Aside from housing, the financial industry was one of the hardest hit sectors during the Great Recession. After all, the industry was the main culprit in the downturn, proving all of those cheap loans, risky derivatives and subprime mortgages. So it's no surprise that broad-based measures of the sector, like the iShares S&P Global Financials (ARCA:IXG), plummeted during crisis. However, as the global macro picture continues to stabilize, the banking sector has shown some muscle. The sector's recent outperformance coupled with growing positive data points could finally make it a buy.

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Lending Increasing
While the banks still face many challenges (i.e. Europe), things are beginning to look up for the sector. Overall, the capital markets seem to be picking up, with credit improving dramatically, along with demands for new loans. According to the Federal Reserve, commercial and business loans rose nearly 6% during the second half of 2011. This echoes similar findings from "The Big Three Banks" of Citibank (NYSE:C), Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM). The trio reported that fourth quarter lending of 2011 was significantly higher than in the fourth quarter of 2010.

Moreover, these loans now have a better chance of being repaid. Problem loans and delinquencies have been falling as the economy continues to improve. Additionally, the recent $20 billion settlement with state attorney generals will provide relief to an estimated 2 million homeowners facing foreclosure. Ultimately, this can be seen as stabilizer for the sector. In the short term, the fees will take a toll on these institutions, but in the long term, it will put an end to the crisis.

With lending beginning to improve, the financial industry is set to increase profits. Banks make money on the spread between which they borrow and at which they offer loans. With short-term rates at historic lows, that spread is wide and banks can get a decent return for their lending activities. In addition, as interest rates rise over the next few years, that net interest margin would increase. This is due to the fact that a bank can usually raise the rate on their loans faster than they have to raise the rates on their deposits, leading to a greater profit spread.

Making a Deposit
With the economy exhibiting the classic signs of an early-stage recovery, it may be time for investors to consider the sector for a portfolio. So far, the expansive Financial Select Sector SPDR (ARCA:XLF), is up around 11.5% in 2012, but more gains could be ahead as the economy strengthens.

The SPDR S&P Bank ETF (ARCA:KBE) allows investors to hone in on the opportunity for an improving lending environment. The ETF tracks 40 different banks, including the previously mentioned Big Three as well as regional's like BB&T (NYSE:BBT). The fund has lost an annualized 17.2% over the last five years, but could see improved profits throughout 2012. Likewise, the fund's miniscule 1.61% dividend yield should see improvement as more banks begin returning excess cash to shareholders. The PowerShares KBW Bank (ARCA:KBWB) can also be used, and offers a more concentrated portfolio of banking firms.

Given the ongoing issues with regards to Europe and housing, perhaps the best plays in the banking sector are the small community banks dotting the country. After all, these smaller institutions haven't extended loans to Greece, and never dabble in fancy derivatives. The First Trust NASDAQ ABA Community Bank (Nasdaq:QABA) can be used a proxy for the sector.

With nearly $27 billion in assets, People's United Financial (Nasdaq:PBCT) could be a great individual choice. According to asset manager Raymond James, the bank trades at 91% of its estimated book value and has been seeing improving credit quality. Shares of the bank yield a healthy 5%. Similarly, Community Bank System (NYSE:CBU) could be a great choice as well, as it finishes a 19-branch acquisition from First Niagara (Nasdaq:FNFG). Analysts estimate that this will lead to great cost-savings opportunities and mid-single digit EPS growth. CBU yields 3.9%.

SEE: An Inside Look At ETF Construction

The Bottom Line

As one of the worst sectors during the Great Recession, the banking industry may have finally turned the corner. Lending data is finally on an uptrend and non-performing loans are decreasing. For investors, now could be time to bet on the sector. The previous picks, along with the Bank of the Ozarks (Nasdaq:OZRK), make great choices to play the trend.

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

Tickers in this Article: XLF, C, JPM, WFC, IXG, KBE, KBWB, QABA, PBCT, CBU, FNFG, OZRK

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