When it comes to banking, it's important for investors to keep in mind that bigger banks generally make better investments. There are three main reasons for that, but before getting to them, here's the list of the 10 biggest banks in America by assets:
For much of U.S. history, a bank's size was capped by federal and state legislation. Until 1994, lenders weren't allowed on a national basis to bank across state lines unless the states themselves permitted the banks to do so. And until 1998, they couldn't operate both commercial and investment banking operations under the same roof. Once these barriers were removed, the industry quickly consolidated, yielding the coast-to-coast lenders we know today.
Far from impeding the bank consolidation process, the financial crisis of 2008-09 fueled it. At the government's behest, Bank of America bought Merrill Lynch, JPMorgan Chase purchased Bear Stearns and Washington Mutual, and Wells Fargo swallowed its larger East Coast rival, Wachovia. As a result, we now have four commercial lenders with assets in excess of $1 trillion each -- and JPMorgan and Bank of America's are more than twice that amount.
At first glance, this isn't a welcome development. After all, one of the issues the government had to deal with during the financial crisis was ensuring that the biggest banks in America didn't fail and, by doing so, bring down the entire economy with them. Citigroup alone needed $45 billion from the government just to stay alive.
If you look more deeply into the matter, however, there are three reasons to believe that consolidation may end up being positive for the industry. To begin with, given the heightened legal and regulatory environment, running a bank has become less profitable. Consequently, the economies of scale the biggest banks offer mean that they should be able to provide banking services without passing as much of the added costs onto consumers. Data from the latest quarter confirm this -- banks with less than $100 million in assets on their balance sheets spent an average of 80.4% of their net revenues on operating expenses. Meanwhile, banks with more than $10 billion in assets spent an average of only 62.4%.
Secondly, almost by definition, larger banks are more widely diversified than smaller banks. This matters because one of the principal ways to control risk, and thereby avert failure when the market takes a turn for the worse, is for a bank to spread its asset portfolio across a broad geographic area. In the 1980s, for instance, Texas banks didn't venture far beyond the Lone Star State and were therefore obliterated when oil prices plunged, taking real estate values in and around the oil patch down as well. The net result was that virtually every bank in Texas failed over the following few years.
Finally, from an investor's perspective there's something to be said about some banks being too big to fail. The magnitude of damage that the failure of a big bank would exert on the national economy is just too large to allow it to ever happen. Federal regulators and legislators have accordingly taken steps since 1984 to ensure that our biggest banks don't simply go out of business.
This isn't to say that shareholders in a big bank won't suffer in the course of a government bailout, as they most certainly will. Bank of America and Citigroup provide two cases in point. Thanks to the need to reimburse the government for tens of billions of dollars in aid, they were forced to egregiously dilute their shareholders at the nadir of the financial crisis. The net result is that these stocks are still off their pre-crisis highs by upwards of 90%. But, of course, that's better than stock prices that went to $0.
One can argue all day long about the unjustness of designating some banks as too big to fail while others aren't similarly protected. But having a handful of banks that are too big to fail is far better than experiencing the economic depression that would almost certainly come about if we allowed the market to exact its revenge. Thus, coupled with the other two advantages associated with size, it seems clear that, at least from the perspective of an investor, bigger banks are the way to go.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Wells Fargo. 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.