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You Can't Control the Banking Meltdown, but You Can Control What You Do About It

Motley Fool - Thu May 11, 6:45AM CDT

Banks are supposed to be boring, but they are anything but that in 2023. At this point, there's no way to pick which of the smaller banks, if any, are heading down next, with wild price gyrations showing up on a daily basis. The way to handle this tense environment is to take a safety-first approach.

What went wrong?

The key to understanding today's banking crisis is to look at the business models behind the trio of midsize bank failures.

One bank was servicing the cryptocurrency industry, a high-risk and high-volatility niche. Another focused on servicing young tech companies, another high-risk area. And the latest failure, First Republic, courted high-net-worth customers who could most easily move their money to another bank. In other words, each had inherent risk in their business approach.

A group of businesspeople walking into an office building.

Image source: Getty Images.

And yet the real problem was that these banks, like many others, had a mismatch between their bond investments and cash demands. Banks are allowed to keep long-term investments on their balance sheets at face value if they say they will hold them to maturity.

With interest rates on the rise over the past year or so, the value of these investments declined (interest rates and bond values generally move in opposite directions). This isn't a problem unless customers start quickly pulling out a lot of money, creating a so-called bank run. Then these banks have to sell the held-to-maturity assets at a loss, and the financial strength that they seemed to possess proves to be illusory.

Any bank could fall prey to this mismatch, but the largest, highest-quality banks are less likely to face such problems. A couple of banks you might want to look at are actually found north of the border.

Sidestepping it all

Bank of Nova Scotia(NYSE: BNS), or Scotiabank, is an interesting option. While the stocks of other banks have nosedived this year, this particular bank has just kept trucking along. The reason? It has minimal exposure to the U.S. market, preferring to focus on its Canadian home market and key countries in Latin America (Mexico, Chile, and Peru).

The strong relative price performance doesn't mean that there is no risk; it just means that Scotiabank isn't facing the same kind of risk. Indeed, operating in Latin America is hardly a risk-free endeavor.

BNS Chart

Data source: YCharts BNS

And yet, with a hefty 6% dividend yield, investors are being paid very well for the risks they are facing. But there's an important factor to consider on the risk front: Scotiabank is based in -- and generates 42% of its earnings from -- Canada.

This is important because the Canadian banking sector is highly regulated, giving the biggest names (which include Scotiabank) entrenched positions. The regulations have also resulted in a generally conservative bias among that country's big banks, which permeates their business no matter the country where they operate. Notably, Scotiabank has paid a dividend since 1833.

Handling it in stride

Another Canadian bank to consider is Toronto-Dominion Bank(NYSE: TD). It benefits from the same conservative bias as Scotiabank, but it has exposure to the U.S. market. The dividend yield is about 4.6% today.

That said, TD Bank, as it is more commonly known, has a very diversified business model, with one of the highest Tier 1 capital ratios in North America (it was No. 2 on the list at the end of the company's fiscal first quarter of 2023). The Tier 1 ratio is a measure of how well a bank is prepared to deal with adversity, with the higher the number, the better. The bank has paid a dividend for 166 years and counting.

Put simply, TD Bank is equipped to take a hit. Meanwhile, it largely operates in Canada and along the U.S. East Coast. So despite being a top 10 bank in North America, it still has plenty of room to expand by heading west in the U.S.

That said, it just canceled a deal to buy First Horizon(NYSE: FHN) because of regulatory headwinds. But that might have been a net win, given the stock declines in the midsize banking sector. TD Bank has ample capacity and room to grow organically while it looks for another acquisition.

A little or a little more

For investors trying to get a handle on the banking's industry's troubles while still ferreting out opportunities, the best course of action today is probably to minimize risk. One way to do that is to take on as little U.S. exposure as possible, which is where Scotiabank stands out. The other is to err on the side of caution with a large, conservative bank that is prepared for adversity, which is where TD Bank shines.

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Reuben Gregg Brewer has positions in Bank Of Nova Scotia and Toronto-Dominion Bank. The Motley Fool recommends Bank Of Nova Scotia. The Motley Fool has a disclosure policy.

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