The Best Argument for Buying Regional Bank Stocks

Regional bank stocks appear to be the industry's long-term sweet spot. Photo credit: iStock/Thinkstock.

If you're going to invest in bank stocks, it seems like the best strategy for the time being is to favor regional banks such as BB&T and PNC Financial as opposed to the nation's largest lenders. There are exceptions to this, but it's a good general rule to keep in mind.

I say this because regional banks still have a lot of room to grow both organically and through mergers or acquisitions. Meanwhile, their too-big-to-failcounterparts can only pursue the first course -- namely, organic growth by way of retained earnings.

Under the Riegle-Neal Act of 1994, which most importantly empowered nationally chartered lenders to operate across state lines, regulators can only approve mergers or acquisitions if the combined companies' deposits don't exceed 10% of total deposits nationwide.

This is a problem for banks like JPMorgan Chase, Bank of America, and Wells Fargo, all of which have already passed the 10% threshold. These banks hold 11.1%, 11.3%, and 10.5%, respectively, of total domestic deposits. Absent a partial repeal of Riegle-Neal, in turn, which seems unlikely given the prevailing sentiment toward the industry, these banks can, for all intents and purposes, only grow by holding onto past earnings.

Banks like BB&T and PNC Financial aren't similarly limited. BB&T's $139 billion deposit base equates to a nationwide market share of 1.32%. PNC Financial's $235 billion in domestic deposits accounts for 2.22%. Both banks are thus free to acquire or merge with any non-too-big-to-fail depository institution in the United States -- assuming they don't run afoul of other rules or regulations.

This is a significant advantage. If you look at the bank industry over the past three decades, mergers and acquisitions have been the primary catalyst for growth of its individual members. Consolidation opened the door for Wells Fargo and Bank of America's nationwide branch networks. And JPMorgan Chase's acquisitions of Bank One and Washington Mutual, among others, allowed it to recapture the top spot in U.S. banking from Citigroupwhen measured by size.

Just as importantly, legislative and regulatory backlash from the role played by too-big-to-fail banks in the financial crisishas hemmed in their profit potential. New laws and regulations now require the nation's largest lenders to hold much more capital on a relative basis than their counterparts in the regional and community banking spaces.

Under the Dodd-Frank Act of 2010, systematically important financial institutions that play a central role in the global financial system must hold an additional "surcharge" of capital to absorb future trading and loan losses. JPMorgan Chase must reserve 4.5% of its capital over the level assessed against smaller banks. Citigroup, Bank of America, and Wells Fargo, must hold an added 3.5%, 3%, and 2%, respectively.

Because banks make money in large part by leveraging their equity by a factor of 9-to-1 or more, requiring them to scale this back means they'll earn less money, almost by definition. Furthermore, when you consider that these same banks can essentially grow only by retaining earnings, their disadvantage compared to regional banks widens.

In sum, while I'm convinced (rightly or wrongly) that there are profitable short-term plays among big bank stocks -- Bank of America and Citigroup, in particular, both of which still trade for double-digit discounts to book value -- I'm equally convinced (again, rightly or wrongly) that the best long-term money to be made in the industry is among high-quality regional lenders like BB&T and PNC Financial.

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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 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.

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