Our thoughts on the banking industry’s widespread competitive advantages.
by Jim Callahan, CFA | 05-01-06 | 06:00 AM

You might be surprised to hear that nearly all banks have a sustainable competitive advantage–an economic moat. Warren Buffett and Charlie Munger were surprised, too. Buffett once remarked, “Charlie and I have been surprised at how much profitability banks have, given that it seems like a commodity business.”

At Morningstar, we’ve long recognized the moats of banks, and it’s nearly impossible to understate their importance. Without a robust analysis of a company’s competitive advantage and the sustainability of that advantage over time, investors run the risk of buying one-hit wonders that burn out fast…along with shareholders’ money.

At Morningstar, we begin each new analysis with the idea that a company has no economic moat until one is proven. But our financial services team believes that the banking industry offers an exception to the rule. We would argue that every bank has, at a minimum, a narrow economic moat.

To review some fundamentals, an economic moat represents a company’s ability to earn returns above its cost of capital and defend its ability to do so over time. After confirming that a company’s historical returns on invested capital exceed its cost of capital–the easier task–one must assess the likelihood of those surplus returns persisting in the future, and here’s where mistakes can be made.

Below is a table of the most common sources of wide economic moats, a brief description of each, and their application to the banking industry. We will then get into some of the more important moat sources for banks.

Sources of Economic Moats

Factor Description Application to Banks
Intangible assets (brands, patents, government licenses, etc.) Unique non-physical assets that limit competition or allow a firm to charge higher prices. Regulation played a more important role historically, and we believe that the industry will continue its long-term trend of deregulation.
Cost advantage Important for commoditylike industries in which pricing power is nil. This advantage is often created through economies of scale. How a bank funds its loans plays a big role in its profitability– banks have access to lower-cost funding than most other businesses.
High customer switching costs When customers are willing to pay higher prices for their convenience or because they can’t easily get serviced elsewhere. Banks have surprisingly high switching costs.
Network effect A rare factor most often seen in technology industries, this is the widespread adoption of a first-mover’s product or service until it becomes the standard. Not applicable to nearly all banks.

The Beauty of the Deposit-Gathering Business

We believe that the true value in the banking industry is in the deposit business. The cost of banks’ deposits can vary widely, ranging from market-rate-bearing deposits to non-interest-bearing deposits. This is because deposits, unlike any other form of debt, can generate revenue. (Imagine being paid to take out a mortgage!) When factoring in the income generated from deposit service fees (think ATM charges or overdraft fees), some banks are actually getting paid to hold depositors’ funds.

Consider this: Banks can borrow money more cheaply than the U.S. government. The U.S. government is known as a risk-free borrower and, therefore, should command the lowest interest rates on its borrowings in the market. Of the largest banks by asset size, we found a five-year average effective deposit cost (interest costs net of deposit service fees) of 1.14% compared to a 2.13% average short-term Treasury bill over the same time period. In fact, a full 87 of the 113 banks (77%) we analyzed boasted average effective deposit costs below that of Uncle Sam’s borrowing rate since 2000, while six banks actually generated deposit fees in excess of their deposit interest costs. Some of the more attractively funded banks we cover, as measured by their average cost of deposits over the last five years, include TCF Financial TCB , Provident Bankshares PBKS , and Cullen/Frost Bankers CFR .

The Advantage of Regulation

We believe that the heavy regulation of the past provided many banks a head start toward their dominant market shares. After the Great Depression, the banking industry became highly regulated. Banks were essentially granted government licenses to operate their depository and lending operations within a specified state or even county.

Further, banks were required to pay depository insurance, allowing the government to guarantee bank customers security from bank runs. The result was that, for any given operating area, one bank dominated the market, had barriers protecting it from new entrants, and was given below-market funding due to the risk-free nature of the deposit business. As long as the bank’s borrowers didn’t default, it was almost guaranteed a profit based upon the spread earned between the cheap funding and the interest rate on its loans. (Further, since the industry became highly fragmented, numerous banks–each operating within their own small market–often had loan officers and customers that developed deep relationships that lasted for years.)

