Frequently Asked Questions about Bank Industry and Bank Stock Investing

We've found that investors interested in banks and thrifts often have similar questions about investing in the small cap banking sector.  We've listed some of the most frequently asked questions and our answers below:

What Is The Outlook For Consolidation In The Banking Industry?

Consolidation has been a powerful force in shaping the financial services landscape. In 1970, there were more than 14,000 individual banks in the US; today that number is about 8,000, a reduction of more than 40%. However, compared to other industrialized countries, including Japan, Germany, Great Britain, France and Canada, where a handful of banks control the vast majority of banking assets, the US market is still fragmented and over-banked. Bank mergers and acquisitions in the US have averaged more than 400 per year since the mid-1980s, and consolidation seems likely to continue. The primary drivers of consolidation include: expansion, either to increase market share or enter a new geographical area; new product lines; revenue growth; and productivity enhancement.  As a rule, the benefits of bank acquisitions have accrued to the shareholder of the selling bank.

How Will Demographic Changes Affect The Banking And Financial Services Industry?

The largest users of banking services are people between 45 and 64 years of age, a group that is expected to grow significantly over the next 20 years as baby boomers move through their highest earning years and ease into retirement. Over that period, they will be the beneficiaries of an estimated $12 trillion of wealth that is expected to be transferred to them from the previous generation.

What Is The Outlook For Bank Earnings?

Commercial bank earnings have historically outpaced total US corporate profit growth.

What About Dividends?

Bank stocks typically carry dividend yields well above the market, which adds to their attractiveness on a total return basis.  This is especially so after 2003 tax law changes reduced income tax rates on most dividends to a maximum of 15%. Banks tend to pay out 25% to 40% of their annual net income in dividends to shareholders, an amount that balances the need to retain sufficient capital to support growth with the desire to provide an income return to shareholders.  Moreover, for the 10 years ending December 31, 2007, publicly traded banks, as a group, have increased dividends at a 10.2% compound annual rate, based on data compiled from the SNL Financial Data Source database.  That growth rate is more than twice the 4.87% compound annual dividend growth rate for the S&P 500 Index over the same period.

How Do Changes In Interest Rates Affect Bank Earnings?

Banks earn income on the spread between the rates they earn on assets (loans and securities) and the rates they pay on liabilities (deposits and borrowings). Bankers have become adept at maintaining that spread within a relatively narrow band by balancing the duration and maturity of their assets and liabilities. Modest and gradual changes in interest rates have only minor impacts on most bank interest margins. In addition, most banks now earn 20% to 40% of their revenues from non-interest sources, such as deposit service charges, trust fees, and fees for other products and services.

Who Regulates Banks And How Are They Evaluated?

Banking is among the most heavily regulated industries in the US and bank managers must constantly balance the need for maintaining regulatory compliance with returning value to shareholders. The Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision are the industry’s primary regulators, but individual states also play a role. In addition to assessing the overall competence of bank management and the adequacy of corporate governance, bank regulators focus on five areas in evaluating banking companies’ soundness:

• Capital — the level of capital in relation to regulatory guidelines and the bank’s risk profile;
   
• Asset Quality — the composition of assets (loans and securities) and their relative risk;
   
• Earnings—the quality and sustainability of the primary components of net income, including interest margins, non-interest revenues, expense drivers, and the adequacy of reserves;
   
• Liquidity— the bank’s ability to obtain sufficient funds at a reasonable cost in light of the mix of short-term versus long-term assets and core deposits versus volatile liabilities;
   
• Sensitivity To Interest Rate Changes—the balance between short-term and long-term assets and liabilities and the bank’s ability to maintain a stable net interest margin under various interest rate scenarios.

Banks that do not receive passing marks are subject to varying forms of regulatory action, including increased supervision, removal of officers and directors, cease and desist orders, and civil money penalties.