A previous post used Bank of England effective interest rate data to show that – contrary to the consensus perception – UK banks' aggregate net interest margin on sterling business remained stuck close to a record low. The margin, however, was expected to improve gradually as high-cost term funding was refinanced at lower rates and banks began to benefit from wider spreads on new lending.

May effective rate statistics released last week are consistent with this story. The average interest rate charged on M4 lending was unchanged on the month, while the average rate paid on M4 deposits declined, mainly reflecting falls on time deposits and notice accounts – see chart. The spread, or net interest margin, therefore rose to its highest level since January.

This may, in fact, understate the improvement in net interest income since banks have also benefited from a falling cost of wholesale funding needed to plug the £490 billion gap between M4 lending and deposits. The spread between three-month unsecured and secured interbank borrowing rates has fallen from 120 to 50 basis points since the start of 2009.

Higher net interest income is needed to provide resources to cover write-offs and support future lending. The current M4 lending / deposit rate spread of 2.1 percentage points compares with an average of 2.8 over 1999-2008. A return to this average would boost UK bank's pre-tax profits by £14 - 17 billion per annum.