What Is the Financial Sector?

The financial sector is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers. This sector comprises a broad range of industries including banks, investment companies, insurance companies, and real estate firms.

Key Takeaways

  • The financial sector is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers.
  • A strong financial sector is a sign of a healthy economy.
  • The financial sector generates a good portion of its revenue from loans and mortgages and thrives in a low-interest-rate environment.
  • The sector is comprised of many different industries including banks, investment companies, insurance companies, and real estate firms.

Understanding the Financial Sector

A large portion of this sector generates revenue from mortgages and loans, which gain value as interest rates drop. The health of the economy depends, in large part, on the strength of its financial sector. The stronger it is, the healthier the economy. A weak financial sector typically means the economy is weakening.

Many people equate the financial sector with Wall Street and the exchanges that operate on it. But there's much more to it than that. The financial sector is one of the most important parts of many developed economies. It is made up of brokers, financial institutions, and money markets—all of which provide the services needed to help keep Main Street functioning every day.

In order for an economy to remain stable, it needs to have a healthy financial sector. This sector advances loans for businesses so they can expand, grants mortgages to homeowners, and issues insurance policies to protect people, companies, and their assets. It also helps build up savings for retirement and employs millions of people.

The financial sector generates a good portion of its revenue from loans and mortgages. These gain value in an environment where interest rates drop. When rates are low, the economic conditions open up the doors for more capital projects and investment. When this happens, the financial sector benefits, meaning more economic growth.

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Financial Sector

Financial Sector Makeup

As mentioned above, the financial sector is made up of many different industries ranging from banks, investment houses, insurance companies, real estate brokers, consumer finance companies, mortgage lenders, and real estate investment trusts (REITs).

The financial sector is one of the largest portions of the S&P 500. The largest companies within the financial sector are some of the most recognizable banking institutions in the world, including the following:

  • JPMorgan Chase (JPM)
  • Wells Fargo (WFC)
  • Bank of America (BAC)
  • Citigroup (C)

While these large companies dominate the sector, there are other, smaller companies that participate in the sector as well. Insurers are also a major industry within the financial sector, being made up of such companies as American International Group (AIG) and Chubb (CB).

Investing in the Financial Sector

Economists often tie the overall health of the economy with the health of the financial sector. If financial companies are weak, this is a detriment to the average consumer. Financial companies provide loans for businesses, mortgages to homeowners, and insurance to consumers. If these activities are restricted, it stunts growth in both small businesses and real estate.

Financial stocks are very popular investments to own within a portfolio. Most companies within the sector issue dividends and are judged on the overall strength of their financial health. During the financial crisis of 2007-2008, the financial sector was one of the hardest hit, with companies like Lehman Brothers filing for bankruptcy. After an influx of government regulation and restructuring, the financial sector is considerably stronger.

Financial ETFs, such as the Financial Select Sector SPDR Fund (XLF)—the largest financial ETF—can provide investors with broad exposure to the sector.

As of the close of trading on Sept. 29, 2020, the financial sector had a combined market capitalization of $5.59 trillion. The sector has underperformed the S&P 500 index in the trailing 12 months (TTM), where the S&P 500 is up 14.3% while the S&P 500 Financials Sector has fallen 13.7%. Part of this is due COVID-19, where the ultimate impact on such areas as mortgage delinquencies and commercial real estate is still unknown.

Special Considerations

Some of the positive factors that affect the financial sector include:

  • Moderately rising interest rates. As rates rise, financial services companies can earn more on the money they have and on credit they issue to their customers. 
  • Reducing regulation. Whenever the government decides to cut back on red tape, members of the financial sector will benefit. This means it could lessen the burden while increasing profits.
  • Lower consumer debt levels. as consumers decrease their debt loads, they lessen the risk of defaults. This lighter load also means they may have a tolerance for more debt, further increasing profitability.

Conversely, investors should consider some of the negative factors that affect this sector as well:

  • Rapid interest rate increases. If rates rise too quickly, demand for credit such as mortgages could drop, which could negatively affect certain parts of the financial sector. 
  • Yield curve flattening. If the spread between long- and short-term interest rates drop too far, the financial sector could start to struggle.
  • More legislation. Government regulation can have a big impact on the financial sector. While it may help protect consumers, more red tape can bog down a business that operates in financial services.