As a general rule, banks aren't safe investments. They're highly leveraged, exposed to a variety of risks, and often run by executives who lack the temperament to steer a lender through multiple credit cycles.
But does this mean you shouldn't invest in them? Absolutely not, as there are few business types with the innate ability to compound returns at a higher rate.
What it does mean, however, is that you should be selective when it comes to choosing bank stocks to add to your portfolio. And, more specifically, I'd encourage you to put a premium on safety.
Identifying safe bank stocks
The essence of a safe bank stock boils down to how effectively it manages credit risk -- that is, the risk of loss stemming from the failure of borrowers to repay loans.
"When you think about what, in fact, distinguishes a bank as a lender," New York Community Bancorp CEO Joseph Ficalora explains, "it's how much money it loses on the asset that it chooses to take risk with."
The objective is thus to identify banks that have figured out how to mitigate credit risk either through an innovative business model or a demonstrated history of prudent risk management.
Two banks that come to mind are The Bank of New York Mellon (NYSE: BK ) and State Street (NYSE: STT ) . Although these are two of the oldest companies in the United States -- the former traces its roots back to Alexander Hamilton, the nation's first Treasury Secretary -- their business models are far from traditional.
Most banks make most of their money by arbitraging interest rates -- click here to learn more about how the typical bank operates. They borrow money from depositors at low short-term rates and then lend it out at higher long-term rates.
By contrast, The Bank of New York Mellon and State Street earn the lion's share of revenue from noninterest sources -- namely, by overseeing massive portfolios of assets under custody, administration, or management.
While State Street's balance sheet boasts consolidated assets of $282 billion, it gets paid to administer a $31 trillion portfolio of its customers' assets. And while The Bank of New York Mellon has $401 billion in balance sheet assets, it oversees $30 trillion in customer-owned assets.
As a result, because the vast majority of profit-generating assets at these two banks aren't in fact owned by them, neither The Bank of New York Mellon nor State Street faces the risk that they will default. In other words, they've mitigated credit risk while retaining the right to earn noninterest income from trillions of dollars' worth of assets.
The Foolish bottom line
One of my favorite quotes about banking is attributed to Carl Webb, the second in command at Diamond A Ford, a bank buyout firm founded by Texas billionaire Gerald J. Ford. "Banks get in trouble for one reason," says Webb. "They make bad loans."
The point here is simple: If you're looking for safe bank stocks, a great place to start is with institutions like The Bank of New York Mellon or State Street that aren't driven to make bad loans by the desire to grow revenue.
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