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An investment bank is a financial institution which raises capital, trades securities, and
manages corporate mergers and acquisitions. Another term used for investment banking is
corporate finance.
Investment banks work for companies and governments, and profit from them by raising
money through the issuance and selling of securities in capital markets (both equity anddebt) and insuring bonds (for example selling credit default swaps), and providing the
necessary advice on transactions such as mergers and acquisitions. Most of investment
banks provide strategic advisory services for mergers, acquisitions, divestiture or other
financial services for clients, like the trading of derivatives, commodity, fixed income,
is a form of banking which finances the capital requirements of
enterprises. Investment banking assists as it performs IPOs, private placement and bond
offerings, acts as broker and helps in carrying out mergers and acquisitions.
An Investment Banker can be considered as a total solutions provider for any corporate,desirous of mobilizing its capital. The services provided range from investment research to
investor service on the one hand and from preparation of the offer documents to legal
compliances & post issue monitoring on the other. A long lasting relationship exists between
the Issuer Company and the Investment Banker.
THE TOOL¡
OF INVESTMENT BAN ¤ ING
Investment banks can raise money from the stock markets or they can raise money for
corporations using advanced products called derivatives. Investment banks can invest their
own money directly into a company, project, etc., as a direct investment for which they
carry the full risk (known as merchant banking). An investment bank can raise money for the
corporation from a high net worth individual and that investment is known as private equity.
An investment bank can raise money for a corporation from a hedge fund that is dedicated
to making direct investments in corporations, which is usually referred to as venture capital,
or as loans with collateral as security to reduce risk. A combination of equity and loans also
exist, such as mezzanine.
FUNCTIONS OF INVESTMENT BAN ING
Investment banks carry out multilateral functions. Some of the most important functions of
investment banking are as follows:
y Investment banking helps public and private corporations in issuance of securities in
the primary market. They also act as intermediaries in trading for clients.
y Investment banking provides financial advice to investors and helps them by
assisting in purchasing and trading securities as well as managing financial assets
y Investment banking differs from commercial banking as investment banks don't
accept deposits neither do they grant retail loans.y Small firms which provide services of investment banking are called boutiques. They
mainly specialize in bond trading, providing technical analysis or program trading as
well as advising for mergers and acquisitions
INVESTMENT BAN ING: AN INTRODUCTION HISTORY AND RECENT TRENDS
Investment banking involves raising money (capital) for companies and governments,usually by issuing securities. Securities or financial instruments include equity or ownership
instruments such as stocks where investors own a share of the issuing concern and
therefore are entitled to profits. They also include debt instruments such as bonds, where
the issuing concern borrows money from investors and promises to repay it at a certain date
with interest. Companies typically issue stock when they first go public through initial public
offerings (IPOs), and they may issue stock and bonds periodically to fund such enterprises as
research, new product development, and expansion. Companies seeking to go public must
register with the Securities and Exchange Commission and pay registration fees, which cover
accountant and lawyer expenses for the preparation of registration statements. A
registration statement describes a company's business and its plans for using the money
raised, and it includes a company's financial statements.
Before stocks and bonds are issued, investment bankers perform due diligence
examinations, which entail carefully evaluating a company's worth in terms of money and
equipment (assets) and debt (liabilities). This examination requires the full disclosure of a
company's strengths and weaknesses. The company pays the investment banker after the
securities deal is completed and these fees often range from 3 to 7 percent of what a
company raises, depending on the type of transaction.
Investment banks aid companies and governments in selling securities as well as investors in
purchasing securities, managing investments, and trading securities. Investment banks take
the form of brokers or agents who purchase and sell securities for their clients; d ealers or
principals who buy and sell securities for their personal interest in turning a profit; and
broker-dealers who do both.
The primary service provided by investment banks is underwriting, which refers to
guaranteeing a company a set price for the securities it plans to issue. If the securities fail to
sell for the set price, the investment bank pays the company the difference. Therefore,
investment banks must carefully determine the set price by considering the expectations of
the company and the state of the market for the securities. In addition, investment banks
provide a plethora of other services including financial advising, acquisition advising,
divestiture advising, buying and selling securities, interest -rate swapping, and debt-for-stock
swapping. Nevertheless, most of the revenues of investment banks come from
underwriting, selling securities, and setting up mergers and acquisitions.
When companies need to raise large amounts of capital, a group of investment banks often
participate, which are referred to as syndicates. Syndicates are hierarchically structured andthe members of syndicates are grouped according to three functions: managing,
underwriting, and selling. Managing banks sit at the top of the hierarchy, conduct due
diligence examinations, and receive management fees from the companies. Underwriting
banks receive fees for sharing the risk of securities offerings. Finally, selling banks function
as brokers within the syndicate and sell the securities, receiving a fee for each share they
sell. Nevertheless, managing and underwriting banks usually also sell securities. All major
investment banks have a syndicate department, which concentrates on recruiting members
for syndicates managed by their firms and responding to recruitments fro m other firms.
A variety of legislation, mostly from the 1930s, governs investment banking. These laws
require public companies to fully disclose information on their operations and financialposition, and they mandate the separation of commercial and investment banking. The
latter mandate, however, has been relaxed over the intervening years as commercial banks
have entered the investment banking market.
HISTORY AND DEVELOPMENT OF INVESTMENT BAN ING
Investment banking began in the United States around the middle of the 19th century. Prior
to this period, auctioneers and merchants particularly those of Europeprovided the
majority of the financial services. The mid-1800s were marked by the country's greatesteconomic growth. To fund this growth, U.S. companies looked to Europe and U.S. banks
became the intermediaries that secured capital from European investors for U.S.
companies. Up until World War I, the United States was a debtor nation and U.S. investment
bankers had to rely on European investment ban kers and investors to share risk and
underwrite U.S. securities. For example, investment bankers such as John Pierpont (J. P.)
Morgan (1837-1913) of the United States would buy U.S. securities and resell them in
During this period, U.S. investment banks were linked to European banks. These
connections included J.P. Morgan & Co. and George Peabody & Co. (based in London);
Kidder, Peabody & Co. and Barling Brothers (based in London); and Kuhn, Loeb, & Co. and
the Warburgs (based in Germany).
