Should we target net interest income?
For many banks and building societies Net Interest Income (NII) is a substantial part of “earnings”. Earnings allow us to add to capital, pay dividends and grow the business. Given its importance should NII be targeted by the Board? By targeting I’m referring to establishing a process that tells you what is happening and where necessary acting on that information.
My interest (no pun intended) comes from seeing executives struggle with this question and more often than not it’s kicked into the long grass. It’s this uncertainty that I want to address. Are we failing to consider a key component of our profitability? Should we do something?
A comparison
One target we are familiar with is inflation, it affects our lives and since the 1990s monetary policy has focussed controlling it, as The Bank of England’s website succinctly puts it:
“The Government sets us a 2% inflation target….. This helps everyone plan for the future.
If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending. But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs.
If we miss the inflation target by more than 1 percentage point either side of the target, we must tell the Government why. So if the Consumer Prices Index (CPI) inflation rate is more than 3% or less than 1%, our Governor writes a letter to the Chancellor to explain why and they set out what we'll do to get it back to 2%”.
The Bank informs us there is a target (2%), it’s reported and there is action to maintain it. The reason why the government targets inflation is because it acknowledges that it can cause problems when it is too high or too low. Could the same be said about your NII?
If it’s too low, you are in danger of not covering costs and if it’s high you have to ask what risks you are taking to get there. NII is therefore a major determinant of your long run success. However, because NII is important it doesn’t automatically follow that it should be targeted and two questions are frequently raised in this respect:
We don’t know what the future holds so how can we decide what our NII will be?
By targeting NII aren’t we increasing risk?
The Bank isn’t certain on inflation, but it doesn’t stop it from being targeted. The important thing is to believe that in some way your action can influence the NII and surely this must be true otherwise your business is wholly dependent on luck not skill.
Furthermore, by not paying close attention to the NII isn’t your risk going up, not down? The right controls that curtail excess in credit, rates and liquidity together with the appropriate cultural and remuneration policies should protect you. Risk taking only gets out of hand if you allow it to happen.
Inertia
Given its importance why is it that many firms don’t target NII? It’s just not a regulatory priority. The main concern for the regulator is whether the capital supports the business. Just as night follows day preoccupation by the regulator on certain things draws in management too. The PRA concentrates on solvency not what makes you solvent. Basis risk also attracts regulatory scrutiny and in a similar way management attention is pulled towards it. Capital and basis risk are linked by the NII.
NII contributes to capital but is partly derived from basis risk. Basis risk itself comes from the strategic decisions made some time ago about how you borrow and lend.
NII therefore provides feedback on how effective your strategy is - something any Board should want to know.
In other words, NII is the real effect whereas basis risk is the abstract cause and real things are just a lot easier for us to talk about.
Boards therefore should have relevant information about the NII. Whether the NII ought to be subject to a limit is a much harder question to answer. My definition of a limit is a maximum or minimum exposure to an identifiable risk where situations outside the limit are acted on. These actions may include reduction of the risk, changes to the limit or waiting. Limits themselves are linked to risk appetite on which the board should have a clear view.
In this respect the target the Bank of England operates is a type of limit set by the government, it’s not set in stone, there’s a 1% leeway either side and this makes sense because there are many variables that influence inflation and its management is nuanced.
Having a minimum NII level to warn you about not covering costs and a higher level to prompt you to think about where the money comes from appears sensible. Just like inflation there may be times when you need to look through the monthly figures to gauge where NII is heading.
In doing so these limits should stimulate debate. How much interest do we need to break even? What generates the margin? Why is it changing? Important questions that help us understand our business and what action we need to take to keep it going.