Read This Before You Invest in a Regional Bank

An introduction to investing in regional banks.

David Post
David Post
Jul 16, 2014 at 4:46PM

Before investing in a regional bank, it is important to know a few key facts about the industry.

Unlike their big bank brethren, those in the regional bank industry typically follow a more traditional banking model.

That model looks like this:

Basically, regional banks attract deposits, find borrowers, and make money on the difference in interest between the two. While doing this they make and lose money from non-loan related activities.

To better understand this model and how the industry is affecting it, lets take a look at a regional bank operating in the Midwest, Huntington Bancshares (NASDAQ:HBAN).

Attracting deposits
The majority of loan-making funds in regional banks are obtained through deposits. The responsibility for bringing these in typically falls on the bank's retail operations.

Banks attract our funds by offering interest on money we deposit in things like savings accounts and certificates of deposit. However, competing for these deposits is difficult -- there are 138 regional banks in the Midwest, not counting local and national competitors to choose from. 

Regional banks, with their local branches and insight, are typically better able to position themselves among the masses based on convenience and customer service.

Huntington is currently winding down from a marketing blitz started in 2009 that increased its marketing budget by 120% highlighting its Fair Play policy in banking. 

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Making loans
Attracting deposits is tough, which is why making loans aren't just being used to make money, but as a key customer retention tool. The industry term is cross-selling and attempts to retain and increase the revenue per existing customer.

A customer who has his savings account and mortgage from the same bank is less likely to switch banks than someone who merely has a checking account. Convincing that individual to use the bank for the loan on his new car strengthens these retention ties and increases his profitability to the bank.

Huntington rakes in more than 60% of its revenue from its cross-selling efforts, which it calls its Optimal Customer Relationship (OCR) initiative. The majority of this comes from the consumer side of the bank with 77.8% of customers using four or more Huntington products. 

That is pretty remarkable when you consider the average for getting customers to use that many products at other banks is only 19%. 

Quality of loans
Of course, it's not enough just to make a mass amount of loans -- the financial crisis taught us that lesson. It's the quality of the loans made that matter, and one way of analyzing this is by analyzing the loan's earning power.

Earning power of a loan can be measured by net interest margin (NIM), the difference between interest made on loans and interest paid on deposits as a percentage of average earning assets. A good NIM is generally between 3% and 4%.

A couple different factors influence NIM; however, one major one is the activity of the Federal Reserve.

When the Fed dropped its interest rate by 5% between 2007 and 2009, Huntington's NIM decreased 25 percentage points. To put this into perspective, a NIM drop like that for Huntington equals about $90 million.

This highlights a distinct peculiarity of the banking industry -- extreme profit sensitivity to the actions of government.

Non-Interest Expenses
Decreases on loan margins aren't the only thing that can affect the profitability of a bank. Non-interest expenses --or the operating expenses, of a bank must be kept in check.

A large majority of these expenses are related to running a bank's branches which have historically served as the main point of interaction between a bank and its customers. Mobile banking, which allows banks to operate without high-overhead branches, aims to disrupt this paradigm.

In addition to online operations, Huntington is meeting this industry shift by modifying its branch expansion model. Of the 120 new branches it aims to open in its recent push into Michigan, 80 will be in-store locations. 

These branches are lower cost and act as a physical element in an increasingly digital banking landscape. 

Non-interest income
Although loans are the main way a bank makes money, they are not the only way. Money a bank brings in from other sources like fees are called non-interest income.
With interest rate income being so fickle, banks have been putting a heavier reliance on developing revenue streams from other sources. Over the past decade, revenue from non-interest sources has gone as high as 40% of total revenue. 

Huntington is right around the average with 36% of total revenue coming from non-interest income, but recently made a rather counter-intuitive move. 

Since 2009, the bank has dropped many non-interest income sources, including a policy cutting lucrative overdraft fees. It's all part of the banks Fair Play approach to attracting deposits. The move has seemed to pay off -- change to non-interest income is minimal while deposits have increased by nearly 20%. 

Use the model
Huntington offers a great example of a typical regional bank and is doing a good job at forging a name for the bank in the future. Of course there are other ways and factors that impact the way a regional bank operates within the industry. This basic model offers an introduction to deeper analysis.