FINANCIAL SERVICES INDUSTRY

FINANCIAL SERVICES INDUSTRY. Until the 1970s, the financial services industry consisted of a few well-defined and separate industries that dealt in money. These included banks and savings and loan associations for personal savings, checking accounts, and mortgages; brokerage houses, such as Merrill Lynch, for investment in stocks, bonds, and mutual funds; and credit card companies, such as Visa USA or MasterCard International, for consumer credit.

The Decline of Banks

Beginning in the 1970s, the profitability of banks declined due in large part to federal regulations that restricted banks from offering the variety of products, such as insurance, mutual funds, and stocks, that their less strictly controlled competitors offered. The gradual shift away from banks as the center of the American financial services industry occurred between 1973 and 1979, when the Organization of the Petroleum Exporting Countries (OPEC) dramatically increased oil prices, leading to double-digit inflation by the end of the decade. As a result, investors with savings accounts receiving the federally imposed 5.25 percent interest rate were losing money. Coupled with inflation was the emergence of investment companies offering consumers money market mutual funds, which enabled the average investor to earn market-rate interest. Mutual funds were also a safe instrument, as they were invested primarily in high-interest federal securities and certificates of deposit (CDs). Mutual funds grew as small investors, lured by huge gains in the stock market during the 1980s, sought ways to earn returns greater than the rate of inflation. The shift to mutual funds hit American banks hard. In the years between 1977 and 1981, consumers went from investing $3.9 billion to investing $181.9 billion in mutual funds rather than putting their money in the bank.

Still, many Americans used their local banks for routine checking and savings. But bank assets continued to decline; in 1960 banks held 34 percent of the total assets of Americans. By 1989 that figure had declined to 26 percent. In the meantime, consumers had a number of alternatives to conventional savings accounts, including CDs and money market funds, both of which yielded higher interest than standard savings accounts.

Despite the approximately 1,295 bank failures between 1985 and 1992, banking advocates stated that the industry was competing effectively in the newly competitive financial services market. Although the traditional business of banks, taking deposits and making loans, had declined, other services more than made up for the loss, resulting in record profits in 1992 and 1993. To remain competitive, banks exploited loopholes in the Glass-Steagall Banking Act of 1933, which sharply restricted their activities. During the 1980s and 1990s, banks responded to competition by selling money market and mutual funds, creating mortgage and financing subsidiaries, and fashioning a huge network of automatic teller machines (ATMs).

The Diversification of the Financial Services Industry

By the mid-1990s, many observers believed that the banking industry and other companies offering financial services were no longer clearly defined, separate entities. Now banks, insurance companies, and brokerage houses converged. Insurance giant Prudential acquired brokerage houses to form Prudential-Bache, and such traditional Wall Street players as Merrill Lynch began to offer accounts that allowed customers to do their banking.

Analysts disagree about the effects these changes have had on the American finance scene. By the early 1990s, some believed that the United States was becoming a bankless society, with such corporations as the Ford Motor Company, General Electric, and General Motors able to offer loans to businesses and credit to consumers, all financial services previously reserved for banks and savings and loans.

Credit Cards

By 1995, Americans faced a bewildering array of choices for even the most routine financial transactions. Credit cards became increasingly popular, with $480 billion in purchases made in 1993 alone. Credit cards offered by an ever-growing number of companies and associations granted premiums and bonuses if consumers used their cards. Those who used the GM MasterCard or Visa, for example, could get credit toward their next auto purchase from General Motors; Exxon Visa cardholders could get back 3 percent of every gasoline purchase made at an Exxon station. Other credit cards offered frequent flyer miles and donations to charities. Other companies issuing credit cards included Sears, AT&T, Chrysler, and Ford Motor Company. Credit cards account for 25 percent of all profits at the ten largest banks in the United States, but with only 14 percent of all merchandise purchased via credit card, there is still room for growth.

