Banks have gotten off to a great start in 2021, with most major bank indexes up significantly since the beginning of the year. The sector has benefited from two large stimulus bills and positive reopening and vaccine news. But the biggest boost has been the increase in longer-term bond yields as shorter-term rates have remained near zero -- otherwise known as a steepening of the yield curve.

That helps banks because they typically like to borrow money short term and lend it out long, so a steepening curve can increase their profit margins on loans and securities. And longer-term rates may continue to rise this year, while shorter-term rates also may increase sooner than expected, although almost certainly not this year. This positions large banks quite well. Here's why.

Impact on net interest income

A major source of revenue for banks is net interest income (NII), which is the difference between the interest income they make on loans and what they pay out to fund the loans. Both interest income and interest expense are tied to the Federal Reserve's federal funds rate, which impacts most shorter- and long-term rates.

When the Fed dropped the federal funds rate in March to practically zero, that hurt most banks' net interest income. That's because many banks are asset-sensitive, meaning more of their assets such as loans repriced downward than their deposits, resulting in lower net interest income.

While banks certainly felt that pain last year, there's really only one direction for net interest income to go (negative interest rates are very unlikely), and more upside because of the abrupt drop in rates last year. Because banks are so reliant on net interest income, which is so dependent on interest rates, banks in their annual and quarterly reports calculate what would happen to net interest income (from their base projection) if rates move in certain directions. They look at situations including what would happen if the Fed increased its short-term federal funds rate, which moves up everything else (referred to as a parallel shift) as well as if long-term rates move up on their own.

Bank Projected NII 2021 NII Increase +100 BPS Long-Term Rates NII Increase +100 BPS Parallel Shift
JPMorgan Chase (JPM 2.51%) $55.5 billion $2.4 billion $6.9 billion
Bank of America (BAC 3.35%) $55 billion $4.3 billion $10.5 billion
Citigroup (C 1.41%) $41.5 billion-$42.5 billion $0.183 billion $1.1 billion
Wells Fargo (WFC 2.74%) $35.3 billion-$36.8 billion $2.6 billion* $6.7 billion

Data source: Bank 10-K filings. * = Assumption made using Wells Fargo forecast of 50 bps in long term rates.

As you can see above, Bank of America projected it would make $55 billion in net interest income in 2021. However, if longer-term rates such as the yield on the 10-year Treasury note were to increase by 100 basis points, or 1 percentage point, net interest income would grow by $4.3 billion. If the Fed were to raise the federal funds rate this year by 1%, a scenario that has basically zero chance of happening, net interest income at Bank of America would grow by $10.5 billion. All the other megabanks would see a pretty significant benefit as well, with Citigroup, which is less dependent on net interest income, seeing more of a marginal benefit.

Longer-term rates have been moving higher significantly this year as more investors begin to prepare for potential inflation. That's why if you've been following bank stocks, you've probably noticed that the sector has been rising when the yield on the 10-year U.S. Treasury note rises. The yield on the 10-year note closed 2020 at about 0.92%. It's now around 1.66% and some experts think it could very well get to 2% by the end of the year, which would result in that full 1% increase and likely give banks the added net interest income.

Long-term potential

While the outlook for net interest income is looking good this year, assuming loan demand can bounce back a bit, the parallel shift projections show you how much a raise in shorter-term rates by the Fed would benefit these large banks. It's unlikely to happen this year, but with expectations for inflation growing, some have surmised that the Fed may begin to raise the federal funds rate in 2022, although many still believe there will be no Fed rate hikes until late in 2023 or 2024.

Short-term rate hikes only benefit banks when longer-term rates move with it, which does happen, but then longer-term yields can move downward on their own afterward. So there's a lot more to it than the Fed just raising the federal funds rate. But given where rates currently are and where they could go in the future, larger banks -- at least from an earnings perspective -- are well positioned right now.