Thus far, 2012 has been a great year for the money center banks; shares of Goldman Sachs (NYSE: GS) and JPMorgan Chase (NYSE: JPM) have all gained more than 30 percent year to date. Solid balance sheets, growing profits and a strengthening domestic economy have underscored the fact that, thanks to aggressive intervention by government and banking authorities at the peak of the financial crisis, American banks are now the strongest in the world.

According to the Federal Deposit Insurance Corporation’s (FDIC) most recent quarterly assessment of the banking industry, the sector posted its tenth consecutive year-over-year gain in quarterly net income, hitting $26.3 billion during the fourth quarter. That’s a better than 23 percent increase over the same period in 2010, as two out of every three banks reported improved net income numbers. Full-year net income also hit a five-year high in 2011, reaching $119.5 billion for an almost 40 percent increase over 2010.

An improving domestic economy has been a huge factor in the positive developments in the banking industry, with declining noncurrent loan balances and falling loan-loss provisions driving much of the sector’s gains. The industry set aside only $19.5 billion in loan-loss reserves in the fourth quarter, a more than 40 percent decline from the same period in 2010, as more than half of banks cut reserves. As loan-loss reserves are reduced, they’re essentially added back into revenue.

Meanwhile, loan books are once again growing, with loan balances up by $130.1 billion in the final quarter of 2011, a gain of 1.8 percent from a year ago. Commercial and industrial loan balances were up 4.9 percent in the quarter, credit card balances rose by 3.2 percent and residential mortgage loans bumped up 1.4 percent, as credit started to flow again.

Unfortunately, the report wasn’t all roses. Full-year operating revenue declined in 2011 versus the prior year, marking only the second year of declines since the FDIC began keeping data in 1938. Net interest income fell by 1.7 percent, as banks struggled to cope with a low-interest rate environment. But the biggest drag on revenue was a 2.3 percent decline in noninterest income, largely due to a 4 percent drop in fees generated through mortgage servicing operations and a 5.9 percent fall in service charges on customer accounts.

While mortgage loan balances are growing, overall activity still remains well below the pre-crisis peak. That will detract from bank revenues for years to come. At the same time, banks are beginning to cope with the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which, among other things, limits the fees banks can charge for things such as low account balances and bounced checks. Fee income has always been a major profit center for banks, so limits on charges create a significant earnings headwind.

But all of this news reinforces my bullish view on SPDR S&P Regional Banking ETF (NYSE: KRE).

The exchange-traded fund (ETF) holds a portfolio of 71 mostly smaller regional banks, with market capitalizations ranging from just $488.8 million to $31.3 billion and offers excellent stock diversification in a growing sector.

While the ETF’s portfolio holdings have a fairly wide range in terms of asset size, about half of them have total assets of less than $1 billion, which is the sleeve of banks in which we’re most interested.

The FDIC breaks its data out according to institution size, offering a decent snapshot of how small- and mid-sized banks perform relative to large money center institutions. The data show that while small banks are at a disadvantage to large banks in terms of their cost of funds–both interest and noninterest expense ratios are higher than at larger banks–they rate much higher in terms of efficiency and financial condition. For example, measures such as earning assets to total assets and tier 1 capital ratios tend to consistently run between 50 basis points and 300 points higher. They also tend to have higher net loans to asset ratios, which reflect the fact that their core business is making loans in their local markets. In other words, these are traditional banks.

While the big banks are clearly doing well for themselves, they’ve become so large and involved in so many business lines beyond simply taking deposits and making loans that they’re now in the crosshairs of the Dodd-Frank Act. Over the coming years, as more of the Dodd-Frank provisions come into force–assuming Congress doesn’t intervene in the meantime–big banks are going to find their profitability squeezed as they are forced to abandon investment banking activities such as proprietary trading and see more of their fee-collecting opportunities curtailed.

But because of specific exemptions built into the Dodd-Frank Act for institutions with less than $1 billion in assets, smaller banks won’t have to cope with the same amount of regulatory oversight. Beyond that, the majority of smaller banks don’t engage in the activities that are prohibited under Dodd-Frank anyway.

As a result, smaller banks will be able to continue building their businesses relatively unfettered by additional regulatory burdens, while, at the same time, they will face less competition from larger banks encroaching upon their areas of operation. In fact, national banks such as Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) are in the process of consolidating branches and pulling out of less profitable markets, offering smaller institutions the opportunity to pursue additional growth.

If you are DIY investor, check out Jim Fink’s article, How to Value Bank Stocks, for some excellent tips on selecting bank stocks.