Investment banking

From Wikipedia, the free encyclopedia

An investment bank is a financial institution that assists individuals, corporations, and governments in
raising capital by underwriting or acting as the client's agent in the issuance of securities (or both). An investment
bank may also assist companies involved in mergers and acuisitions and provide ancillary services such as market
making, trading of derivatives and euity securities, and F!"" services (fi#ed income instruments, currencies,
andcommodities).
$nlike commercial banks and retail banks, investment banks do not take deposits. From %&'' ((lass)*teagall Act)
until %&&& ((ramm)+each),liley Act), the $nited *tates maintained a separation between investment banking and
commercial banks. -ther industriali.ed countries, including (/ countries, have historically not maintained such a
separation. As part of the 0odd)Frank Wall *treet 1eform and "onsumer 2rotection Act of 34%4 (Dodd-Frank Act of
2010),5olcker 1ule asserts full institutional separation of investment banking services from commercial banking.
6here are two main lines of business in investment banking.
6he 7sell side7 involves trading securities for cash or for other securities (e.g.
facilitating transactions, market8making), or the promotion of securities (e.g.
underwriting, research, etc.).
6he 7buy side7 involves the provision of advice to institutions concerned with buying
investment services. 2rivate euity funds, mutual funds, life insurance companies,
unit trusts, and hedge funds are the most common types of buy side entities.
An investment bank can also be split into private and public functions with an information barrier which separates
the two to prevent information from crossing. 6he private areas of the bank deal with private insider information that
may not be publicly disclosed, while the public areas such as stock analysis deal with public information.
An advisor who provides investment banking services in the $nited *tates must be a licensed broker8dealer and
sub9ect to*ecurities : ;#change "ommission (*;") and Financial !ndustry 1egulatory Authority (F!<1A) regulation.
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Organizational structure=edit>
!nvestment banking is split into front office, middle office, and back office activities. While large service investment
banks offer all lines of business, both 7sell side7 and 7buy side7, smaller sell8side investment firms such as boutiue
investment banks and small broker8dealers focus on investment banking and sales?trading?research, respectively.
!nvestment banks offer services to both corporations issuing securities and investors buying securities. For
corporations, investment bankers offer information on when and how to place their securities on the open market, an
activity very important to an investment bank's reputation. 6herefore, investment bankers play a very important role
in issuing new security offerings.
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Core investment banking activities=edit>
!nvestment banking has changed over the years, beginning as a partnership form focused on underwriting security
issuance, i.e. initial public offerings (!2-s) and secondary offerings, brokerage, and mergers and acuisitions, and
evolving into a 7full8service7 range including securities research, proprietary trading, and investment management. !n
the modern 3%st century, the *;" filings of the ma9or independent investment banks such as (oldman
*achs and @organ *tanley reflect three product segmentsA (%) investment banking (fees for @:A advisory services
and securities underwriting)B (3) asset management (fees for sponsored investment funds), and (') trading and
principal investments (broker8dealer activities including proprietary trading (7dealer7 transactions) and brokerage
trading (7broker7 transactions)).
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!n the $nited *tates, commercial banking and investment banking were separated by the (lass)*teagall Act, which
was repealed in %&&&. 6he repeal led to more 7universal banks7 offering an even greater range of services. @any
large commercial banks have therefore developed investment banking divisions through acuisitions and hiring.
<otable large banks with significant investment banks include C2@organ "hase, ,ank of America, "redit
*uisse, 0eutsche ,ank, ,arclays, and Wells Fargo. After the financial crisis of 344D)344/ and the subseuent
passage of the Dodd-Frank Act of 2010, regulations have limited certain investment banking operations, notably
with the 5olcker 1ule's restrictions on proprietary trading.
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6he traditional service of underwriting security issues has declined as a percentage of revenue. As far back as
%&E4, D4F of@errill +ynch's revenue was derived from transaction commissions while 7traditional investment
banking7 services accounted for GF. However, @errill +ynch was a relatively 7retail8focused7 firm with a large
brokerage network.
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Front office=edit>
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Front office is generally described as a revenue generating role.
6here are two main areas within front officeA
!nvestment ,anking and @arkets, which includesA *alesB 6radingB 1esearchB *tructuring. !nvestment ,anking
involves advising the world's largest organisations on mergers, acuisitions, as well as a wide array of fund raising
strategies. 6his is, on average, the most prestigious and highest paid department in the bank with first year analysts
typically making IE4,444 upwards (depending on individual, team and firm performance).
