Financial Sector

Consists of businesses and institutions that manage money and operate as an intermediary to allocate capital effectively in the economy

Adin Lykken

Reviewed by

Adin Lykken

Expertise: Consulting | Private Equity

Updated:

March 14, 2023

What do you think when you hear the word "financial sector"? Most people will think only about the "traditional bank." Sure, banks operate in this sector, but what are the other financial sector players? 

As the name suggests, the such sector consists of businesses and institutions that manage money and operate as an intermediary to allocate capital effectively in the economy.

Generally, any business that deals with capital is a financial company. But here is the tricky part. Don't confuse a financial company with a company from any other industry. Let me explain it.

The regular company offers goods (tangible products, manufactured goods) and services (retailing, tourism, medicine, IT, etc.) to customers. They get other people's money from stocks and bonds, but they use that capital to produce goods and services.

The financial company offers only financial services. What kind of companies operate in this industry? Banks, insurance companies, brokerage firms, and asset management companies.

These companies offer deposits, credit services, security brokerage, mutual funds, and ETFs. Unlike a standard company, the financial company gets funding from its customers via "deposit," "insurance premium," or any other service.

I would say that this sector is probably the most integrated into the economy and our daily life. I bet most of you:

- use credit or debit cards for your daily payments, 

- invest some of your money via a brokerage platform (like Robinhood) in an S&P 500 index fund (SPDR by State Street).

You may also insure your health or property via Liberty Mutual or another similar insurance firm. Even Social Security Tax and Medicare Tax programs (in the US) are insurance policies that cover disability and other casualties.

Since financial institutions deal primarily with other people's money, the sector is considered the most leveraged sector of the economy. It's also cyclical because financial companies invest in all economic segments and are dependent on them.

Also, the government requirements on capitalization are high. As a result, financial institutions (mainly banks and insurance firms) must have vast reserves to operate.

Overall, there are five industries in the sector:

  • Banking
  • Insurance
  • Real estate financing (mortgage REITs)
  • Asset management
  • Brokerage 

Importance

So why is this sector important? How does the economy benefit from this sector? How does it affect all other industries, and why should you care about it? Ok, let's discuss it one by one.

Let's imagine that the economy is the body. In that case, the financial sector is its heart, and money is its blood. Financial institutions effectively distribute capital across different economic sectors. 

The financial industry provides liquidity and enables the flow of money in the market and the economy.

If the financial sector is strong, it can provide more capital (in the form of loans and investments) to other industries. 

More investments in other sectors mean more employment in other sectors. More job means consumers have more money and demand more products. More demand leads to more production. So, the economy will grow.

The opposite is true for economies with failing financial systems. Fewer investments or lending for other sectors means less money among firms. Firms employ fewer people. Unemployment reduces demand and economic output. So, the economy will be in recession.

That is why this sector directly affects all households and companies. This is the factor that every entrepreneur or analyst should consider before predicting the company's future.

Types

These are the types of major financial institutions:

Retail Banks & Commercial Banks

These are traditional banks that take deposits and pay interest on those savings. They also offer loans, credit cards, and other credit for specific needs. The income is generated by lending at a higher rate than the interest on savings.

The banks or other lending institutions earn the difference between the interest paid on savings and the interest from loans. The largest retail banks in the world are Bank of America, BNP Paribas, Royal Bank of Canada, Mitsubishi UFJ, and HDFC Bank. 

These banks are also known as commercial banks. Corporate banks are similar and offer banking products for big national or multinational corporations.

Investment Banks

These banks are quite different than traditional banks. They focus on corporate finance services. So, they offer such advisory services as M&A advisory, helping with IPO and debt raising.

Investment banks also offer securities brokerage for individual and institutional clients.

The business model of investment banks is quite simple. They earn the fees on their advisory, underwriting, and brokerage services. They also generate income from trading in financial markets.

Some of the commercial and retail banks have investment banking arms. However, due to Dodd-Frank Act and other regulations, investment banks must be separate from commercial banks. 

Thus, many banks hold an investment banking arm as an independent subsidiary company.

Investment banks also have a private banking department. This department offers private banking and wealth management services for high-net-worth individuals (HNWIs) or ultra-HNWIs (UHNWIs).

The most famous investment banks are Goldman Sachs, JPMorgan Chase, and Morgan Stanley.

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Investment Managers

As the name suggests, this segment offers investment management services to individuals and institutional clients. The typical industry players are mutual funds, exchange-traded funds (ETFs), and hedge funds.

These funds typically work in the public securities markets. The mutual and exchange-traded funds offer services for retail investors. The hedge funds work only with UHNWIs and institutional clients.

Private equity (PE) and venture capital (VC) funds also work with UHNWIs and institutional investors. But, they work in private markets. PE and VC funds invest in private companies and sell them to private or public investors after 5-10 years.

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Investment companies in both public and private markets make money with management fees. Management fees are calculated as a % of the total assets under management. In addition, they can charge performance fees if they achieve certain returns.

The most prominent investment management companies are Vanguard (mutual funds), BlackRock (ETFs), Bridgewater Associates (hedge fund), Blackstone (private equity), and Sequoia Capital (venture capital).

Government Institutions

Government institutions are significant players in the financial sector since they regulate the financial markets and the economy. The most influential government financial institution is the central bank.

Central banks issue national currency in the economy. They regulate the domestic economy through monetary policy, interest rates, and foreign exchange (FX) markets.

During the recession, the central bank implements an expansionary monetary policy. The policy is implemented by raising the monetary reserves in the financial system. The more money the economy has, the more money could be lent, invested, and spent.