Since European banks and investors could not assess businesses in the United States easily,
they worked with their U.S. counterparts to monitor the success of their investments. U.S.
investment bankers often would hold seats on the boards of the companies issuing the
securities to supervise operations and make sure dividends were paid. Companies
established long-term relationships with particular investment banks as a consequence.
In addition, this period saw the development of two basic components of investment
banking: underwriting and syndication. Because some of the companies seeking to sell
securities during this period, such as railroad and utility companies, required substantial
amounts of capital, investment bankers began under-writing the securities, thereby
guaranteeing a specific price for them. If the shares failed to fetch the set price, the
investments banks covered the difference. Underwriting allowed companies to raise the
funds they needed by issuing a sufficient amount of shares without inundating the marketso that the value of the shares dropped.
Because the value of the securities they underwrote frequently surpassed their financial
limits, investment banks introduced syndication, which involved sharing risk with other
investment banks. Further, syndication enabled investment banks to establish larger
networks to distribute their shares and hence investment banks began to develop
relationships with each other in the form of syndicates.
The syndicate structure typically included three to five tiers, which handled varying degrees
of shares and responsibilities. The structure is often thought of as a pyramid with a few
large, influential investment banks at the apex and smaller banks below. In the first tier, the"originating broker" or "house of issue" (now referred to as the manager) investigated
companies, determined how much capital would be raised, set the price and number of
shares to be issued, and decided when the shares would be issued. The originating broker
often handled the largest volume of shares and eventually began charging fees for its
services.
In the second tier, the purchase syndicate took a smaller number of shares, often at a
slightly higher price such as I percent or 0.5 percent higher. In the third tier, the banking
syndicate took an even smaller amount of shares at a price higher than that paid by the
purchase syndicate. Depending on the size of the issue, other tiers coul d be added such as
the "selling syndicate" and "selling group." Investment banks in these tiers of the syndicatewould just sell shares, but would not agree to sell a specific amount. Hence, they functioned
as brokers who bought and sold shares on commissi on from their customers.
From the mid-i800s to the early 1900s, J. P. Morgan was the most influential investment
banker. Morgan could sell U.S. bonds overseas that the U.S. Department of the Treasury
failed to sell and he led the financing of the railroad. He also raised funds for General
This legislation also required companies to regularly file financial statements in order to
make known changes in their financial position. As a result of these acts, bidding for
investment banking projects became competitive as companies began to select the lowest
bidders and not rely on major traditional companies such as Morgan Stanley and Kuhn,
Loeb.
The last major effort to clean up the investment banking industry came with the U.S. v.
Morgan case in 1953. This case was a government antitrust investigation into the practices
of 17 of the top investment banks. The court, however, sided with the defendant
investment banks, concluding that they had not conspired to monopolize the U.S. securities
industry and to prevent new entrants beginning around 1915, as the government
prosecutors argued.
By the 1950s, investment banking began to pick up as the economy continued to prosper.
This growth surpassed that of the 1920s. Consequently, major corporations sought new
financing during this period. General Motors, for example, made a stock offering of $325
million in 1955, which was the largest stock offering to that time. In addition, airlines,
shopping malls, and governments began raising money by selling securities around thistime.
During the 1960s, high-tech electronics companies spurred on investment banking.
Companies such as Texas Instruments and Electronic Data Systems led the way in securities
offerings. Established investment houses such as Morgan Stanley did not handle these
issues; rather, Wall Street newcomers such as Charles Plohn & Co. did. The established
houses, however, participated in the conglomeration trend of the 1950s and 1960s by
helping consolidating companies negotiate deals.
The stock market collapse of 1969 ushered in a new era of economic problems which
continued through the 1970s, stifling banks and investment houses. The recession of the1970s brought about a wave of mergers among investment brokers. Investment banks
began to expand their services during this period, by setting up retail operations, expanding
into international markets, investing in venture capital, and working with insurance
companies.
While investment bankers once worked for fixed commissions, they have been negotiating
fees with investors since 1975, when the SEC opted to deregulate investment banker fees.
This deregulation also gave rise to discount brokers, who undercut the prices of established
firms. In addition, investment banks started to implement computer technology in the
1970s and 1980s in order to automate and expedite operations. Furthermore, investment
banking became much more competitive as investment bankers could no longer wait forclients to come to them, but had to endeavour to win new clients and retain old ones.
estment banking: is the traditional as ect of investment banks that involves
helping c
stomers raise funds in the capital markets and advise them on mergers and ac uisitions ! Investment banking can also involve subscribing investors to a
security issuance " negotiating with a merger target and coordinating with bidders !
y Sales and trading: Depending on the needs of the bank and its clients # the main
function of a large investment bank is buying and selling products $ In market making,
the traders will buy and sell securities or financial products with the goal of earning
an incremental amount of money on every trade $ Sales is the term that is used for
the sales force, whose primary job is to call on institutional and high-net-worth
investors to suggest trading ideas and take orders
y Resear%
h: Two categories of research areEquity Research (Stock) and Fixed Income
Research (Bonds). Research analyst reviews the company for its financial strength
and ability to meet its obligations and promises. Each analyst covers 10-15
companies in a particular industry segment or sub-segment. The aim of the equity
research undertaken on a company is to come up with a fair price of the company
share. Depending upon the prevailing market price, the analyst will issue Buy,
Hold or Sell rating. Fixed income research, deals with corporate bonds, though
the considerations are almost similar as in equity, however, there is a little
difference in the approach to accommodate the differences in the characteristics of
the instruments i.e., debt vs. equity.
Bank makes money by publishing these researches and selling them for a price. Research
analysts also advise high net worth clients on investments.
An investment bank may be involved in providing both advisory services and conducting
research on a company for example, same investment bank may be lead underwriter for a
companys next public issue and the company may also covered by banks research analyst.
As is suspected there is possible situation for conflict of interest. In absence of regulations,
research will issue high recommendations for the issue that is underwritten by the bank. To
avoid such situation there are strict regulations and a Chinese Wall is put up between
research and advisory services desks of the bank i.e. there is no communication in any way
between these two businesses. Investment banks follow these regulations religiously
without any fail.