Over the decades, of course, things have changed. Banks can apply for a charter to operate in any state and can engage in many nonbanking businesses, such as investment banking, asset management, and insurance brokerage. But the foundation upon which the industry was formed is still present. The banks that dominated certain cities 75 years ago remain (in various forms) today. Think of Wells Fargo WFC in San Francisco, Fifth Third FITB in Cincinnati, and Washington Mutual WM in Seattle. We believe that this stems from banks’ integral roles within their respective communities: In assessing risk, they must know a borrower well, and in making loans, a bank is essentially financing the growth of a community over time.

Switching Costs

On a related note, we’d highlight the surprisingly high switching costs in the industry. Now, at first glance, it would appear easy enough to switch accounts from one bank to another. However, on average, deposits have proven to be fairly “sticky.”

The development of alternative distribution channels–first ATMs, then in-store branches, then Internet banking—have made banks more accessible to customers. This availability lowers the chance of a customer leaving simply because a competing bank’s branch is more convenient to, say, the workplace or school. Online bill payment and automatic direct deposits further increase a deposit account’s “stickiness.” It can be tedious setting up payees and dollar amounts upon initiating an online bill payments, making the thought of switching to another bank and having to go through the process again somewhat of a mini-barrier to exit. (We say mini-barrier because, as we speak, various technology firms are developing software to help transfer such information from one bank to another with the simple click of a button.) The bottom line is that the average life of a deposit account is surprisingly long, offering banks more opportunities to earn the spread between its borrowing and lending activities.

A Caveat: International Banks

The U.S. market is somewhat of a special case. Our comments thus far have focused on the U.S. banking industry, and the biggest difference when looking beyond the domestic banking market is that, unlike in the U.S., many countries’ banking industries are largely consolidated. In fact, the U.S. ranks as one of the most fragmented banking industries in the world. Although the moat characteristics we’ve described broadly apply to the international banks we follow, there are exceptions to the rule, and we’d advise thorough research prior to investing internationally. (See our two-part article from January on how we approach investing in international banks.)


Banks are good businesses because of their fundamental design. Although many believe that banking is a commodity business, we believe that the basic business of banking and the industry’s average profitability tell investors something different. Simply put, the proof of the industry’s narrow economic moat is in the numbers: The average bank over the last 15 years has generated a 13%-14% tangible return on equity, above our 10%-11% estimated cost of capital. Those are the kind of numbers that turned the heads of Buffett and Munger.

A quick review of Morningstar’s bank coverage reveals 59 domestic banks and 29 international banks. Of the domestic banks, 49 have narrow moats and 10 have wide moats. Currently, we believe the best investment opportunities are in large-cap, wide-moat banks, and we encourage investors to take a closer look.

CommentBy Gannon:

Superficially, banking appears to be a commodity business. In fact, it appears to be a particularly poor commodity business, because capacity is not constrained by the need to invest in a substantial physical infrastructure. True, whatever investments are made in tangible assets are usually intended as a means to acquire more intangible assets; however, a branch is hardly comparable to an oil well.

A bank’s ability to lend money (and thus produce income) is not completely and inextricably linked to the size of its deposits. In other words, loans are the result of both a bank’s capacity to lend money and its willingness to lend money.

It’s hard to find a parallel in tangible commodity businesses. Theoretically, this should make little difference in the long run. However, the lack of physical supply constraints in the market for loans creates the possibility for large, industry-wide mistakes. Pricing in such an industry can get very weak at times.

There’s one catch here. The underlying assumption whenever the commodity business label is used is that both the demand for a product and the supply of that product are general in nature. They can’t be specific, because that would destroy the involuntary nature of pricing within the industry.

For example, if all pineapples were unbranded, identically tasting fruits the demand side of the business would meet the requirement for a commodity business. However, if most pineapples take eighteen months to grow, but there is one magical plantation where the fruit develops fully in just three months, the supply side of the business does not meet the requirement for a true commodity business. The magical pineapple plantation would produce six times as much fruit per acre and thus the plantation owner would be able to undercut his competitor’s prices. He would earn extraordinary profits, because the return on capital in his business would be much higher than that of the industry as a whole.

What does this fairy tale have to do with banking? It suggests extraordinary profits can come from having “sticky” customers or lower costs. The lower costs needn’t be the result of lower marginal inputs. The magical pineapple plantation turned the crop over faster; it didn’t need access to below market prices for any of its inputs.

