There has been a lot of consolidation in the banking industry lately, and the next few years will probably see even more.
In this segment from the Industry Focus: Financials podcast, Gaby Lapera and David Hanson explain how the sector's regulatory environment has changed since the financial crisis, and why consolidation is the best way for many banks to survive it.
A transcript follows the video.
This podcast was recorded on April 25, 2016.
Gaby Lapera: The other thing that I was reading is that apparently consolidation has increased among banks, and I think that's mostly due to the regulatory requirements. Banks are required to have so much capital on hand that's just hard for the smaller banks to survive in this regulatory environment. The other piece of news that I saw today about small banks is there is this guy, what was his name? He used to work for Warren Buffett and he left under a haze of, something fishy happened with their stock trading.
David Hanson: I know what you're talking about; his name escapes me as well at the moment. Yeah, it was a couple years ago.
Lapera: He is actually out in Virginia now, and he owns a huge interest in Middleburg Bank, which is a local bank, and he is pushing to get them bought by someone else, because he says that anyone under $2 billion can't survive. I think to the average person, you hear $2 billion and you think, "whoa, that's a lot of money." But in banking, it's really nothing.
Hanson: Not when you're dealing with balance sheets that have trillion-dollar asset bases; for JPMorgan [Chase] (NYSE:JPM) or Bank of America (NYSE:BAC), $2 billion is a rounding error for them. On the consolidation in those banks, big banks becoming bigger, that scares some people. There are obvious downsides to that; it's very hard to understand everything that's going on in banks as they consolidate and get bigger. I know you and Jay talked about that last week, too. I think you mentioned Citigroup (NYSE:C); I look at Citigroup's 10-K and it's like, what in God's name is this business? And what's going on in here?
But I think there is a benefit to that as well, that the perceived complexity, or the actual complexity of these big banks, may artificially depress the valuations that they're getting as well. Maybe that's always going to be an overhang, but I think if you take the other side of that, it may be a benefit. You're saying, there's this bank out here that has a lot of earning power, Citigroup, JPMorgan, Bank of America, they have the potential to generate returns on equity over 10%. But because they're so complex in the short run, people don't fully understand where all that's coming from. You can pay less for it. I think there's a balance there that's like, you have the complexity of Citigroup, but you're getting a discount because of that complexity. As opposed to a small bank that you may look at and say, "I understand exactly what they do, they're only in West Virginia doing this type of loan." In that lack of complexity you're going to probably have to pay more for that on the valuation side. I don't fully say "complex bank bad, never buy it" I think you're always paying for it regardless of whether there's a lot of complexity or not.
Lapera: As we've been seeing with the oil-patch banks, that lack of diversity can really hurt a bank in the long term if things go sour for them.
David Hanson owns shares of JPMorgan Chase. Gaby Lapera has no position in any stocks mentioned. The Motley Fool recommends Bank of America. 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.