For Banks, Debt Is the Tail That Wags the Dog

How do you identify a great bank stock?

That's the question addressed in our latest free report about five things that make a bank great.

But even beyond these factors, there's one advantage that the best banks have over competitors: fantastic deposit franchises.

At the most fundamental level, a bank is nothing more than a leveraged fund. They borrow money at low interest rates and then reinvest that money in higher-yielding assets -- namely, loans and fixed-income securities.

A key component of this equation is the so-called "cost of funds." As the term implies, this represents how much it costs a bank to borrow the funds which it then reinvests. Suffice it to say, the cheaper they can do so, the better.

I was reminded of this recently when reading through a presentation given by the chief executive officer of Zions Bancorp (ZION -2.13%), a regional lender operating in the western half of the United States.

In the midst of his discussion about how the bank plans to decrease its financing costs, he noted that, "If you look at our total interest expense in the second quarter, 75% of it came from long-term debt." But here's the kicker, as he went on to note, "that's despite the fact that deposits are 93% of our funding."

Source: Zions Bancorp.

I apologize for reiterating the point, but as you can see in the chart above, three-quarters of Zion's interest expense came from only 7% of its funding. This truly is an example of a tail that wags the dog.

But while Zions is one of the worst performers in this regard, it isn't alone. In fact, virtually every bank carries some amount of debt if for no other reason than to ensure another source of funding.

You can see this in the table below, which compares the percent of funding that's accounted for by debt (relative to deposits) to the proportion of interest expense.

Source: S&P Capital IQ.

While none of these banks have as large of a disparity as Zions does, all of them are, to varying degrees, in the same boat. M&T Bank leads the way with a 62 percentage point difference, followed by Regions Financial, SunTrust Banks, and U.S. Bancorp, with differences of 61, 32, and 17 percentage points, respectively.

The point is this: Every bank has a different funding profile. But for some, like Zions, the opportunity to improve their metrics rests in part on tweaking this relationship.