The Finance Professor
Understanding the Financial Sector: Banks
Scott Rothbort
03/25/08 - 02:37 PM EDT
Financial service companies have taken the spotlight as the credit crisis has continued to spread from the mortgage market to the equity 
market.
The financial services sector is one of the ten industry groups in the S&P 500. It makes up approximately 20% of this index. This sector is clearly a vital component of the financial markets and the global economy. Yet, a common mistake made by many investors and the media is to lump all of the financial services into one broad category.
As is the case with many industry groups, there are many sub-sectors into which we can divide the broad financial group or overall sector. By differentiating between the range of sub-sectors, as an investor, you can start to identify the opportunities and the pitfalls in your financial-stock selection. This series of the Finance Professor will break down the financial services sector into clearly delineated categories of activity.
Let's start with the banks.
The Money Center Banks
Along with the investment banks (read on), money center banks are at the heart of the credit and mortgage problem. Money center banks typically operate across many states and foreign countries. Their main purpose: provide banking services for individuals, businesses and institutions such as trusts, pension plans and even governments.
What kind of services? Mostly deposit vehicles such as savings accounts, checking accounts and time deposits like certificate of deposits (CDs). Other prevalent services amongst money center banks are safe deposit vaults, trust services, money wiring and custody services.
How money center banks make money: they act as primary dealers in U.S. government securities and have direct access to the Federal Reserve Bank for the purpose of borrowing money at the "discount window." In turn, these institutions will earn their profits by lending money to their clients in the form of business loans, mortgages, and other consumer credit (like credit cards and auto loans). Fee revenues are also generated from many of the services they provide to their clientele.
Examples of some of the larger money center banks are Bank of America BAC, JP Morgan Chase JPM, Citigroup C, Wells Fargo WFC and Wachovia WB.
The Investment Banks
Historically, investment banks provide services under three major categories: brokerage, investment banking and asset management.
Here's a breakdown:
Brokerage. This includes the execution of client orders in an agent capacity for both individuals and institutions , covering the full range of asset classes , such as stocks , bonds and commodities .
The brokerage business also covers institutional trading, where essentially the bank will put up its own capital to facilitate the execution of institutional client trading or for its own proprietary risk-taking.
An offshoot of institutional trading, many brokerages create structured investment products and derivatives , such as mortgage-backed securities , asset-backed securities and over-the-counter derivatives.
The structuring and proprietary positioning of mortgaged- and asset-backed securities have been key drivers in the creation of huge credit market crisis.
Brokerage operations also produce investment research. I cover this concept in greater detail in "Investment Research: Ignore the Ratings, Read the Reports."
services, such as equity and debt issuance. This is often referred to as IPO activity.
Investment banking also provides merger and acquisitions (or M&A) advisory, where the investment bank will work with its big business clients to structure the purchase, sale or merger of one or more corporate entities.
Additionally, investment banks offer asset management (or investment advisory) to high net worth clients, including services that cover mutual funds , separate account management, private equity management and hedge fund management.
As we have seen with the demise of Bear Stearns BSC, investment banks can expose shareholders to great risk (see "Bear Stearns, Financial Investing and You").
However, risk and reward are intertwined, as these companies have the capacity to also generate huge profits when their operations are managed properly and economic conditions are right.
Aside from Bear Stearns, the largest investment banks are Goldman Sachs GS, Merrill Lynch MER, Morgan Stanley MS and Lehman Brothers LEH.
The Savings and Loans
Savings and loans (or S&Ls) are community-based banking institutions which tend to be concentrated in local geographic regions, such as cities or states -- although some have expanded across state lines.
These banks provide many of the same savings and checking services as the money center banks provide. However, S&Ls also provide funding for loans and mortgages to homeowners and small, businesses with a local focus
Many of the current S&Ls are survivors from the last banking crisis in the United States, which led to a government bailout engineered by the Resolution Trust Company (see "Five Lessons From the Mortgage Meltdown").
Since then, some of the current S&Ls got involved in "subprime" lending and mortgage-backed securities. This activity has dragged some, but not all, of the S&Ls directly into the current credit crisis.
Some of the largest S&Ls around today are Washington Mutual WM, Hudson City Bancorp HCBK, New York Community Bancorp NYB and Sovereign Bancorp SOV.
The Demise of the Glass-Steagall Act and You
In 1933 the Glass-Steagall Act was enacted as a measure to help prevent a reoccurrence of the failure of the banking system, which gave rise to the Great Depression . A significant component of that legislation was the separation of money center banking from investment banking and brokerage. As an example, JP Morgan had to separate its commercial bank from its investment bank, which became known as Morgan Stanley.
This all changed in 1999.
Under intense pressure from the money center banks and the investment banks, the Gramm-Leach-Bliley Act was enacted and Glass-Steagall was essentially repealed. As a result, the walls between money center banks and investment banks were broken and many of those institutions began to provide services across the whole banking spectrum.
So today, we see Citi acting as a money center bank, an investment bank and a broker-dealer. Some might argue that it was Gramm-Leach-Bliley that created the environment that led to the credit market crisis that we're combating today, and that if Glass-Steagall was still operable it would have prevented the current "crunch."
The financial sub-sectors and banks discussed in this lesson are those which are most impacted by the current credit market crisis. Other groups and companies have also felt the sting of the decline of the housing and mortgage markets, while some are relatively unaffected.
Next, we'll take a look at insurance companies.
In the meantime, review your portfolio and identify any banks that you might own. Then determine which category they fall into and what risks might be associated with holding them. This same homework applies if you don't own a bank stock right now, but are considering investing in one.
To stay up to date on the banks, bookmark and visit TheStreet.com's Financial Services section.