For a couple years now we've been witnessing the nasty fallout from poor decision-making and risk management at major U.S. banks like Bank of America
Banks still don't seem to be out of the woods quite yet. At the same time new government regulation seems to be looming, while the industry can't seem to escape bad press. It wouldn't be surprising if investors started wondering whether it's worthwhile to bother investing in banks at all.
While the industry has certainly been dragged through the mud of late -- much of it self-inflicted -- I think it'd be a mistake for investors to avoid this sector completely.
The banking basics
At the basic level, banking is a very simple and attractive business. Banks take a relatively small amount of capital, leverage it with low-cost loans -- think customer deposits, CDs, time deposits, and short-term debt -- and then make loans at interest rates above what they're paying out.
Through the interest spread, sound management of loan quality, and financial leverage, banks are able to pocket a significant chunk of change for providing their various services. As far as business models go, core banking operations are about as simple as it gets.
This ain't no Johnny-come-lately
While the robotic surgical machines that Intuitive Surgical
This is a significant consideration since it takes a lot of the guesswork out of figuring out whether this will be a viable industry for the next year, five years, or 100 years. While government regulations and "financial innovation" will continue to change the landscape to some degree, we should be able to expect that in the year 2109 there will still be banks and they will still be taking deposits and lending money.
The ugly side of banking
That's not to say that there aren't considerable risks when it comes to investing in banks. As we've seen over the past few years, financial innovation can lead the banking industry down paths that can lead to massive losses and destruction of shareholder value. Unfortunately, it doesn't seem likely that this will change -- even for a short period of time. Massive banks like JPMorgan Chase
But exotic financial operations aren't the only risk that bank investors face. The pages-long list of U.S. banks that participated in the U.S.'s TARP program -- not to mention the 130-plus banks that have failed so far this year -- highlights the fact that even banks that didn't have crazy slicing and dicing securitization arms have fallen on hard times recently. Poor risk management and getting caught up in overextension of credit -- as we saw with the housing market -- can take down even the simplest, most straight-forward bank.
Is there competitive advantage in banking?
Another issue that investors face when diving into the banking industry is trying to find banks that have some competitive advantage to set them apart from the thousands of other banks out there.
When talking about core banking operations, it's tough to bring too much true differentiation to the product. However, there are still opportunities for banks to give themselves a leg up over the competition. Huge banks like Bank of America and HSBC can gain an advantage in efficiency due to their size. Smaller banks such as Umpqua Holdings
The trick, of course, is weeding through the multitude of banks out there and knowing how to find the best of the bunch.
Jumping into the fray
At the outset of the New Year, I'm going to be diving further into the banking industry to review some of the key metrics, explore competitive advantage in the industry, and look at some of the best banks that the public market has to offer. But I need your help. Scroll down to the comments section below and let me know what aspects of the banking industry you'd be most interested in reading about.
Let's make 2010 a year where Foolish investors show that top-notch banks can shake off the industry's ills and be valuable additions to investors' portfolios.
Akamai Technologies and Intuitive Surgical are Motley Fool Rule Breakers recommendations. Umpqua Holdings is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletters today, free for 30 days.
Fool contributor Matt Koppenheffer (sigh) owns shares of Bank of America, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...