There's some good news in the Federal Deposit Insurance Corp.'s latest quarterly report. The banking industry had a profitable year in 2010, its first since 2007. The FDIC expects fewer banks to fail this year than last. The amount banks set aside last quarter for bad loans declined 50% year over year. The deficit -- yes, deficit -- in the FDIC's deposit insurance fund improved to $7.4 billion exiting December from $8 billion exiting September.

The bad news? Last year, the FDIC shut down 157 banks, an 18-year high. The FDIC's list of "problem" banks -- at risk of failing -- grew during the fourth quarter, to a whopping 884 from 860. That's nearly 12% of U.S. banks. About 21% of banks remain unprofitable.

Oh, and a primary reason profits improved in 2010 was because less money was set aside for bad loans. Well, duh. Upcoming regulations like debit interchange fee ceilings have the potential to hurt profit-rich fees. Loan demand is weak. Insisting borrowers actually be creditworthy is also limiting new loans. Even though the steep yield curve creates a great profit environment for banks, profits are still pretty wimpy.

Foolish takeaway
Small and midsized banks are particularly risky. The FDIC doesn't disclose which banks are on its problem list, but its failed bank list is full of community banks.

With regional banks failing, investors may want to be more selective than buying broad exchange-traded funds such as the First Trust Nasdaq ABA Community Bank Index Fund (Nasdaq: QABA), the SPDR KBW Regional Bank Industry ETF (NYSE: KRE), and the iShares Dow Jones US Regional Banks Index Fund (NYSE: IAT). And when researching individual bank stocks, remember that assets on bank balance sheets don't reflect fair values.      

Broader financial sector ETFs are diversified into subsectors such as real estate investment trusts and insurance, which substantially reduces their exposure to problem banks. For example, the Financial Select Sector SPDR (NYSE: XLF) has only 19.3% of assets in commercial banks and 0.4% in thrifts and mortgage finance. The Rydex S&P 500 Equal Weight Financial ETF (NYSE: RYF) has 17.1% of assets in commercial banks and 2% in thrifts and mortgage finance. That said, RYF has greater exposure to small institutions than a market-cap-weighted ETF such as XLF, because of its equal weighting of holdings. In XLF, "too big to fail" banks make up a significant portion of the portfolio weight and mitigate downside risk.

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Fool contributor Cindy Johnson has been underweight financials since 2008, which has been a good move overall (albeit not lately). She does not own shares in any security in this story. No way. The Fool owns shares of SPDR KBW Regional Banking. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.