Yahoo Finance’s Brian Cheung breaks down how banks make money in this weeks Yahoo U.

Video Transcript

ZACK GUZMAN: Speaking of the banks here, want to take a moment here to focus in on one of the questions that we've gotten from a few viewers out there when it comes to banks in this environment of a steepening yield curve. Of course, financials have been some of the strongest performers year-to-date here on the hopes that they could start to make a little bit more money.

But want to bring on here Yahoo Finance's Brian Cheung with us for a closer look at how banks see improved business when we do see that happening. And Brian, its-- it's technical here, but that's what Yahoo U is all about.

BRIAN CHEUNG: That is what it's all about. And winter break is over. We were actually a few weeks paused on Yahoo U, but we are back for the spring 2021 semester. So welcome to Yahoo U. Class is in session today with bank earnings kicking off.

Let's talk a little bit about bank profitability. So as we know, banks are extremely interest rate sensitive. But based on their earnings this morning, what kinds of things do we need to look for in a bank earnings release to tell us how they're managed in a world with interest rates as low as they are?

So let's start off with the basics of banking as I bring up my slides here, especially, which is appropriate, because I just lost the background on my TV just right now. But I want to show you just what a model looks like for the banking industry. Most of us have used a bank, but think about the bank business model from the bank side, right.

So when you deposit money, that's you lending money to the bank. And you're going to be paid interest on any sort of deposits that you have there. So think about a 12-month or an 18-month CD. And then conversely, the bank will take money, and they'll loan it out to people, right, at interest as well, so think about a loan to a business or a loan for your mortgage, for example. This is pretty easy stuff.

So bank business model's predicated on interest paid-- rather paid to depositors and then made on loans. So net interest margin is a key way to measure the profitability of that model. So pretty easy here. You take the interest that you make on loans you made subtracted by the interest that you paid on deposits, and then you divide that by the total amount of interest earning assets that you have on your balance sheet.

And then boom. You have Net Interest Margin, or NIM. Now, unless you're a trash bank, I mean, you should be earning more on the amount that you loan out than you do paying out on deposits. But think about the duration component of all this, right.

A business loan, for example, might be something around 10 years, whereas deposits, again, maybe 12, 18 months, one to two years. So there is a duration difference in this type of business model. And this is where what they call term premium comes into play.

So interest rates are often proxy by the yield on US treasury securities, so let's take a look at what it was as of the close yesterday. The two-year yield was about 16 basis points. The interest rate on a 10-year was about 1.15%. Now, the difference here is going to be about 100 basis points, I mean, 99 basis points, to be exact.

Now, of course, this is going to make sense, right. It's going to cost you more broadly to borrow longer than it is to borrow shorter. But because banks tend to borrow short, they lend long, this helps them make money. Now, of course, our older viewers are going to take a look at that two-year yield and go that's a joke. I know high single-digit, even double-digit, interest rates from the '80s, for example.

And for that we have the Federal Reserve to thank, right. So when you hear the Federal Reserve talk about changing interest rates, that concerns short-term interest rates, which is kind of measured as a benchmark as the effective federal funds rate. And over the last 10 years, the highest that it got-- about 2.5%. And obviously right now we're at near zero because of the COVID-19 crisis. But this is the reason why two-year yields and your deposit rates are so small.

Now, think about this picture if you're a bank, right. If you're a bank, how much room do you have to price your loans when interest rates are that low? And for that reason net interest margin, if we kind of loop back to that idea at the US banks which is shown in this chart, have come down enormously in this low-rate environment.

This data comes from the St. Louis Fed, and you notice how it tracks pretty closely with the interest rate hikes that were begun by then Fed Chair Janet Yellen and then extended by Jerome Powell, obviously before the China trade issues and then COVID pushed the Fed to lower everything back down to zero.

Now, of course, this is a very simplistic view on how to make money, right. Banks have a lot of other ways that they make money when you think about the huge trading desks at the likes of JP JPMorgan Chase and Citigroup. But this is really the bread and butter of where banks make their money, loaning money and then taking in deposits. So for those that are trying to invest in the bank stocks, always remember Net Interest Margin, or