Regional banks ready to rally

In 2012, large bank stocks have outperformed regional banks.

NEW YORK (CNNMoney) -- Investors may be able to find some big bargains while betting on smaller regional banks.

Financial stocks are in the midst of a 2012 comeback, but shares of regional banks haven't enjoyed the same surge as their larger peers. While Keefe Bruyette & Woods' large bank index (BKX) is up more than 26% in 2012, its regional bank index (KRX) is up about 15.5%.

Still, analysts say it could be time for the stocks of regional banks to shine.

Several hundred banks closed or were taken over by the FDIC since 2008. The remaining community and regional banks are a healthier bunch and are well positioned to benefit from the nascent uptick in demand for consumer and business loans.

"So many banks went belly up during the crisis that the regional and community banks that are left are in much stronger condition to pick up market share now that lending is picking up," said Scott Siefers, head of equity research at Sandler O'Neill.

Merger activity among community and regional banks may finally be set to increase too.

California bank Pacific Capital Bancorp (PACIFIC CAPITAL BANCORP) agreed to be bought by UnionBanCal for $1.5 billion earlier this month, a 60% premium to Pacific Capital's share price.

Several investment bankers and analysts say we're in the beginning of what's expected to be extensive consolidation among the roughly 7,000 U.S. banks.

The too-big-to-fail set of banks are mostly excluded by regulators from engaging in M&A activity by regulators. But regional banks may be ready to pounce. Investment bankers said lenders with assets between $500 million and $2 billion are in the sweet spot for many potential acquirers.

In a recent note, Keefe Bruyette & Woods listed First Horizon (FHN), BancorpSouth (BXS), Regions Financial (RF, Fortune 500), and Synovus Financial (SNV) as banks that could look to sell themselves.

While investors continue to pore over individual earnings reports from large banks like Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) to determine who is now healthy, investors have largely painted regional banks with one broad brushstroke

"Whether you were a good or bad performer, regional banks were cut off at the knees equally," said Josh Siegel, a managing director at StoneCastle Partners, an asset management that invests in community banks. "Investors started thinking that most regional banks were sitting on land mines of embedded losses."

Siegel said now many regional banks have overestimated potential losses from potential defaults and are now rolling back what they had in reserve as payments pick up.

Of course, some regional banks may still run into trouble. Analysts say investors should avoid regional banks with more than 10% of their loan portfolio in residential construction.

Even with a pickup in loan demand, smaller banks also still must grapple with the Federal Reserve's promise to keep interest rates low until 2014. Low interest rates make it harder to turn a profit on the difference between what banks charge for loans and pay out to depositors.

But while big banks have more diversified revenue streams, investors may still be nervous about possible exposure to Europe's debt crisis and the low volume trading environment on Wall Street.

Investors in smaller banks, on the other hand, can breathe a little easier. It's a lot easier to clearly see where profits and losses are coming from with banks that are mainly lending money and taking in deposits.

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