Financial Sector Outlook 2014

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What Will the Financial Sector Look Like For the New Year

The Financial sector has still yet to recover from the financial crisis.  Margins are still being squeezed due to increased regulation and decreased business activity.  Financial firms will also see new challenges emerging; remaining responsive to the needs of their clients, embracing new technology and products and reconfiguring their core business lines in order to not only comply with regulations but to remain profitable.

After a banner year for financial markets in 2013, financial firms will find out in 2014 will be the year where it all comes together.  With the profit margins of many firms under pressure due to increased compliance costs and lower demand for financial products, many firms face a dual-edged sword; while financial institutions enjoy record profits and levels of capitalization, they also face slowing GDP growth and an uncertain fiscal environment in the U.S.

In their 2014 forecast, Deloitte likened the environment in a unique yet succinct statement:  “It was the best of times; it was the worst of times”.

Deloitte also observed in their financial sector forecast that not only will financial institutions consolidate themselves but they will also divest themselves of more risky assets and embrace other alternatives as part of a more risk-averse approach to their portfolios.  The Mergers and Acquisitions (M&A) market for financial institutions will also be more active as Deloitte notes that small and mid-sized banks will try to become bigger or will acquire portfolios from other companies looking to exit certain business lines, such as commodities or derivatives trading.

Most of all, the financial sector is set to be affected by other entities who are entering the same business lines that financial institutions have traditionally been involved, such as crowdfunding platforms that may take the place of smaller investment banks for capital markets activities for smaller companies.  Private equity firms and hedge funds have also taken the place of investment banks, and proxy advisory firms can make or break the nominations of a new board of directors.

Push for Profitability Vs. Reducing Risk

Accounting firm Grant Thornton mentioned that regulators persist in pushing for stricter capital requirements despite a slight improvement in overall industry capital ratios in recent years.  With more profitability coming from operations and in some instances, shrinking balance sheet additional capital  requirements proposed under Basel III, the global banking regulatory standard may potentially put a strain on financial institutions that could affect profitability.

A number of community banks, for example were surprised that Basel III proposals included them in the proposed capital requirements, which underscores another potential crisis that financial institutions may face; increased compliance scrutiny without significant comprehensive reform or clarification from regulatory bodies. Banking institutions in particular have begun preparations for the new requirements, as the template for securities law has provided a sort of “roadmap” for banking institutions to follow.  Needless to say, as both banking and securities laws are fundamentally different, the past lessons of repealing the Glass-Steagal Act of 1934 and the financial crisis of 2008 show that they have become ever more a mirror image of one another.   This has caused many financial institutions to not only cut back on traditional banking services such as lending (as most of their capital has seemingly earmarked towards the aforementioned M&A deals between each other) but also has led to other entities who will step in their place that do not have the stringent requirements that traditional financial institutions have.

M&A activity among financial institutions have been held back by capital restraints of potential acquirers and the overall depressed stock valuations of banking and financial companies along with the perceived risks of acquiring an institutions with potential credit or capitalization issues.  The CAMELS system, used by bank examiners, helps measure the soundness of a bank. Each letter stands for one of the six components of a bank’s condition; capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk.  Regulators have even larger banks that any approvals for any acquisitions other than for minor deals will be very difficult, unlike the large, lateral moves that were made among financial institutions in the 1990s and early 2000s.

Bank M&A activity has been hampered by capital restraints of potential acquirers and the overall depressed stock valuations of banking companies, along with the perceived risks of acquiring a bank with potential credit issues. It has also become pretty clear that banks rated worse than a 2 in CAMELS ratings will have a more difficult time obtaining regulatory approval of acquisitions. (Bank examiners use the CAMELS system to help measure the safety and soundness of a bank. Each letter stands for one of the six components of a bank’s condition: capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk.)

Indeed, the regulators have even told the larger banks that approvals for any acquisitions other than for relatively minor deals will be very difficult.

Financial institutions are also mindful that ultimately, regulators will scrutinize banking activities that their clients use but also, how much their services will generates in the way of fees and commissions.  Though some firms have already started to put new revenue growth plans to work, much needs to be done.  Simply targeting affluent customers for expanded wealth management services is not the solution that will lead the way.  Success of this strategy will rely on technology to reach out to customers and more robust data management and analytical tools can help break down demographics and further help secure its systems.

Many analysts see 2014 as a continuation of the recovery of the financial sector, still feeling the effects of the financial crisis and from increased regulatory scrutiny will also have to contend with other economic headwinds such as unresolved government debt issues, potential monetary tightening and higher interest rates, which still remain on the minds of investors.