@arkets are then split into further divisionsB sales, trading, some research and also structuring. 6hough the average
investment banker will make considerably more than the average trader, the best trader will make significantly more
than the best investment banker.
Investment banking=edit>
"orporate finance is the traditional aspect of investment banks which also involves helping customers
raise funds in capital markets and giving advice on mergers and acuisitions (@:A). 6his 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 7mergers and acuisitions7.
A pitch book of financial information is generated to market the bank to a potential @:A clientB if the pitch is
successful, the bank arranges the deal for the client. 6he investment banking division (!,0) is generally divided into
industry coverage and product coverage groups. !ndustry coverage groups focus on a specific industry ) such as
healthcare, public finance (governments), F!( (financial institutions group), industrials, 6@6 (technology, media, and
telecommunication) ) and maintains relationships with corporations within the industry to bring in business for the
bank. 2roduct coverage groups focus on financial products ) such as mergers and acuisitions, leveraged finance,
public finance, asset finance and leasing, structured finance, restructuring, euity, and high8grade debt ) and
generally work and collaborate with industry groups on the more intricate and speciali.ed needs of a client.The Wall
Street Journal, in partnership with 0ealogic, publishes figures on investment banking revenue such as @:A in its
!nvestment ,anking *corecard.
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Sales and trading=edit>
-n behalf of the bank and its clients, a large investment bank's primary function is buying and selling products. !n
market making, traders will buy and sell financial products with the goal of making money on each trade. Sales is
the term for the investment bank's sales force, whose primary 9ob is to call on institutional and high8net8worth
investors to suggest trading ideas (on a caveat emptor basis) and take orders. *ales desks then communicate their
clients' orders to the appropriatetrading desks, which can price and e#ecute 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 comple# structured products which typically offer much
greater margins and returns than underlying cash securities. !n 34%4, investment banks came under pressure as a
result of selling comple# derivatives contracts to local municipalities in ;urope and the $*.
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Strategists advise
e#ternal as well as internal clients on the strategies that can be adopted in various markets. 1anging from
derivatives to specific industries, strategists place companies and industries in a uantitative framework with full
consideration of the macroeconomic scene. 6his 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. ,anks also undertake risk through proprietary trading,
performed by a special set of traders who do not interface with clients and through 7principal risk7Krisk undertaken
by a trader after he buys or sells a product to a client and does not hedge his total e#posure. ,anks seek to
ma#imi.e profitability for a given amount of risk on their balance sheet. 6he necessity for numerical ability in sales
and trading has created 9obs for physics,computer science, mathematics and engineering 2h.0.s who act
as uantitative analysts.
Research=edit>
6he euity research division reviews companies and writes reports about their prospects, often with 7buy7 or 7sell7
ratings. !nvestment banks typically have sell8side analysts which cover various industries. 6heir sponsored funds or
proprietary trading offices will also have buy8side research. While the research division may or may not generate
revenue (based on policies at different banks), its resources are used to assist traders in trading, the sales force in
suggesting ideas to customers, and investment bankers by covering their clients. 1esearch also serves outside
clients with investment advice (such as institutional investors and high net worth individuals) in the hopes that these
clients will e#ecute suggested trade ideas through the sales and trading division of the bank, and thereby generate
revenue for the firm. 1esearch also covers credit research, fi#ed income research, macroeconomic research, and
uantitative analysis, all of which are used internally and e#ternally to advise clients but do not directly affect
revenue. All research groups, nonetheless, provide a key service in terms of advisory and strategy. 6here is a
potential conflict of interest between the investment bank and its analysis, in that published analysis can affect the
bank's profits.
Front and middle office=edit>
Risk management=edit>
1isk management involves analy.ing the market and credit risk that an investment bank or its clients take onto their
balance sheet during transactions or trades. "redit risk focuses around capital markets activities, such as loan
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syndication, bond issuance, restructuring, and leveraged finance. @arket risk conducts review of sales and trading
activities utili.ing the 5a1 model and provide hedge8fund solutions to portfolio managers. -ther risk groups include
country risk, operational risk, and counterparty risks which may or may not e#ist on a bank to bank basis. "redit risk
solutions are key part of capital market transactions, involving debt structuring, e#it financing, loan
amendment, pro9ect finance, leveraged buy8outs, and sometimes portfolio hedging. Front office market risk activities
provide service to investors via derivative solutions, portfolio management, portfolio consulting, and risk advisory.
