Banks need to boost their profitability in order to generate additional capital to support higher lending. Yet a measure of the gap between their average lending and deposit rates is close to its lowest level for at least 10 years.

Recent government-sponsored capital injections were calibrated to provide banks with a buffer against coming loan losses rather than support an expansion of lending. With market capital available, if at all, only on penal terms, banks are reliant on retained earnings to build the additional cushion necessary to support lending growth.

Net interest income is the largest element of banks’ earnings. The chart below shows estimates of average interest rates on banks’ and building societies’ sterling lending to the private sector and their M4 deposit liabilities. The estimates are derived from Bank of England data on effective interest rates on different types of loan and the composition of balance sheets.

The gap between the average lending and deposit rates – the net interest margin – recently reached its lowest level in the history of the data since 1999.

This may understate current pressure on banks’ profitability for three reasons. First, a compression of the margin from 2003 was offset by rapid balance sheet expansion, which is now ending.

Secondly, sterling lending exceeds M4 deposits by £476 billion, with the resulting “funding gap” bridged mainly by wholesale market borrowing. The cost of such borrowing has risen significantly since the credit crisis erupted.

Thirdly, fee income has fallen in reflection of weakness in financial markets.

Cuts in Bank rate may not boost the net interest margin much, if at all. Suppose the average loan rate is linked to Bank rate while the deposit rate varies with interbank rates – this is a simplifying assumption but may contain an element of truth, given government pressure to “pass on” Bank rate cuts and competition for savings. Bank rate cuts that were not fully reflected in interbank rates would then reduce the margin.

The three-month overnight indexed swap (OIS) rate – which measures market expectations of Bank rate – is currently 280 bp below its average in September (the last date in the chart), while three-month LIBOR is only 170 bp lower (based on yesterday’s fixing). Actual and prospective cuts in Bank rate have therefore yet to be fully reflected in interbank rates.

The government is further contributing to earnings woes via the charges levied for its various support measures. The fees on the special liquidity and credit guarantee schemes are significantly higher than for their US equivalents, as is the coupon on government-purchased preference shares. Banks are also partially liable for the cost of recent payouts to depositors under the Financial Services Compensation Scheme.