Financial Services Transformed: The New Economy Makeover

By Jeff Miller
Analyst, mPower

Financial services and the Internet now go hand-in-hand. In fact, it's hard to imagine a business-devoted media source that doesn't focus in some way on the Internet, or financial services. Financial services companies have provided the capital that fuels the technology and Internet engines, and the Internet has been responsible for bringing the stock market to the masses.

Access to information is key to making sound financial decisions, and the Internet is providing individuals this access. But the industry hasn't gotten where it is today without help.

New Legislation Enables the Consolidation Trend…

Bankers and brokers engaged in a debate over the last decade - bankers wanted to be able to underwrite securities, and brokers wanted to be able to manage the bank customers' brokerage accounts. But the Glass-Steagall Act, a law written in response to the stock market crash of 1929, didn't allowed these two entities to work together. The act was passed to protect the public from alleged improprieties in the underwriting and banking business.

The debate ended with the Financial Services Modernization Act of 1999, or the Gramm-Leach-Bliley Law (commonly known as Gramm-Leach). Signed into law November 12, 1999, this act reforms U.S. banking regulation, including eliminating restrictions on affiliations among companies in the securities, banking, and insurance industries.

Gramm-Leach repeals the Glass-Steagall Act, thus, banks and brokerages are no longer prevented from participating in each other's businesses.

Here's a breakdown of the different sectors in the financial services industry:

…And Creates Financial Services Supermarkets

Gramm-Leach created a new legal entity, the Financial Services Holding Company (FSHC). An FSHC can own several different financial services companies, and this has opened the door for the creation of financial services supermarkets. Now, for example, a traditional bank can buy an investment bank and have access to high-flying Internet stock-underwriting fees, which make up for a loss in revenues from potential interest rate hikes. (When interest rates rise, traditional bank profits fall because borrowing costs go up and the demand for loans falls.)

"An FSHC can own several different financial services companies, and this has opened the door for the creation of financial services supermarkets."

Under Gramm-Leach, "financial companies can elect to maintain their current legal structures; however, for banks wishing to affiliate with non-bank financials (investment banks, insurance companies, brokerages), the new FSHC structure will be required," according to the Merrill Lynch Commercial Banks & Securities Broker Dealers, Quarterly Review, An Analysis Of The New Gramm-Leach Law #4422, December 1999.

With the way paved for consolidation, the result has been increased competition, as large industry players acquire and merge with each other to form financial services giants. These companies offer everything from basic checking accounts to stock underwriting. Any firm that doesn't offer one-stop-shopping will be left behind, so the consolidation trend will probably continue.

The New Wall Street

Along with consolidation, the Internet has revolutionized the way investors use financial services.

The Internet-driven transformation of the financial services industry should not come as a surprise. This industry requires an electronic exchange of funds, rather than a physical exchange of goods. Consumers will likely benefit from the industry-wide shift to Internet brokerage and banking, since financial services has seen lower brokerage commissions and banking fees, faster execution, and innovative products.

Knowledge Is Money

"Online investors spend a day or more, on average, making their investment decisions, and use research tools such as analyst reports, earnings reports, and news." - Roper Starch Survey, commissioned by Ameritrade, Inc., November 1999. Nasdaq.com. Reprinted with permission.

Plus, and this is a big plus, the consumer suddenly has the power of knowledge. Price transparency provided by the Internet allows shopping for the best product at the best price, and sales departments are now dealing with more sophisticated investors across income and regional lines. The decentralization of industry knowledge has provided choice. The emergence of alternative trading systems, or electronic communication networks (ECNs), has given investors a choice of what market to trade on. ECNs are electronic trading networks that investors can participate in outside of Nasdaq.

There's another benefit for consumers partaking in Internet-driven financial services. Internet competition drives down prices and forces companies to adapt to the new market through merging, or acquiring, the business components needed to compete. On the new Wall Street, it is becoming increasingly important for financial companies to diversify their business. To succeed in the new economy, brokerage houses must now practice what they preach.

But perhaps the main benefit for consumers is that it seems everybody wants a piece of the investment banking pie, and this is contributing to the consolidation trend, which, in turn, increases competition.

Are International Mergers the Next Big Thing?

The reality of the Glass-Steagall Act was that a lot of financial services companies found ways around the law's restrictions years ago, and most of the big domestic mergers have already occurred. Citigroup and Morgan Stanley Dean Witter are good examples.