On the basis of what kind of employer employs the analysts, research could be Buy-side
or Sell-side.
Buy-side: analysts are usually employed by mutual funds, hedge funds, pension funds, etc.
The objective with which buy-side analysts undertake research is to determine how
promising investment in a particular company will be and how it fits the investment strategyand goals of the money manager. The analysts hired are paid for by the fund and these
researches are not generally available for use by other parties.
Sell-side: analysts work for brokerage firms, involved in managing individual accounts and
issue recommendations regarding the performance of the stock or bond they are covering.
The purpose of the research is to help their clients make knowledgeable decision to buy or
sell a security.
.
DEVELOPMENT OF THE INVESTMENT BAN &
Investment bankers originated in the Middle Ages, when governments and kings received
long-term loans for conducting wars and maintaining courts. Notable among the early
money lenders were the Hansa merchants who supplied funds to many of the European
kings and emperors, but usually with assurance of return. The ruler received a certain sum
of money in the form of gold or silver bullion, and in return he gave the lender the rights
over revenue derived from tariffs or taxes for a certain period of years. Loans were also
extended on real property such as mines, fisheries, and forests owned by the government,
and the products of the mines were applied to the payment of principal and interest. These
early magnates were also merchants, and they were able to use their own money directly in
granting loans, and in this way they differed from the modern investment bankers who act
as intermediaries in gathering the funds of others for making advances to borrowers. With
the close of the Napoleonic wars financial supremacy shifted from Amsterdam and the
Continent to London and with this change the modern investment bank as an intermediary
institution between borrower and lender was developed.
The same general evolution was repeated in the financial history of the United States.
During the first quarter of the nineteenth century American states and municipalities
secured whatever capital they needed from merchants. During the second quarter, the
westward movement caused an extension of such internal improvements as canals and
railroads, and capital for these purposes was raised mainly from investors in England and in
other European countries. Securities marketed in this country consisted largely of municipal
bonds which were sold, usually without public notice, to local bankers who in turn marketed
them among insurance companies, savings banks, and private investors. In order to secure a
better price for bonds, municipalities began to advertise their new issues and their sales
were conducted on a competitive basis. Blocks of these bonds were purchased by
individuals for the purpose of selling them on a retail basis, and these individuals thus
performed in a small way the mediation function of the modern investment bankers.
The development of free banking encouraged the organization of many banks, and until the
opening of the Civil War there was considerable investment of capital in bank stock. After
the Civil War the growth of transcontinental railways led to the issue of large blocks of
bonds which were absorbed by American and European investors, whose contributions of capital made possible also the organization and development of great industrial trusts at the
opening of the twentieth century. The war changed the movement of capital between
Europe and America. At first a large proportion of American railroad and industrial securities
held abroad were repurchased, and later the war obligations of the European governments
found a market in the United States.
FUNCTIONS OF AN INVESTMENT BAN '
As already indicated, the types of investment banks considered perform in general one ormore of the following functions: (1) investigating proposals, (2) forming syndicates for
underwriting, (3) selling securities. In addition, investment houses may render the public
such services as advice in selecting securities, information to customers, and protection in
case of failure of the corporation issuing the securities.
Investment banks have multilateral functions to perform. Some of the most important
functions of investment banking can be jot down as follows:
y Investment banking help public and private corporations in issuing secur ities in the
primary market, guarantee by standby underwriting or best efforts selling and
foreign exchange management. Other services include acting as intermediaries in
trading for clients.
y Investment banking provides financial advice to investors and serves them by
assisting in purchasing securities, managing financial assets and trading securities.
y Investment banking differs from commercial banking in the sense that they don't
accept deposits and grant retail loans. However the dividing line between the two
fraternal twins has become flimsy with loans and securities becoming almost
substitutable ways of raising funds.
y Small firms providing services of investment banking are called boutiques. These
mainly specialize in bond trading, advising for mergers and acquisitions, providing
technical analysis or program trading.
Financial Advisory Services:
An investment bank is involved heavily in financial advisory services. Investment banks give
companies advice on mergers and acquisition, when and how capital should be raised,tracking the market for the best possible time to offer an IPO or secondary offering etc.
Apart from advisory services, investment bank operates extensively in Capital
Markets arena. The term capital markets, relates to equity and bond markets, both
domestic and international, as well as cover derivatives and other financial instruments.
Over years with development of securitization and derivatives market a whole new segment
of Structured Transaction has surfaced in investment banking business.
To work in research and financial advisory services area of Investment Banks, one requires
expertise in excel based financial modelling and valuation. Though, a job in capital market
groups will require in-depth knowledge of functioning of capital markets, analytics of various financial instruments like convertible securities, derivatives etc and excel based
modelling skills.
There are certain other banking related activities that might be undertaken by an
investment bank itself or by firms specializing in these areas, for example Private Equity,
Private equity implies equity investment in companies that are not traded
publically. Private equity investment may be in the form of Leveraged Buy-Outs, Venture
Capital or Distressed Financing.
Private Equity capital is very risky investment with huge payout potential. However, each
kind of private equity investment has different risk return profile.
In case of leveraged buyouts, private equity fund buys a large portion of a publically traded
company and takes it private, turns it around by taking over management and a complete
operational overhaul. The investment horizon is generally 5-9 years, at the end of which
company is taken public again and the private equity fund gets it investment back along
with huge returns.
CLASSES OF INVESTMENT BAN ) S
Investment institutions may be divided into three general groups - wholesale houses, large
retail houses, and small retail, or bond, houses. The first group is composed of about a
dozen large banking firms with many correspondent connections abroad. These housesundertake the marketing of the larger issues of railroads and of foreign governments,
exceeding at times $100,000,000 in amount, by selling them, usually not. to the public
directly, but indirectly through other houses. As wholesale houses are engaged mainly in the
purchase of securities, the organization of their buying department is of special importance,
and so it usually retains the services of engineers, accountants, lawyers, and other experts
for the complete evaluation of the properties on the basis of which the securities are issued.
