Hurt by Hard Times, Financial Services Firms Seek New DirectionsPublished: August 13, 2003 in Knowledge@Wharton
The past decade has been a tumultuous one for investors and for the financial services industry. The last half of the 1990s seemed, in many ways, the best of times. A soaring stock market created vast amounts of wealth and funded the startup of thousands of new companies using new technologies to implement new ideas. Investing -- speculating, actually -- became the hot topic of conversation and news media coverage. Thousands of men and women quit perfectly good jobs to become tic-obsessed day traders. And, of course, the stunning number of initial public offerings, mergers and acquisitions made rock stars of venture capitalists, investment bankers and securities analysts.
Within the financial services industry itself, profits and competition had never been hotter. Unlikely mergers brought together such disparate firms as Morgan Stanley and Dean Witter. The ultimate dealmaker, Sandy Weill, had the audacity to dare Congress to stand in the way of his urge to merge. By merging Travelers with Citicorp, he single-handedly forced the demise of the Glass Steagall Act barring the union of commercial and investment banks.
Of course, much of it ended badly. The bubble burst early in 2000, wiping out the vast stock fortunes that were going to fund the early retirements of hundreds of thousands of baby boomers. The IPO and mergers and acquisitions markets went into a deep sleep. An ambitious New York State Attorney laid bare the deep conflicts of interest that pervaded Wall Street research and former rock stars were transformed into greedy spinmeisters lining their own pockets at the expense of individual investors.
The worst of the bad times is probably over. Immense tax cuts and historically low interest rates early this year appear to having their intended effect. The stock market has rallied, interest rates are climbing and corporate profits are beginning to improve. The recovery is still tenuous and could come undone. But given the volatile events that rocked the financial world over the past decade, one wonders what the next 10 years hold for the financial services industry.
The details, of course, are impossible to predict. But a few broad trends are taking shape and accelerating, according to experts at Wharton. One of the most notable is the interest in globalization. While often discussed as a strategy for commercial and investment banking, at least some experts already perceive that the pursuit of wealthy investors anywhere in the world will be an important strategic direction for such retail services as banking, brokerage and mutual funds. And that dovetails closely with another dominant theme that is posing competitive challenges to the financial services industry within the U.S. — the effort to win the business of high-net-worth individuals. The financial services industry in the U.S. is adopting a myriad of strategies and business models aimed at winning market share and profits from both trends. Those evolving strategies will be tested in the next decade, for better or worse.
Investment banking is one of the principal engines driving the fortunes of the largest players in financial services. Yet, as described by Wharton finance professor Andrew Metrick, it is an amazingly simple business. "Their fees are the main source of revenue and the main costs are labor costs," he explains. Competition often revolves around personal connections and reputations, he says. For example, Merrill Lynch might try to lure away bankers from other firms who develop huge reputations in specific industries. "The only thing that’s a problem is when the merger activity dries up and they have to fire a lot of people. As long as they can manage their costs and bring in big chunks of money and put a lot of it out as labor costs, the business overall will generate tremendous amounts of profit over the years."
Metrick portrays the investment banking business as a primarily cyclical business that is also affected by a trend component. The cyclical part of the business is tied closely to the performance of the stock market. "It’s perceived, and there’s some evidence that it’s true, that what drives mergers and acquisitions is a lot of people who see their stock values as a form of currency," he says. Thus it’s fairly easy to predict that the M&A business will do well when the stock market is rising and will perform poorly in a bear market.
The trend component, on the other hand, is a little more difficult to predict, although Metrick contends that once a trend begins, it tends to persist. "Merger and acquisition activity reacts to fads as well as to real economic forces that drive companies," he says. There was, for example, the conglomeration wave of the 1960s, which led to the creation of vast empires of disparate companies. LTV Corp., for example, made jet fighters, steel and canned hams. It was followed in the 1990s by the de-conglomeration wave in which companies shed non-core assets to focus on a single business, albeit businesses that are still, as demonstrated by AOL Time Warner’s vision of what constitutes "media," somewhat disparate.
