A:

The financial services sector is huge – more than $7 trillion in market cap in the United States alone. Most market trends have some impact on the financial services sector, but very few trends are so significant as to have a large influence. Historically, the performance of financial services companies is closely tied to interest rates and other macroeconomic indicators. This is especially true of banks, which comprise the largest portion of the sector.

To see what drives financial services earnings, it's important to understand which companies perform financial services and when those services are in the greatest demand.

What Industries Are Considered Financial Services?

The financial services sector can be broken down into eight smaller sub-sectors. The largest of these by far are banks, which make up a little more than half of total sector value. The banking industry entered a bit of a post-crisis journey following the crash of 2008-2009 and has also had to deal with issues in cybersecurity. Nevertheless, banking remains a critical part of the global economic system, and any economic growth is likely to involve higher bank earnings.

Insurance providers are the largest of the remaining seven subsectors. This includes health insurance, property and casualty insurance, and life insurance. Next in size are capital markets and real estate investment trusts (REITs). The four remaining subsectors combine to make up only a little more than 10% of the financial services industry: diversified financial services, consumer finance, real estate services, and thrifts and mortgage finance.

Drivers of Financial Services Performance

Most of the largest financial services companies are major lenders and investors; their portfolio performance is driven by the earnings of other sectors. When the economy is healthy and businesses are expanding, part of that increased revenue returns to the banks as payment on capital. Banking profits tend to drop when the economy struggles.

Central bank policy plays a huge role in the financial services sector. Capital requirements are set by central banks, and interest rates help drive arbitrage opportunities between short- and long-term rates. When interest rate spreads are high, the sector performs well. Low rate policies also encourage businesses and individual consumers to borrow money, which takes place through the banking system.

Investor confidence affects the profitability of investment service providers. Asset management companies, private equity firms and other related services rely on investors who want to make trades. The velocity of transactions is important. This same concept can be applied to mortgage companies and home loans.

Government Regulation

The years following the financial crisis saw the implementation of a host of new regulations, oversights and accounting standards for the financial services industry. A 2013 survey of more than 1,000 financial services executives from around the world indicated that nearly 90% of companies in this sector are "challenged in managing regulatory change."

Exactly what impact these changes will have on sector profitability is unknown, but it's well-known that regulatory compliance is not cost-free. Future growth will have to occur in spite of the challenges of government intervention.

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