The term "competitive advantage" has become a cliche, something that business people and investors talk about without actually understanding its meaning.

When a company says that its "people are its competitive advantage," for instance, that doesn't do the term justice. Great employees, while important, can be hired by competitors who are willing to pay more. Thus, even if a particular bank has the best people in the industry, it's not an immutable moat.

By contrast, to take a story from history, when Cornelius Vanderbilt operated a steamship line between New York City and San Francisco to serve the Gold Rush of 1849, he ran it through Nicaragua, shaving off hundreds of miles from competing steamboat lines that traversed Panama. He did so under an arrangement with the Nicaraguan government that gave him exclusive access to the shorter route. This translated into lower coal costs, a steamboat operator's biggest variable expense, which empowered Vanderbilt to undercut his competitors' prices while still generating a respectable return.

True competitive advantages, in other words, aren't intangible and immeasurable traits. They're instead obvious and quantifiable.

In the context of banking, size is often cited as one of the greatest competitive advantages in the industry. This follows from two facts:

  • Big banks like Wells Fargo (NYSE:WFC) can spread credit risk over a larger population of borrowers, which, when done correctly, reduces a bank's exposure to downturns in a particular industry or geographic area. In the 1980s, for example, virtually every major bank in Texas failed because their loans were concentrated in the region's energy sector, which was reeling at the time from the consequences of the 1973 OPEC oil embargo.
  • Big banks also benefit from economies of scale. You can see this in the chart below, which breaks down the efficiency ratios (the percent of revenue consumed by operating expenses -- lower is better) of the nation's banks by size.

Wells Fargo serves as a case in point. With $1.7 trillion in assets on its balance sheet, it's the fourth largest commercial bank in the United States. It operates in all 50 states following its 2008 acquisition of Wachovia, serving one in three American households. This comes through in its 58.5% efficiency ratio, which outpaces smaller banks which spend an average of 70% or more of their net revenue on expenses.

It's important for investors to understand, however, that there's more to the competitive advantage of size than meets the eye. In fact, thanks to regulations passed in the wake of the financial crisis of 2008-09, size can now work against a bank as well. This is because the nation's biggest and most complex financial institutions -- so-called systematically important financial institutions, or SIFIs -- must now hold more capital than their smaller, simpler peers.

The biggest and most complicated bank in America, JPMorgan Chase, is required to hold 2.5 percentage points more capital than the slightly smaller and simpler Wells Fargo, as you can see in the figure above -- to be clear, these heightened capital requirements phase in over the next few years. The consequences of this are undeniable. Namely, because banks generate revenue largely by leveraging their capital with vast amounts of debt that's then reinvested into interest-earning assets, a bank that's able to use more leverage has a distinct advantage over one that is obliged to use less.

Taken together, then, Wells Fargo gets the competitive advantage of size (i.e., efficiency), without the competitive disadvantage of too much size (i.e., the capital requirements facing the likes of JPMorgan Chase and Citigroup, among others). Needless to say, this positions Wells Fargo to outperform its rivals in the years to come.