The transformation of the global financial services industry is continuing at a rapid pace. Technological change and deregulation are forcing banks, insurance companies, and other financial services firms to diversify into each others’ traditional territories to capture a larger share of the rapidly growing market for financial services around the world. Over the last ten years, US household financial assets managed by banks, insurance companies or pure asset managers have grown by an average of 15 percent per year, more than twice as fast as nominal GDP.
Consolidation across Europe over the last ten years has been accompanied by a very strong improvement in profitability. From 1992 to 2001, the return on equity of the largest quoted European banks rose from 6.4 percent to 13 percent (having been 18 percent in 2000)
Gains reflect favorable economic trends as well as structural change. For instance, the structure of the US insurance industry has improved thanks to the listing of mutual companies, which have since adopted more rational pricing behaviors in order to maximize their earnings.
There is no sign that the transformation of the global financial industry is about to end. Aging populations in the US, Europe, and Japan, combined with the crisis of most government-sponsored retirement schemes should boost savings for at least the next ten years. In Europe and Japan, the revenue growth of the savings industry should be boosted by a shift of the households savings mix from cash/fixed income based products with low margins to more sophisticated equity based products for which financial institutions can charge higher fees.
The financial services industry comprises firms that help individuals, corporations or other institutions to insure property, to save, to invest, to borrow or to lend. The development of the financial services industry in any country is intimately associated with the amount of wealth accumulated in that country. The wealthier the country, the bigger the financial services sector. There are three key drivers of the financial services industry today: demographics, technology and deregulation.
Demographic factors directly influence the demand for loans and the pool of savings available. To oversimplify, the very young and the very old consume and don’t produce while young adults borrow whatever they can in order to build their lives and older working adults save for their retirements and their children’s needs. The crisis of most government sponsored pension schemes in the more developed countries because of aging populations is another factor that has the potential to generate substantial savings growth over the next several years. For instance, it is estimated that pension fund assets should grow from around 33 percent of Europe’s GDP in 1999 to 40 percent of GDP in 2010 and to 50 percent in 2020 in the wake of the pension reforms recently introduced in several continental European countries.
The IT revolution of the last 20 years made possible the spectacular growth of the financial services industry which involves storing, processing and transmitting an ever increasing amount of information. Technological change is transforming the finance industry in the following ways.
First, technological change speeds up the disintermediation process. By allowing the exchange of information on a real-time basis via electronic communications, technology reduces the need for intermediaries in financial services as in other industries. Second, technological change has transformed what used to be a local business into a global one. By reducing the need to establish a physical presence in any particular country in order to access customers, the Internet allows (for example) European companies to expand beyond their domestic retail market.
Third, technology makes it possible to manage large companies. Control issues have long acted to limit corporate size. Now, one bank head office can control an unlimited number of branches and naturally a few are trying to do it. Mergers will continue because there is no longer any limit as to how big a financial company can be.
Lastly, technology also levels the playing field for new companies if they can spot an opportunity that the larger firms have missed. Several large credit card issuers in the US, such as Capital One and MBNA, have not been handicapped when competing against the enormous resources of (say) a Citigroup or a Bank One. In fact, the smaller companies are doing better because they have developed statistical models that allow them to attract customers at better rates while incurring lower losses.
The financial services industry has been massively deregulated over the last 20 years. Most industrialized countries had to deregulate their capital markets in the 80s in order to make it easier to finance their growing public deficits. Also, regulators have become more relaxed about the ability of managements to control risks thanks to the increased capabilities of information technologies. Deregulation has been a major positive as it has forced managements to become more focused on creating value for their shareholders’ by maximizing earnings instead of worrying about local politics.
Generally speaking, finance has three main sub-sectors: Banks, insurance companies and other financial institutions.
The banks have all the customers and enormous amounts of capital. Their big challenge is disintermediation. If all depositors switched to mutual funds and all borrowers issued bonds and stock, there would be no business left. So, the banks have to broaden their product line and compete against mutual fund companies and investment banks.
Many insurance companies have a lot of capital, but sell through agents and thus have little distribution power. We invest primarily in companies with their own distribution force; and that therefore have some tie to the customer other than the lowest price. We are keen on life insurance companies that have successfully moved into the asset-gathering business, as it requires no capital and benefits from demographic trends. Other financial institutions offer real growth opportunities they benefit from the disintermediation of banks and insurers, are less heavily regulated since they are newer companies, are often still run by their entrepreneurial founders, and in some cases, represent good global opportunities. Representative companies within this category are Banca Fideuram in Italy, Goldman Sachs in the US, and the Promise Corporation of Japan.
We may conclude from the above that investing within the financial services sector can be challenging for investors due to the rapidly changing economic and investment environment. As a result, perhaps the best way to participate within this exciting sector of the market is by investing in an actively managed, diversified financial services mutual fund.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management.)