For the selling of these securities the wholesale houses in most cases associate themselves
with the large retailers, who are much more numerous. These usually have their home
office in New York City, in some other Eastern money center, or in Chicago, and operate in
other important cities through their own branches or through partnerships and corporationswhich are independently organized, but always closely affiliated with the home office. The
securities companies of national banks and the bond departments of trust companies are, of
course, not permitted to organize branches, but instead operate correspondent offices
which perform about the same activities as private investment banks. The large retailers will
purchase securities for their own account directly from the issuing corporations to a limited
extent only, and for relatively small amounts. In the case of large issues, the retailers will
not usually assume the responsibility alone, but join with others in a syndicate or group of
houses, of which each takes over a portion of the securities. As the main task of a large
retail house is the disposing of securities, the sales department is the most important unit in
its organization.
Large retail houses may be grouped according to the form of the securities or the nature of
the issues in which they are interested. Thus there are houses specializing in bonds or
stocks, or in both forms of securities. Other firms handle only such issues as government
bonds, railroad, public utility, or industrial securities. While most investment banks naturally
press the sale of their own specialties or issues, at the same time they will also execute
orders to buy and sell other stocks and bonds either directly as members of the various
stock exchanges or indirectly through brokers.
The branches and the affiliated offices of the large retailers throughout the country come
into active competition with the bond houses or small retailers. These are of several classes,
such as small banks and brokerage houses dealing in all kinds of securities, or handling
specialties such as Standard Oil stocks, equipment bonds, and issues of local corporations.
The organization of the small investment house is quite similar to that of the large retail
firm, but on a more limited scale, for usually the buying and selling departments areconducted by only one person, who controls the entire business. The small bond house at
times finds difficulty in obtaining high-grade securities, for those yielding a satisfactory
profit are handled by the large retail houses themselves, which allow only a small
commission on these sales.
ROLE OF AN INVESTMENT BAN 0
The major work of investment banks includes a lot of consulting. For instance, they offer
advices on mergers and acquisitions to companies. The other arena where they give adviceare tracking the market and determining when should a company come out with a public
offering and what is the best possible way to manage the public assets of businesses. The
role that an investment bank plays sometimes gets overlapped with that of a private
brokerage house. The usual advice of buying and selling is also given by investment banks.
There is no demarcating line between the investment banking and other forms of banking in
India. This has been observed majorly of late. All banks nowadays want to provide their
customers the best of services and create a niche for themselves and that is why apart from
investment banks, all other banks too are aiming at making it big.
At the macro level, investment banking is related with the primary function of assisting thecapital market in its function of capital intermediation, i.e., the movement of financial
resources from those who have them (the investors), to those who need to make use of
them for producing GDP (the issuers). Over the decades, investment banks have always
suited the needs of the finance community and thus become one of the most vibrant and
exciting segment of financial services.
Globally investment banks handle significant fund-based business of their own in the capital
banking solutions through its extensive distribution network to cater to the varied needs of
its retail and corporate clients. The firm is listed under the Monetary Authority of Singapore
(MAS) and Financial Services Authority, UK and has an authoritative place in the core
divisions of its functional areas such as consultant services, fiscal good distribution, Equity
Capital Markets Advisory Services, etc.
5. IDFC: Initiated in 1997 in Chennai, IDFC undertook the responsibility of providing financial
support to 332 projects accruing a profit of upto Rs 2, 20, 400 million. The sectors under
IDFC's financial assistance are infrastructure, agri related business, transportation,
healthcare, tourism and others.
6. Kotak Mahindra Capital Company: Initiator and leader in equity capital markets, Kotak
Investment Banking has undertaken the developmental work of most ground breaking
advances in the Indian capital markets comprising the launch of book building and Qualified
Institutional Placements (QIPs) in India. The investment bank has an impressive track recordof controlling various sectors and has played a major role in the government's milestone
disinvestments.
7. SBI Capital Markets: SBICAPS is India's foremost investment bank and project consultant,
aiding local firms in capital enlistment endeavors for last many years. The firm started it
operations in 1986 and is an entirely owned subordinate of the State Bank of India. Asian
Development Bank (ADB) possesses 13.84% stakes in equity segment of SBICAPS.
8. Tata Investment Corporation Limited (TICL): A non-banking financial company (NBFC), TICL
is listed with the Reserve Bank of India under the group of 'Investment Company'. The firm's
commercial activities constitute mainly of endowing in long-standing investments in equity
of the firms in various sectors. The chief source of return for the firm entails income on
investment trading and income accrued on dividend.
9. Yes Bank: This Investment Banking association is engaged in the classification, arrangement
and implementation of deals for their clients in varied sectors and nations. Some of the
10. UTI Securities Ltd: Endorsed as a self-regulating professional body in 1994, UTI Securities
Ltd., is one of the renowned investment bank of India. After the termination of Unit Trust of India (UTI) Act, the total share fund of UTISEL is now controlled by superintendent of
particular enterprise of UTI. The firm has been offering all sorts of investment associated
activities which incorporates investment banking and corporate consultation facilities.
The investment banking and securities dealing industry underwent massive disruptions over
the past two years. The year 2008 saw a complete makeover of the industry as Bear Stearns
fell into the hands of JP Morgan, Lehman Brothers filed for bankruptcy protection, Merrill
Lynch staved off collapse with a Bank of America takeover and the two remaining giants,
Goldman Sachs Group and Morgan Stanley, converted into bank holding companies to
qualify for government assistance. We have seen an incredible destruction of the industry
that was years in the making. Many of the causes came from perverse regulatory incentives
as the industry transitioned from a natural oligopoly into freer competition.
