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Valuation of the Financial Services Industry

The financial services industry, SIC codes 60 - 62, covers banking institutions, related credit institutions, and securities brokers. Companies in the financial services sector work closely with both individual consumers and corporate clients to help them meet their financial needs. The industry is subject to considerable regulation and oversight from federal agencies.

The Banking sector

Overall, the banking industry turned in a respectable earnings performance for the second quarter of 2004. Profit isn't really growing, however. Many banks are having an increasingly hard time achieving revenue growth. As the corporate world remains cautious about capital spending, businesses are borrowing less. In addition, the interest rates banks are currently paying on deposits are already low due to of the economic decline in recent years. As a result, banks can't really decrease their interest payments further to offset declines in the profit they make from loans and investments.

In response to declining revenues, banks have been taking cost cutting measures. Recently, some banks have also begun to tap into loan loss reserves to bolster their earnings. These reserves are normally maintained to help banks absorb losses on defaulted loans. With loan opportunities on the decline, however, the reserves may serve the banks better bolstering their bottom lines. Such measures should be short term at best. As the overall economy continues to recover, banks may have to make additional expenditures to take advantage of new business opportunities.

Bank of America, the largest consumer bank in the United States, has announced that it is offering a free person-to-person payments service, similar to the online transfer service provided to corporate clients by Citigroup, US Bancorp, and other large financial instituions. When Bank of America announced free online banking in 2002, other retail banks were forced to consider online services in order to remain competitive. Bank of America's new money transfer service may have the same impact across the industry. Retail banks have traditionally been wary of providing easy transfers that would allow consumers to move their funds to other financial institutions, but Bank of America's payment service allows money to be transferred to and from accounts handled by other banks. Whether other banks will follow suit remains to be seen, but analysts predict that many will.

Other Financial Services

The securities brokerage sector did well in the first quarter of 2004, as investment activity continued to rise from 2003. Growth slowed in the second quarter, however, due to a number of factors including rising energy costs, geopolitical uncertainties, and an anticipated impending interest rate hike.

Many companies in the credit, investment, and securities sectors have focused their attention on high net worth individuals - clients who are more likely to seek fee-based services, such as asset management. Such fee-based services provide more reliable revenues than loans and investments.

Investment bankers and private equity funds are seeing an increase in business driven by corporate mergers and aquisitions. The second quarter of 2004 saw a fair number of completed M&A transactions. While the number of announced transactions has declined since the end of the second quarter, the numbers are still significantly higher than in the previous year. As a result, equity investors backing M&A deals continue to be in demand.

Regulatory Issues

The financial services industry must continually deal with changes in government regulation and oversight. Current legal issues in the industry include potential changes to the rules governing student lending, payday loans, and agricultural lenders.

Lawmakers have recently introduced potential legislation that could end a subsidy that supports non-bank lenders that provide money to students. The proposed legislation would eliminate a subsidy for education loans made with taxexempt bonds. Under the current system, such lenders are guaranteed a 9.5 percent interest rate while charging their borrowers about 3.5 percent. The Consumer Bankers Associations has stated its support for the bill.

Tom Curry, a board member of the Federal Deposit Insurance Corporation, has publicly challenged partnerships between banks and payday lenders. Curry claims that banks are using these partnerships "to provide a vehicle to evade state usury and licensing laws." He further stated that "These partnerships, which yield significant fee income for participating banks, have marginal, if any, direct bank involvement." Curry stated that banks should develop their own short-term loan products instead of working through payday lenders.

Curry doesn't speak for the whole of the FDIC, however. Donald Powell, the chairman of the FDIC, defended payday partnerships. "Like other third-party affiliations, payday lending is a legal and permissible activity," he said.

A bid from Dutch company Ribobank to acquire Farm Credit Services of America has prompted Congress to consider the first changes to the Farm Credit Act in over 30 years. In response to the deal, legislation has been introduced that would increase the waiting time for a Farm Credit institution to get approval to merge with a company in the private sector. Some lawmakers are going even further, calling for legislation to prohibit Farm Credit lenders from being acquired from outside the Farm Credit system. Proponents of the legislation argue that the sale of Farm Credit Services of America will leave many farmers without a regulated lender of last resort.

Outlook

Since the financial services industry is both closely tied to the economy and subject to changes in regulation, its future is difficult to predict. If the economy continues to improve, the industry should see continued growth, although revenue growth in the banking sector may remain limited. The continued development of new products and offerings can be expected to draw consumers to the industry. Financial services providers will need to remain aware of potential regulatory changes and prepare to meet the challenges they bring.

Sources: American Banker, Knight Ridder Tribune Business News, Value Line

By Andrew Dolbeck

Editor