If you're looking for bank stocks that still have room to run, then I encourage you to add M&T Bank (NYSE:MTB), KeyCorp (NYSE:KEY), and Comerica (NYSE:CMA) to your watchlist. These three banks have uniquely valuable deposit franchises that will yield outsized profits once interest rates head higher.
It's important to remember that lenders make money doing one thing in particular: arbitraging interest rates. They borrow at low short-term rates, generally from depositors, and then lend those same funds out at higher long-term rates. The bigger the difference between the two, known as the "interest rate spread," the larger the profit.
It follows that there are two principal ways for a traditional lender to boost its bottom line. It can increase its yield on earning assets by investing in riskier loans and/or securities. This is the least attractive option, as it ratchets up the possibility that credit losses will eat into capital and weigh on returns.
Alternatively, a much safer approach is to decrease the cost of funds -- in other words, the interest rate it pays to borrow money. The most effective way to accomplish this is to accumulate a large portfolio of interest-free checking accounts, referred to in the industry as "demand deposits."
It's with this in mind that I encourage you to keep an eye on M&T Bank, KeyCorp, and Comerica. As you can see in the chart above, these banks rely on demand deposits for a greater percentage of funding than any other bank of comparable size.
Comerica leads the way with 40% of its funds consisting of demand deposits. Second is M&T Bank at 33%. And rounding out the top three is KeyCorp at 32%.
Now, just to be clear, there's more to running a safe and profitable bank than accumulating a large base of demand deposits. For instance, a good bank must also be adept at managing credit risk and thereby not underwriting bad loans or investing in questionable securities. On top of this, it's critical to keep operating costs low lest they consume a disproportionate share of revenue.
But these caveats aside, a large demand deposit franchise is one of the principal hallmarks of a great bank. And while it's impossible to say for sure whether any or all of these banks have what it takes to outperform going forward, their success on the deposit front certainly makes them worth watching.
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John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of KeyCorp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.