Better Credit Quality

There are investment opportunities for those willing to do their homework in the banking sector in 2008, analysts say.

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Samuel Caldwell, CFAKeefe, Bruyette & [email protected]

Outlook: We believe that the core-funded components of the KRX, the KBW Regional Bank Index, are among the most profitable and best performing components of the KRX. In 2007, these names have outperformed the balanced and non-core funded banks by over 1500 basis points. We define core funding as tangible equity and non-CD deposits as a percentage of tangible assets. Core-funded banks have at least 60 percent of tangible equity and non-CD deposits funding their tangible asset base.

We believe these banks also display above-average profitability and have greater value in their respective deposit bases. The core-funded banks in the KRX have an average ROA of 1.44 percent over the last 12 months and an average ROE of nearly 14 percent. Return on tangible equity is even better at nearly 23 percent. Net interest margin is also better for core-funded banks, as the average NIM for core-funded banks was 4.47 percent versus 3.63 percent for balanced-funded banks and 3.12 percent for non-core funded banks.

Interestingly, we also see better credit quality from core-funded banks, with NPAs (non-performing assets) at 0.43 percent of loans versus balanced-funded banks at 0.61 percent and non-core funded banks at 1.57 percent of loans. Core-funded banks also have slightly higher capital levels and higher reserves as a percentage of loans.

The core-funded components of the KRX include Bank of Hawaii (BOH), Boston Private Financial Holdings, Inc. (BPFH), Commerce Bancshares, Inc. (CBSH), Cullen/Frost Bankers, Inc. (CFR), City National (CYN), First Community Bancorp (FCBP), Prosperity Bancshares, Inc. (PRSP) Sterling Bancshares, Inc. (SBIB), Signature Bank (SBNY), SVB Financial Group (SIVB), Trustmark (TRMK), UnionBanCal (UB), Umpqua Holdings (UMPQ), Westamerica Bancorporation (WABC) and Whitney Holding (WTNY).

Core-funded banks also have performed well historically. The banks in the group with the highest core-funding mix had by far the best five-year total return at 56.4 percent on average. The banks in the middle group had an average total return of 18.2 percent for the five-year period, while banks in the group with the lowest core-funding percentage had an average total return of 11.9 percent for the five-year period.

Even given the risks of continued rate cuts, core-funded banks are still the more profitable, less risky, better long-term investment, and more likely to outperform near term than less core-funded peers.

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