Continue Reading Below
Despite having the second-largest economy in the United States, Texas isn't home to a single major bank.
The state's biggest bank, Comerica, has a modest $70 billion in assets, which ranks 14th among the nation's largest lenders. And Comerica, while based in Dallas, actually traces its roots to a consortium of Michigan banks that entered the Texas market in 1988.
If a bank's size is generally determined by the size of the surrounding economy, then why isn't Texas home to a host of the nation's leading financial institutions?
The answer to this question offers a striking illustration of the relationship between the diversification of banks' loan portfolios and their vulnerability to failure.
Continue Reading Below
The destruction of Texas' banks
Thirty years ago, Texas was home to more banks than any other state in America. They thrived not only on the riches of the state's oil industry, but also on Texas laws banning out-of-state lenders from operating there.
As former FDIC Chairman William Seidman explained in his bookFull Faith & Credit: The Great S&L Debacle and Other Washington Sagas:
Texas had been a locked-up state, with no foreign -- which to Texans meant no out-of-state -- banks allowed. Texans believed their banks were the most profitable, the best capitalized, and the best managed in the country. ... They felt they had too good a deal to share.
But these advantages came to a screeching halt in the mid-1980s.
Thanks to geopolitical developments during the 1970s -- specifically, two OPEC-initiated oil embargoes punishing the United States for its support of Israel during the 1973 Arab-Israeli War -- the price of oil soared from less than $20 a barrel at the beginning of 1973 to more than $114 per barrel by the end of the decade.
This trend reversed itself with equal ferocity in the 1980s. After the embargoes were lifted, the price of oil dropped by 79%. This threw the Texas economy into a recession and led its banks to focus on the commercial real estate market for growth.
One of Texas' leading banks at the time, First City Bancorporation of Texas, serves as a case in point. Real estate accounted for only 20% of the once-venerable Houston-based institution's loan portfolio in 1982. By 1987 that figure had almost doubled to 35%.
Bolstered by tax incentives that catalyzed the flow of capital into commercial real estate, this second boom came to an abrupt end in 1986 after Congress removed the tax incentives as part of a sweeping overhaul of the U.S. tax code. This drove down real estate values and left a wide swath of Texas' bank industry on the brink of insolvency.
By the end of the 1980s, virtually every major Texas-based bank had either failed or been acquired for pennies on the dollar by out-of-state institutions such as North Carolina's NationsBank (known today as Bank of America) and Michigan's Comerica.
A lesson from Texas' bank crisis
Aside from robbing the Lone Star State of its otherwise fair share of nationally recognized banks, the downfall of Texas' major lenders in the 1980s remains a valuable lesson for bankers and bank investors about the importance of a diversified loan portfolio.
It also, as JPMorgan ChaseCEO Jamie Dimon pointed out in his latest shareholder letter, offers a compelling defense for the ever-increasing size of the nation's biggest banks -- JPMorgan being foremost among them, with $2.6 trillion in assets on its balance sheet.
Far from making a bank riskier, Dimon argued, the geographic diversification achieved by large interstate lenders improves their ability to survive localized crises like the one that destroyed Texas' financial industry three decades ago:
Many large banks had no problem navigating the  financial crisis, while many smaller banks went bankrupt. Many of these smaller banks went bankrupt because they were undiversified, meaning that most of their lending took place in a specific geography. A good example was when oil collapsed in the late 1980s. Texas banks went bankrupt because of their direct exposure to oil companies and also because of their exposure to real estate whose value depended largely on the success of the oil business. Since the crisis began seven years ago, more than 500 smaller banks have gone bankrupt, and JPMorgan Chase has contributed approximately $8 billion to the Federal Deposit Insurance Corporation to help pay for the resolution of those banks.
The takeaway is that big isn't necessarily bad when it comes to banking. In fact, if you're interested in not only profiting from bank stocks but also in preserving your capital, then you would be smart to think long and hard before investing in a bank that doesn't have exposure to a variety of industries across multiple geographic markets.
The article Why Almost Every Big Texas Bank Failed in the 1980s originally appeared on Fool.com.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.