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The current credit crunch has decimated America’s banking sector and the list of casualties seems to expand by the day.  Yet I profoundly believe that investors need to have some exposure to financials, particularly regional banks, as the sector has and will continue to produce extraordinary amounts of wealth.

Due to the hybrid nature of the U.S. banking system, with both state and nationally chartered banks, there are still a considerable number of participants in the marketplace, and while bank consolidation has been occurring nearly continuously for the past twenty years there is still significant consolidation that needs to take place.  This consolidation will likely occur between the local and regional banks as the money center banks such as Bank of America (NYSE: BAC) and Citigroup (NYSE: C) lack the resources and the ability to expand into every market.  With the current difficulties being experienced by the weaker regional and local banks, the ones that remain strong and well capitalized well likely benefit greatly over the next several years as they are able to gain market share.

In order to participate in this sector it is important to know what you are looking for while researching any particular regional bank.  After all, you do not want to end up picking the next blowup or IndyMac Bancorp (NYSE: IMB).  I am going to try to write about some of my favorites in the coming weeks but first I wanted to give my readers an idea of what I am looking for. 

I strongly believe that regional and local banks are incredibly cheap right now, especially with the artificially low interest rates being put in place by the Federal Reserve and I urge every investor to take a second look at the sector.  It is only a matter of time in my opinion before the large institutional investors and mutual funds begin to take positions in some of the better banks.  Here is a link to a blog entry I wrote discussing the start of the mutual fund inflows into the sector, you may find it worthwhile.  Interest by institutional investors in the sector, coupled with strong earnings well likely prove to be a catalyst for the stock price of the better regional banks.

One of the most important characteristics of a strong regional bank is the strength of the bank’s management team.  Management should have considerable experience in the field, a long time association with the bank they are presently employed with and a significant ownership interest in the company.  I have found in the past that the management has been especially effective and therefore protective of the bank’s capital if they are members of the founding family or investor group; during times like these this is definitely something you want in management.  This is because a strong capital position ensures that the bank’s management has the ability to take advantage of opportunities that will likely present themselves in the future.

The second most important thing that should be considered when looking at regional banks to invest in is the bank’s loan portfolio.  I have found that the best regional banks generally steer away from residential loans in favor of commercial loans.  Banks tend to do this because commercial loans tend to have higher interest rates, higher levels of collateral (that tends to be more liquid), and allow for the building of better and more intimate client relationships.  Along with looking at the bank’s loan portfolio, make sure to evaluate the banks level of non-performing assets to loan loss allowances and the credit quality of the portfolio in general.  If there is anything funny looking I would stay away.  A large number of construction and/or land loans should be considered a warning sign as well. 

Management’s commitment to the bank can be measured by the plans for the future that the bank has.  All well run banks are continuously looking to expand their geographic footprint as well as to enter market places where they have some kind of distinct advantage that well allow them to succeed.  Their quest for deposits should in no way be discounted, as they will provide the bank with the resources it needs to expand its loan base.  Often times the best banks will partner with local business leaders and/or community banks when first entering the marketplace.  If you find this, I would bet almost anything that you have found a winner.  Partnering like this should not be viewed as a sign of weakness but as a sign of strength, as it shows that management realizes its limitations and is reaching out to others in order to over come these limitations.

When you are buying most bank stocks you are in actuality buying the bank’s holding company.  It will therefore be important to determine the financial health of the holding company, as it can be a point of major stability for the main bank.  Furthermore, if the holding company holds other financial service businesses this should be seen as a good thing as it adds diversification to the holding company.  Some of the better banks own insurance companies, brokerage firms and other specialty finance companies.  For the most part their liabilities usually never fall down to the bank and instead tend to use the bank’s client base as their own, increasing the holding company’s revenue per client.  

 Now for some numbers. I strongly advise that you find local and regional banks with a return on equity of between 12% and 15% and a tier 1 capital level of over 10%.  If you can find a bank with a return on equity of over 15% with no issues and of similar characteristics to those I mentioned above you have found a winner.  Good luck with your search, I’ve got a couple banks I’ll try to write about over the next several weeks.