So what is the current trend or trends that will drive the merger and acquisition business for the next several years? Metrick thinks vertical integration may be at least one important trend. "You’re seeing a lot more vertical integration of companies," he says. "It’s technology driven. Supply chain management becomes much easier."
Another trend is beginning to take shape in Europe, he says, where cross-border mergers and acquisitions are likely to occur in increasing numbers. At the same time, many family-owned companies in Europe are likely to be sold or taken public in the next decade. "There’s a sense that you want to be global firm because there’s going to be a lot of European M&A over the next 10 to 20 years,” he says.
If the high-stakes M&A business is simple, the somewhat lower stakes retail business is far from it. Within the U.S. a wide range of companies vies for the retail business, including traditional banks, securities firms and mutual fund and insurance companies. Within any single one of those industries there is also a wide range of strategies and business models in play. Perhaps the best example of the difference in approaches can be found in the competition between the two largest players in the mutual fund business. Fidelity has built an immense business on the basis of research-driven fund management, while Vanguard has assembled almost as large an empire based mostly on a low-cost indexing strategy.
The good news following the stock market boom and bust of the past ten years is that the average investor doesn’t appear to be permanently scarred by the experience. Wharton finance professor Jeremy J. Siegel, a prolific author on investment topics, says that as long as things don’t get worse -- and he thinks the worst is over -- the psychological damage inflicted by the boom and crash will be repaired.
"I find that even though we have had a very massive bear market -- worse than the 1973-74 bear market -- I don’t see the discouragement about stocks that I think pervaded the market then," he says. "People are certainly less gung-ho. A lot of people are going to have to work longer than they thought and that’s a bitter pill. They don’t want any hot tips these days. But most people are sticking with equities in their 401(K)s."
Siegel suggests that while there isn’t nearly as much interest in the stock market as there was at the height of the market boom, interest is at about the same level as it was six or seven years ago. At the same time, however, he notes that as they have through much of history, investors are still chasing yesterday’s returns -- bond funds and residential housing have been the hot markets of the past few years -- and are likely to find out the hard way that those assets, too, can go down in value as well as up.
While it is certainly good for the financial services industry that investors haven’t been frightened out of the market, it is becoming very clear that not every retail investor is worth pursuing. That explains the growing focus among the biggest firms on high-net-worth individuals. The challenge is to provide the kind and range of services those clients seek while finding ways to attract and keep a base of average investors at a minimal cost. Strategies to accomplish that goal are tending to draw firms that were once very different from one another -- Schwab and Merrill Lynch, for example -- toward a middle ground.
Merrill Lynch, which years ago was the only brokerage firm that many Americans outside of New York had ever heard of, has chosen to relegate its average retail customer to what is essentially a low-cost call-center operation. Investors can get advice and transact business with Merrill Lynch, but not with the same Merrill representative each time. The days of being able to tell friends that "my broker told me…" are gone for those investors.
Schwab, of course, was among the pioneers of discount brokerage in which investors made their own decisions and simply executed that decision through Schwab. It also developed a big online presence over the last decade. Merrill Lynch, meanwhile, created a new division internally to handle its high-net-worth clients, who still get custom tailored advice and a personal representative to provide counsel and executive decisions. Schwab is attempting to do the same thing, albeit with a stand-alone subsidiary, U.S Trust, which offers fee-based trust management, estate planning and private banking services.
While the two companies are looking more alike than they ever have, some key differences -- and questions -- remain about the course they are pursuing. Schwab, for example, still has a sizable element of commission-income, which can be very volatile, rising sharply amid the euphoria of a bull market, only to recede as quickly when investors hunker down in bear markets. Merrill, meanwhile, has moved decisively toward fee-based revenue in the hopes of generating income in good times and bad. The question facing Merrill, however, is the same one that has confronted some big airlines that have tried to break into the discount air travel market by creating low-cost subsidiaries: Can it operate a high-end private client service while at the same time providing a low-cost service for average investor within the same firm?
