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
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