If you are reading about bank stocks, then you probably know that the sector has been hammered during the coronavirus pandemic. While the S&P 500 is hitting new highs, the KBW Bank Index, which tracks 24 of the largest banks in the U.S., is down more than 33% from the beginning of the year. The KRE index, which measures regional banks, is also down about 33% from the beginning of the year, while the QABA index, which tracks community banks, is down close to 32%.

You've probably read plenty of articles about the big banks, both good and bad. But smaller bank stocks often get left out of the fray. Sure, this sector faces lots of challenges and uncertainty right now, but that's also why some of these stocks could have significant upside. Like many industries, the largest factor weighing on the sector is how soon the coronavirus pandemic subsides and how quickly a vaccine is approved and distributed. But there are still other pros and cons to consider when looking at smaller bank stocks.

A partial view of a bank entrance

Image source: Getty Images.

Con: Heavy reliance on loans

A problem for smaller bank stocks is the heavily reliance on loans, whereas a big bank like JPMorgan Chase (NYSE:JPM) or Bank of America (NYSE:BAC) collects a large percentage of its revenue from its asset management or investment bank divisions. Plenty of community banks offer asset management services and most regional banks offer some kinds of capital markets services, but those services make up a much smaller percentage of revenue, most of which is from interest income from loans.

For instance, for all banks with assets between $1 billion and $10 billion, which is mostly community banks and perhaps some small regional banks, net loans made up close to 70% of total assets at the end of the first quarter of this year, according to the Federal Deposit Insurance Corporation (FDIC). For banks with assets between $10 billion and $250 billion, encompassing mostly regional banks, net loans made up about 64% of total assets. But for the largest banks with more than $250 billion in assets, net loans only made up roughly 44% of total assets, according to the FDIC.

While loans have always been the main way banks make money, having more loans is not a good thing right now. For one, the coronavirus pandemic has all banks bracing for heavy loan losses. The more that loans make up your portfolio, the more vulnerable you are. Additionally, because the Federal Reserve has dropped rates to zero, many loans are going to see smaller spreads, equating to less total revenue, so the more diversity a bank has in its portfolio right now, the better. 

Pro: Smaller banks are under less scrutiny

Some advantages for smaller bank stocks is that they don't face the same scrutiny from regulators and the general public as the large banks, which more than a decade later, still face some backlash for the role they played in the Great Recession.

Following its annual stress testing in June, the Federal Reserve restricted the 33 largest banks in the country from issuing third-quarter dividends higher than what they paid out in the second quarter. The Fed also limited dividends to an amount not higher than average net income from the four preceding quarters, essentially making a bank's dividend highly dependent on its ability to generate a profit during an extraordinarily difficult time for the industry. As a result, large banks like Wells Fargo (NYSE:WFC) and Capital One Financial (NYSE:COF) have had to make large dividend cuts, and more large banks may face a similar fate in the fourth quarter. Additionally, the Fed has banned stock buybacks from these large banks.

These restrictions, however, do not apply to smaller banks. In fact, some have been conducting stock buybacks through the pandemic. Waterstone Financial (NASDAQ:WSBF), a $2.2 billion-asset bank based in Wisconsin, said on July 21 that it would repurchase roughly 7.7% of outstanding shares of common stock. A few other smaller banks have gone ahead with stock buyback plans as well. Many smaller banks are holding off right now, given the uncertainty, but without regulators focusing on them as much, many small banks could probably more quickly resume buybacks when they feel the time is right.

Smaller banks may also be able to reap more profits from the Paycheck Protection Program (PPP), in which the banking system helped the U.S. Small Business Administration (SBA) disburse hundreds of billions of dollars in loans to businesses devastated by the coronavirus pandemic. For every loan disbursed, banks received an origination fee as high as 5% of the loan amount from the government. Many large banks such as JPMorgan have said they do not intend to profit from PPP. But the same cannot be said for smaller banks.

Take a bank like Live Oak Bancshares (NASDAQ:LOB). This roughly $8.2 billion-asset bank specialized in SBA lending before the pandemic, so it was ready for the PPP program. The bank originated $1.75 billion in PPP loans, which equates to fees of more than $60 million. The bank is giving $7 million of those fees back to its employees, but then the bulk of these fees will be recognized as income once the loans are forgiven, which will likely occur in the fourth quarter of 2020 and the first quarter of 2021. Assuming the bank takes in another $50 million in fees, that's a huge tailwind when you consider Live Oak did only about $62 million in interest income on loans in the second quarter, the highest that number has been in any quarter over the last year. 

Don't write small bank stocks off

The banking sector obviously faces some challenges before the pandemic is over, and there is a lot of uncertainty baked into that. Smaller banks could likely see more trouble than large banks, considering more of their assets are typically tied up in loans, which could turn into heavy losses. But small banks also hold some advantages because they are not restricted from conducting stock buybacks, and will also likely reap more of a profit from the PPP program, so I wouldn't write them off just yet. I would look for community bank stocks with a strong handle on credit, because it could lead to a nice gain once the pandemic subsides.