From Consolidation to Regulation FD: Financial Services Face a Major UpheavalPublished: November 07, 2001 in Knowledge@Wharton
Consolidation. Regulation FD. Conflicts of interest. Global competition.
In discussing the state of the financial services industry, it’s hard not to reference the events of Sept. 11. Yet even before that day, the industry was facing significant change on a number of fronts.
Just how significant that change is, and what it means for customers, employees, analysts, managers and others, were the focus of two separate events last month, the Wharton Finance Conference and the Wharton Investment Management Conference.
Consolidation driven by client demands, technology and the relaxation of financial regulations, for example, is creating huge conglomerations of banking, insurance and securities firms – a development that is "likely to continue, especially in a down market," said Art Penn, head of the global financial sponsors group at UBS Warburg. Penn was one of the participants in a finance conference panel entitled "Trends in Financial Services for the Next Decade."
Clients have been demanding that financial service companies provide capital and advice under one roof, he noted. But if the major investment firms grow too large and unwieldy, some clients and employees may eventually migrate to smaller, boutique firms.
Richard B. Saltzman, chief operating officer of the investment banking division at Merrill Lynch, said banks are eager to acquire high-margin securities firms. At the same time, noted David Head, global co-head of mergers and acquisitions within the financial institutions group of Salomon Smith Barney, securities firms want access to retail banking customers. "By focusing on the point of sale, you are seeing securities firms take the best part of the banking business," he said.
For example, securities firms are going after the corporate lending business of banks, but they are not likely to take on expensive, low-margin businesses such as global cash management. "Our clients are saying to us, ‘If you want to underwrite our securities you’re going to have to lend to us,’" Head added.
Panel moderator and Wharton legal studies professor William C. Tyson pointed out that much of this consolidation was possible only after the 1999 repeal of the Glass-Steagall Act, which had erected a wall between commercial banking and investment banking.
Saltzman explained that commercial banks held huge stakes in the stock market going into the Depression and thus had a huge exposure in the 1929 market crash. Glass-Steagall, enacted in 1934, was an attempt by the government to prevent banks from speculating in the stock market.
According to Penn, it was also viewed as undue influence if a bank could link its lending decisions to whether it would receive underwriting or other business from an investment house. "Now 80 years later, that is what our clients want us to do and that’s what we want to do," he said.
Tyson noted that many countries never had such legislation. Indeed, Saltzman said, another force driving consolidation is clients’ need to have integrated services globally, a point echoed by Per Sekse, vice president of global risk management at energy giant Enron Corp. To remain competitive, Sekse said, his company has devoted a massive internal effort to incorporating new technology and management systems to help it operate swiftly and efficiently around the globe. Fully integrated financial service companies, with the power to lend as well as underwrite, would help that process. "A big corporation has to move fast. If it takes you six months to make a decision, you’re probably going to be an also-ran," Sekse said.
Regulation FD: Increased Volatility?
Tyson asked how the Security and Exchange Commission’s disclosure rule, Regulation FD, has impacted financial services companies since it took effect in September 2000. The regulation requires companies to disclose material information to all investors at the same time. Tyson said that prior to the rule change, companies gave information to Wall Street analysts who were then able to use that information for trading at their own firms or for preferred clients before the public became aware of the information.
Saltzman, like all the panelists, said he supported the goals of Regulation FD, but pointed out that the rule has created more of a burden for corporate clients than for financial companies.
Head added that before Regulation FD, information would work its way into the marketplace and its eventual effect on prices would be gradual. Now, he said, company news goes out not only to all analysts at once but to retail investors as well. "That has led to more radical price swings and increased volatility."
For equity analysts, he said, Regulation FD means less trolling for tidbits from management and a return to what was once the core of their work, pouring through balance sheets and footnotes.
Gary Silverman, U.S. banking editor at the Financial Times, fears some companies are now using the regulation as an "all purpose excuse" to withhold information from all investors which, he suggested, does not seem to be in the spirit of what the SEC was trying to achieve.
Analysts: ‘Damning with Faint Praise?’
Tyson also questioned whether it is a conflict for financial firms to be in both the research business and the investment business. Head said a strong research operation is key to a large, global financial company. Institutional clients expect it, and it is a marketing draw for retail clients. In a large global firm it takes $300 to $400 million a year to run a research business, he noted. "Clearly there is integration between both sides of the organization. But I don’t see it ever being divested." Research, particularly in the aftermath of the technology bubble, has now become a "whipping boy for people who made poor investment decisions."
