The business model of banks can be summed up as the management of
three types of risk: credit, liquidity, and interest rate.
Investors should focus on conservatively run institutions. They should seek out firms that hold large equity bases relative to competitors and provision conservatively for future loan losses.
Different components of banks' income statements can show volatile
swings depending on a number of factors such as the interest rate and credit
environment. However, well-run banks should generally show steady net
income growth through varying environments. Investors are well served to
seek out firms with a good track record.
Well-run banks focus heavily on matching the duration of assets with the
duration of liabilities. For instance, banks should fund long-term loans
with liabilities such as long-term debt or deposits, not short-term fund
ing. Avoid lenders that don't.
Banks have numerous competitive advantages. They can borrow money at rates lower than even the federal government. There are large economies of scale in this business derived from having an established distribution network. The capital-intensive nature of banking deters new competitors. Customer-switching costs are high, and there are limited barriers to exit money-losing endeavors.
Investors should seek out banks with a strong equity base, consistently
solid ROEs and ROAs, and an ability to grow revenues at a steady pace.
Comparing similar banks on a price-to-book measure can be a good way
to make sure you're not overpaying for a bank stock.
