When it comes to opportunity in the banking sector, there are few better places to explore than the vast expanse between community lenders and their money-center brethren. Sandwiched in the middle are a wide array of regional banks.

Small enough to adroitly manage their operations yet large enough to serve corporate clients and diversify risk across multiple states, some of the best-heeled regional lenders have offered investors extraordinary returns over the past few decades.

What is the regional bank industry?

Given the term's familiarity, it may come as a surprise that there's no agreed-upon definition for a regional bank. Theoretically, these institutions occupy the space between community banks and money-center lenders. But beyond that, and particularly on the margins where these classifications come into contact, there's considerable room for interpretation.

The closest thing to an official definition is provided by the FDIC's characterization of midsize banks. "We call 'midsize' any banking organization (bank or thrift holding company, independent bank, and independent thrift) that has aggregate assets of more than $1 billion, excluding the 25 largest banking organizations," an analyst at the agency wrote in a 2004 study. Even she was quick to note, however, that "although banks of this size are often called regional banks, some are heavily concentrated in one market or one state: in many ways they are more like super-size community banks."

Given this, it's helpful to define regional banks according to certain characteristics. In the first case, these are large lenders. They almost, by definition, must have at least $1 billion in assets to eclipse the realms of community banking. By the same token, anything above $1 trillion almost necessarily qualifies one as a money-center institution. In the second case, as the name implies, a regional bank's loans and deposits generally derive from multiple states as opposed to just one. And finally, even though regional banks are in many cases sizable institutions, they still confine the lions' share of their activities to those of a traditional bank -- that is, taking deposits and making loans.

How big is the regional bank industry?

Using these characteristics as a guide, one can get a relatively good feel for the size of the regional bank industry in the United States.

At the end of 2012, the FDIC counted a total of 6,788 banking organizations. Of these, 6,194 had less than $1 billion in assets on their respective balance sheets and are thus considered community banks. An additional 330 shared enough qualities with local lenders that they too were given the community bank classification. This left organizations that were large and geographically dispersed enough to be characterized, at the very least, as regional banks.

Breaking the final subset down further, the FDIC concluded that only four institutions were so large that it simply wouldn't be accurate to consider them regional lenders. These are the so-called money-center banks. They are huge. One could even argue that they are beyond a person's ability to genuinely contemplate their scale. Included in this group are JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo. Together, at the time of the FDIC's 2012 report, these four banks alone accounted for nearly $6 trillion in assets, equating to 45% of the entire bank industry's holdings.

This leaves 260 bona fide regional lenders. At the time, these institutions accounted for approximately $1.2 trillion in collective assets, or slightly less than 10% of the industry's total. Among these are well-known lenders like Minnesota-based U.S. Bancorp, Pennsylvania-headquartered PNC Financial, the mid-Atlantic lender BB&T, and SunTrust Banks in the Southeast.

How does the regional bank industry work?

The business model of a regional bank is relatively straightforward. Like any other enterprise, a bank's owners seed it with capital -- on the balance sheet this is referred to as equity. The capital is then leveraged by accepting deposits from customers and arranging for credit lines from other financial institutions. Finally, the combined proceeds are lent to borrowers or used to buy fixed-income securities such as Treasury bonds or, quite commonly, mortgage-backed securities.

The net result is that most regional banks make most of their money by arbitraging interest rates. That is, they pay depositors a fraction of a percent to borrow money and then lend the very same funds out at, say, 5% to individuals or institutions in need of capital. The difference between what they pay and receive in interest contributes to their revenue and thus profit.

Beyond interest income, moreover, there is a multitude of ways these lenders earn so-called noninterest income. They charge monthly fees for checking accounts. They assess overdraft and insufficient fund fees. They collect fees to originate mortgages and auto loans. And particularly in the case of the bigger players, they generate revenue by arranging stock and bond sales, facilitating mergers, and providing consulting services that were once the exclusive province of investment banks.

What are the drivers of the regional bank industry?

The profitability of a typical regional bank derives from three sources. In the first case, given that most in this classification generate a considerable portion of revenue from arbitraging interest rates, it stands to reason that these rates are the primary driver of bank earnings. The ideal environment is one in which short-term interest rates are low and long-term rates are high. In this situation, the yield curve is said to be steep.

An inherent paradox in the system is that a steep yield curve generally materializes in the immediate aftermath of an economic downturn. And during downturns a second driver of profitability, the credit cycle, weighs on bank earnings as a result of elevated loan losses. We saw the latter exert its influence following the financial crisis, during which regional lenders such as SunTrust, Regions Financial, and Huntington Bancshares were forced to dilute their shareholders in order to replenish capital lost due to imprudent lending.

The final driver of profitability for regional banks is the efficiency ratio, which measures how much an institution spends on operating costs relative to top-line revenue. It cannot be emphasized enough how important this variable is when the typical investors scours the industry for a regional bank to invest in. Indeed, virtually every bank stock that's been worth owning over the last few decades has been a leader on this front, with an efficiency ratio somewhere between 40% and 60%.

The bottom line on regional banks

Every sector and industry has a unique set of risks and rewards. And while the regional banking space is no different, it offers enormous opportunity for enterprising investors. Pick up the wrong one and you could lose your entire investment during the next banking panic. But by picking the right one and holding onto it for decades could singlehandedly make you rich.