Large and regional banks in the U.S. receive much more attention than smaller banks. That makes sense, because they stretch into much broader swaths of the economy. Some of the biggest banks, such as JPMorgan Chase and Bank of America, hold trillions of dollars in assets and carry out a wide array of financial functions. And many of the large banks have performed relatively well through the first half of the year when you consider what has happened to the economy.

But, while you would never know it, they are getting beaten badly by their smaller bank counterparts, who have been much more successful in the first two quarters of the year, at least when it comes to profitability. Let's take a look.

The exterior of a bank.

Image source: Getty Images.

Better returns

Every quarter, the Federal Deposit Insurance Corp. comes out with a banking profile that provides loads of information on how all FDIC-insured institutions -- both public and private -- are performing. It also groups banks by asset class and breaks out how those groups are performing compared to one another.

It's clear from data in the first and second quarter that smaller banks under $10 billion in assets are outperforming regional and large banks from a profitability perspective. Let's look at two metrics that analysts lean on heavily to examine banks' profitability. Return on assets (ROA) shows how well a company uses its assets to generate earnings -- 1% is considered strong in the banking industry. Return on equity (ROE) is a measure of how much potential value a company is providing to its shareholders -- 10% is considered strong.

Bank Asset Class ROA Q1 2020 ROA Q2 2020 ROE Q1 2020 ROE Q2 2020
$100 million to $1 billion 1.09% 1.3% 9.03% 11.29%
$1 billion to $10 billion 0.76% 1.09% 6.40% 9.74%
$10 billion to $250 billion (0.16%) 0.38% (1.37%) 3.43%
$250 billion-plus 0.52% 0.15% 5.15% 1.55%

Data source: FDIC.

As you can see above, in both the first and second quarters of the year, banks between $100 million and $1 billion in assets, as well as those between $1 billion and $10 billion, generated much better ROA and ROE than banks with assets totaling more than $10 billion.

Interestingly, in three of the four quarters in 2019, banks in the $10 billion to $250 billion asset class generated the highest ROA in the group, although all asset classes performed similarly. In two quarters of 2019, banks with more than $250 billion in assets generated the best ROE, and then performed similarly to the rest of the asset classes in the other two quarters, so there has been a change since the pandemic.

A few things could explain the success of the smaller banks. For one, the smaller banks continue to have smaller levels of charge-offs (debt unlikely to be collected) and non-current loans (those that haven't been paid on for 90-plus days) than the bigger banks. Most small banks don't have credit-card portfolios, so they don't need to set aside reserves for those. Most large banks with much bigger operations also likely have more uncertainty in regard to asset quality, forcing them to set aside more cash to cover potential loan losses. Additionally, the net interest margin (difference between what banks pay out on deposits and earn on loans) at the smaller bank asset classes have held up better during the coronavirus, particularly against the $10 billion to $250 billion asset class. This asset class historically has competed with smaller bank asset classes on margins, whereas banks over $250 billion regularly have smaller margins compared to the smaller banks.

Another interesting data point in the FDIC's quarterly profile looks at banks' efficiency ratio, a measure of a bank's expenses as a percentage of its total revenue. A lower efficiency ratio is better because it means a bank is spending less to generate more revenue.

Bank Asset Class Q3 2019 Q4 2019 Q1 2020 Q2 2020
$100 million to $1 billion 65.52% 67.51% 68.21% 63%
$1 billion to $10 billion 59.31% 61.83% 64.03% 59.43%
$10 billion to $250 billion 56.86% 56.07% 68.20% 58.42%
$250 billion-plus 56.43% 61.07% 58.65% 61.06%

Data source: FDIC.

As you can see above, banks in the smaller asset classes that typically had larger efficiency ratios have really narrowed the gap. Again, the asset class between $10 billion and $250 billion, which typically had the lowest efficiency ratios in the group, saw this ratio spike in the first quarter of 2020. Even when it normalized, it was only slightly higher than banks in the $1 billion to $10 billion asset class.

Larger banks, in theory, should be able to have smaller efficiency ratios because their size creates scale, and therefore the ability to better manage regulatory requirements from a cost perspective. But when the coronavirus pandemic struck, many regional and larger banks saw increased expenses to get their entire work forces set up remotely, and to make their branches and offices safer for employees and customers. So their expenses may normalize, but it's still interesting to see the smaller bank groups bringing down their expenses while they rise at larger banks.

Give smaller bank stocks a look

The banking industry is obviously a risky play, but if you are looking at the lagging stock prices as an opportunity, don't only look at the large banks. As I've written previously, the smaller bank stocks may benefit from things like less regulatory scrutiny and fees from the Paycheck Protection Program, which most of the largest banks are not planning to profit from. Small banks typically have a higher percentage of their assets tied up in loans, which could be problematic because of potential loan losses and the low-rate environment reducing margins. But small banks also likely know their client base better, giving them a better view of overall asset quality. The performance by small bank stocks through the first two quarters of the year shows there is potential opportunity in the space.

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.