Since the early 1970s, the use of credit cards has expanded from infrequent large purchases to include such everyday purchases as groceries, fast food, and telephone calls. Thanks to less stringent underwriting criteria at major credit card companies, credit cards are also more easily available than ever before. In 1989, 56 percent of American families had at least one general use credit card such as MasterCard or Visa. By 1998, that number had climbed to 67.5 percent. Credit card companies have also targeted new groups for their product. Offering cards to students on many college and university campuses has led to easier access to credit for those who may not yet have established a credit history. For credit card companies, this persistence has paid off: Americans charged more than $1 trillion in purchases with their credit cards in the year 2000, more than they spent in cash.

Industry Convergence

The convergence of companies offering financial services has blurred the conventional boundaries that once separated banks, brokerages, and insurance companies. This trend has now become global. As a result, the convergence of financial services has created a new class of financial provider. These financial services conglomerates strive to provide customers with a vast portfolio of integrated financial services.

Perhaps the most significant example of convergence came in April 1998 with the announcement of the merger of Citicorp and Travelers Insurance. The creation of Citigroup, already a financial giant with a presence in 100 countries across six continents, offered a glimpse of a new business model in the financial services industry: a full-service provider with formidable assets in banking, insurance, stockbrokerage, mutual funds, and more. With assets valued at $697.5 billion, Citigroup became the largest financial services company in the world. A week later, on 13 April, Banc One announced its merger with First Chicago NBD Corporation, with the new company's value now estimated at $116 billion. That very same day, Nations Bank joined with Bank America, creating a new corporation with deposits of $346 billion, making it the second largest bank in the United States and the fifth largest in the world.

It was clear that through these mergers a complex and ongoing revolution was transforming the very nature of the financial services industry. At the very center of this revolution, however, was a conflict between what banking experts called "consolidation" and the process called "disintermediation," which meant the removal of intermediaries such as banks from financial transactions. Proponents of disintermediation, such as the software giant Microsoft, believed that the future belonged to those companies who mastered the new technology, which in turn, would give customers and investors almost complete control over their finances.

Turbulent Times

Despite its growth and its profits, the financial services industry has not escaped crises or disasters. On 19 October 1987, the New York Stock Exchange experienced the largest single-day drop in its history, losing 508.32 points, or 22.6 percent of its value. Although many factors accounted for this huge decline, a major concern was the impact of computerized trading programs, which bought and sold huge blocks of securities automatically. The market quickly rebounded from Black Monday, but the Securities and Exchange Commission enacted rules that limited the ability of computerized programs to affect the market.

One of the defining moments in the financial services industry came during the 1980s with the failure of hundreds of savings and loan (S&L) institutions. Unlike the fall of the stock market, the S&L disaster produced much more enduring consequences. A partial explanation for the failures came from the debt burden that the S&Ls carried as the result of offering low-interest mortgages, in some cases as low as 3 percent, during the 1970s when inflation was high and interest payments to depositors were as much as 12 percent. Fraud and corruption also played a role in approximately half of the failures. A government bailout costing an estimated $500 billion to $1 trillion implemented over a period of thirty years was required to pay insured depositors of failed institutions.

Like much of the United States, the financial services industry suffered a terrible tragedy in 2001 when terrorists attacked the World Trade Center (WTC) in New York City and the Pentagon in Washington, D.C. The assault had a profound and lasting impact on the financial services industry because the WTC was home to dozens of banks, insurance companies, brokerages, and securities firms. Many companies with offices in the WTC lost dozens of key personnel. Some companies were virtually wiped out, losing all their documents and records. As of 2002, other companies have recovered from effects of 11 September, but are still experiencing cash flow problems because of the interruption of normal business.

The industry felt the effects of the attacks in other ways as well. In addition to their own financial losses, they suffered from the further general contraction of an already languishing American economy. The events of 11 September have led the financial service industry to reevaluate how the industry will function in the future. Many foresee a move toward electronic and virtual markets.

The Financial Services Industry and the Law

In 1999, Congress passed the Gramm-Leach-Bliley Act (GLBA), or the Financial Modernization Act, the most sweeping legislation directed at banks and other financial institutions since the Great Depression. Intended to monitor cross-industry mergers and affiliations, customer privacy, and lending to lower-income communities, the GLBA created opportunities for financial institutions to engage in a broader spectrum of activities. The legislation also placed additional burdens on financial institutions, such as new consumer privacy safeguards and disclosure requirements.