The investment banking industry directly correlates to economic growth given that its ability
to profit derives from the securitization of businesses. Generally, mergers, acquisitions and
other underwriting services depend on the overall level of corporate activity. Corporate
activity directly follows from earnings increases of individual companies and the general
economic outlook and confidence in business prospects. So the fate of investment banking
revenues relies heavily on the fate of the overall economy. Given some of the key structural
characteristics of the investment banking industry, investment banks must seek to form
long-term relationships with individual firms while respecting others banks relationships in
a naturally oligopolistic industry. First, investment banks must perform significantly deep
and pointed research into the companies that they offer securitization services to. The initial
enticement into private placements is largely dependent on the solid reputation of the lead
investment banks promoting the security. In orde r to find buyers for a particular stock issue
that the investment bank wishes to sell to the public, the bank puts its own reputation on
the line claiming its high-standards and due diligence of financial statement review give the
investor security. An investor needs to be able to trust the investment banks opinion on the
future prospects of the company and the investment. No investment bank will survive longshould it promote the securities of soon-failing institutions. Any individual bank promoting
worthless companies will soon go bankrupt as investors realize the ill-advised investments
they are taking. This is clearly why so-called chop shops and penny-stock promoters
typically never gain respected status and fail in short order or are shutdown by the SEC for
fraud. The major players in the industry have had collective breakdowns in underwriting
standards in times of the past but generally banks must be trustworthy and provide
accurate assessments of future business prospects. (2001 Anand & Galetovic) Initially, then,
a bank must study the company and its prospects and assign an appropriate valuation. This
initial due diligence is costly and results in sunk costs in order to begin a relationship with
outside firms. The costs are necessary but are undertaken because the bank clearly believes
it can garner greater profits in the future by having a relationship. (2001 Anand & Galetovic)These unrecoverable costs are worthwhile if the bank can create a lasting relationship
where it reuses the same information for future deals and is able to recoup the costs
associated to that particular company as well as the sunk costs lost on firms where potential
deals were rejected due to lower credit quality. These sunk costs relate to another trait in
the investment banking industry, the misaligned connection between costs and fee revenue.
(2001 Anand & Galetovic) Investment banks only generate revenue when they create and
execute a particular security deal. While banks may spend months and months studying a
company, gauging market buying interest, promoting a deal, offering advice, they are only
paid fee income once the deal is finally consecrated. Ultimately a bank may provide a great
deal of services and never collect fee revenues. A third characteristic of the industry is a
banks inability to claim any rights over the information it generates about a particular firm
it is investigating for a potential deal. (2001 Anand & Galetovic) The firm may spend
hundreds of man hours dedicated to deal but it has difficulty m aintaining that information
as proprietary. The risk of a lead person on the deal team to be hired away by another bank
is high. Banks can attempt to reduce this risk through non-compete agreements but given
the global nature of todays financial system, non-competes can fail rather easily given their
geographical limitations. Then, this employee who is hired away would bring with them all
the information they had gathered in hours of research at the bank. Also, once the bank has
researched the potential company for underwriting, it must use its reports to generate
outside interest among investors. In seeking these outsider investors, the research is pushed
into the public forum and its privacy is lost. These three traits of the industry point to why
investment banking is naturally oligopolistic. In perfect competition, investment banks
would allow other firms to incur the initial sunk costs for a deal and then free ride off the
information obtained. A bank could easily achieve this by stepping in late in the deal just
before the security is actually created and sold and undercut the initial firm. A simple way to
create the relationship would be to hire away the lead employee on the deal who has the
most intricate knowledge of the company and the deal at hand. For example, Deutsche
Bank built a global investment bank in a year (Deutsche Morgan Grenfell) by hiring away
staff en masse from other major banks (2001 Anand & Galetovic). The information and
advice exchanged prior to a deals completion give strong incentive for another investment
bank to free ride and offer the deal at a much lower price having not incurred the setup
costs. Therefore, the investment banking industry cannot be perfectly competitive and must
result in a voluntary cooperation among banks not to undercut each other in ruinous
competition that will ultimately destroy the incentives to create long-lasting relationships
with firms. Evidence of this dynamic has been studied in various literatures. In Struggle and
Survival on Wall Street written in 1994, Matthews found that firms have charged 7/8percent for underwriting top quality bonds for decades. Matthews concluded that there
must be some type of unspoken collusion among banks for this to occur so systematically
for so long. Chen and Ritter reported that gross spreads received by underwriters on initial
public offerings in the United States are much higher than in other countries. Furthermore,
in recent years more than 90 percent of deals raising $20-80 million have spreads of exactly
seven percent, three times the proportion of a decade earlier. The spreads were not near
or around seven percent, they broke down to exactly seven percent. In a more competitive
industry, one would expect to find spreads in a range where banks would compete with
each other at least to some degree. Chen and Ritter go on to claim that investment bankers
will openly admit that they dont want to turn it into a commodity business so banks do
not compete on the prices charged for initial public offerings. The ability to perform high-yielding securities deals is the lifeblood of the investment banking industry and executives
have made sure not to cause a breakdown in the fee schedule. These implicit agreements
show the oligopolistic structure of the investment banking industry. In such a structure,
there is a relatively fixed size of each individual dominant firm in the industry. If firms are all
too small, they will free ride off each others information and ruin each other. While if a
particular firm is too large relative to the others, the smaller firms will have increased
incentive to free ride to the detriment of the large firm. Therefore, no firm can become too
large without other, smaller firms attacking it and driving up its costs and reducing its fee
revenues through undercutting. The large firms operate on mutual high reputations and an
implicit agreement not to fall into ruinous competition. This creates the boys club that
Wall Street is sometimes seen as. The high barriers to entry in the industry also help support
the Wall Street club. The Securities and Exchange Commission has set a high standard of
capital and regulatory requirements that must be passed in order to setup as an investment
bank (2009 IBIS). The capital standards require large initial investments for conducting
business. More recently, increased regulation of the industry is likely thus further increasing
the barriers to entry for companies not able to produce significant economies of scale to
spread the high costs of compliance with legal regulations. Yet, once a bank is established,
their fixed capital costs are relatively low in comparison to variable labour costs. The
services provided by investment banks require a large amount of administrative work and
are highly labor intensive in general (2009 IBIS). These employees are typically highly
educated and very specialized in their field resulting in outsized wage expenses to maintain
the workforce. This relatively large portion of variable costs helps banks deal with
downturns in economic activity and massive layoffs are an understood part of the business
in times of economic contraction. But, as a barrier to entry into the industry, it can be
difficult to attract the well-qualified candidates in order to setup an enterprise espe cially in
investment banking because of its reliance on a bonus as a significant portion of an
employees compensation. This bonus is very large relative to the employees salary and is
only guaranteed if the firm can guarantee its ability to perform high profile securities deals.
