Investment banking

An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities.

Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass–Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G8 countries, have historically not maintained such a separation.

There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) is the "sell side", while dealing with pension funds, mutual funds, hedge funds, and the investing public (who consume the products and services of the sell-side in order to maximize their return on investment) constitutes the "buy side". Many firms have buy and sell side components.

An investment bank can also be split into private and public functions with a Chinese wall which separates the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas such as stock analysis deal with public information.

An advisor who provides investment banking services in the United States must be a licensed broker-dealer and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulation.[1]

Contents

Organizational structure

Main activities

Investment banking is split into the so-called front office, middle office, and back office. While large service investment banks offer all of the lines of businesses, both sell side and buy side, smaller ones sell side investment firms such as boutique investment banks and small broker-dealers focus on investment banking and sales/trading/research, respectively.

Investment banks offer services to both corporations issuing securities and investors buying securities. For corporations, investment bankers offer information on when and how to place their securities on the open market, an activity very important to an investment bank's reputation. Therefore, investment bankers play a very important role in issuing new security offerings.

Core investment banking activities

Front office

Other businesses that an investment bank may be involved in

Middle office

Back office

Size of industry

Global investment banking revenue increased for the fifth year running in 2007, to a record US$84.3 billion,[4] which was up 22% on the previous year and more than double the level in 2003. Subsequent to their exposure to United States sub-prime securities investments, many investment banks have experienced losses since this time.

The United States was the primary source of investment banking income in 2007, with 53% of the total, a proportion which has fallen somewhat during the past decade. Europe (with Middle East and Africa) generated 32% of the total, slightly up on its 30% share a decade ago. Asian countries generated the remaining 15%. Over the past decade, fee income from the US increased by 80%. This compares with a 217% increase in Europe and 250% increase in Asia during this period. The industry is heavily concentrated in a small number of major financial centers, including City of London, New York City, Hong Kong and Tokyo.

Investment banking is one of the most global industries and is hence continuously challenged to respond to new developments and innovation in the global financial markets. New products with higher margins are constantly invented and manufactured by bankers in the hope of winning over clients and developing trading know-how in new markets. However, since these can usually not be patented or copyrighted, they are very often copied quickly by competing banks, pushing down trading margins.

For example, trading bonds and equities for customers is now a commodity business, but structuring and trading derivatives retains higher margins in good times—and the risk of large losses in difficult market conditions, such as the credit crunch that began in 2007. Each over-the-counter contract has to be uniquely structured and could involve complex pay-off and risk profiles. Listed option contracts are traded through major exchanges, such as the CBOE, and are almost as commoditized as general equity securities.

In addition, while many products have been commoditized, an increasing amount of profit within investment banks has come from proprietary trading, where size creates a positive network benefit (since the more trades an investment bank does, the more it knows about the market flow, allowing it to theoretically make better trades and pass on better guidance to clients).

The fastest growing segment of the investment banking industry are private investments into public companies (PIPEs, otherwise known as Regulation D or Regulation S). Such transactions are privately negotiated between companies and accredited investors. These PIPE transactions are non-rule 144A transactions. Large bulge bracket brokerage firms and smaller boutique firms compete in this sector. Special purpose acquisition companies (SPACs) or blank check corporations have been created from this industry.

Vertical integration

In the U.S., the Glass–Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities, and led to segregation of investment banks from commercial banks. Glass–Steagall was effectively repealed for many large financial institutions by the Gramm–Leach–Bliley Act in 1999.

Another development in recent years has been the vertical integration of debt securitization. Previously, investment banks had assisted lenders in raising more lending funds and having the ability to offer longer term fixed interest rates by converting lenders' outstanding loans into bonds. For example, a mortgage lender would make a house loan, and then use the investment bank to sell bonds to fund the debt, the money from the sale of the bonds can be used to make new loans, while the lender accepts loan payments and passes the payments on to the bondholders. This process is called securitization. However, lenders have begun to securitize loans themselves, especially in the areas of mortgage loans. Because of this, and because of the fear that this will continue, many investment banks have focused on becoming lenders themselves,[5] making loans with the goal of securitizing them. In fact, in the areas of commercial mortgages, many investment banks lend at loss leader interest rates in order to make money securitizing the loans, causing them to be a very popular financing option for commercial property investors and developers. Securitized house loans may have exacerbated the subprime mortgage crisis beginning in 2007, by making risky loans less apparent to investors.

2008 Financial crisis

The 2007 credit crisis proved that the business model of the investment bank no longer worked[6] without the regulation imposed on it by Glass-Steagall. Once Robert Rubin, a former co-chairman of Goldman Sachs became part of the Clinton administration and deregulated banks, the previous conservatism of underwriting established companies and seeking long-term gains was replaced by lower standards and short-term profit.[7] Formerly, the guidelines said that in order to take a company public, it had to be in business for a minimum of five years and it had to show profitability for three consecutive years. After deregulation, those standards were gone, but small investors did not grasp the full impact of the change.[7]

Investment banks Bear Stearns, founded in 1923 and Lehman Brothers, over 100 years old, collapsed; Merrill Lynch was acquired by Bank of America, which remained in trouble, as did Goldman Sachs and Morgan Stanley. The ensuing financial crisis of 2008 saw Goldman Sachs and Morgan Stanley "abandon their status as investment banks" by converting themselves into "traditional bank holding companies", thereby making themselves eligible[6] to receive billions of dollars each in emergency taxpayer-funded assistance.[7] By making this change, referred to as a technicality, banks would be more tightly regulated.[6] Initially, banks received part of a $700 billion Troubled Asset Relief Program (TARP) intended to stabilize the economy and thaw the frozen credit markets.[8] Eventually, taxpayer assistance to banks reached nearly $13 trillion dollars, most without much scrutiny,[9] lending did not increase[10] and credit markets remained frozen.[11]