Gramm-Leach's biggest impact may come from the fact that foreign-owned financials will be treated equally with domestic companies in terms of allowed transactions. Foreign-owned financial companies are now free to enter the American investment banking business (something that is easier said than done).

In the globalized banking industry, it seems, movement to fewer, but larger, distribution centers will be the future.

Investing in New-Economy Financials

The prevailing market sentiment on financials is to stay out during the current period of rising interest rates. This comes at a time when the industry itself is in flux, when changes are threatening the traditional financial company.

However, earnings are strong and there is no end in sight to the revenue growth in investment banking, barring a recession. The traditional banking industry is a different story, since is currently dealing with shrinking margins and rising interest rates, which have led to lackluster returns. But Gramm-Leach gives traditional banks the chance to overcome those factors.

The larger banks have established an Internet and investment-banking presence that will make them attractive to investors. So, what kind of changes can we expect?

Competition is going to intensify in the online brokerage markets, as the entrance of old-line brokers, like Merrill Lynch, cause a shakeout in the industry. And, as the low-commission war is played out, the 100-plus online brokers will consolidate and there will be another industry shakeout. The online brokerage survivors will be the companies that differentiate themselves with access to research, stock offerings, and brand names.

The top online brokers will continue to prosper as they diversify their businesses and add services their customers need. Recent moves by E*TRADE to buy both Telebank, an online bank, and CCS, a major independent ATM operator, shows this company's commitment to expanding its product offering.

New-Economy Fundamentals to Look For

One question to ask when looking at financial stocks: Is a company aggressively expanding its Internet presence? The leaders will be diversified and will be an integral part of the new economy. To actively participate in the booming capital markets, the leading financial services companies need to offer consumers the opportunity of resolving all business and personal finance needs under one roof.

Globalization is also a key aspect to look for in terms of the transforming financial services companies. Expansion into Europe's capital markets is essential for investment banks ¾ this opportunity depends not only on the ability to advise on merger and acquisition activity, but also on their Internet presence, considering the potential Internet boom in Europe.

In What Financials Sector Are Portfolio Managers Investing?

Professional money managers have likely scaled back on certain areas of financials, while increasing their exposure to the market leaders in the investment banking and brokerage sectors. Value managers are likely to find attractive stocks in the beaten-up banking and insurance sectors.

The S&P 500 contains 15% financials, including Citigroup, which recently bought the remaining 15% of Travelers ¾ an acquisition that stimulated some interest in the insurance industry that many managers have recently been selling out of.

The market is also watching for potential takeover targets that may include asset management companies, which are largely trading in the value range (and attracting interest from potential buyers) due to the fee revenues generated from asset management.

It may be worth taking a look at developments in the banking sectors as well. It is unlikely that interest rates, rising steadily, will recover fully in the near term. In the long term, the large banks that diversify their business, and build a strong Internet presence, will likely perform admirably. Financial stocks are clearly in the value side of the spectrum, making up 26% of the S&P 500 Barra/Value Index, while making up only 5% of the S&P 500 Barra/Growth Index. Right now, value managers are likely more heavily invested in financials than growth managers are.

Financials Are Poised, Once Again, to Have Their Day

Both the record trading volume on Nasdaq and record stock underwriting numbers are helping large investment banks generate staggering profits ¾ easily beating analyst forecasts. Asset management and trading fees have also helped boost investment-bank earnings. Merger and acquisition activity, in both the U.S. and Europe, is driving investment-bank earnings and growth potential as well. Proof of the industry's strength can be seen in the Dow Jones Securities Broker Index, which is up 37% year-to-date, compared to the S&P 500's 4% return over the same time period.

Financials have had a difficult time recently, and many individual company stocks in this industry show this in their negative returns. It is important to remember, however, that financial services companies are fueling the new economy.

Two fundamentals that will help financials once again have their day?

Brokerages and banks that have an Internet presence, and that also diversify revenues, will have a distinct advantage over the competition. Both of these factors will only help performance, in a declining margin environment.