Meanwhile, other, smaller firms are finding niches in which they may prosper. Edward D. Jones, for example, has built a strong business in the nation’s hinterlands, offering personal brokerage and financial services in small towns all across America. So far Jones’s approach doesn’t seem to have been unduly hurt by the rise of online banking and investment services that tend to diminish the need for a local bricks-and-mortar presence. At the same time Prudential has left the retail business altogether through the sale of its retail operations to Wachovia, the big east-coast bank, which now becomes a bigger factor in the full-service brokerage business.
Attracting and serving the high-net-worth investor may be the trend du jour, but it raises a question for the financial services industry: what will the next generation of wealth need and want in financial services? As Siegel points out, no matter what happens to the estate tax, "trillions of dollars are going to cascade from one generation to another in the next few decades."
Convenience is a watchword when thinking about how to attract and hold not only the current generation, but the coming generation as well, Siegel says. He sees a trend developing toward what he calls "comprehensiveness," the ability of a financial services firm to offer a wide range of advice and products that provide an investor the convenience of one-stop shopping.
"The financial advisor won’t just be a broker that you use to buy stocks or bonds and someone else handles your estate planning and insurance needs," he says. "A lot of this is being driven by increasingly complex tax laws and we need advisors to be moving in that direction."
Yet what Siegel describes as "comprehensiveness," his colleague, Robert E Mittelstaedt Jr., vice dean and director of the Aresty Institute of Executive Education at Wharton, dismisses as "bundling," a strategy that he says the financial services industry has been trying -- unsuccessfully -- to implement for decades. Mittelstaedt points to Citigroup, the ultimate example of a financial services firm that has tried to be everything to everyone. Sandy Weill built the Citigroup empire piece by piece, starting with a little down-and-out consumer finance company called Commercial Credit to which he added insurance (Travelers), investment banking (Salomon Brothers), retail brokerage (Smith Barney) and, ultimately, commercial banking (Citicorp). "Citigroup has been very successful, but the company’s divestiture of part of Travelers’ property and casualty operations shows that whether from a business portfolio standpoint or a customer preference standpoint, complete bundling rarely succeeds," Mittelstaedt says.
"Banks have been pushing the notion that everyone wants a full-service bank, but the reality is that people are smarter than that," he says. "There’s all kinds of evidence that people will shop for the best product value, whether it’s phone services, travel services or financial services, based on an individual product basis. They don’t do it on the total portfolio of products."
Mittelstaedt, an avocado aficionado, cites his own example of how people shop. His regular grocery store sells avocados for $2 each. A nearby Trader Joe’s sells them for $1 each. Needless to say, Mittelstaedt often stops at Trader Joe’s on his way home from the grocery store. "You may want a grocery store that has everything because that’s convenient," he says, "but if you really like avocados and you drive right by Trader Joe’s anyway, chances are you’ll stop there and load up on a week’s worth of avocados."
In any event, variety is one thing that investors will continue to seek, Siegel says. And although the current offerings from the mutual fund industry seem staggering in their variety--some 8,000 funds are available to U.S. investors--there are new areas that are destined to attract more investors.
"There’s a definite trend toward the globalization of asset choices," he says, "and not in the traditional sense of ’how much should I have in Japan, how much in Europe, and so on. Rather, people are beginning to think in terms of sectors of the global economy. If someone wants a sector fund in tech hardware, they want to own tech hardware stocks anywhere in the world. Where a company has its headquarters doesn’t matter."
A longer-term trend that Siegel thinks holds very important implications for the financial services industry is the rise of the developing countries that is occurring now and that will probably accelerate in the next decade. As the economies of India, China and other developing countries grow and prosper, they will create a new generation of "wealth acquirers," the entrepreneurs and heirs of family fortunes. They, like American investors seeking exposure to foreign assets, will be seeking exposure to American and European assets. "The rising generation of baby boomers will not be selling their stocks to their children, they’ll be selling them to Chinese and Indians," he says. "If I were a financial firm right now, I’d want to have a foothold in those countries."
Siegel notes, however, that British and European investment firms have historically been more global in their thinking than U.S. firms. "We’re geographically more insular and less cosmopolitan," he says. "That will have to change if we’re going to participate in or dominate those markets of the future."