Recessions are generally a lousy time to own bank stocks. Loan portfolios tend to become troubled, assets are written down, and book values fall. The losses and writedowns often extend past the bottom of the recession and into part of the rebound.

But if you think the worst of the coronavirus-induced economic downturn might already be over and you want to dip a toe into the banking sector, you might want to stick with the banks with the lowest credit risk. Citigroup (NYSE:C) is more of a traditional bank that makes its money by taking credit risk. Northern Trust (NASDAQ:NTRS) is a specialized bank which earns its income mainly from fees. Depending on the economic backdrop, one model may be preferable to the other. 

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What do we know about these banking institutions?

When you think of Citigroup, you generally think of credit cards, mortgages, and corporate lending. In other words, a typical money-center bank. A new credit loss accounting standard developed in 2016 and finally implemented in 2020 called current expected credit losses (CECL) has lead to big writedowns for most of these big banks because they are now required to keep a certain percentage of funds in reserve to deal with potential losses expected during this latest round of economic uncertainty. In the first quarter, Citi took a $4.9 billion incremental allowance for loan losses due to COVID-19, which amounted to 0.22% of assets.

Trust Banks like Northern Trust have a fundamentally different business model than the typical bank (which makes its income from taking deposits and making loans). Northern Trust earns most of its revenue from fee income by managing accounts on behalf of institutional investors, pension funds, central banks, and large corporations.

Trust, investment, and other servicing fees accounted for 63% of Northern Trust's revenue in the first quarter. These services include fund administration, accounting, outsourced investment operations, securities lending, and corporate Treasury services. The bank is paid a percentage of assets under custody or administration. At the end of the first quarter, these assets managed by Northern Trust totaled $10.9 trillion. 

Fee income will generally ebb and flow with the markets, but there is a lagged component to it since fees are generally set quarterly based on ending asset balances. For example, during the first quarter, Northern Trust's assets under custody fell as markets dropped 10%, but fee income was up since it was based on Dec. 31 balances.

Wealth management and securities lending

Northern Trust's wealth management business involves professionally managing securities portfolios for institutions and clients with high net worth. Securities lending is an offshoot of wealth management and is another great business that carries little risk.

When you short a stock, you need to "borrow" shares from your broker. When you borrow a stock to short, you pay a fee. Institutional investors who keep their securities portfolio at Northern Trust will allow the bank to lend those securities out. The stock lender basically gets a risk-free return on someone else's money. 

Valuation issues

In the first quarter, Northern Trust took a CECL provision for loan losses of $61 million. That worked out to be 0.04% of assets. This was much lower than Citi's provision of 0.22% and represents the lower-risk loans that Northern Trust generally makes (secured loans collateralized by securities held at the bank and investment-grade portions of corporate real estate) compared with Citi's portfolio of consumer and commercial real estate loans.

Northern Trust is much more profitable as well, with a return on assets of 1.2% and a return on equity of 13.4%, compared with Citi's 1% return on assets and 10.4% return on equity. Northern Trust pays a 3.7% dividend yield as well, while Citi's yield is 4.6%. Citi's stock price is down about 50% year to date, while Northern Trust is down about 35%. That difference in performance is a big driver of the difference in yield. 

It is probably still too early in the current economic cycle to start taking a stake in bank stocks. If you already hold them, the time to sell has passed, but they are not yet ripe to buy. That said, if you want to maintain exposure to the sector, then the safest banks to own are the trust banks like Northern Trust, which generate most of their returns from fee income. Once it looks like the big banks have finished their COVID-19 writedowns, it might make sense to swap into the more credit-sensitive banks like Citi. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.