Globalization is the key, however, to unlocking money to be made "across the pond" (in Europe), and experienced U.S. investment banks have a distinct advantage. Non-U.S.-based investment banks will continue to make their mark on the U.S. market with the easing of bank regulations, which will make the industry competitive on a global scale, leaving only the most innovative and aggressive financial companies standing.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Financial Services Transformed: The New Economy Makeover

By Jeff Miller
Analyst, mPower

Financial services and the Internet now go hand-in-hand. In fact, it's hard to imagine a business-devoted media source that doesn't focus in some way on the Internet, or financial services. Financial services companies have provided the capital that fuels the technology and Internet engines, and the Internet has been responsible for bringing the stock market to the masses.

Access to information is key to making sound financial decisions, and the Internet is providing individuals this access. But the industry hasn't gotten where it is today without help.

New Legislation Enables the Consolidation Trend…

Bankers and brokers engaged in a debate over the last decade - bankers wanted to be able to underwrite securities, and brokers wanted to be able to manage the bank customers' brokerage accounts. But the Glass-Steagall Act, a law written in response to the stock market crash of 1929, didn't allowed these two entities to work together. The act was passed to protect the public from alleged improprieties in the underwriting and banking business.

The debate ended with the Financial Services Modernization Act of 1999, or the Gramm-Leach-Bliley Law (commonly known as Gramm-Leach). Signed into law November 12, 1999, this act reforms U.S. banking regulation, including eliminating restrictions on affiliations among companies in the securities, banking, and insurance industries.

Gramm-Leach repeals the Glass-Steagall Act, thus, banks and brokerages are no longer prevented from participating in each other's businesses.

Here's a breakdown of the different sectors in the financial services industry:

…And Creates Financial Services Supermarkets

Gramm-Leach created a new legal entity, the Financial Services Holding Company (FSHC). An FSHC can own several different financial services companies, and this has opened the door for the creation of financial services supermarkets. Now, for example, a traditional bank can buy an investment bank and have access to high-flying Internet stock-underwriting fees, which make up for a loss in revenues from potential interest rate hikes. (When interest rates rise, traditional bank profits fall because borrowing costs go up and the demand for loans falls.)

"An FSHC can own several different financial services companies, and this has opened the door for the creation of financial services supermarkets."

Under Gramm-Leach, "financial companies can elect to maintain their current legal structures; however, for banks wishing to affiliate with non-bank financials (investment banks, insurance companies, brokerages), the new FSHC structure will be required," according to the Merrill Lynch Commercial Banks & Securities Broker Dealers, Quarterly Review, An Analysis Of The New Gramm-Leach Law #4422, December 1999.

With the way paved for consolidation, the result has been increased competition, as large industry players acquire and merge with each other to form financial services giants. These companies offer everything from basic checking accounts to stock underwriting. Any firm that doesn't offer one-stop-shopping will be left behind, so the consolidation trend will probably continue.

The New Wall Street

Along with consolidation, the Internet has revolutionized the way investors use financial services.

The Internet-driven transformation of the financial services industry should not come as a surprise. This industry requires an electronic exchange of funds, rather than a physical exchange of goods. Consumers will likely benefit from the industry-wide shift to Internet brokerage and banking, since financial services has seen lower brokerage commissions and banking fees, faster execution, and innovative products.

Knowledge Is Money

"Online investors spend a day or more, on average, making their investment decisions, and use research tools such as analyst reports, earnings reports, and news." - Roper Starch Survey, commissioned by Ameritrade, Inc., November 1999. Nasdaq.com. Reprinted with permission.

Plus, and this is a big plus, the consumer suddenly has the power of knowledge. Price transparency provided by the Internet allows shopping for the best product at the best price, and sales departments are now dealing with more sophisticated investors across income and regional lines. The decentralization of industry knowledge has provided choice. The emergence of alternative trading systems, or electronic communication networks (ECNs), has given investors a choice of what market to trade on. ECNs are electronic trading networks that investors can participate in outside of Nasdaq.

There's another benefit for consumers partaking in Internet-driven financial services. Internet competition drives down prices and forces companies to adapt to the new market through merging, or acquiring, the business components needed to compete. On the new Wall Street, it is becoming increasingly important for financial companies to diversify their business. To succeed in the new economy, brokerage houses must now practice what they preach.

But perhaps the main benefit for consumers is that it seems everybody wants a piece of the investment banking pie, and this is contributing to the consolidation trend, which, in turn, increases competition.

Are International Mergers the Next Big Thing?

The reality of the Glass-Steagall Act was that a lot of financial services companies found ways around the law's restrictions years ago, and most of the big domestic mergers have already occurred. Citigroup and Morgan Stanley Dean Witter are good examples.

