6/11/13 – Financial Services Under Fire

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 11, 2013 9:39:23 AM

and tagged Yesterday's News

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One of the sectors that investors are looking at closely now is financial services. The idea is that, as the economy recovers, banks and other such companies will be well positioned to profit. In fact, the argument goes, they will be well positioned to return to the profit levels of the mid-2000s.

I have my doubts, for several reasons, but one of the most important is the change in the political environment. As I’ve said before, when the narrative changes, you need to watch out. And the narrative on the financial industry has definitely changed.

I was struck by this when I opened the papers today. A story on the front page of the Wall Street Journal, “Regulators Turn Up Heat Over Bank Fees,” covers the new Consumer Financial Protection Bureau’s report on overdraft fees. These fees accounted for about $32 billion, with a b, in revenue last year. The fact that they’re now on the public agenda, with a federal agency specifically looking into them, suggests that fees are more likely to be a target of regulatory action going forward. At a minimum, their use as a revenue-generating tool looks to become more difficult for banks.

On the front page of the New York Times, we have “Banks Faulted As Taking Role In Web Fraud,” about how banks are enabling scammers to target the elderly. The story zeroes in on one bank and one company in particular, describing how the bank red-flagged the company’s transactions for multiple reasons but kept putting them through—despite the red flags—because the business was a gold mine. The last line of the article is a quote from the director of President Obama’s Financial Fraud Enforcement unit: “Nothing sharpens the focus for banks like an enforcement action.” Sounds like an indicator of the future.

Banks aren’t the only ones under fire. On the front page of the NYT’s business section, “A Rise in Broker Requests to Wipe the Slate Clean” notes that investment brokers are increasingly able to have offenses deleted from the online complaint database available to investors. Much of the article goes into what it describes as the flaws in the current system. A number of other articles have sounded similar themes recently.

So, how has the narrative changed? There is now a consistent message, even in the WSJ, that the government will be taking a much closer look at how the financial sector operates. More, there is now a federal agency tasked with doing exactly that.

Over the past 30 years or so, four trends enabled a vast expansion in the role of financial services in the economy:

  • The first was the democratization of credit, which favored lenders, as the issuance of credit cards to all and sundry, combined with the housing and mortgage boom, brought many people into the financial system who simply hadn’t been there before.
  • The second was the expansion of borrowing, as consumers borrowed in every way they could to spend more, which also favored lenders.
  • The third was the creation of the individual investor market, as 401(k)s replaced pensions and baby boomers saved and invested to prepare for retirement, which supported the growth of the investment industry.
  • The fourth supporting trend for all of these factors was the general deregulatory, laissez-faire atmosphere, which allowed companies to operate without a heavy supervisory hand.

We have seen each of these trends reverse in the past several years. First, credit is more restrictive now, rather than more expansive, and it is harder for borrowers to qualify for loans. Second, consumers are now paying off loans rather than taking them out. Third, the retirement of the baby boomers means that they’ll now start spending their savings and drawing down their investments. And the reversal of the fourth trend is what I’m talking about in this post.

What this means, in my opinion, is that the era of easy growth and an ever-expanding pie is over. We will see increasing competition for market share in all areas of the financial services sector, as well as continued regulatory pressure that narrows margins and limits fees. Rising interest rates and a recovering economy will certainly be tailwinds for the sector, but investors should remember the headwinds as well.

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