Have banks branched out too far?

In an effort to jump-start revenue growth, increasing numbers of banks in recent years have moved into businesses that promised better returns than plain old lending. At first many of those efforts paid off as a steadily rising stock market ignited profits in newly acquired trust management, investment banking and stock brokerage businesses.

But now, as the economic slowdown and increasing competition squeeze profits in these areas, investors and analysts are wondering whether the diversification kick was indeed such a good idea. The plunge in first-quarter profits at a number of newly diversified banks illuminated the risk many banks took on by buying into faster-growing but more volatile areas. The lesson, observers say, is that beyond a few well-managed names, diversification isn't a recipe for success for banking investors.

Paying the Price

Putnam Lovell

banks analyst Jennifer Thompson says banks' weak first-quarter results point to what she calls the price of revenue diversification. "A lot of these large-cap banks have been pretty aggressive in getting into asset-management and investment banking," says Thompson. But she notes that doing so comes at the cost of increased volatility and uneven results.

Indeed, nowhere is the unevenness more evident than at

J.P. Morgan Chase

(JPM) - Get Report

, which used its private equity arm to jump on the New Economy bandwagon by investing heavily in technology start-ups. The unit has been largely responsible for an earnings roller coaster at the firm. A

blowout first quarter in early 2000 was succeeded by increasingly weaker ones, with operating profit tumbling 65% in the fourth quarter and 28% in the first quarter on a year-over-year basis.

Banking and financial services are "very difficult businesses to run consistently profitably on a risk-adjusted basis," says David Hendler, global financial services analyst at

CreditSights.com

. "Some players look really smart and profitable, but it's because they are taking big risks. Chase's venture capital unit looked incredibly profitable, but on a risk-adjusted basis it wasn't."

Costs and Benefits

And in an increasingly competitive environment, banks that haven't branched out with a well-thought out plan are finding themselves squeezed out of certain businesses altogether. "A much slower U.S. economy has started to expose the fact that the emperor has no clothes," says Hendler, who believes

Wachovia's

(WB) - Get Report

belated attempt to play the expansion game may have cost it its independence.

Wachovia's foray into national syndicated lending eventually yielded an uptick in

bad loans last June, contributing to a fiscal-year profit shortfall and catching many investors off-guard. And last month, Wachovia sold its $8 billion credit card portfolio to

Bank One

(ONE) - Get Report

, saying it couldn't properly compete in the business.

"You can't just buy expertise overnight or expect new businesses to work overnight," says Hendler. "Too far behind to morph into a brokerage or asset-gathering specialist, the company seemed to throw in the towel and throw its fate in with the gods of

First Union

(FTU)

." Last month, Wachovia made a sudden and surprising

decision to merge with First Union in a deal that had virtually no premium for Wachovia shareholders.

How to Play It

Of course, not all of the new business ventures have proved unsuccessful. For

Bank of New York

(BK) - Get Report

and

Mellon Financial

(MEL)

, trust and custody management has been a steady and extremely lucrative business, which has given the banks rich valuations. As most banks struggled with falling profits in the first quarter, Bank of New York boasted a 14% gain, while Mellon's earnings rose 8%.

Still, as Hendler points out, "There are only maybe a half dozen players in the U.S. that have a shot at making

trust their primary franchise. Going out to buy it now might be very expensive."

For those trying to predict the winners in the growth game, Hendler says the handful of banks that have sustainable business models and can "crank out revenues and profitability through different credit, interest rate and economic cycles" usually fall into two camps, specialization and cost-control. Specialization can mean focusing on a narrow area of expertise, such as credit cards, but it can also mean being skillful at playing the merger-and-acquisition game, he says.

Not surprisingly,

Citigroup

(C) - Get Report

and

Wells Fargo

(WFC) - Get Report

are pegged for their strong track records on acquisitions. "Both have a seasoned executive who is disciplined in the acquisition process," which means not overpaying for deals, says Hendler.

And Midwestern bank

Fifth Third

(FITB) - Get Report

draws consistent praise from a number of corners. "I think the model for expansion is Fifth Third," says Christopher Marinac, banks analyst at

Robinson Humphrey

in Atlanta. "They never really got into the brokerage business, but it hasn't stopped them from producing consistent profit growth quarter in and quarter out," he says.

Stephen Gresdo, manager of a hedge fund and co-founder of

bankstocks.com

, has a similar view. In the past he has called the bank a company you "can set your watch to" and described its performance as "consistent excellence." Thompson, of Putnam Lovell said Fifth Third "once again took the top spot in our rankings."