A Smoother Ride for Smaller Banks

 | Feb 23, 2012 | 5:00 PM EST
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The way Uncle Sam tells it, smaller is better -- at least as far as banks go. Recently enacted legislation smooths the way for banks with less than $10 billion in assets. But banks that expand beyond that threshold trigger a series of regulations aimed at making the financial system safer and less prone to significant shocks.

It's no surprise that with these extra demands come additional complexity and expenses for these banks. Banks with $10 billion or more in assets come under the watch of the newly created Consumer Financial Protection Bureau, which requires these banks to strengthen their risk-management measures and undergo annual stress tests.

This regulatory oversight gives banks with less than $10 billion in assets a significant edge over banks in excess of that figure. Some CEOs whose banks are nearing the $10 billion threshold are choosing to forgo growth in exchange for avoiding the additional layer of regulatory oversight, and the costs that come with it.

Bank CEOs are acutely aware of tripping this wire. Citizens Republic Bancorp (CRBC), for example, has decided to stay below the $10 billion threshold. CEO Cathleen Nash recently told The Wall Street Journal that she believes staying below $10 billion is important for the time being. Investors interested in buying bank stocks should take note of something else Nash said in that interview: "You don't have to always be bigger to be more profitable."

In addition to less oversight, many small regional banks have extremely clean and well-capitalized balance sheets. That makes them incredibly attractive investment opportunities, as they trade at depressed valuations due to the stigma still associated with the financial industry. Capital Federal Financial (CFFN) is an exceptionally clean thrift with less than $9 billion in assets. The Kansas-based bank trades at book value, which may seem expensive in today's world. But CFFN generates a return on assets of 0.7%. In addition, it has committed to paying a vast portion of its earnings as dividends, suggesting a disciplined management team. Shares already yield 2.6%.

Much-smaller bank Oneida Financial Corp (ONFC) also illustrates the advantages of being small. The upstate New York bank generates a return on assets of 0.8% and yields an incredible 5%. Oneida is a recently converted thrift, so its capital structure is very solid. Shares trade for about $9.50 against book value per share of $12.50.

Also, consider this: Wells Fargo (WFC), arguably the best run of the big banks, generates a return on assets of 1.2%. For a smaller bank to generate that kind of ROA, it is an indication of a very well run, conservative institution with a clean balance sheet. And with a less onerous cost structure going forward, these banks are likely to remain profitable.

The entire banking industry is depressed right now. Issues with the larger banks carry over to the smaller ones, despite the smaller banks having no financial issues to speak of, except for a lower-growth environment. That reduced growth opportunity is mitigated by a lower cost structure. Investors would be well served to look at smaller banks given the arbitrage created by this regulatory environment.

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