The law permits the convergence of the banking, insurance, and securities industries as long as appropriate safeguards are in place to protect the consumer and guarantee the solvency of the institution. At the same time, the law almost completely eliminated the legal barriers that once separated the various components of the financial services industry. Although superseding state legislation, the GLBA also recognized the importance of state regulation of financial services companies and so endorsed the "functional regulation" of institutional activities by both state and federal regulatory agencies. State laws could not discriminate against banks in licensing or authorizing securities and insurance activities, but a state could impose reasonable and necessary licensing and consumer protection requirements consistent with federal regulations.

The law also limited the extent to which financial institutions could share personal information about customers, stating that individuals must be informed about the privacy policies and practices of financial institutions. The law also gave consumers limited control over how financial institutions used and shared personal information.

Three years after the law was enacted, the freedom that the GLBA granted was in jeopardy. In 2002, the financial services industry became the subject of federal scrutiny as Congress debated new legislation that would more closely regulate the industry. The inquiries came amid scandals involving such high-profile financial firms as J. P. Morgan Chase and Company and Merrill Lynch, with accusations that company executives were guilty of deception and fraud with regard to the financial collapse of the Enron Corporation. Once willing to keep government out of the way, legislators now called for tougher laws that would mandate keener overseeing of corporate finances. Additional legislation would overhaul the Financial Accounting Standards Board.

The USA Patriot Act, also passed in 2001, will require mutual fund companies, operators of credit card systems, registered broker-dealers, futures merchants, and money services businesses to adopt programs similar to those that banks have been required to use since 1987. This piece of legislation law is aimed at curbing money-laundering activities, including those that help fund terrorism. As of 2002, some sectors of the financial services industry, such as insurance, finance, and non-mutual fund companies, remained exempt from the law.

The Future Is Now

As the financial services industry becomes more fast-paced and competitive, technology will be an even more important component of success. Probably more than any other sector of the American economy, financial services rides the crest of technological innovation. Finance is increasingly a twenty-four-hour, seven-day-a-week global activity with vast sums flashing between markets over the electronic communications web. The ability to instantaneously interpret the financial markets and anticipate their movement can bring huge profits or avoid disastrous losses. With large sums committed in the markets, financial organizations need to calculate how much risk they are accepting.

The sheer speed and complexity of financial markets has compelled banks and other financial institutions to look beyond conventional analytical techniques and computer systems. A bank's technological stockpile can include object-oriented technology, neural networks, data visualization, and virtual reality. The Citibank Corporation, for instance, files its annual report with its regulator by sending the document electronically; the physical copy is posted later merely to satisfy the requirements of law. The Federal Reserve Board, which functions as the central bank of the United States, posts complete information on bond and money markets each day on a computer bulletin board.

As more financial information is disseminated electronically, the ability to manipulate it is also growing. Advertisements on electronic bulletin boards match buyers with sellers, and borrowers with lenders. Transactions are instantly verified and settled through a global, real-time payment system. Innovations in self-service delivery, such as ATMs, telephone transactions, kiosks, and more recently, Web-enabled services through Internet "portals," have forever altered consumer expectations. Technology has also enabled new and often nontraditional competition to enter the market space of traditional providers. In response, many financial services companies are currently deploying new technologies to support an integrated product approach, wagering that their customers will find value and convenience in getting all their financial services from a single institution.

Thanks to the growing electronic market, many analysts believe that this diversification will dampen both inflation and, possibly, speculation. Bankers may also become an endangered species. At present, they control payment systems, assess creditworthiness, and transform short-term deposits into long-term loans. In the future, some experts say, many, if not all, of these functions will be performed either by individual customers or by more specialized firms, removing whatever influence banks still have over other financial service companies. If they are to survive and prosper, banks will need to find different niches, such as credit card processing, asset management, or, as in the case of Bankers Trust, the pricing and management of financial and other types of risk. Securities houses may also find themselves in jeopardy. As the costs of doing business begin to virtually disappear, consumers will have even greater opportunities to bypass financial firms all together. Finally, one of the most provocative of the claims that financial experts now put forth is that today's financial services customers could become tomorrow's rivals. Bypassing banks and securities firms, corporations might soon bid against them for financial business.

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Meg GreeneMalvasi