Financial Sector

What Is The Financial Sector?

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, such a sector consists of businesses and institutions that manage money and operate as intermediaries to allocate capital effectively in the economy.

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

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

The financial company offers only financial services. What kind of companies operate in this industry? Some are:

• Banks
• Insurance companies
• Brokerage firms
• Asset management companies

These companies offer deposits, credit services, security brokerage, mutual funds, and ETFs. Unlike non-financial companies, financial companies obtain funding from customers through mechanisms like "deposits," "insurance premiums," or other financial services.

Understanding the Financial Sector

This sector is probably the most integrated into the economy and daily life. Probably, most of you use credit or debit cards for your daily payments or 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.

Financial institutions, dealing primarily with other people's money, are considered to be leveraged. It's also cyclical because financial companies are interconnected with various economic segments and depend on broader economic cycles.

Additionally, government regulations impose high capitalization requirements on financial institutions, particularly banks and insurance firms. 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 (including mortgage REITs)
• Asset management
• Brokerage 

Importance of Financial Sector

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 often likened to the heart of the economy, with money serving as an important facilitator of economic activities.

Financial institutions effectively distribute capital across different economic sectors. It provides liquidity and enables the flow of money in the market and the economy.

If the financial sector is strong and supported by favorable economic conditions, it can potentially provide more capital to other industries through loans and investments. 

More investments in other sectors mean more employment in other sectors. Increased employment generally gives consumers more income, potentially leading to higher demand for products and services. 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.

Classification Of Financial Sector

These are the types of major financial institutions:

1. Retail Banks & Commercial Banks

These are traditional banks that accept deposits and pay interest on savings while also earning interest from loans. 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 primarily earn income from the difference between the interest paid on savings and the interest from loans, along with various other revenue streams such as fees and investments.

The largest retail banks in the world are:

• Bank of America
• BNP Paribas
• Royal Bank of Canada
• Mitsubishi UFJ
• HDFC Bank

These banks are also known as commercial banks. Commercial banks are similar and offer banking products for big national or multinational corporations through their corporate banking divisions.

2. 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 involves various complex financial services, including advisory, underwriting, brokerage, and income generation from trading in financial markets.

They earn the fees on their advisory, underwriting, and brokerage services. They also generate income from trading in financial markets.

Some commercial and retail banks have investment banking arms. However, due to the Dodd-Frank Act and other regulations, there are measures in place to regulate and limit certain activities, promoting a degree of separation between investment banking and commercial banking. 

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

Commercial banks or financial institutions focusing on wealth management often have private banking departments, while investment banks usually do not provide such services directly.

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
•  Morgan Stanley

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3. 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 typically earn revenue through various channels, including management fees calculated as a percentage of total assets under management and performance fees based on achieving certain returns, advisory fees, and transaction fees.

The most prominent investment management companies are:

• Vanguard (mutual funds)
• BlackRock (ETFs)
• Bridgewater Associates (hedge fund)
• Blackstone (private equity)
• Sequoia Capital (venture capital)

4. 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 a recession, the central bank implements an expansionary monetary policy, which may involve various tools such as adjusting interest rates, increasing monetary reserves, and employing other measures.

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 transparency, integrity, investor protection, and market efficiency by requiring full disclosure from different financial institutions and public companies.

These regulators penalize illegal activities like insider trading.

Examples of government institutions are: 

• Federal Reserve (central bank)
• Securities and Exchange Commission (SEC)
• Federal Deposit Insurance Commission (FDIC)

5. Exchanges and Clearing Houses

Financial assets, particularly stocks and bonds, are traded on public exchanges, where they must be listed and sold. 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 by settling accounts between market participants and providing risk management services, particularly in the derivatives market.

They primarily work in the derivatives market, where they settle cash contracts and act as a central counterparty, ensuring the performance of contracts and managing associated risks.

The clearing houses assign the counterparties (payers and receivers) the amount buyers must pay. The most common stock exchanges and clearing houses are:

• New York Stock Exchange (NYSE)
• NASDAQ
• Central Counterparty Clearing (CCP)
• CME Clearing
• Chicago Mercantile Exchange (CME)

6. 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 handle a substantial volume of transactions, particularly for debit and credit card payments, although other forms of transactions may not necessarily involve traditional payment processors.

The payment processor communicates the transaction details to the user's bank, verifies the transaction, and securely transfers 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:

• Visa
• Mastercard
• American Express
• China union pay
• Discover

7. 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 regular insurance premiums, the amount of which depends on factors such as coverage, risk, and individual circumstances.

Insurance companies serve individuals and institutions. They provide:

• Health and life insurance
• Property and casualty insurance (house, car, etc.)
• Reinsurance (insurance to insurance companies)

Some of the most famous insurance companies are:

• MetLife
• Liberty Mutual
• Manulife
• MunichRe (reinsurance)

Special Considerations in the Financial Sector

Three factors fuel the growth of the financial industry:

1. Moderately rising interest rates: Moderately rising interest rates can benefit financial firms, allowing them to earn more interest income on loans and investments.
2. 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.
3. Lower consumer debt levels: If consumers have a low level of debt, they have a lower risk of default. The lower risk of default leads to a higher likelihood of debt repayment. That way, financial companies ensure the solidity of their revenue.

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

• Rapid increases in interest rate: 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.
• Yield curve flattening: The financial industry might struggle if there is a yield curve flattening, indicating a low difference between long- and short-term interest rates.
• 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.

Monetary Policy and the Financial Sector

Central banks employ expansionary monetary policies to mitigate the impact of an economic downturn. These strategies involve boosting the available monetary reserves within the financial system to encourage increased lending and stimulate economic activity.

One approach to executing such monetary policies is through a method called Quantitative Easing (QE).

In the context of QE, the central bank acquires top-tier securities from banks, providing them with cash in return. This influx of cash serves dual purposes:

• To fulfill regulatory reserve requirements
• To fuel escalated lending and investment activities

By implementing these measures, central banks aim to revive the economy during periods of economic depression, encouraging financial stability and sustained growth.

Researched and Authored by Almat Orakbay | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Banking Fundamentals
• Central Bank
• Credit Default Swap (CDS)
• Financial Crisis
• Quantitative Finance