Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest

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Management of Financial Institutions - MGT 604

Lecture # 28

Role of Investment Banks

Investment banks

It helps companies and governments (or their agencies) raise money by issuing and selling

securities in the capital markets (both equity and debt).

Almost all investment banks also offer strategic advisory services for mergers, acquisitions,

divestiture, or other financial services for clients, such as the trading of derivatives, fixed

income, and foreign exchange, commodity, and equity securities.

Trading securities for cash or securities (i.e., facilitating transactions, market-making), or

the promotion of securities (i.e., underwriting, research, etc.) is referred to as "sell side."

The "buy side" constitutes the 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. Many firms have both buy and sell side components.

Organizational structure of an investment bank

The main activities and units

The primary function of an investment bank is buying and selling products both on behalf of

the bank's clients and also for the bank itself. Banks undertake risk through proprietary

trading, done by a special set of traders who do not interface with clients and through

Principal Risk, risk undertaken by a trader after he or she buys or sells a product to a client

and does not hedge his or her total exposure. Banks seek to maximize profitability for a

given amount of risk on their balance sheet.

An investment bank is split into the so-called Front Office, Middle Office and Back

Office.

Front Office

Investment Banking is the traditional aspect of investment banks which involves

helping customers raise funds in the Capital Markets and advising on mergers and

acquisitions. Investment banking may involve subscribing investors to a security

issuance, coordinating with bidders, or negotiating with a merger target. Other terms

for the Investment Banking Division include Mergers & Acquisitions (M&A) and

Corporate Finance (often pronounced "corpfin").

Investment management is the professional management of various securities

(shares, bonds, etc.) and other assets (e.g. real estate), to meet specified investment

goals for the benefit of the investors. Investors may be institutions (insurance

companies, pension funds, corporations etc.) or private investors (both directly via

investment contracts and more commonly via collective investment schemes eg.

mutual funds) .

Sales and Trading is often the most profitable area of an investment bank,

responsible for the majority of revenue of most investment banks In the process of

market making, traders will buy and sell financial products with the goal of making

an incremental amount of money on each trade. Sales is the term for the investment

Management of Financial Institutions - MGT 604

banks sales force, whose primary job is to call on institutional and high-net-worth

investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales

desks then communicate their clients' orders to the appropriate trading desks, who

can price and execute trades, or structure new products that fit a specific need.

Research is the division which reviews companies and writes reports about their

prospects, often with "buy" or "sell" ratings. While the research division generates

no revenue, its resources are used to assist traders in trading, the sales force in

suggesting ideas to customers, and investment bankers by covering their clients. In

recent years the relationship between investment banking and research has become

highly regulated, reducing its importance to the investment bank.

Structuring has been a relatively recent division as derivatives have come into play,

with highly technical and numerate employees working on creating complex

structured products which typically offer much greater margins and returns than

underlying cash securities.

Middle Office

Risk Management involves analyzing the market and credit risk that traders are

taking onto the balance sheet in conducting their daily trades, and setting limits on

the amount of capital that they are able to trade in order to prevent 'bad' trades

having a detrimental effect to a desk overall. Another key Middle Office role is to

ensure that the above mentioned economic risks are captured accurately (as per

agreement of commercial terms with the counterparty), correctly (as per

standardized booking models in the most appropriate systems) and on time (typically

within 30 minutes of trade execution). In recent years the risk of errors has become

known as "operational risk" and the assurance Middle Offices provide now includes

measures to address this risk. When this assurance is not in place, market and credit

risk analysis can be unreliable and open to deliberate manipulation.

Back Office

Operations involves data-checking trades that have been conducted, ensuring that

they are not erroneous, and transacting the required transfers. While some believe it

provides the greatest job security with the bleakest career prospects of the divisions

within an investment bank, many have outsourced operations. It is however a critical

part of the bank that involves managing the financial information of the bank and

ensures efficient capital markets through the financial reporting functions. In recent

years due to increased competition in finance related careers, college degrees are

now mandatory at most Tier 1 investment banks. A finance degree has proved

significant in understanding the depth of the deals and transactions that occur across

all the divisions of the bank.

Technology: every major investment bank has considerable amounts of in-house

software, created by the Technology team, who are also responsible for Computer

and Telecommunications-based support. Technology has changed considerably in

the last few years as more sales and trading desks are using electronic trading

platforms. These platforms can serve as auto-executed hedging to complex model

driven algorithms.

Management of Financial Institutions - MGT 604

Size of industry

Global investment banking revenue increased for the third year running in 2005, to $52.8bn.

This was up 14% on the previous year, but 7% below the 2000 peak. The recovery in the

global economy and capital markets resulted in an increase in M&A activity, which has

been the primary source of investment banking revenue in recent years. Credit spreads are

tightening and intense competition within the field has ensured that the banking industry is

on its toes.

The US was the primary source of investment banking income in 2005, with 51% of the

total, a proportion which has fallen somewhat during the past decade. Europe (with Middle

East and Africa) generated 31% of the total, slightly up on its 30% share a decade ago.

Asian countries generated the remaining 18%. Between 2002 and 2005, fee income from

Asia increased by 98%. This compares with a 55% increase in Europe, and a 46% increase

in the US, during this time period.

Recent evolution of the business

New products

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.

Throughout the history of investment banking, many have theorized that all investment

banking products and services would be commoditized. New products with higher margins

are constantly invented and manufactured by bankers in hopes 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 is highly profitable. Each OTC 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).

Vertical Integration

In the US, 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 which led

to segregation of Investment Banks from Commercial Banks. Glass-Steagall was repealed

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 the 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

Management of Financial Institutions - MGT 604

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 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.

Possible conflicts of interest

Potential conflicts of interest may arise between different parts of a bank, creating the

potential for financial movements that could be 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 which prohibits communication between

investment banking on one side and research and equities on the other.

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

Historically, equity research firms were founded and owned by investment banks.

One common practice is for equity analysts to initiate coverage on a company in

order to develop relationships that lead to highly profitable investment banking

business. In the 1990s, many equity researchers allegedly traded positive stock

ratings directly for investment banking business. On the flip side of the coin:

companies would threaten to divert investment banking business to competitors

unless their stock was rated favorably. Politicians acted to pass laws to criminalize

such acts. Increased pressure from regulators and a series of lawsuits, settlements,

and prosecutions curbed this business to a large extent following the 2001 stock

market tumble.

Many investment banks also own retail brokerages. Also during the 1990s, some

retail brokerages sold consumers securities which did not meet their stated risk

profile. This behavior may have led to investment banking business or even sales of

surplus shares during a public offering to keep public perception of the stock

favorable.

Since investment banks engage heavily in trading for their own account, there is

always the temptation or possibility that they might engage in some form of front

running. Front running is the illegal practice of a stock broker executing orders on a

security for their own account (and thus affecting prices) before filling orders

previously submitted by their customers.

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