Banks are judged largely by their net interest income (NII), which accounts for about 60% of revenue for your typical regional bank (about 40% is from fee income), but NII includes two very different components – income from lending activities and from the bank’s securities portfolio.

NYCB Banks

“Although securities portfolios contribute a comparatively small share of revenue, it is important to note that the incremental margin on this revenue is much higher than the incremental margin on revenue from lending,” writes Citi analyst Josh Levin. “Although investors typically lump together the NII from lending and the securities portfolio into a consolidated earnings or PTPP number, we believe this is misleading.”

Lending and investing shouldn’t be valued at the same multiple: Levin

Levin argues that while lending is a core activity for regional banks, and one that other types of businesses can’t offer, while investing in securities is easily reproducible and doesn’t create shareholder value in the same way. There are differences between the types of risk that banks choose to take when putting together a securities portfolio, but investors can take on credit or duration risk exposure on their own if they choose, they don’t need to get it through their investments in banks. For that reason, Levin doesn’t think it’s reasonable to apply the same multiple to a bank’s investment portfolio as you would to its lending activities or fee income.

If splitting NII into separate streams, each of which should have its own PE multiple, is correct, than it stands to reason that some banks are currently being over or undervalued (since other investors are applying the same multiple across the board).

To figure out which banks those might be, Levin proposes two normalizing securities assets to the industry average as either a percentage of earnings assets or as a percentage of deposits. The first accounts for excessive (or anemic) risk taking by management, while the second accounts for a sudden inflow or outflow of deposits.

NYCB outperforming on securities: Levin

Using an informal straw poll of clients, he values the normalized portfolios at 8x, and concludes that Zions Bancorporation (NASDAQ:ZION) and Comerica Bank (CMA) are underperforming on their securities portfolios while New York Community Bancorp, Inc. (NYSE:NYCB) is outperforming.

His method makes some big assumptions (probably the biggest is that he applies the same yield to each normalized portfolio, which washes out credit and duration risk but also implies that each portfolio is equally well-assembled), so the conclusions should be taken with a grain of salt, but the underlying idea could be a source of new investment ideas.