Tough Times Ahead For Financial Services Sector

Although the long-term prognosis for the financial services industry remains positive, the industry still has to overcome a number of short-term difficulties resulting from the attacks of September 11, said analysts from Ernst & Young.

The September 11th attacks took its toll on the financial services economy in several ways: the direct destruction of approximately $13 billion in private equity and government equity; an estimated $35 billion to $50 billion in insured losses; a slowdown in GDP in the third quarter of 2001; and an increase in stock market volatility.

Financial services firms must also implement new anti-money laundering regulations and cope with deteriorations in credit quality.

TOUGH TIMES

As part of the Annual Shared National Credit Program, federal bank supervisors collectively analyze large syndicated credits and publish the resulting data. The 2001 results published in October indicate a worsening of credit quality, with $193 billion in adversely rated credits out of a total $2.05 trillion included in the program, or 9.4% of the total. The comparable figure for last year was 5.1%.

To exacerbate matters, the October figures represent data only through April. "If anything, the situation has worsened," said Donald Vangel, director of bank regulatory advisory services for E&Y.

On top of deteriorating asset quality, banks have the burden of implementing the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, or IMLA-FATA. This may be an especially acute challenge for firms that had not been covered by the previous regulations, such as life insurance companies and broker-dealer firms.

It's hard to say how much that'll cost the industry. "You obviously can't quantify it," said Vangel.

Furthermore, the challenge of detecting dirty money differs from that of detecting clean money held by terrorists. Looking for irregularities in small accounts at a retail bank is "very atomistic," said Vangel. "It could require some substantial investment."

Yet there's a new spirit of cooperation between law enforcement and the financial industry that bodes well for both sides. "IMLA-FATA will hopefully focus efforts of the industry where there's likely to be the most bang for the buck," said Vangel.

For example, financial services firms will be asked to work with the U.S. Treasury on increasing the quality of suspicious activity reports while also cutting their volume.

MOST LIKELY TO SUCCEED

Among the companies likely to succeed in this environment are those that can focus on low-cost production in specialized segments of the financial services marketplace. That bodes well for firms with back office excellence.

"The back office has been raised to a core competency in a world where execution differentiates one institution from another," said Beth Morrow, senior industry analyst in E&Y's financial services industry practice. "Operational efficiencies create opportunities to lower production costs."

However, there's still room at the top for diversified financial services giants with global brands and exceptional management, such as GE and AIG. Yet it won't be easy to achieve excellence across the board.

"It's been hard for financial institutions to be all things to all people, said Peter Porrino, director of insurance industry services at E&Y. "Cross-sells always seem better on paper than they do after the execution."