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Regional Banks are the New Black

  +Follow November 26, 2013 9:56AM
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In about any industry operating in a free market system, the end game is market consolidation. In most nascent fields, it starts with a lot of small companies competing. Then the weak are culled from the herd, and there are fewer, larger companies. After awhile, there are even fewer. Eventually, the biggest three or four end up duking it out pretty much nonstop, and sometimes ending with just one Globochem-like behemoth ruling an entire industry. At that point, the government steps in to level the field, and the Standard Oils and Bell Telephones get broken up, to begin the whole cycle anew.

But something fascinating is happening in the world of banking. While there are unquestionably major, long-established market leaders in the US – the “Big Four” of Bank of America (BAC) , Wells Fargo (WFC) , JP Morgan Chase and Co. (JPM) and Citigroup (C) – the financials sector is experiencing something of a re-emergence from the little guys. An indie revolution, if you will.

In an industry literally driven by the bucks, it makes sense that the banks with the most money would be able to effectively squeeze out the competition without blinking an eye. But both customers and investors continue to propel regional banks, which so far have had a stellar 2013. To illustrate this success, look at investments that track a wide swath of the regional bank industry. The well diversified exchange traded fund SPDR KBW Regional Bank ETF ($KRE), which tracks 78 different regional bank, is up an impressive 41.51 percent on the year.

In a market that logically should be dominated by the big boys, why are regional banks not just surviving, but thriving? To answer that question, it helps to answer two other questions: why do customers still use regional banks, and why do investors continue to invest so heavily into them?

The Customer Case for Regional Banks

Regional banks tend to be friendlier to customers and offer surcharge-free ATM transactions. For the average customer, that’s pretty much all they want out of a bank. Lower prices attract more customers.

And how can regional banks, who have far less capital to work with, undercut the Buig Four on prices? Equities.com’s quantitative research analyst Nicholas Bhandari explained it as being a result of the Big Foiur being “squeezed for cash. (The Big Four’s) lines of business are so diversified. So the reasons they’re getting squeezed may have nothing to do with the commercial banking sector.”

In short, how they treat customers is not necessarily tied into how the economy is doing. Bhandari pointed out that in 2013, with the economy improving, “some of these regional banks can actually give customers better interest rates, and not charge for as many things, and they turn out to be better options” for customers.  

But it’s not just the tangible prices that attract customers. The gut feeling of trust continues to drive customers into picking smaller banks, with Bhandari saying simply “Regional banks are comfortable. And customers trust them more”

The Investor’s Case for Regional Banks

That diversification of the Big Four’s business model that distorts the relationship between the performance of the economy and the performance of those stocks is also what draws retail investors to regional banks.  Regional banks, in their lack of diversification into complex investment banking areas, tend to be cleaner plays with less unexpected risks.

Bhandari explained that “The Big Four have their fingers in so many different industries that it’s almost impossible to determine their risk exposure, when they’re going to take a huge trading loss. You’re not getting a pure play on commercial banking – even with Wells Fargo it’s a little wishy-washy. With regional banks, you’re getting a pure play on the banking industry, which is almost a pure play on the economy.” So regional banks, and to a wider extent regional bank ETFs, continue to be popular with retail investors who like a simpler, less opaque play on the market.

So when the economy is doing well – as it is in late 2013 – regional banks follow suit. As the economy continues to improve, regional banks should carry on defying the overarching trend of capitalism and encroach on the established market leaders.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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