Understanding the Financial Sector: Banks

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."