Decline Of The Independent Broker-Dealer
There have been estimates that the number of broker-dealers registered with FINRA fell by nearly 10% between 2005 and 2010, a trend that has continued over the past couple of years, and is expected to be seen in the future, due to a couple of key factors. Below is an overview of the key trends driving the continued decline of independent broker-dealers.

Industry Consolidation
Very challenging industry conditions following the credit crisis started a trend by which smaller broker-dealers either closed up shop or were snapped up by larger rivals. Consolidation in the industry has continued, with large players including LPL Financial (Nasdaq:LPLA), Raymond James (NYSE:RJF) and insurance firms cited as looking to be more active in acquiring smaller broker-dealers. Low interest rates help make buyout activity more affordable, and the larger players are said to be interested in the steady fees that the more profitable broker-dealers are able to bring in each year. Stronger stock market returns are also increasing the appeal of acquiring market share because higher asset levels boosts fees that are based off assets under management.

Stock market gains boost profit margins, but low interest rates lower them. Smaller brokers that don't have the scale of the larger players and are more focused on fixed income are having a tougher time generating sufficient profits in today's investment climate. Scale allows larger brokers to spread fixed costs across a larger network of brokers and puts the smaller players at a disadvantage. As such, this is thought to be driving them into the arms of the bigger industry players.

Heightened Regulatory Environment
Since the peak of the financial crisis, the financial services industry has been under fire by politicians and the main regulatory bodies. In addition, high profile scandals, including Bernie Madoff's Ponzi scheme, the collapse of MF Global and Peregrine Financial Group, and multi-billion dollar losses at money center bank JPMorgan Chase courtesy of a trader nicknamed the "London Whale" have shaken faith in the industry considerably. In a backlash of sorts but also warranted in many respects, politicians and regulators, including the Securities and Exchange Commission and FINRA, have set out to make the industry safer for the investing public.

The most significant piece of legislation to stem from the financial debacle is the Dodd Frank Financial Regulatory Reform Bill. The text of the bill is nearly 850 pages and was officially passed by Congress in 2010; but more than two years later, many of the provisions and stipulations are still being finalized. This has both increased the costs and uncertainty of adhering to financial regulation. It also puts smaller, independent broker dealers at a disadvantage, in terms of higher fees to hire attorneys and accountants to try and decipher all of the bill's details.

The larger broker-dealers have proven better able to navigate new regulations. In some cases, such as with the bulge-bracket brokers, they have considerable lobbying resources and are able to influence the outcome of regulation. This is something smaller firms have little hope of doing.

Technology Needs
Heightened regulation increases the need for broker-dealers to maintain records and regulatory filings. The software developers in the industry are releasing tools to help them keep files organized and retrieved easily, but some of the offerings are expensive. One industry consultant mentioned that the larger brokers can more easily handle higher capital expenditures in these areas. Scale, again, helps them spread these costs across a wide broker network.

Other Considerations
There are other reasons why independent brokers are increasingly exiting the industry or merging with larger rivals. Examples include a broker that ran out of capital due to higher regulatory costs. Another cited higher insurance costs with needing to close its doors. Of course, there are also those that aren't managed well or see a downturn in business; some have experienced excessive client complaints or defections, which can kill profitability.

It is also interesting to know which types of firms are leading the industry consolidation. In addition to the larger brokers cited above that have turned acquisitive, private equity firms are thought to be moving more aggressively into the industry. They look for the independent broker-dealers that demonstrate above-average profitability or growth prospects. Interestingly, insurance firms, which used to look to buy broker-dealers to improve their own sales distribution channel, are getting out of the business to return focus to their traditional insurance operations. Low interest rates have hurt annuity sales and the ability to sell them profitably.

The Bottom Line
A consultant from the firm Booz Allen recently estimated that consolidation among broker-dealers should continue for at least the next three to five years. Overall, the number of investment professionals has remained steady in recent years, but brokers look to be increasingly working for the larger broker-dealers out there.

At the time of writing, Ryan Fuhrmann did not own shares of any of the companies mentioned in this article.



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