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It's All about Risk
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Banks possess an enviable spot in the global economy. They're the funnel in the capital formation process and the engine that keeps the car humming. Without banks, corporations would struggle to scrounge up money to expand, and consumers would face a near-insurmountable obstacle in their quest to buy a home or to profitably save and invest. Because the service that banks provide is so vital to long-term economic growth, the banking industry is almost certain to grow in line with the world's total output, no matter which sector generates the greatest need for capital. Whether the demand for money comes from an industry such as technology or pharmaceuticals or consumers' incessant demand for housing, banks will benefit.

The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers, profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as nomnterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.

Banks have a number of inherent strengths that help create a competitive advantage. By assembling large, diverse portfolios of loans, banks reduce their risks and pass some of the resulting savings along to all borrowers, thus lowering the cost of capital in the marketplace compared with what it would be if borrowers and lenders worked directly with one another. 1 This unique advantage forms one of the bases for a strong and lasting economic moat for the banking industry.

In addition, the federal government has all but given the keys to the liq­uidity kingdom to banks by essentially subsidizing the banking industry The federal government guarantees well over half of the banking industry's liabilities (via FDIC insurance), and banks can turn to the Federal Reserve as a lender of last resort if they're caught in a short-term liquidity crunch. These implicit subsidies, which other corporations don't have, allow banks to effectively borrow at below-market rates. They also make the banking industry the lowest cost, safest producer of liquidity in the world. The low cost of borrowing—combined with the advantage banks have on the lending side—allows banks to earn attractive returns on their spread.

That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank better than another? There isn't a formula, but throughout this chapter, we'll show you what to look for. Here are a few examples of wide-moat banks with different strategies:

Citigroup uses its worldwide geographic reach and deep product bench
to increase revenues and diversify its risk exposure, which allows it to per­
form "well in even difficult environments.

Wells Fargo is an expert at attracting deposits, which are a key source of
lower cost funds, and it has a deeply ingrained sales culture that drives
revenues. Fifth Third has an aggressive sales culture, a low-risk loan philosophy, and a sharp focus on costs.

Whether a financial institution specializes in making commercial loans or consumer loans, the heart and soul of banking is centered on one thing: risk management. Banks accept three types of risk: (i) credit, (2) liquidity, and (3) interest rate, and they get paid to take on this risk. Borrowers and lenders pay banks through interest or fees because they are unwilling to manage the risk on their own, or because banks can do it more cheaply.

But just as their advantage lies in mitigating others' risk, banks' greatest strength—the ability to earn a premium for managing credit and interest rate risk—can quickly become their greatest weakness if, for example, loan losses grow faster than expected.

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