The same is true of a grocery store. Two stores that buy and sell cans of soup at the same exact prices may have very different returns on capital, if one of the stores turns over its inventory more quickly, because the fixed costs will be spread over a larger number of sales.

How does this relate to banking? While a quick turnover (or some other form of operational efficiency) is the most common reason for one firm’s unusual profitability in a commodity type business, there are other ways to earn extraordinary profits. Some of them are conceptually quite similar to the idea of owning a magical, one of a kind pineapple plantation. In such situations, the product appears the same to the consumer; but, the producer is actually unique (or at the very least special).

All of this helps to explain why some banks are more profitable than others. However, it doesn’t address the question posed by Morningstar. So, do all banks have moats?

Before answering that question, it might be best to ask under what circumstances all banks could have moats. What could insulate an entire industry from the ravages of competition? This is the question I discussed in the podcast episode: “Nature of Competition”. Why can some industries support plenty of profitable players, while others merely support a handful, one, or none?

Switching costs are one of the most commonly cited reasons for a wide moat. I think the matter is actually a lot more complicated than that. Financially prohibitive switching costs do create moats. However, most wide-moat companies don’t have truly prohibitive switching costs. What they do have is a situation in which it makes little sense to switch to a competitor and/or a tendency for their customers to not actively seek to learn more about competing products.

Where the cost of a product is particularly small per cash outlay, consumers are usually apathetic about seeking out alternatives. The key here is that the amount has to seem very small to the buyer at the time the purchase is made.

If you buy a cup (or two) of coffee every morning, it does not occur to you that you are spending hundreds or thousands of dollars a year on that coffee and that you could save a lot of money by buying the cheaper alternative. However, if you’re buying an appliance or piece of furniture the difference is immediately obvious and thus price is a major concern.

Generally, if a product can be sold over and over again at a very low price per transaction, profits will be higher, because the buyer will not make much of an effort to compare prices. Likewise, if a customer is billed for a variety of different products or services each amounting to only a small charge, the customer’s price awareness will be lower than if the charges were combined and listed as a single item.

Where price visibility, comparability, or immediacy is reduced, extraordinary profitability becomes more likely. People are very sensitive to price differences between large, juxtaposed numbers. If tomorrow the federal government prohibited gas stations from posting their prices per gallon, drivers would begin to become less concerned about gas prices.

There would be an uproar at first. But, over the years, gas prices would receive less and less news coverage and would fall off the list of consumer concerns. Obviously, a crude oil price quoted in dollars also contributes to price awareness. But, the point remains the same. Where prices are less visible, price competition is less fierce.

Compounding is a great way to exploit a lack of price awareness. The differences between various interest rates always seem small when placed side by side. Over time, these differences become quite large. However, the fact that no large differences are clearly visible at the time a decision is made about where to bank helps to minimize price competition between banks.

It also increases the relative importance of other aspects of banking like convenience and service. Usually, the cost to make a good impression is very low compared to the size of the assets that could result from attracting more deposits.

On the other hand, the importance of making a good second and third impression is minimal. Once a depositor uses a particular bank, he is unlikely to visit competitors. When he needs to do his banking, he will go directly to his own bank (or its website).

This is very different from the environment found in most consumer businesses. Packaged goods companies have their products placed next to their competitor’s products on store shelves. Retail stores are usually clustered. Whether they are located in malls or in free standing buildings, it’s a safe bet the customer has to pass at least one competing retail outlet to shop at their favorite location. In most cases, the other location won’t compete in every category as the customer’s favorite store; but, it will offer at least some competing products. As a result, the shopper is offered the option of switching every time she makes the trip.

When someone walks into a bank, it’s usually their own bank. They don’t have any use for other banks (after all, their money isn’t there). The cost of switching banks isn’t very high. However, the amount of active effort required to make the switch is substantial.

Switching banks isn’t as easy as switching toothpaste. But, more importantly, the alternative isn’t as obvious in banking. We all know other banks exist. But, unless we have a reason to consider switching from our current bank, we don’t even bother to check out the competition.

The result is a very narrow, very real moat.