The process of identifying suitable bank stocks seems hard, but it really isn't.
In previous articles, I've discussed the two most important characteristics underlying great banks -- namely, demonstrated histories of prudence (i.e., low loan losses) and thrift (i.e., a low efficiency ratio).
In addition to these, however, it's my opinion that investors should add one more fundamental metric to their screening process. That is, as a general rule, you should avoid banks that don't generate a considerable portion of total revenue from noninterest income.
How big of a portion? I'd recommend 40% -- though, to be clear, there are certainly exceptions.
While it probably seems obvious that noninterest income is important -- it is, after all, income -- what's critical to appreciate is that it is not an end in itself. Its true importance lies instead in the spillover effect it has on risk management.
For one thing, by decreasing a bank's reliance on net interest income -- that is, the difference between a bank's cost of funds and its income from earning assets -- noninterest income reduces the sensitivity of a bank's top line to changes in interest rates.
This may not seem important right now, as short-term interest rates are only bound to increase and thereby boost most banks' net interest income, but this won't always be the case. At some point in the future, interest rates will once again be high and the Fed will find it necessary to push benchmark rates back down. It will be at that time, in turn, that noninterest income will act as a stabilizing force.
Additionally, by reducing the focus on net interest income, fee income diminishes the pressure on a bank's executives to maximize profitability by reaching for yield -- which is typically accomplished by loosening credit standards in the short run and, consequently, increasing loan losses in the long run.
This is a point that Mike Hagedom, the president and CEO of UMB Bank, which is a subsidiary of UMB Financial, touched on in a recent interview with American Banker:
If you're competing for the highest quality credit, by definition it's going to be on the lower end of the pricing spectrum. [...] If that's what's important to you, then how do you supplement lower yields in your loan book? And you do that with the diversity that fee businesses bring to your revenue streams.
Now, just to be clear, a lot of banks pass this test, many of which aren't suitable for the average investor's portfolio.
In 2013, for instance, Bank of America generated almost 53% of its income from fee-based sources such as investment banking, trading, and wealth management. And in case you're wondering, it's my opinion that Bank of America isn't a prudent investment for the typical investor.
Additionally, some very good banks, such as M&T Bank, only slightly exceed the 40% threshold. Last year, a total of 41% of its net revenue derived from noninterest income.
Thus, at the end of the day, this isn't a hard-and-fast rule. It's instead a rough guideline that investors can (and should) use at the outset of identifying specific bank stocks that are worthy of further research.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.