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Selling Liquidity
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There's no doubt that a top-notch credit culture—along with the subsequent borrower/lender relationships that banks establish—can create a competitive advantage for firms in the industry. Less intuitive, but equally attractive from a business perspective, is the role that liquidity management plays. This is the second main type of risk that a bank has to deal with.

Suppose in a friction-free world that there were no banks and that lenders (depositors) worked directly with borrowers. That's perfectly acceptable as long as lenders know exactly when they'll need their money back. But, if something unexpected happened and the lender suddenly needed cash sooner rather than later, the lender might have to sell the loan for a big discount. In a bank-filled world, however, they can just run to the nearest branch and make a withdrawal.

Banks offer liquidity management services in many forms. For instance, many businesses pay banks a standing fee to maintain a back-up line of credit. Essentially, the bank has sold nothing but a promise. Some firms also sell their receivables to financial services firms at a discount in a service known as fac­toring, because the business wants or needs cash as soon as possible.

Less obvious to many consumers is that they are actually paying for liq­uidity services, as well. Consider the case of Wells Fargo, one of the nation's largest retail banks. In 2OO2, depositors paid the bank $2.2 billion in fees on their accounts. The bank paid depositors about Si.9 billion in interest on de­posits. Netting these two numbers, account-holders at Wells paid the bank nearly $300 million to hold on to their money. Then the bank turned around, lent the money out, and made more money on it.

There is no other business in the world where you can take money from people and effectively charge them to take it off their hands. Can you imag­ine walking up to someone on the street and offering to hold on to his $100 bill if he pays you a few bucks? It's ludicrous. Yet, that's what banks do every day. In this sense, liabilities in the form of deposits are truly assets for banks. Low-cost core deposits (e.g., checking accounts) are very stable and cheap.

This is "why it's important to track deposit levels. For example, check to see whether deposits are increasing or decreasing. In particular, check to see if low-cost deposit categories such as checking and savings accounts are growing. Most banks provide a breakout of deposit categories in their annual reports. If management has been talking about the importance of a strong deposit base and deposits have been declining over the last five years, they aren't getting the job done.

Investors must also pay close attention to a bank's balance sheet. Seek out firms with a diverse stable of loans to prevent rising defaults in any one sector from causing the bank to get into trouble. The annual report shows details about the type of loans a bank holds, and investors should track how it has changed over time. Has a bank that has traditionally been a mortgage lender expanded into indirect auto loans, a much riskier type of lending? It takes time to become familiar with the characteristics of different types of loans, and you shouldn't invest in any financial services company "without a feel for the types of loans it makes and without confidence that the firm has plenty of experience in making those types of loans.

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