The Best Business Model for Banks

By Markets Fool.com

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While there is no such thing as the perfect business model for banks, there are a number of factors that make certain banks more profitable than others. Here are the four most important.

1. Bigger can be better
First and foremost is size. While it's true that bigger isn't necessarily better, size helps an otherwise well-run bank further outpace the competition.

This is because bigger banks can spread their overhead costs -- from marketing, compliance, and other operations -- over a larger revenue stream. Smaller banks generally allocate a larger share of their net revenue to operating expenses than larger banks.

According to the Federal Deposit Insurance Corporation, banks with less than $100 million in assets on their balance sheets spent an average of 80.4% of their net revenue on expenses in the first quarter of this year, compared to only 62.4% for banks with more than $10 billion in assets.

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2. Geographic diversification
Bigger banks also tend to be more geographically diversified than smaller banks. Bank of America , the first truly national bank following its 1998 merger with NationsBank, is a textbook example. Its 4,835 branches stretch without interruption from California to Florida.

This matters because geographic diversification insulates a bank from regional economic downturns, such as the deep recession that enveloped the oil patch in the mid-1980s. As JPMorgan Chase chairman and CEO Jamie Dimon explained in his latest letter to shareholders:

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.

3. Product-line diversification
Along these same lines, it's important for a bank to offer a variety of fee-based financial services in addition to simply accepting deposits and making loans. This reduces the sensitivity of a bank's earnings to interest rate fluctuations, as fee-based businesses often do better when interest rates fall. It also reduces the pressure on banks to reach for yield (and thus risk) in their loan portfolios.

As Wells Fargo chief financial officer John Shrewsberry noted earlier this year during the company's fourth-quarter conference call:

The benefit of our diversified business model is that we have over 90 businesses that performed differently based on interest rates in the economic environment.

While the balance between spread and fee income has remained consistent over time, the drivers of fee income have varied. For example over the past five years, mortgage banking as a share of total fee income has been its highest 28%, but because of the decline in mortgage refinancing activity, mortgage banking fees have declined as expected and represented 15% of fee income in the fourth quarter.

However, other businesses have benefited from current market conditions; our trust in investment fees have steadily increased over the past five years and were 36% of fee income in the fourth quarter.

These examples demonstrate the benefit of our diversification and how our business mix enables us to focus on meeting our customer's financial needs, while retaining our risk discipline.

Mike Hagedorn, president and CEO of UMB Bank, made a similar point in an interview with American Banker magazine:

If you're competing for the highest quality credit, by definition it's going to be on the lower end of the pricing spectrum. ... If that's what's important to you, then how do you supplement lower yields in your loan book? And you do that with the diversity that fee businesses bring to your revenue streams.

4. A culture that promotes prudence and efficiency
Finally, it's critical that a bank has a deeply ingrained culture that promotes both lean operations and prudent risk management.

No company has done this better than Wells Fargo. It's so good at balancing these cultural traits, in fact, that competitors have long sought to poach executives from Wells Fargo to help them instill their own version of the so-called "Wells way."

A perfect example is Jerry Grundhofer, one of the masterminds behind the 2000 merger of equals that spawned U.S. Bancorp . As Bank Directormagazine's Jack Milligan explained at the time:

Grundhofer, like his 61-year-old brother, rose through the ranks of Wells Fargo bank in California. Both took to heart the 1980s-era cost management principles instilled by former Wells chief executive Carl Reichardt. Jerry would later adapt what became known as the "Wells way" -- an intense focus on efficiency balanced by strategic investments and generous employee incentives -- into what might be terms a "Firstar way."

Given this, it should come as no surprise that these two banks are far and away the best-managed large lenders in the country -- or that they've generated some of the industry's best shareholder returns since at least the mid-1980s.

So if you're looking for the best business model for banks -- one that translates into a stable and profitable investment -- then you could do worse than Wells Fargo and U.S. Bancorp. Both are big, well-diversified, and governed by cultures that emphasize the two most important qualities of successful banks: efficiency and prudence.

The article The Best Business Model for Banks originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. 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.