WFC Total Return Price data by YCharts .
The two principal downsides to investing in traditional banks are that, as already mentioned, they're less diversified than universal banks, and they tend to be less efficient because they don't get as of a boost from economies of scale. The typical traditional bank with less than $100 million in assets spends more than 80% of its net revenue on operating expenses, compared to only 62% for the average $10-plus billion bank, according to FDIC data .
Importantly, Wells Fargo and U.S. Bancorp are exceptions to this. Both of these banks run notoriously lean operations, with efficiency ratios that have historically trended toward 50%. The significance of this can't be overstated, as the efficiency ratio is arguably the single most important metric when it comes to identifying great bank stocks.
3. Investment banks
Publicly traded investment banks are somewhat of a misnomer in the aftermath of the financial crisis, as few emerged as independent, stand-alone entities. One that did is Lazard , a $4.1 billion firm that specializes in advisory work and asset management.
Meanwhile, three of the five biggest investment banks on the even of the crisis either failed or were acquired by better capitalized commercial banks in 2008:
- JPMorgan Chase bought Bear Stearns
- Bank of America acquired Merrill Lynch
- Lehman Brothers went bankrupt
The two others, Goldman Sachs and Morgan Stanley , survived only by converting to bank holding companies. This gave them access to the Federal Reserve's discount window, pre-empting likely liquidity crises at both. But it also means that the storied Wall Street firms have as much in common with universal lenders as they do with pure-play investment banks.
This nuance aside, the benefit of investing in firms like Goldman Sachs and Morgan Stanley (and Lazard) is that they expose your portfolio to some of the best and brightest minds on Wall Street, if not across America. The detriment is that they do so without the offsetting diversification of a universal bank, which counterbalances its investment banking business with consumer and commercial lending.
4. Custodial banks
The fourth type of bank is the most mercurial -- custodial banks, such as The Bank of New York Mellon , State Street , and Northern Trust .
These banks provide the infrastructure for America's capital markets. They stand between institutional investors such as pension funds, sovereign wealth funds, and university endowments on the one hand and the universal banks that manufacture and distribute fixed-income securities and derivatives on the other.
As I explained in a piece last year about The Bank of New York Mellon:
What's particularly interesting about these two banks is that you'd never know the extent of their role in the global financial system merely by looking at their balance sheets, which rank among regional banks in terms of size. For instance, U.S. Bancorp most recently weighed in at $416 billion in assets, while The Bank of New York Mellon and State Street came in at only $377 billion and $247 billion, respectively.
The difference is that most of the assets administered by custodial banks aren't on their balance sheets, but are instead classified as assets under custody or management. The Bank of New York Mellon oversaw $28.5 trillion worth of such assets for clients as of the end of the third quarter 2015, while Boston-based State Street had $27.7 trillion. This is why the CEOs of both firms were among the dozen financial executives that worked alongside government policy makers at the nadir of the financial crisis. It's also why they're both classified for regulatory purposes as systematically important financial institutions.
The benefit to owning shares of these banks -- as Warren Buffett's Berkshire Hathaway does in the case of The Bank of New York Mellon -- is that the barriers to enter their field are insurmountable for all but a few of the biggest financial companies in the world. This presumably should help them protect their margins and generate above average profitability over an extended period of time. The detriment, however, is that, like investment banks, they offer little diversification that could help offset a decline or temporary setback in their primary business lines. They're also, like the biggest universal banks, subject to elevated capital requirements compared to run-of-the-mill traditional lenders.
5. Niche banks
The final type of bank that you can invest in consists of a hodgepodge of niche lenders -- banks like New York Community Bancorp and SVB Financial Group , the parent company of Silicon Valley Bank.
Superficially, these banks resemble traditional lenders. But the difference is that they concentrate in specific industries. New York Community Bancorp specializes in financing rent-controlled multifamily apartment complexes in the New York City metropolitan area. SIVB Financial Group provides financial services to start-up companies in and around San Francisco, California.
Both models have worked well for these banks in the past, with New York Community Bancorp in particular ranking among the best-performing bank stocks of the past quarter century. Its biggest competitive advantage is its pristine record of risk management. Because the buildings that collateralize its loans are rent-controlled, and thus almost always 100% occupied even in the worst of economic times, its borrowers rarely default. While the average bank charged off 2.9% of its loan portfolio in 2010, New York Community Bancorp's net charge-off ratio crested at a mere 0.2%.
The problem in New York Community Bancorp's case, however, is that it recently announced a merger with a more traditional lender that could dilute this advantage. Moreover, because its merger partner, Astoria Financial , outsources much of its credit risk to third-party mortgage originators, as discussed at length here and here , it opens up the possibility that New York Community Bancorp's history of outstanding risk management could be in jeopardy.
Either way, the detriment associated with owning shares of New York Community Bancorp and SIVB Financial Group is that they will rise and fall with the industries they cater to -- multifamily real estate in the former's case and technology in the latter's. To be clear, neither of these are necessarily bad investments; they're just potentially less resilient than, say, a universal bank like JPMorgan Chase or Wells Fargo.
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The article The 5 Types of Banks You Can Invest In originally appeared on Fool.com.
John Maxfield owns shares of Bank of America. The Motley Fool owns shares of and recommends Berkshire Hathaway and Wells Fargo. The Motley Fool has the following options: short January 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. 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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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
