What Trends Affect Profitability in Financials?

What Are Financial Services?

The economy is made up of a number of different sectors, such as the manufacturing sector, the agricultural sector, and the utility sector. But the largest one is probably the financial services sector.

This sector is made up of corporations that deal in finance, money management, and investments. From banks and credit card companies to lenders and insurance companies, large conglomerates dominate this sector, but it also includes a diverse range of smaller companies. This segment of the economy leads the world in earnings and equity market capitalization.

Most market trends have some impact on the financial services sector, but very few trends are significant enough to have a large influence. The performance of financial services companies is historically tied to interest rates and other macroeconomic indicators. This is especially true of banks, which comprise the largest portion of the sector.

To see what drives financial services earnings, it's important to understand which companies perform financial services and when those services are in the greatest demand.

Break Down of the Financial Services Sector

As mentioned above, the financial sector provides a variety of services to corporations and individuals. As such, this segment is broken up into commercial and personal financial services. Together, these segments provide banking, money management, investing, credit card and lending services, insurance, and real estate services to the public.

The financial services sector is made up of eight smaller subsectors. Banks are the largest part of this segment, making up a little more than half of the total sector value. The industry hit a snag following the financial crisis of 2007-2008 as well as cybersecurity issues but it remains critical to the global economy. This means any economic growth involves higher bank earnings. Some of the world's largest banks include JPMorgan Chase, the Bank of China, Goldman Sachs, Deutsche Bank, and Barclays.

The next three subsectors are broken up as follows:

• Insurance providers, including health insurance, property and casualty insurance, and life insurance
• Capital markets
• Real estate investment trusts (REITs)

The four remaining subsectors combine to make up only a little more than 10% of the financial services industry. They are diversified financial services, consumer finance, real estate services, and thrifts and mortgage finance.

Key Drivers of Profitability in Financials

Most of the largest financial services companies are lenders and investors. Their portfolio performance is driven by the earnings of other sectors. When the economy is healthy and businesses expand, part of that increased revenue returns to banks as payment on capital. Banking profits usually drop when the economy struggles.

Central bank policy plays a huge role in the financial services sector. Capital requirements are set by central banks and interest rates help drive arbitrage opportunities between short- and long-term rates. When interest rate spreads are high, the sector performs well. Low rate policies also encourage businesses and individual consumers to borrow money, which takes place through the banking system.

Investor confidence affects the profitability of investment service providers. Asset management companies, private equity firms, and other related services rely on investors who want to make trades. The velocity of transactions is important. This same concept can be applied to mortgage companies and home loans.

The Effect of Regulations

The years following the financial crisis led to new regulations, oversights, and accounting standards for the financial services industry. One of the most comprehensive laws was the Dodd-Frank Wall Street Reform and Consumer Protection Act. This massive piece of legislation was passed in 2010, bringing in sweeping changes to the financial services industry, including:

• monitoring financial stability making sure banks have enough capital on hand and aren't too big to fail
• setting up the Consumer Financial Protection Bureau (CFPB)
• restricting investment activity of banks through the Volcker Rule
• establishing the Securities and Exchange Commission's (SEC) credit rating office
• expanding the whistleblower program

A 2013 survey of more than 1,000 financial services executives from around the world indicated that nearly 90% of companies in this sector were "challenged in managing regulatory change." In the wake of regulatory changes, financial services companies cited some of the biggest challenges included the overburdening of banks over other parts of the sector and the increased costs associated with compliance. Critics also argued that the requirement to hold more capital put American institutions at a disadvantage over their international counterparts in the global market.

In May 2018, the Trump administration eliminated some of the measures that many financial companies called overly burdensome. For instance, the new law raised the threshold for stress tests from $50 billion to $250 billion in assets, exempting certain financial institutions from regulatory requirements. The changes also ensure that the largest institutions are protected if they ever collapse. Banks with less than $10 billion in assets are also exempt from the Volcker Rule, which makes larger investments by banks in venture capital and other funds harder to do.

COVID-19: A New Challenge

The financial services sector took steps to quickly adapt to the coronavirus pandemic that swept the world. Supply and demand have been affected, while the prices of oil and equities, as well as bond yields, have dropped significantly. At the onset and throughout the spread of the virus, financial institutions had to learn how to keep their businesses going while protecting liquidity and cash flows.

Some of the major concerns of companies in the financial industry during this period include:

• The financial impact
• The potential for a global recession
• Productivity of the workforce and/or reduction
• Decrease in consumer confidence
• Disruptions in supply chains

Banks and other institutions have seen an increase in fraud, cyber attacks, and security issues. And because of stay-at-home orders and social distancing requirements, companies in this sector have also had to deal with transitioning to remote working situations. This can be especially challenging, especially for a sector that often relies on face-to-face contact between employees and their clients.

Experts suggest that the global market for financial services is expected to grow despite these hurdles. This is due to the restructuring of operations and recovery during and after the pandemic. The rise in digital technology for the lending side of the sector and increased electronic payments are poised to help boost the bottom line of these companies.