Over the previous decade, banks have began to play an rising half within the portfolio of Warren Buffett (Trades, Portfolio) at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).Some analysts have reacted with shock at this. Buffett’s circle of competence has at all times been insurance coverage and fast-moving shopper items.Nonetheless, from my view, banks do appear to suit the template of the types of firms Buffett has at all times appreciated. What’s extra, these companies are comparatively simple to know.The banking model The essential bank enterprise model is comparatively easy to clarify and perceive. Depositors entrust their cash to the bank at a particular fee of curiosity. The bank then loans this cash out at a fee it believes supplies an acceptable revenue. For instance, if the bank paid 0.3% curiosity on checking accounts, it might loan the cash out at a 2% rate of interest.There are another elements to think about, similar to asset and legal responsibility matching and length matching. Nonetheless, at its core, the enterprise of banking is all about lending cash out at a better fee than what’s paid to depositors.Utilizing this enterprise model, banks can generate enormous returns on tangible capital. Buffett has at all times been involved in companies that may earn substantial returns on invested capital, so it is smart that he’d be involved in banks.Certainly, the Oracle of Omaha stated as a lot on the 2003 annual assembly of Berkshire’s shareholders:”The query about banking, , banking — in the event you can simply steer clear of following the fads, and actually making a whole lot of dangerous loans, banking has been a remarkably good enterprise on this nation….And there are a lot of — there are particular banks, I ought to say — on this nation which can be fairly giant which can be incomes, , possibly 20% on tangible fairness. And if you assume you are dealing in a commodity like cash, that is pretty stunning to me. So, I might say that I suppose I have been shocked by the diploma to which margins in banking haven’t been competed away in one thing as basic as cash… Now, a part of it’s that they push — they’ve pushed the loan-to-capital ratios increased than 30 or 40 years in the past, however that — however they earn excessive charges of returns. They earn a lot increased charges of returns on property alone, after which they’ve larger leverage of assets-to-capital in order that produces returns on capital that actually are fairly extraordinary.” These feedback assist clarify the core causes behind Buffett’s curiosity in bank stocks. In 2003, he additionally warned of the dangers of dangerous behaviour at banks, particularly lenders taking over too many dangerous loans or an excessive amount of leverage.Bank traders will at all times be uncovered to those kind of dangers. As the dimensions of monetary establishments has elevated, it has develop into more durable and more durable for traders to ascertain how they’re producing earnings and if there are any weak areas on the steadiness sheet.However, giant banking establishments are comparatively shielded from dangerous loans by way of diversification. They’re additionally considerably higher capitalized at the moment than they had been earlier than the monetary disaster. Rules have been tightened as a part of policymakers’ efforts to tidy up the sector.Low rates of interest in recent times have brought on issues for monetary establishments, however as Buffett defined in 2003, even with rates of interest at low ranges, banks can nonetheless earn enticing returns on tangible capital. Leverage performs a component, and so do economies of scale. The world will at all times want banks, and our dependence on these monetary establishments is simply rising as cash is phased out.Firms with excessive returns on tangible capital and enticing long-term prospects are simply the kind of companies that the Oracle of Omaha desires to personal.Disclosure: The writer owns shares in Berkshire Hathway.Learn extra right here:Not a Premium Member of GuruFocus? Join a free 7-day trial right here.This text first appeared on GuruFocus.