Gramm-Leach's biggest impact may come from the fact that foreign-owned financials will be treated equally with domestic companies in terms of allowed transactions. Foreign-owned financial companies are now free to enter the American investment banking business (something that is easier said than done).

In the globalized banking industry, it seems, movement to fewer, but larger, distribution centers will be the future.

Investing in New-Economy Financials

The prevailing market sentiment on financials is to stay out during the current period of rising interest rates. This comes at a time when the industry itself is in flux, when changes are threatening the traditional financial company.

However, earnings are strong and there is no end in sight to the revenue growth in investment banking, barring a recession. The traditional banking industry is a different story, since is currently dealing with shrinking margins and rising interest rates, which have led to lackluster returns. But Gramm-Leach gives traditional banks the chance to overcome those factors.

The larger banks have established an Internet and investment-banking presence that will make them attractive to investors. So, what kind of changes can we expect?

Competition is going to intensify in the online brokerage markets, as the entrance of old-line brokers, like Merrill Lynch, cause a shakeout in the industry. And, as the low-commission war is played out, the 100-plus online brokers will consolidate and there will be another industry shakeout. The online brokerage survivors will be the companies that differentiate themselves with access to research, stock offerings, and brand names.

The top online brokers will continue to prosper as they diversify their businesses and add services their customers need. Recent moves by E*TRADE to buy both Telebank, an online bank, and CCS, a major independent ATM operator, shows this company's commitment to expanding its product offering.

New-Economy Fundamentals to Look For

One question to ask when looking at financial stocks: Is a company aggressively expanding its Internet presence? The leaders will be diversified and will be an integral part of the new economy. To actively participate in the booming capital markets, the leading financial services companies need to offer consumers the opportunity of resolving all business and personal finance needs under one roof.

Globalization is also a key aspect to look for in terms of the transforming financial services companies. Expansion into Europe's capital markets is essential for investment banks ¾ this opportunity depends not only on the ability to advise on merger and acquisition activity, but also on their Internet presence, considering the potential Internet boom in Europe.

In What Financials Sector Are Portfolio Managers Investing?

Professional money managers have likely scaled back on certain areas of financials, while increasing their exposure to the market leaders in the investment banking and brokerage sectors. Value managers are likely to find attractive stocks in the beaten-up banking and insurance sectors.

The S&P 500 contains 15% financials, including Citigroup, which recently bought the remaining 15% of Travelers ¾ an acquisition that stimulated some interest in the insurance industry that many managers have recently been selling out of.

The market is also watching for potential takeover targets that may include asset management companies, which are largely trading in the value range (and attracting interest from potential buyers) due to the fee revenues generated from asset management.

It may be worth taking a look at developments in the banking sectors as well. It is unlikely that interest rates, rising steadily, will recover fully in the near term. In the long term, the large banks that diversify their business, and build a strong Internet presence, will likely perform admirably. Financial stocks are clearly in the value side of the spectrum, making up 26% of the S&P 500 Barra/Value Index, while making up only 5% of the S&P 500 Barra/Growth Index. Right now, value managers are likely more heavily invested in financials than growth managers are.

Financials Are Poised, Once Again, to Have Their Day

Both the record trading volume on Nasdaq and record stock underwriting numbers are helping large investment banks generate staggering profits ¾ easily beating analyst forecasts. Asset management and trading fees have also helped boost investment-bank earnings. Merger and acquisition activity, in both the U.S. and Europe, is driving investment-bank earnings and growth potential as well. Proof of the industry's strength can be seen in the Dow Jones Securities Broker Index, which is up 37% year-to-date, compared to the S&P 500's 4% return over the same time period.

Financials have had a difficult time recently, and many individual company stocks in this industry show this in their negative returns. It is important to remember, however, that financial services companies are fueling the new economy.

Two fundamentals that will help financials once again have their day?

Brokerages and banks that have an Internet presence, and that also diversify revenues, will have a distinct advantage over the competition. Both of these factors will only help performance, in a declining margin environment.

Globalization is the key, however, to unlocking money to be made "across the pond" (in Europe), and experienced U.S. investment banks have a distinct advantage. Non-U.S.-based investment banks will continue to make their mark on the U.S. market with the easing of bank regulations, which will make the industry competitive on a global scale, leaving only the most innovative and aggressive financial companies standing.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.