In this way, the top firms of the industry are naturally supported by their employees who
stay with the reputation and success guaranteeing their income at the end of the year. Also,
one of the greatest components for success for an investment bank is its reputation.
Reputations are not made in short order but rather take years of quality servicing and then
decades to establish the firm commitment to maintaining integrity in its dealings. Gaining
acceptance from firms as a desired promoter and underwriter of securities is a long, hard -
won battle that substantially hinders new entrants from the market. Reputation and brand
can be measured by goodwill accounting within the financial statements. Goldman Sachs,for example, records an asset value of over $5 billion for its goodwill and intangible assets
on its financial statements (2009 GS). UBS valued its goodwill at over $4 billion for the year
ended December 31, 2008 (2008 UBS). These goodwill measurements indicate the value of
the business segments that exceed the discounted expected future cash flows and point to a
valuation of a companys reputation, brand image and customer loyalty. According to U.S.
Census Bureau statistics, the investment banking industry had 5,583 firms in 2007
generating a total of $207.4 billion in sales and employing over 140,000. The industry
experienced rapid growth over the previous five-year period with a 109.7 percent growth in
revenues fuelled by a relatively minor 19.7 percent growth in the number of firms coupled
with a miniscule 6.4 percent increase in the number of employees. Compensation increased
57 percent over the same period from 2002 to 2007, a 9.5 percent compound annualgrowth rate. (2009 Census)The state of New York is, by far, the dominant player in the
investment banking industry in terms of revenue, but not hardly so in terms of the number
of institutions. While accounting for only 20.8 percent of the total firms in 2002, New York
firms produced 77.9 percent of the total revenues generated in the industry. California takes
up second in the total revenues with a measly 4.1 percent of total sales. This divergence
clearly points to the dominance of Wall Street and the large market shares of a limited
number of firms. (2009 Census)The year 2008 saw an extraordinary 93.0 percent drop in
industry revenue as the sector imploded in the wake of the subprime mortgage meltdown.
As recently as the year 2007, the top six investment banking firms accounted for 86 percent
of the total market. By the end of 2008, major consolidation had occurred and the top three
firms now had market share of 65 percent. The top six investment banks in 2007, in order of
market share, were Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear
Stearns and JP Morgan. By the end of the 2008, Goldman Sachs and Morgan Stanley had
survived only by converting to bank holding companies to qualify for government capital
infusions. Merrill Lynch was forced into an acquisition by Bank of America after Lehman
Brothers dramatically collapsed in a short time. Bear Stearns was the first to fall in early
2008 forcing a takeover by JP Morgan. The composure of the investment banking industry
has dramatically changed and will continue to change in the futu re. There are no
independent investment banks remaining of any sizable importance. (2009 IBIS) The current
industry now has four key players accounting for 80 percent of the market. JP Morgan, after
acquiring Bear Stearns in May of 2008, now holds a 26 pe rcent share operating with assets
of $1.6 trillion and 180,000 employees. JP Morgan bartered an exceptional deal with the
Federal Reserve Bank bearing only the first $1 billion in potential losses from the acquisition
while the Fed bears the next $29 billion offering JP a great chance to snap up huge market
share gains without excessive risk of losing capital. JP participated in the same leveraged
loans and mortgage investments that other banks did but on a much more conservative
scale so that still maintained profitability in 2008 with incomes declining 64%. (2009
IBIS)Goldman Sachs, one of the two remaining firms from the group of the five independent
investment banks, comes in second in market share with 23 percent. Goldman also
weathered the subprime meltdown relatively well as it hedged its positions wisely and
experienced an 80 percent decline in net income in the year 2008. Morgan Stanley ranks
third in share with 16 percent and Bank of America rounds out the top four with 15 percent
market share. These four companies dominate the investment banking industry in the
United States now. Citigroup is the fifth largest and holds a measly one percent share. (2009
IBIS)The 54 percent drop in the equity market from the October 2007 high to the March
2009 low has left many market participants asking why the crisis occurred. Given that thecrisis was first felt within the walls of Wall Street firms, it makes one ask how investment
banks could have incurred such massive losses. The top five firms as well as other
commercial banking institutions threatened the collapse of the entire global financial
system with their extraordinarily excessive leverage and concentration in subprime
mortgage backed securities. Much of the changes in banking habits can be traced back the
Gramm-Leach-Bliley Act (GLBA) of 1999. The GLBA most notably repealed Section 20 of the
Glass-Steagall Act of 1933 (2009 Geyfman & Yeager). After the stock market crash in 1929
the Federal government passed many new wide-ranging sweeping measures to curtail
excessive risk-taking in the financial markets by large banking institutions. The SEC was
formed to regulate entities and Federal Deposit Insurance Corporation was founded to
insure the deposits of individual customers. Along with these two entities which haveproved to be major successes in creating stability in financial markets, the Glass-Steagall Act
had the specific provision of Section 20. Section 20 prohibited commercial banking
institutions from engaging in securities activities. Banks that held customer deposits were
now prohibited from engaging in or having affiliations with firms that engaged principally in
the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or
through syndicate participation of stock, bonds, debentures, notes or other securities (Title
12, U.S Code, Section 20).Section 20 intended to separate the riskiness of activities that
dealt with securities and the necessity of safety for consumer depositors. Glass-Steagall
looked to curtail the negative effects losses in securities dealing would have on the security
of banking deposits in a firm participating in both aspects of the financial system. As with
many other industries, the move to deregulation seen in the United States throughout the
1980s had its effects on the financial services industry as well. The slow erosion of Section
20 finally culminated in the passing of GLBA, otherwise known as the Financial Services
Modernization Act in 1999. This Act allowed ba nk holding companies to convert into
financial holding companies and perform dealings in securities through subsidiaries without
regulatory limits. (2009 Geyfman & Yeager) The repeal of Section 20 was strenuously lobbied
for in Congress by banking institu tions on the premise that major synergies could be
achieved without it creating significant economies of scale. Investment banks must undergo
costly creditworthiness evaluations in order to underwrite securities. These activities are
linked to a firms day-to-day financial activities. A bank holding company holding the
deposits and providing credit lines to an institution will have already conducted evaluations
