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A series on financial services
An investment bank is a financial institution that raises capital, trades securities and manages corporate mergers and acquisitions. Another term for investment banking is corporate finance.
Investment banks work for, and profit from, companies and governments, by raising money through issuing and selling securities in capital markets (both equity and debt) and insuring bonds (e.g. selling credit default swaps), and providing advice on transactions such as mergers and acquisitions. A majority of investment banks offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.
In terms of regulatory qualification, to perform these services in the United States, an adviser must be a licensed broker-dealer, and is subject to Securities & Exchange Commission (SEC) (FINRA) regulation. Until 1999, the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G7 countries, have not maintained this separation historically. Trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) was referred to as the " sell side".
Dealing with the pension funds, mutual funds, hedge funds, and the investing public who consumed 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.
Organizational structure of an investment bank
Main activities and units
An investment bank is split into the so-called front office, middle office, and back office. While large full-service investment banks offer all of the lines of businesses, both sell side and buy side, smaller sell side investment firms such as boutique investment banks and small broker-dealers will focus on investment banking and sales/trading/research, respectively.
Investment banks offer security to both corporations issuing securities and investors buying securities. For corporations investment bankers offer information on when and how to place their securities in the market. The corporations do not have to spend on resources with which it is not equipped. To the investor, the responsible investment banker offers protection against unsafe securities. The offering of a few bad issues can cause serious loss to its reputation, and hence loss of business. Therefore, investment bankers play a very important role in issuing new security offerings.
Core investment banking activities
- Investment banking is the traditional aspect of the investment banks which also involves helping customers raise funds in the capital markets and advise on mergers and acquisitions. Investment banking may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Another term for the investment banking division is corporate finance, and its advisory group is often termed mergers and acquisitions (M&A). A pitch book of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance, equity, and high-grade debt and generally work and collaborate with industry groups in the more intricate and specialized needs of a client.
- Sales and trading: On behalf of the bank and its clients, the primary function of a large investment bank is buying and selling products. In 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 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. Structuring has been a relatively recent activity 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. Strategists advise external as well as internal clients on the strategies that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place companies and industries in a quantitative framework with full consideration of the macroeconomic scene. This strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products. Banks also 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 buys or sells a product to a client and does not hedge his total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and trading has created jobs for physics and math Ph.D.s who act as quantitative analysts.
- 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. There is a potential conflict of interest between the investment bank and its analysis in that published analysis can affect the profits of the bank. Therefore in recent years the relationship between investment banking and research has become highly regulated requiring a Chinese wall between public and private functions.
Other businesses that an investment bank may be involved in
- Global transaction banking is the division which provide cash management, custody services, lending, and securities brokerage services to institutions. Prime brokerage with hedge funds has been an especially profitable business, as well as risky, as seen in the " run on the bank" with Bear Stearns in 2008.
- 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 e.g. mutual funds). The investment management division of an investment bank is generally divided into separate groups, often known as Private Wealth Management and Private Client Services.
- Merchant banking is a private equity activity of investment banks. Current examples include Goldman Sachs Capital Partners and JPMorgan's One Equity Partners. (Originally, "merchant bank" was the British English term for an investment bank.)
- Commercial banking see article commercial bank. Examples being Goldman Sachs and Morgan Stanley growing into the commercial banking businesses even before the financial crises of 2008.
- 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.
- Corporate treasury is responsible for an investment bank's funding, capital structure management, and liquidity risk monitoring.
- Financial control tracks and analyzes the capital flows of the firm, the Finance division is the principal adviser to senior management on essential areas such as controlling the firm's global risk exposure and the profitability and structure of the firm's various businesses. In the United States and United Kingdom, a Financial Controller is a senior position, often reporting to the Chief Financial Officer.
- Corporate strategy, along with risk, treasury, and controllers, often falls under the finance division as well.
- Compliance areas are responsible for an investment bank's daily operations' compliance with government regulations and internal regulations. Often also considered a back-office division.
- Operations involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While some believe that operations provides the greatest job security and the bleakest career prospects of any division within an investment bank, many banks have outsourced operations. It is, however, a critical part of the bank. 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 refers to the information technology department. Every major investment bank has considerable amounts of in-house software, created by the technology team, who are also responsible for technical support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading. Some trades are initiated by complex algorithms for hedging purposes.
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.
Size of industry
Global investment banking revenue increased for the fifth year running in 2007, to $84.3 billion. This was up 22% on the previous year and more than double the level in 2003. Despite a record year for fee income, many investment banks have experienced large losses related to their exposure to U.S. sub-prime securities investments.
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 centres, including London, New York City 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. Throughout the history of investment banking, it is only known that 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 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.
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 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 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. 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 financial crisis of 2008 saw the last of the US investment banks which hadn't gone bankrupt or been acquired in a bankrupt-like state convert over to 'bank holding companies' which are eligible for emergency government assistance.
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 equity research and trading 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 behaviour 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 before filling orders previously submitted by their customers, thereby benefiting from any changes in prices induced by those orders.