When it comes to the stock market, bigger isn’t always better. Everyone heard the phrase “too big to fail” during the most recent financial crisis. The phrase referred to financial institutions that are so large and interconnected that they have become critical cogs in the economy. The idea is that if a “too big to fail” institution were to falter, it could bring down the entire financial system. Therefore, the government needs to step in to help prop up the failing company to prevent systemwide damage.
Large banks are being pressured by multiple sources to decrease their size. For example, Federal Reserve Chairman Ben Bernanke has called “too big to fail” banks a moral hazard, and Mervyn King, the former governor of the Bank of England, has suggested large banks be cut down to size. Former Fed Chairman Alan Greenspan has said that large banking institutions should be broken up by regulators because taxation and fees aren’t sufficient to control their influence and growth.
It’s not just the “too big to fail” syndrome that hangs over large banks, as readers of my recent article on the 10 most vulnerable retail banks are aware. A study by management consulting group CG42 estimates that the 10 retail banks with the greatest numbers of frustrated customers will lose a combined $92 billion in deposits and $5 billion in revenue over the next year.
Top 10 Retail Banks By Vulnerability
Source: CG42
Although these numbers are only projections, the fact remains that many customers of large banks are not happy with their institutions — and the money pulled out of these banks by dissatisfied customers needs to go somewhere. The obvious destination for these funds would be smaller regional banks.
This idea led me to look into the regional banking sector — and what I discovered impressed me enough to dig deeper and name my favorite regional bank stock.
I first looked at the SPDR KBW Regional Banking (ETF) (NYSEARCA:KRE), which is a representation of 78 regional bank stocks. Up 18% this year, this exchange-traded fund is a quasi-equally weighted fund with no single name having an allocation of more than 1.98%. The primary drivers for the regional bank’s performance have been an improving economy combined with the potential for rising interest rates.
Banks borrow at lower short-term rates and lend at long-term rates, locking in profits. In other words, the yield curve is steepening with interest rates, which is creating a perfect environment for banks to profit.
Like regional banks, large banks are also poised to benefit from the recovering economy. However, large banks have heavy headwinds like the “too big to fail” dilemma and a large number of unhappy customers. Therefore, I see regional banks as the better long-term play.