of the firm that can then be transferred into underwriting activities without repeat of the
initial sunk costs independent investment banks must endure. Recent studies have shown a
modest risk diversification benefits in the post-GLBA era (2009 Geyfman & Yeager) and
significant revenue synergies between IB and commercial banking (2005 Yasuda). On the
other hand, now banks are participating in a significantly riskier world of securities dealing
with the downside of the risks to be felt by those seeking safety in simple depository
transactions with the bank. Geyfman and Yeager found that universal banks had similar
systemic risk but sharply higher total and unsystematic risk than more traditional banks
(2009). This finding points to the inherent risks in securities dealing and the possible spill
over disruptions these activities could have on traditional commercial banking activities. The
GLBA led to significant changes in the investment banking industry. The five largest
independent investment banks that had operated under implicit cooperation were forced to
produce earnings elsewhere as many new competitors entered the market. Previously an
unhindered oligopoly, the top five independent investment banks found themselves
competing for securities deals with the new so -called universal banks, major players like JPMorgan, Citigroup and Bank of America. Every banking institution was now allowed in on
the deal-making turf and held significant sway over firms making securitization decisions
because of the existing relationship with banks holding depository funds. A study in 2005
showed that companies having existing banking relationships will more often choose that
particular bank as their underwriter in securities deals (2005 Yasuda). This poses a great
challenge to investment banks that do not hold deposits because customers that were
previously forced to seek out an independent investment bank were now choosing the bank
holding companies they already had established relationships with for securities deals. After
five years of competing with all other firms in the banking world for securities deals,
investment banks needed a new way to make money. The new solution included employing
a great deal of leverage. One of the most crucial elements of the financial industry collapsewas the major change the SEC passed in legislation in 2004. Since 1975, the SEC had limited
broker dealers a debt-to-net capital ratio of 12-to-1. Most banks exhibit leverage ratios
between 9 and 12 percent depending on the managements appetite for risk. Investment
banks though, have always found ways to exceed those ratios but the 2004 SEC rules gave
them free reign. The SEC now allowed the top five investment banks to leverage up 30, even
40 to 1. (2008 Para Pundit)One of the most striking elements of the leverage equation is
that it does not include many off-balance sheets obligations and does not account for the
and Morgan Stanley, 21.7 percent. By 2007 every bank had large increases in their debt to
capital ratios: Bear Stearns, 21.5 percent increase to 33.5 percent; Goldman Sachs, 16.6
percent increase to 22.4 percent; Lehman Brothers, 19.2 percent increase to 30.7 percent;
Merrill Lynch, 73.2 percent increase to 32.0 percent; and Morgan Stanley, 53.8 percent
increase to 33.4 percent (2008 Epicurean). These banks took advantage of the SEC rule
change to the fullest extent pushing their balance sheets to the limit, and then over the
limit. While the top four investment banks had market share totalling 39.1 percent in 2002,
the leverage fueled large gains and by 2007, the top four firms had combined market share
of 69.0 percent (2009 IBIS).Leverage is a great bonus in boom times as seen in the housing
market throughout the early 2000s as real estate prices soared. But, leverage is much more
of a zero-sum game than most would like to admit and the fall in housing demand towards
the end of 2007 caused losses in banking portfolios and ultimately resulted in billions of
dollars in writedowns. In the end, none of the top five investment banks existed in its
independent investment banking form by the end of 2008. Bear Stearns collapsed and was
sold off to JP Morgan at a pittance of its former stock price. Lehman Brothers found the
government unwilling providers of bailout monies and claimed bankruptcy in September2008. Merrill Lynch, seen as the next domino in a falling cascade, was forced into an
acquisition by Bank of America to salvage the company. Goldman Sachs and Morgan Stanley
soon converted into bank holding companies to receive access to the Federal Reserve
discount window. This conversion dictates a major reduction in leverage for the two banks
to comply with regulation. The underlying regulatory structure created economic incentives
that fueled the boom and bust in the investment banking industry. A naturally oligopolistic
industry that would fall victim to ruinous competition under a perfectly competitive market
found itself in a state of implicit cooperation. Investment banks chose no t to compete on
price for securities deals as evidenced by clustering of spreads on corporate bonds offerings
and initial public offerings in equities sold by banks. The repeal of Section 20 from the Glass -
Steagall Act of 1933 allowed a new field of entran ts into the investment banking arena. Therise of the universal bank allowed institutions that held depository accounts to now be the
one-stop shop for all a firms financial needs. As studies have shown, firms are more likely to
use the bank they already have a relationship with in going forward on securities deals. So,
the independent investment bank found itself in a tough spot. Its oligopoly was invaded by a
swath of new competitors and it had to find a new competitive advantage. The solution was
disastrous in the long-run even while providing five years of record-setting growth rates.
Investment banks leveraged up their mortgage dealings and engaged in a variety of high-risk
Global Finance names the World¶s Best Investment Banks 2010
New York, April 19, 2010 ² Global Finance announces its selection of the World¶sBest Investment Banks 2010 to be published in its June 2010 issue.
Global Finance editors, with input from industry experts, used a series of criteria to
arrive at their selections. These included market share, number and size of deals,service and advice, structuring capabilities, distribution network, efforts to addressmarket conditions, innovation, pricing, after -market performance of underwritings andmarket reputation. Deals announced or completed in the last three quarters of 2009or the first quarter of 2010 were considered.
³The last 12 months were decidedly mixed for investment bankers,´ said GlobalFinance publisher Joseph D. Giarraputo. ³But many institutions continue to providethe best possible services to their clients, and we salute them.´
For editorial information please contact: Dan Keeler, Editor, email: [email protected]
Lead Managers Credit Suisse, QNB Capital,Barclays Capital,
Goldman Sachs, and J.P. Morgan
Best M&A Deal Berkshire Hathaway-Burlington
Northern Santa Fe
Advising target Goldman Sachs
WHAT ARE THE MAIN DIFFERENCES BETWEEN COMMERCIAL BANKING AND INVESTMENT
BANKING?
An Investment bank is financial intermediary that performs a variety of services including
underwriting (guarantees the purchase of securities if the market fails to purchase them),
acting as an intermediary between an issuer of securities and the investing public,
facilitating mergers and other corporate reorganizations, and also acting as a broker for
institutional clients.
