Since the financial crisis, banks of all makes and models have been broadly painted as risky investments. In some cases that may be true, but in others it isn't. You just need to know how to tell the difference between the stable, low-risk options and the banks that have rightfully earned their risky reputations.
What makes a low-risk bank stock
The business of banking is built on risk. Banks make loans, and those loans must be repaid. If they aren't, then the bank will suffer losses and could even fail if enough loans go bad at the same time. But some banks do a better job of managing that risk, and they do it in a few specific ways.
First, these banks have diversified income streams. They aren't totally dependent on just mortgage loans or just commercial real estate or just investment banking. Some of their income comes from lending, some from insurance, some from wealth management, and so on. If there's trouble in the loan business, the other revenue streams can dampen the effect, and vice versa.
Low-risk banks also avoid business lines that increase their overall risk profile. Lending is risky enough; that's why conservative banks generally don't engage in complex derivatives trading, investing in hedge funds, or making large bets in the stock market. Think Main Street instead of Wall Street.
Further, low-risk banks maintain capital and liquidity levels in excess of regulatory requirements. Having a fortress-like balance sheet protects the bank from unforeseen economic problems, rising problem loans, and ultimately losses.
One of the easiest ways to accumulate capital is through retained earnings, meaning that strong capital and strong earnings typically go hand in hand. Strong earnings also drive a bank's valuation higher and can fuel dividend increases. That's why the lowest-risk banks paradoxically tend to have the best returns on assets and equity through all stages of the credit cycle.
Last but not least, low-risk banks generally have a history of making good loans. The credit cycle is one of boom and bust. Therefore, as low-risk investors, we should seek out banks that have proven cultures of prudent and profitable lending through both expansions and contractions. There's no guarantee that these institutions have problems in the future, but you'd be excused for believing that they'll have fewer and smaller issues than their less historically prudent peers.
Wells has a traditional business model that relies on a combination of interest income from loans and fee income from wealth management, insurance, brokerage, and deposit products. It's an old-school approach for the third largest bank in the U.S.
The bank reported a common equity Tier 1 ratio of 10.5% as of the second quarter, well in excess of regulatory requirements. Net income for the quarter was $5.7 billion, which translates into a return on assets of 1.3% and a return on equity of 12.7%.
The easiest way to judge Wells' performance through prior credit cycles is to review its total return price, a measure that incorporates the bank's stock price and dividends. Loan losses are the largest variable in bank profits over the long run. As a result, the banks that minimize them the most will show the best performance. Total return price is thus an excellent proxy for this.
The story is largely the same with M&T Bank. The company's CEO, Robert Wilmers, described M&T's purpose by saying that: "To me, banks exist for people to keep their liquid income, and also to finance trade and commerce. ... [M&T will] find ways to continue to attract deposits, make sound loans, and grow in accordance with our historic credit quality standards."
No mention of derivatives trading, excessive leverage, or anything remotely high-risk. It's all about serving the basic financial needs of Main Street businesses.
M&T reported a common equity Tier 1 ratio of 9.92% for the second quarter, with an ROA of 1.18% and an ROE of 9.37%.
And, similar to Wells Fargo, M&T has an exceptional history of success through multiple credit cycles.
About as low-risk as you can get
Banking is unique among business models in that loans, the primary product banks sell, must be returned to the bank for it to survive. It's a fundamentally different approach from any other business -- with the exception, perhaps, of car rental companies. And yes, it can be pretty risky.
However, with a little homework into the metrics that matter, any investor can find bank stocks that present a markedly lower risk profile than the rest of the industry. Wells Fargo and M&T Bancorp epitomize those banks, and for the low-risk investor, they are a great place to start your research.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends 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.