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Weekly UpdatesSince the mid 1970s trends in the financial services industry have been driven by the efforts of the companies in the industry to reform the Glass Steagall Act of 1933 that prohibited them from conducting banking, investment and insurance activities in the same corporate entity. Those efforts culminated in 1999 with the passage of the Gramm Leach Bliley Act, allowing for the creation of bank or financial services holding companies that could conduct those activities under a single corporate structure. This resulted in the recent dominant trend in the industry: the efforts of companies to integrate the manufacturing and delivery of financial services to consumers and businesses. Citigroup, the amalgamation of Citibank, Salomon Smith Barney and Travelers Insurance, epitomized this new financial services model. When Citigroup had difficulty making the model work, supporters of the concept maintained that the model was right, Citi was just doing it wrong.
Then came the subprime mortgage mess, the implosion of Bear Stearns, the failure of Lehman Brothers, AIG and the credit crisis, etc. The entire financial services industry has had a great fall, and the whole idea of the financial services holding company has come under question. It has also become clear that Gramm Leach Bliley failed to allow for the regulation of the new hybrid products these entities could now create, own, package and sell, products like black box CDO's and credit default swaps that fell between the cracks of functional regulation.
The result of recent events is that there is a clamor for new regulation to replace Gramm Leach Bliley, and once again the specter of new regulation will be the driving force of trends in the financial services industry. While it is obviously difficult to predict what the new regulation will bring, a review of the proposals that are being made by the Treasury, Congress and the industry leads me to the following conclusions. There will be sweeping, new financial services regulation--let's call it the Frank-Schumer Financial Services Act of 2010--that will create regulatory structure modeled after the Financial Services Authority (FSA) in the United Kingdom, which integrated nine regulators in 1998.
The FSA in the U.K. is a single, self-regulatory body that regulates the entire financial services industry in that country. It is accountable to Her Majesty's Treasury and through it to Parliament. The FSA's responsibilities are separated into three sectors: Retail Markets, Wholesale and Institutional Markets and Regulatory Services. There are sector leaders for Auditing and Accounting, Asset Management, Capital Markets, Financial Stability, Banking, Insurance, Retail Intermediaries and Mortgages, all under one regulatory umbrella.
Given the current political environment in the United States and the recent real and perceived abuses in our financial system, it is highly unlikely that new financial services regulation here will be self-regulatory in nature. However, I believe that the Frank-Schumer Act will create a single regulator for all banking, insurance and investment activities in the U.S. It will be responsible to the Treasury and through it, to the Congress. Its governance will consist of a Board of Overseers, a Chairman and Vice Chairman for Banking, Insurance, Investments and Consumer Protection, and such departments that are necessary to carry out its responsibilities.
The Banking Division will assume the regulatory responsibilities and powers that the Treasury, Federal Reserve, and Comptroller of the Currency now have concerning banking activities, and will coordinate its efforts with those agencies. The SEC, with some modifications and expanded powers, budgets and staff, will be responsible for the investment activities of the industry. The Insurance Division will be responsible for the federal regulation of insurance activities, coordinating with the individual states as necessary and appropriate.
This new regulatory structure will set the trends in the financial services industry in the following ways:
1. Financial services holding companies.
Under the new legislation the financial services holding company model will not only survive, but will flourish, and will be the effective and successful model for the industry in the future. Citigroup, the archetype for this model, will survive, albeit in a modified form, as a provider of all financial services to its customers as a manufacturer and/or distributor. There will be only large, medium and small financial services holding companies and boutique specialty firms. JPMorgan Chase, Bank of America and Wells Fargo are already financial services holding companies, and Goldman Sachs and Morgan Stanley have each applied to become one.
2. Banks.
The larger financial services holding companies will continue to acquire smaller national and regional banks, and regional banks will combine to form smaller holding companies. Community banks will be absorbed to some extent but will have the option of remaining independent because their small town, face to face, I know you, you can trust me persona will fit what their local markets want for the foreseeable future.
Community banks could well turn in the best performance of all banks in the next decade, providing a full range of services, including and even featuring financial planning, while returning to their roots as the financial centers in their communities.
In this new alignment, the terms brokerage and investment banking and insurance will describe an activity, not a company.
3. Financial Advisors.
For financial advisors, a new regulatory structure under a single regulator will mean an end to the current contention about the differences between brokers, financial advisors and financial planners, and how they should be regulated. There will be no distinction between brokers and investment advisors. All brokers will be considered investment advisors, and all investment advisors will be considered as having a fiduciary relationship with their clients.
FINRA, or a comparable SRO, will regulate all investment advisors including those who are currently registered as registered investment advisors directly with the SEC. Financial planners might be classified as a separate category, but the SRO would also regulate them unless they opt for state regulation where they would be licensed and regulated by the states. The terms broker, brokerage firm, wire house and insurance agent will disappear. Financial Advisor, Financial Consultant, Financial Planner and Wealth Manager will be the terms used to describe financial advice givers, with Wealth Manager dominating in the high end of the market and rapidly moving down market overtime.
There will be increased emphasis on education. As part of its consumer protection efforts, the new regulator will focus on the training and continuing education of financial advisors. There will be an M.B.A. and Ph.D. in Financial Services, and in Financial Planning.
New entrants into the financial advice business will come from the training programs of the financial services holding companies, and increasingly from the growing undergraduate financial planning programs in the nation's colleges and universities.
There will be significantly more opportunities for financial advisors to work with companies and employees regarding their 401k plans as the move to eliminate company liability exposure for advice-giving accelerates under the new regulations.
The potential of the Internet will finally come into play in the 401k market in the delivery of low-cost hourly advice for a fee, using computer camera interaction.
4. Money Management.
In the money management business there will be more boutique firms by asset class and style. Their assets under management will grow as the financial services holding companies continue to move away from proprietary products and install open architecture investment platforms, maintaining the separation of their money management activities from their distribution.
5. Mutual Funds.
Mutual fund companies will continue to have a respite from regulatory scrutiny. They are no longer everybody's whipping boy. However, the growth of assets in mutual funds will continue to be flat as a higher percentage of new money goes into non-managed and managed ETFs that earn significantly less in fees.
The days of mutual fund assets growing from $100 billion in 1980 to $1 trillion in 1990 and $8 trillion in the 2000s are gone.
The management fees on traditional mutual funds will be maintained and their managers will continue to enjoy 25% to 35% profit margins because the introduction of '40 Act funds, that can sell short and earn performance fees, will offset the increases in their operating costs. The management of Separate Accounts that feed the open architecture platforms of the big financial services companies also pays higher fees than traditional mutual funds.
There are few buyers for mutual fund companies in the current environment, but merger and acquisition activity will pick up when the market stabilizes and the regulatory climate clears up. Sellers will be more anxious than buyers. Many fund managers turned down spectacular offers in the past decade and will not make that mistake again.
6. Insurance.
Insurance companies will become part of the financial services holding companies when they become federal rather than state regulated.
While all the financial services holding companies sell all kinds of insurance, they have not acquired any of the larger insurance companies. After GLB, the initial reason was that many of the insurance companies had just converted from mutual to stock companies and were restricted from selling or merging for two to five years after their initial public offerings. Now, the hesitation on the part of the financial services holding companies is the fact that insurance companies are regulated by the states, and these companies do not want to deal with 50 regulators.
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