-A ma jor function of investment banks is the provision (underwriting) of long term equity
and debt to corporations and governments (debt raising for business banks and institutions
- derivatives, bonds, corporate paper or IPO). Private placement (of equities) occurs where
an investment bank offers large holdings in a company coming to the market to its top 10 or
so stock holders; usually large hedge funds. Investment banks also mediate M&A (mergers
and acquisitions), which can include hostile takeovers or joint ventures.
Commercial banks traditionally deal in basic loans and deposit taking within the corporate
business sector. However, this has changed rapidly over the last 10 years as large
commercial business has been able to offer their own debt (corporate bonds). Now
commercial banks are less about lending to multinational companies and more about
advising them, which has blared line between Commercial Banking and Investment banking.
Although, in times of financial hardship like the GFC when corporate debt dries up (i.e. theliquidity crisis), firms still require commercial banking for funds.
Basic Functions of Commercial Banks
-Domestic lending from domestic deposits
-Large amounts of cross border lending - trade/finance, specifically currency exchange, is
bread and butter of commercial banking: Global risk due to subsidiaries, currencies, and
securities. In contrast, for large offerings, the managing banks may create a syndicate
including more than 100 investment banks.
Investment houses continued to be innova tive and introduce new financial instruments for
both issuers and investors. Some of the most significant innovations include fixed -income
and tax-exempt securities, which have grown in popularity since their inception in the
1980s. Some key fixed-income securities have been debt warrants, which are bonds sold
with warrants to buy more bonds at a specific time; and debt -equity swaps, where
companies offer stock to existing bondholders.
With a growing number of mergers and acquisitions as well as corporate restructurings,
investment banks have become increasingly involved in the process of arranging these
transactions as part of their primary services. Because of changing economic, competitive,
and market conditions, several thousand small and mid-sized companies as well as a handful
of large corporations agree to merger and acquisition deals each year. Investment banks
facilitate this process by providing advice on such transactions, negotiating on behalf of
their clients, and guaranteeing the purchase of bonds for acquisitions that rely on debt,
known as leveraged buyouts.
The rapid expansion of the Internet in the mid-to-late 1990s provided an impetus for
stockbrokers to begin offering trading services through the Internet. Because of the
popularity of online trading, brokers began offering investment banking services. Early in
1999, E-Trade established the online investment bank "E-Offering," which provides online
initial public offering services.
Since the passage in 1933 of the Glass-Steagall Act, the U.S. banking industry has been
closely regulated. This act requires the separation of commercial banking, investment
banking, and insurance. In contrast to investment banks, commercial banks focus on taking
deposits and lending. Nevertheless, there have been recent endeavours to repeal the actand to relax its measures. While the act has not been overturned even with efforts
continuing in 1999, the Federal Reserve, which oversees commercial banking, has allowed
commercial banks to sell insurance and issue securities. Consequently, investment banks
and insurers support the latest round of activity to overturn the act. Japan and the United
States are the only major industrial countries that require the separation of commercial and
investment banking.
FUTURE OF INVESTMENT BANKING IN INDIA
Investment banking India has always been very crucial for the smooth flow of market
transactions between various investors, companies, firms and the government. These banks
will have a role to play even in the future, irrespective of the economic conditions in the
Investment banking companies generally help their clients to access capital through equity,
debt and other kinds of investment products. These firms also tra de in equities and
derivative products and also help companies with merger and acquisition deals. About a
couple of years back, when the world economy was reeling under a recession, many
investment banking firms either collapsed or were on the brink of clo sure. Even a few firms
in India were affected by this global downturn. This led to many sceptics writing off the
revival of these firms.
What is in store for the future?
The economic downturn revealed that only the strong can swim against the tide and still
remain afloat. Those sceptical must realize that the market has its own upheavals anddownturns. When you look at the financial strength of these companies, you just cannot
ignore them. No wonder, most of these firms bounced back once again. However, the future
of Investment banking companies in India looks good, even though we may see new
investment guidelines.
Expected Investment Guidelines
Considering what is happening after the economic crash in the United States, even our
policy makers may be tempted to bring in some stringent guidelines for investment bankingservices in India. This may be done with a view to ensure better risk management. Another
option which the law makers may think of is tinkering with the claw back option. This will
certainly protect the investment companies against fraudulent and unethical traders and
companies who might trigger a market crash, thereby causing huge losses. This provision
will ensure recovery of their profits. Lastly, banks may be advised to go slow on short term
funding in order to reduce mismatch between assets and liabilities.
CONCLUSION
The industrial investment bank of India is one of oldest banks in India. The Industrial
Reconstruction Corporation of India Ltd., set up in 1971 for rehabilitation of sick industrial
companies, was reconstituted as Industrial Reconstruction Bank of India i n 1985 under the
IRBI Act , 1984. With a view to converting the institution into a full -fledged development
financial institution, IRBI was incorporated under the Companies Act , 1956, as Industrial
Investment Bank of India Ltd. (IIBI) in March 1997. IIBI of fers a wide range of products and
services, including term loan assistance for project finance, short duration non -project
asset-backed financing, working capital/ other short-term loans to companies, equity
subscription, asset credit, equipment finance as also investments in capital market and
money market instruments.
In view of certain structural and financial problems adversely impacting its long-term
viability, IIBI submitted a financial restructuring proposal to the Government of India on 25
July 2003. IIBI has since received certain directives from the Government of India, which,
inter alias, include restricting fresh lending to existing clients approved cases rated
corporates, restrictions on fresh borrowings, an action plan to reduce the overhead
expenditure, disposal of fixed assets and a time-bound plan for asset
recovery/reconstruction. The Government of India had also given its approval for the
merger of IIBI with IDBI and the latter had already started the due diligence process.
But on 17 December 2005 the IDBI rejected any such merger.
SiD
e of industry
Global investment banking revenue increased for the fifth year running in 2007, to a record
US$84.3 billion,[5]
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 durin g 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 centres, including 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 mark ets.
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,[citation
needed ]but structuring and trading derivatives retains higher margins in good timesand 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