On the surface banking shares offer a remarkably attractive proposition; huge (trailing) dividend yields and low prices relative to earnings.

National Australia Bank Ltd. (ASX: NAB) is a great example, currently trading at an earnings multiple of 10 and a dividend yield of 7.6%, after falling 32% in the last year. But whether it’s NAB or Commonwealth Bank of Australia (ASX:CBA), it’s important to understand some of the specific risks that come with investing in banks.

Why bank shares are falling

The banking sector is prized for its ability to ‘create money’ by lending out much more than it holds onto in customer deposits. This is called fractional reserve lending and it contributes to keeping the giant economic wheel greased.

However, as every bank investor should understand, when the economy falters and loans can’t be paid back, bad debts can quickly start to reduce a bank’s balance sheet. And when this happens, it’s not depositors or the bank’s bond holders who get hit, it’s your equity from ‘Tier 1’ capital, which is retained earnings and common shares.  When you become an investor in a bank, you agree to being first on the hook.

Recently, the big falls in commodity prices and fears about slowing property markets have stoked investor concerns about rising bad debt levels and several banks have had to raise additional capital to meet the required total capital ratio of 8%. In May last year NAB raised its capital buffer through a $5.5 billion equity issue.

Money is the ultimate commodity

It’s also useful to remember that money is the ultimate commodity and there is heavy competition to lend each and every dollar. Greater competition brings the risk of margins getting squeezed and potential for lower future earnings.

Competition is also creeping into niche areas of banking to steal customers. For example Ozforex Group Ltd (ASX:OFX) is growing in the currency exchange space, while peer-to-peer lending has been estimated by PWC to grow to US$150 billion in the U.S. by 2025, from just US$5.5 billion today.

Foolish takeaway

As compelling as shares in the big banks may look on the surface, it’s useful to understand the nuances of the industry and some of the potential risks before parting with your money.

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Motley Fool contributor Regan Pearson has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.