If you are reading about bank stocks, then you probably know that the sector has been hammered during the coronavirus pandemic. While the S&P 500 is hitting new highs, the KBW Bank Index, which tracks 24 of the largest banks in the U.S., is down more than 33% from the beginning of the year. The KRE index, which measures regional banks, is also down about 33% from the beginning of the year, while the QABA index, which tracks community banks, is down close to 32%.
You’ve probably read plenty of articles about the big banks, both good and bad. But smaller bank stocks often get left out of the fray. Sure, this sector faces lots of challenges and uncertainty right now, but that’s also why some of these stocks could have significant upside. Like many industries, the largest factor weighing on the sector is how soon the coronavirus pandemic subsides and how quickly a vaccine is approved and distributed. But there are still other pros and cons to consider when looking at smaller bank stocks.
Con: Heavy reliance on loans
A problem for smaller bank stocks is the heavily reliance on loans, whereas a big bank like JPMorgan Chase or Bank of America collects a large percentage of its revenue from its asset management or investment bank divisions. Plenty of community banks offer asset management services and most regional banks offer some kinds of capital markets services, but those services make up a much smaller percentage of revenue, most of which is from interest income from loans.
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For instance, for all banks with assets between $1 billion and $10 billion, which is mostly community banks and perhaps some small regional banks, net loans made up close to 70% of total assets at the end of the first quarter of this year, according to the Federal Deposit Insurance Corporation (FDIC). For banks with assets between $10 billion and $250 billion, encompassing mostly regional banks, net loans made up about 64% of total assets. But for the largest banks with more than $250 billion in assets, net loans only made up roughly 44% of total assets, according to the FDIC.
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While loans have always been the main way banks make money, having more loans is not a good thing right now. For one, the coronavirus pandemic has all banks bracing for heavy loan losses. The more that loans make up your portfolio, the more vulnerable you are. Additionally, because the Federal Reserve has dropped rates to zero, many loans are going to see smaller spreads, equating to less total revenue, so the more diversity a bank has in its portfolio right now, the better.
Pro: Smaller banks are under less scrutiny
Some advantages for smaller bank stocks is that they don’t face the same scrutiny from regulators and…
Read More: The pros and cons of smaller bank stocks