing 54 crore rupees. Its net interest income is 46 crore rupees. After 25 crore rupees in operating costs and 10 crore rupees set aside for bad loans, its profit before tax is 11 crore rupees. A rise in bad loans could quickly wipe that out.

Why it matters to customers

Understanding bank economics explains why savings accounts pay low interest while credit cards charge high interest, and why banks encourage customers to use fee-generating products.

Thinking banks simply lend out the exact money deposited

Banks create new deposits when they make loans, and they manage their balance sheets as a whole. But the basic business model still relies on earning more on assets than they pay on liabilities, while managing the risk of losses.

Key takeaways

Banks earn most of their profit from the gap between lending and deposit rates.
The net interest margin measures this gap relative to interest-earning assets.
Fee income adds to profits, while credit risk is the biggest threat.
Interest rate changes can widen or squeeze bank margins.