Continental Illinois: The original "too big to fail" bank. Source: Wikimedia Commons user Beyond My Ken.
No one wants to have all of their equity investments wiped out for any reason -- doubly so if that loss comes at the heavy hand of government intervention. In the world of risk management, that is pretty much as bad as it gets.
For that reason, many investors have turned away from the banking industry because of its complexity, opacity, and prolonged recovery from the financial crisis. That's a shame, as plenty of banks out there are worthy of your investment.
Complexity and risk
Before we go any further, let's talk about risk in the banking business.
All banks face the risk of failure. That isn't what separates a "too big to fail" bank from other, less systemically important financial institutions. Banks fail all the time, and even more so when the economy turns for the worse.
The Federal Reserve Bank of New York.
What separates a too-big-to-fail bank from the rest has more to do with complexity. These banks are intertwined like a ball of yarn wrapped around the entire globe. And they are absolutely gargantuan.
They don't just accept deposits and make loans. They have trillions of dollars in complex derivatives contracts. They own and operate huge hedge funds that take towering positions in commodities, equities, bonds, and even more esoteric asset classes. And there's even more to them than that.
The point is not that smaller, simpler banks are not risky. The point is that we can actually understand the risks of an old-school, traditional bank. No one can truly understand the risks inherent in a too-big-to-fail bank. That's the critical difference.
Simplifying the equation
Every year, the international Financial Stability Board releases a list of the world's too-big-to-fail banks. Let's go ahead and remove all 30 of this year's designees from our prospective bank investment list. I don't understand them, you don't understand them, and I seriously doubt anyone else really understands them.
To narrow our search even further, let's add in some regulatory considerations. When a bank exceeds $50 billion in total assets, financial regulations require that institution to take part in annual stress tests administered by the Federal Reserve. These banks are not necessarily systemically important on a global scale, but the Fed still keeps a close eye on them. If it takes extra supervision for the Fed to get comfortable with these banks, then they are probably still too complex for our search. Let's scratch these banks as well.
So, after narrowing our search to U.S. banks with less than $50 billion in total assets, we can start looking at specific banks.
The list
To separate the best banks from the rest, we'll use return on assets. Warren Buffett has stated that ROA is his favorite metric for starting a bank analysis, and I agree. To read more about why ROA is such a powerful metric, click here.
Every quarter, the FDIC releases aggregated industry metrics for all U.S. banks in its Quarterly Banking Profile. At the time of this writing, the most recent data available is for the second quarter of 2014, and the FDIC reported that the average ROA for U.S. banks was 1.07%.
The data for the specific banks below is as of the third quarter and provided by S&P Capital IQ.
| Company Name | Total Assets | Last 12 Months' Return on Assets |
|---|---|---|
| Prosperity Bancshares (PB 3.80%) | $21.1 billion | 1.5% |
| BankUnited (BKU 0.65%) | $17.6 billion | 1.3% |
| International Bancshares (IBOC 0.16%) | $12.4 billion | 1.3% |
| East West Bancorp (EWBC 2.52%) | $28.5 billion | 1.2% |
All of these banks are reasonably sized, are primarily engaged in traditional banking activities such as deposit gather and lending, and do not carry excessive leverage on their balance sheets (East West Bancorp is the most levered at a reasonable 10.3 times equity to assets).
As an added bonus, all four of these banks sport a dividend yield above 1.8%, led by BankUnited's 2.8%.
All banks are not created equal
This analysis alone is not enough to justify investing in one of these banks. This is just the starting point.
Going through this process allowed us to identify a handful of banks that have business models that the average investor can understand. They are small enough to manage and simple enough to make risk assessment possible. And they are all delivering above-average financial returns as defined by return on assets.
All banks are not created equal. A savvy investor will look past the stigma of "too big to fail" to find the best banks hiding just below the radar
