Financial Services Sector

Consisting of a variety of financial firms including banks, finance companies, lenders, investment houses, real estate brokers, and insurance companies, Financial Services is the third largest sector in the economy. It is primarily made up of large conglomerates, however there is a diverse array of smaller firms that also facilitate the flow and allocation of capital and liquidity. This sector is fundamental to the operation of the economy as it provides banking, mortgage, credit card, payment, tax preparation/planning, accounting, investing, insurance, and asset management services. The Financial Services Sector represents approximately 15% of the total market capitalization and contributes significantly to US GDP. As of 2022, the financial services industry employed over 8 million people in the United States. By 2030, it is expected to grow 8%, adding over 750,000 jobs. Today’s Bureau of Labor Statistics data suggests that we are heading in that direction.

In 2023 , the US financial services market size reached a value of nearly 60.65 billion USD. The sector’s performance is influenced by factors such as interest rates, economic growth, regulatory changes, and technological advancements. A couple other major industry drivers include the growing demand for insurance and loans, global economic growth, and the rising number of start-up businesses. The sector’s long-term prospects are also influenced by demographic trends, such as aging populations and the growing middle class in emerging markets, which drive consistent demand for financial services. Despite facing challenges such as regulatory scrutiny and market volatility, the sector remains resilient, offering investors opportunities for income generation through dividends and capital appreciation.

Broader Financial Services Markets:

In 2023, the Financial Services Sector was fraught with uncertainty, led by the collapse of the Silicon Valley Bank, decreasing the public’s confidence in the US banking system. As a result, some depositors acted in a “flight to safety” as they moved deposits to Systemically Important Banks (SIBs). Regional banks, in particular, underperformed. Nevertheless, interest rates stabilized, and the stock market was able to rebound. Globally, the financial services market size was valued at 25.51 trillion in 2022 and is expected to surpass 58.69 trillion by 2031, expanding at a CAGR of 9.7% from 2023-2031. The growth of the market can be attributed to the digitalization of many financial institutions, the rapid expansion of commercial lending, and the rise of FinTech startups that are offering innovative ways to deliver financial services. This includes mobile banking, robo-advisors, peer-to-peer lending platforms, and cryptocurrency exchanges. As per an IMF report released in 2021, financial services constitute nearly 24% of the global economy.

Industries Within the Financial Services Sector:

The Financial Services Sector is divided into several key industries, as follows:

– Banking: This industry is the largest within the Financial Services Sector.  It involves the provision of banking services, including checking and savings accounts, loans, credit cards, and wealth management. Most financial institutions that offer banking services provide ways for you to qualify to borrow money. Banks are grappling with the challenge of digitizing their services while maintaining compliance with regulations. Banks earn revenue primarily on the difference in the interest rates charged for credit accounts and the rates paid to depositors.

– Insurance: This segment includes companies that underwrite insurance policies, providing protection against various risks such as life, injury, wrongdoing, health, and property. Insurers are adapting to changing risk landscapes and customer expectations, with a focus on personalized coverage and digital claims processing. Insurance is a critical component of the financial services sector, offering financial protection against unforeseen events and liabilities.

– Asset Management: This industry involves helping retail and institutional clients manage their investments in order to meet specific goals. Asset managers are leveraging technology to offer more personalized and efficient investment services, while also navigating the complexities of regulatory compliance. Asset management is a key service within the financial services sector, focusing on the growth and preservation of clients’ wealth through strategic investment decisions. This subsector experiences more moderate growth than the others.

– Investment Services: This sector includes brokerages, trading platforms, and other intermediaries that facilitate the buying and selling of securities. Firms in this sector are investing in technology to enhance trading capabilities and customer service, while also dealing with the challenges of market volatility and regulatory oversight. Investment services play a crucial role in connecting buyers and sellers of financial securities, enabling the efficient allocation of capital across the economy.

