The Interest Income to Interest Expense Ratio

Given the length of the recovery since the 2008 financial crisis, the business cycle is believed by many in the market to be in the mid-to-late stages before a recession. Because of this, market observers have kept a close eye on indicators that have seen some successful record of identifying the final cycle stages before a recession, for example a yield curve inversion. One metric that has not (to the best of knowledge) been mentioned in financial commentary is the ratio of interest income to interest expense for the banking industry.

Interest Income Over Interest Expense

The interest income to interest expense ratio has shown cyclical behavior throughout the last three business cycles. While interest-driven income and expense obviously has a relationship with interest rates in the market, they are influenced by many other factors as well such as loan and deposit trends.

While a pattern of behavior is visually obvious, a basic explanation of the rationale behind the phenomenon also provides support. In general, interest rates are expected to rise when the economy is good and fall when the economy doesn't do well.

Banking loans, which provide the interest income numerator, tend to be longer term than banking deposits, which provide the interest expense. So, when rates fall, for example when the Federal Reserve decreases rates due to economic weakness (e.g. a recession), the interest expense from short term deposits would decrease more quickly than the interest income from long term loans. Thus, explaining the rise in the ratio during recessionary periods. Eventually, the trend hits an inflection point and the ratio begins to decrease until just before the start of a new recession.

So, this metric, like the many others often referenced in financial commentary, will be important to watch in the near future as the economy continues to move into the late stage of the business cycle, as an upward inflection may indicate a new recession.

Related Content

Take me back to the homepage.

An analysis of the equity multiplier for the banking industry.

An analysis of return on equity for the banking industry.