All of them increase economic activity. For example, one of the central banks' most common methods is quantitative easing (QE). In other words, the central bank purchases securities (usually government bonds) from commercial banks in exchange for cash.

Then, the cash is used to lend to and invest in other sectors of the economy. That way, the central bank can retaliate against recession and economic downturn. 

Securities regulators oversee the public securities markets. These regulators ensure the financial markets' transparency and integrity and require full disclosure from different financial institutions and public companies to ensure transparency.

These regulators penalize illegal activities like insider trading.

The examples of government institutions are: 

Exchanges, Payment Processors, and Insurance Firms

Exchanges and Clearing Houses

The financial assets are traded in this place. The stocks and bonds must be listed and sold in public exchanges. The most common type of exchange is the stock exchange.

Stock exchanges have specific criteria for companies to be listed. They collect orders from market participants and share them in the order book. The trades are executed if the buy and sell orders match each other. 

Most exchanges operate online. Thus they facilitate millions of transactions/day.

Clearing houses operate differently. They settle accounts between market participants. They primarily work in the derivatives market, where they settle cash contracts. One part of the contract delivers cash based on the underlying asset's price. 

The clearing houses assign the counterparties (payers and receivers) the amount buyers must pay.

The most common stock exchanges and clearing houses are:

Payment Processors

Payment processors facilitate payments among different parties. For example, they work with many financial institutions and ensure that funds transfer is done securely.

These payment processors process the majority of transactions. This is especially applicable for debit and credit card payments. The payment processor informs the transaction to the user's bank and securely sends the funds to the vendor's account.

Payment processors charge a small fee for every transaction made by their network. The famous payment processors are:

Insurance Providers

The insurance industry is a large segment of this sector. They provide insurance policies that protect you against financial losses from accidents, disasters, or casualties. These insurance policies are underwritten for small regular insurance premiums.

Insurance companies serve individuals and institutions. They provide:

The most famous insurance companies are:

Special Considerations

Three factors fuels the growth of the financial industry:

  • Moderately rising interest rates

More interest rates mean financial firms can earn more interest income on loans and investments.

  • Reducing regulation

When the red tape is banned, or there is less paperwork, the efficiency of the business grows. So, the financial industry is not an exception.

  • Lower consumer debt levels

If consumers have a low level of debt, they have a low risk of default. The lower risk of default leads to a higher likelihood of debt payout. That way, financial companies ensure the solidity of their revenue.

But, there are also negative factors that you should consider in the financial industry:

If the interest rates rise too fast, consumers and businesses might be unwilling to get a loan, debt, or credit. That might negatively affect the sector.

The financial industry might struggle if the difference between long- and short-term interest rates is too low.

  • More legislation

The financial business is the first and the most affected by the government. More regulation and bureaucracy lead to less freedom to operate the business and more cost of compliance. As a result, it's harmful to the financial industry.

Investing in the Financial Sector

"Ok, I understood about the financial sector. But how do I invest in financial companies?"

Good question. I will answer your question in terms of publicly-traded companies. 

But keep in mind that any investment inherits a certain amount of risk and that everyone is personally responsible for their gains and losses. 

Please, keep in mind that this is not professional advice. Before making any investment decision, you must talk to your financial advisor or qualified consultant.

You have two options to invest in this sector:

1. Individual companies

You can invest in individual corporations across different fields:

2. Mutual funds and exchange-traded funds (ETFs)

This route is the most common and less risky than individual financial companies. You can invest in mutual funds and ETFs that solely focus on the financial services industry. By investing in ETFs and mutual funds, you are doing two things:

  1. First, you are investing in different industries in the financial sector.
  2. You are investing in the asset (investment) management industry. Because mutual funds and ETFs are funds that manage your money.

The largest ETF in the financial sector is Financial Select Sector SPDR Fund (XLF).

Ok, now the exciting part. What ratios can we use to analyze financial stocks?

  • Return on Equity (ROE) and Return on Assets (ROA) - these two ratios are annual profits expressed as a % of shareholders' equity (ROE) and total assets (ROA). 
  • Net interest margin (NIM) is the difference between the interest rate received and the interest rate paid by the bank. In other words, NIM = Int. Rate Received - Int. Rate Paid.
  • The efficiency ratio shows how much the bank spends to generate revenue. For example, a 40% efficiency ratio indicates that a bank pays $40 to generate every $100 in revenue. The lower the ratio, the better the financial institution is.
  • The net charge-off (NCO) ratio indicates the quality of assets among different financial companies. NCO measures how much % of the total loans will be written off as bad debt.
  • Price-to-book (P/B) ratio is a company's stock price divided by the net asset value. The price-to-tangible-book-value (P/TBV) is more prominent and excludes all intangible assets (difficult to measure), such as brand name and goodwill.

And two more metrics for insurance stocks:

  • Combined ratio - ($$$ paid out in claims + other business expenses) / collected premium income). Make sure that this ratio is less than 100%. The lower the ratio, the better the business is.
  • Investment margin - investment income is often the primary source of profits for an insurance company. This is because insurance firms only hold some % of premiums as reserves for claims payout and invest the rest of the money. 

This margin shows how profitable the investments made by an insurance firm are.

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Researched and authored by Almat Orakbay | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

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Adin Lykken is a member of WSO Editorial Board which helps ensure the accuracy of content across top articles on Wall Street Oasis. Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. This content was originally created by member WallStreetOasis.com and has evolved with the help of our mentors.