Investing in the Financial Services Sector:

Investing in the Financial Services Sector is important to maintaining a well-diversified portfolio. The sector includes a large group of companies such as mega banks, regional banks, asset managers, custody banks, consumer finance companies, transaction and payment processors, securities and brokerage firms, and insurers. Financial services play an integral role in the lives of consumers, businesses, and institutions, making up a significant portion GDP. Investors can gain exposure to the sector through stocks of financial institutions, ETFs focused on the sector, and mutual funds. The sector’s performance is influenced by economic conditions, regulatory changes, and technological advancements. However, investors must be aware of the risks associated with regulatory changes, market volatility, and the impact of economic cycles on the sector. The Key industry players within the financial services sector include Berkshire Hathaway (BRK-B), JPMorgan Chase & Co (JPM), Visa Inc. (V), Bank of America Corporation (BAC), Mastercard Incorporated (MA), Wells Fargo & Company (WFC), The Goldman Sachs Group, Inc (GS), Morgan Stanley (MS), and American Express Company (AXP). 

Advantages and Disadvantages of Financial Services Sector Investing:

There are a set of advantages and disadvantages to investing in the Financial Services sector that individuals must carefully consider when deciding to make an investment.

In terms of benefits, investing in the Financial Services Sector plays a crucial role in the economy, contributing a substantial portion to GDP, thus driving high demand for its services. Various subsectors within Financial Services, especially banking, offer diversification to one’s portfolio. Additionally, many of the stocks in this sector pay dividends which can act as a proxy of the quality of the company. This sector yields high returns when the economy is flourishing, for instance when GDP is rising, or the housing market is booming. The sector’s resilience and the potential for growth in emerging markets and digital services makes it an attractive investment opportunity. Additionally, the sector’s importance to the economy ensures its relevance, even in challenging times.

However, the sector is heavily regulated, and failure to abide to those regulations can lead to litigation. There are high costs associated with these legal settlements which could hurt the firm’s profitability and capitalization, and thus reduce their ability to generate returns and lower their share prices. Additionally, if financial reform and capital requirements become overly sensitive, financial services companies may not be able to grow earnings as they have historically. Furthermore, financial services companies are highly sensitive to changes in interest rates. Meaning, greater volatility in interest rates may lead to greater stock volatility. Companies within the sector are also very susceptible to loss from the overall health of the economy. During troublesome economic times, the share prices of financial services companies have the potential to be negatively impacted. Investors must also consider the impact of technological disruption and the competitive landscape, which can lead to consolidation and changes in business models.

Future Outlook and Opportunities:

With higher interest rates, greater regulatory pressure, and (moderating yet persistent) inflation looming, transformation within the Financial Services Industry is bound to take charge. The increased prevalence of generative AI, transition to the cloud, increased fraud and cyber risk, and the blurring of industry lines (including the embedded finance trend), necessitates those financial services leaders be more vigilant than ever.

The use of generative AI is expected to be the most influential trend permeating the financial services sector in 2024. One example of this is within the insurance subsector. AI can help insurers create personalized products which could lead to more accurate risk assessments, thus easing insurance costs for individuals. Cloud computing is also likely to get increasingly popular as 2024 progress. In their 2023 US Technology Survey, KPMG found that 56% of the companies surveyed support the operation of emerging technologies including AI, quantum computing, etc.

Furthermore, sustainability efforts and ESG consideration are anticipated to take flight into the new year. Organizations within the Financial Services Sector will place increased emphasis on reducing their carbon footprint and prioritizing green initiatives. In terms of banking, the use of APIs and opening banking is predicted to gain relevancy within the industry. APIs may become the preferred method to help banks connect technologies to their intern systems and streamline processes. Statistically speaking, the US Financial Services Sector is predicted to grow at a CAGR of 7.47% (less than 2% lower than the global CAGR outlook) between 2024 and 2032, indicating that it is an advantageous industry.

On the flip side bank profitability, which is the largest financial services subsector, will be challenged in 2024 due to higher funding costs and sluggish revenue growth, slightly below an ROAE of 12%. Bank profitability will remain subdued, with ROA percentages stagnating into 2026. By 2025, robo-advisors are projected to manage around $8 trillion in assets/ The wealth management market is expected to reach $118 trillion by 2025. Financial sector stocks are predicted to potentially outperform the S&P 500. Overall, the future is looking bright for the Financial Services Sector.

These trends indicate that the Financial Services Sector is, and will continue to be, a leading choice for investors. It is characterized by its resilience and offers a range of opportunities for growth and diversification. Long-term growth trends like a growing global population, globalization of world economies, and technological advancements will positively drive this sector in the long run. Due to its sheer size and relevancy within US GDP, there is consistent demand for financial services.
 
Links:
https://www2.deloitte.com/us/en/pages/financial-services/articles/future-of-financial-services.html