The Financial Times’ Silverman said business journalism has added to the problems now associated with research. With the explosion of financial reporting that accompanied the 1990s bull market, journalists were required to become instant experts on complex financial matters, he pointed out. One shortcut was to contact a research analyst and boil down a complex report, or series of reports. Often there was no room in the story for an analyst’s niggling, but almost always cautionary, asides. "A lot of the scandal really was on our side," said Silverman.
Analysts need to appear friendly to management to gain access to information, said Head. But, he added, careful readers of analysts’ reports can detect trouble in a flat or muted report that is "damning with faint praise." He also said analysts are frequently blunter in a telephone call to an institutional client than they are in a public report.
Head suggested that the industry can expect more disclosure to eliminate potential conflicts between the research and investment side of firms, adding, however, "I’m not sure the model is broken."
Back to Basics
Speaking at the Wharton Investment Management Conference, whose theme was "Back to Basics: Successful Investing in Any Market," Brian Fullerton, global chief risk officer at Merrill Lynch Investment Management, noted that in a world full of risk, investment managers not only face challenges within their portfolios, but deep structural change that will reshape the entire industry.
With a market slump and broader economic downturn already underway, the attacks on the World Trade Center and Pentagon have only added to the risk in evaluating portfolios, said Fullerton. He likened investing to navigation. After a course and arrival time is set, it is up to the navigator to adjust to the conditions of the seas in order to remain on track. "The winds and waves are always on the side of the ablest navigator," he said.
And right now, the economy is taking on water.
In early summer, even before Sept. 11, analysts were forecasting corporate earnings declines of six percent. By early September, earnings were down 15%. By that month’s end, earnings were down 20%. "These are fairly hideous numbers," Fullerton said. "This is probably one of the worst declines in history and it’s probably the issue that concerns me most."
He is also worried that corporations, with little left to lose this year, will go on a write-down binge in the fourth quarter although an already cool market climate had kept the investment management industry under-leveraged going into this fall. "There was a good amount of cash sitting in portfolios so we didn’t have a liquidity crisis." Investors are also holding onto cash, keeping equity markets anemic. From 1994 to 2000, investors viewed market drops as a buying opportunity. "I think they’ve been cured of that," said Fullerton.
In response to a question, Fullerton warned that the Federal Reserve’s willingness to generate liquidity could rekindle inflation. But he said the government’s intent is to turn the economy around in six to 12 months. "That’s what the history books have shown. So I think that’s the focus."
He said Merrill Lynch strategists are "fairly optimistic," about the markets, but cautioned: "I’ll say that within the next few months we believe we’ll be testing the September lows."
A New Business Model
Beyond the turmoil in the markets, Fullerton predicted the investment management industry itself is about to undergo major adjustments. "The markets have changed," he said, "but the business model has changed substantially."
According to Fullerton, the industry is now entering a third distinct stage of an evolution that began in the 1970s. From 1970 to 1985 the industry remained a clubby, specialty business focused on institutional clients, such as pension funds. "You didn’t get into it unless your father was in the business."
But in the mid-1980s, the industry entered a period of rapid expansion. "There were no barriers to entry. Anyone who could go to Wharton, anyone who could understand financial theory and understand the market, could generate some returns in what was a growth market."
Fullerton said the investment industry will need to become more like the businesses it passes judgment upon. Investment managers grew spoiled by rapid growth without adhering to basic business rules that are a way of life at mature companies, such as a sales plan. "A growth market really moved us along. Business management was virtually nonexistent."
In the next five years Fullerton expects the industry to segment into firms operating on four different business models: Distribution specialists concentrating on sales; investment "manufacturers" generating the actual returns; financial holding companies, like Merrill Lynch, offering a broad set of services inhouse; and financial conglomerates made up of a collection of boutique-style companies.
The industry will continue to be driven by information technology that will allow it to offer investors custom products. And investment companies will have to broaden their base beyond the high- and ultra-high net worth individuals they prefer to court today.
As for the promise of global marketing, it has yet to deliver for investment firms, said Fullerton, although it seems inevitable. "When you look at the numbers, it’s like, ‘When is this going to come?’ The pressure is building on everyone in the industry."
Meanwhile the new emphasis on simple business management will require investment managers to take a long-term view of caring and feeding their clients. "We’re going to actually have to go out and work with people on their portfolios," he said, adding that the industry has been focused on developing and selling new products and has paid little attention to helping customers manage their portfolios.
He cited an example: Very few individual investors have a fixed-income component in their portfolio, something that would have been extremely helpful in the current market.
Ultimately, investment managers should find a way to balance individual portfolios for the retail investor the way chief executives, offshore clients and institutions balance theirs. "Who can figure out how to make money helping people invest the correct way rather than selling them something?" Fullerton asked. "I hope that’s what happens, but I don’t know how long it will be until we get there."