A number of former Goldman-Sachs top executives, such as Henry Paulson and Ed Liddy moved to high-level positions in government and oversaw the controversial taxpayer-funded bank bailout.[12] The TARP Oversight Report released by the Congressional Oversight Panel found, however, that the bailout tended to encourage risky behavior and "corrupt[ed] the fundamental tenets of a market economy".[13]

The TARP has all but created an expectation, if not an emerging sense of entitlement, that certain financial and non-financial institutions are simply “too-big-or-too-interconnected-to-fail” and that the government will promptly honor the implicit guarantee issued for the benefit of any such institution that suffers a reversal of fortune. This is the enduring legacy of the TARP. Unfortunately, by offering a strong safety net funded with unlimited taxpayer resources, the government has encouraged potential recipients of such largess to undertake inappropriately risky behavior secure in the conviction that all profits from their endeavors will inure to their benefit and that large losses will fall to the taxpayers. The placement of a government sanctioned thumb-on-the-scales corrupts the fundamental tenets of a market economy – the ability to prosper and the ability to fail.

—Congressional Oversight Panel, TARP Oversight Report

Under threat of a subpoena by Senator Chuck Grassley, Goldman Sachs revealed that through TARP bailout of AIG, Goldman received $12.9 billion in taxpayer aid (some through AIG), $4.3 billion of which was then paid out to 32 entities, including many overseas banks, hedge funds and pensions.[14] The same year it received $10 billion in aid from the government, it also paid out multi-million dollar bonuses to 603 employees and hundreds more received million-dollar bonuses. The total paid in bonuses was $4.82 billion.[15][16]

Morgan Stanley received $10 billion in TARP funds and paid out $4.475 billion in bonuses. Of those, 428 people received more than a million dollars and of those, 189 received more than $2 million.[17]

Possible conflicts of interest

Conflicts of interest may arise between different parts of a bank, creating the potential for market manipulation. Authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall to prevent communication between investment banking on one side and equity research and trading on the other.

Some of the conflicts of interest that can be found in investment banking are listed here:

Top 10 banks

The ten largest global investment banks as of December 31, 2010, are as follows (by total fees):[18]

Rank Company Fees ($m)
1. J.P. Morgan $5,533.85
2. Bank of America Merrill Lynch $4,581.59
3. Goldman Sachs $4,386.52
4. Morgan Stanley $4,055.48
5. Credit Suisse $3,379.12
6. Deutsche Bank $3,286.80
7. Citi $3,238.67
8. Barclays Capital $2,864.44
9. UBS $2,614.44
10. BNP Paribas $1,433.89

World's biggest banks are ranked for M&A advisory, syndicated loans, equity capital markets and debt capital markets.

For more information on investment banking revenues, please visit Financial Times and Wall Street Journal websites or see Bloomberg M&A and Capital Markets League Tables:

External links

Further reading

See also

References

  1. ^ U.S. Securities and Exchange Commission
  2. ^ Rachel Sanderson (October 22, 2010). "UniCredit municipal deal nullified". The Financial Times. http://www.ft.com/cms/s/0/0fb16d54-de18-11df-88cc-00144feabdc0,dwp_uuid=eddfd4e0-4bc3-11da-997b-0000779e2340.html. Retrieved October 23, 2010. 
  3. ^ J.P. Morgan – J.P. Morgan Global Careers
  4. ^ BANKING City Business Series
  5. ^ Morgan Stanley Real Estate Lending
  6. ^ a b c Jagger, Suzy (September 22, 2008). "End of the Wall Street investment bank". The Times (London). http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4800550.ece. Retrieved March 7, 2011. 
  7. ^ a b c Matt Taibbi, "The Great American Bubble Machine" Rolling Stone magazine (April 5, 2010). Retrieved March 7, 2011
  8. ^ Erin Nothwehrm "Emergency Economic Stabilization Act of 2008" University of Iowa (December 2008). Retrieved March 7, 2011
  9. ^ "The true cost of the bank bailout" PBS/WNET "Need to Know" (September 3, 2010). Retrieved March 7, 2011
  10. ^ Samuel Sherraden, "Banks use TARP funds to boost lending – NOT!" The Washington Note (July 20, 2009). Retrieved March 7, 2011
  11. ^ "Fed May Keep Rates Low as Tight Credit Impedes Small Businesses" Bloomberg Businessweek (April 26, 2010). Retrieved March 7, 2011
  12. ^ Matt Taibbi, "The Great American Bubble Machine" Rolling Stone magazine (April 5, 2010). Retrieved March 7, 2011
  13. ^ Edward Niedermeyer, "TARP Oversight Report: Bailout Goals Conflict, Moral Hazard Alive And Well" (January 13, 2011). Retrieved March 7, 2011
  14. ^ Karen Mracek and Thomas Beaumont, "Goldman reveals where bailout cash went" Des Moines Register (July 26, 2010). Retrieved March 7, 2011
  15. ^ Stephen Grocer, "Wall Street Compensation–’No Clear Rhyme or Reason’" The Wall Street Journal Blogs (July 30, 2009). Retrieved March 7, 2011
  16. ^ "Goldman Sachs: The Cuomo Report’s Bonus Breakdown" The Wall Street Journal Blogs (July 30, 2009). Retrieved March 7, 2011
  17. ^ "Morgan Stanley: The Cuomo Report’s Bonus Breakdown" The Wall Street Journal Blogs (July 30, 2009). Retrieved March 7, 2011
  18. ^ Investment Banking Review, Financial Times, December 31, 2010.