Well8known risk groups in C2@organ "hase, (oldman *achs and ,arclays engage in revenue8generating activities
involving debt structuring, restructuring, loan syndication, and securiti.ation for clients such as corporates,
governments, and hedge funds. C.2. @organ !, 1isk works with investment banking to e#ecute transactions and
advise investors, although its Finance : -peration risk groups focus on middle office functions involving internal,
non8revenue generating, operational risk controls.
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"redit default swap, for instance, is a famous credit risk
hedging solution for clients invented by C.2. @organ's ,lythe @asters during the %&&4s. 6he +oan 1isk *olutions
group
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within ,arclays' investment banking division and 1isk @anagement and Financing group
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housed in
(oldman *ach's securities division are client8driven franchises. However, risk management groups such as
operational risk, internal risk control, legal risk, and the one at @organ *tanley are restrained to internal business
functions including firm balance8sheet risk analysis and assigning trading cap that are independent of client needs,
even though these groups may be responsible for deal approval that directly affects capital market activities. 1isk
management is a broad area, and like research, its roles can be client8facing or internal.
Middle office=edit>
6his area of the bank includes treasury management, internal controls, and internal corporate strategy.
"orporate treasury is responsible for an investment bank's funding, capital structure management, and liuidity
riskmonitoring.
Financial control tracks and analy.es 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 e#posure and the profitability and
structure of the firm's various businesses via dedicated trading desk product control teams. !n the $nited *tates and
$nited Lingdom, afinancial controller is a senior position, often reporting to the chief financial officer.
!nternal corporate strategy tackling firm management and profit strategy, unlike corporate strategy groups that
advise clients, is non8revenue regenerating yet a key functional role within investment banks.
6his list is not a comprehensive summary of all middle8office functions within an investment bank, as specific desks
within front and back offices may participate in internal functions.
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Back office=edit>
Operations=edit>
6his involves data8checking trades that have been conducted, ensuring that they are not wrong, and transacting the
reuired transfers. @any banks have outsourced operations. !t is, however, a critical part of the bank.
Technology=edit>
;very ma9or investment bank has considerable amounts of in8house software, created by the technology team, who
are also responsible for technical support. 6echnology has changed considerably in the last few years as more sales
and trading desks are using electronic trading. *ome trades are initiated by
comple# algorithms for hedging purposes.
Firms are responsible for compliance with government regulations and internal regulations.
Other businesses=edit>
Global transaction banking is the division which provides cash management,
custody services, lending, and securities brokerage services to institutions. 2rime
brokerage with hedge funds has been an especially profitable business, as well as
risky, as seen in the 7run on the bank7 with ,ear *tearns in 344/.
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 investors. !nvestors 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). 6he 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 can be called 7very personal banking7B merchant banks offer
capital in e#change for share ownership rather than loans, and offer advice on
management and strategy. @erchant banking is also a name used to describe the
private euity side of a firm.
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"urrent e#amples include 0efoe Fournier : "ie. and
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C2@organ's -ne ;uity 2artners and the original C.2. @organ :
"o. 1othschilds, ,arings, Warburgs and @organs were all merchant banks.
(-riginally, 7merchant bank7 was the ,ritish ;nglish term for an investment bank.)
Industry profile=edit>
6here are various trade associations throughout the world which represent the industry in lobbying, facilitate
industry standards, and publish statistics. 6he !nternational "ouncil of *ecurities Associations (!"*A) is a global
group of trade associations.
!n the $nited *tates, the *ecurities !ndustry and Financial @arkets Association (*!F@A) is likely the most significantB
however, several of the large investment banks are members of the American ,ankers Association *ecurities
Association (A,A*A)
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while small investment banks are members of the <ational !nvestment ,anking Association
(<!,A).
!n ;urope, the ;uropean Forum of *ecurities Associations was formed in 344D by various ;uropean trade
associations.
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*everal ;uropean trade associations (principally the +ondon !nvestment ,anking Association and
the ;uropean *!F@A affiliate) combined in 344& to form Association for Financial @arkets in ;urope (AF@;).
!n the securities industry in "hina (particularly mainland "hina), the *ecurities Association of "hina is a self8
regulatory organi.ation whose members are largely investment banks.
Global sie and revenue mi!=edit>
(lobal investment banking revenue increased for the fifth year running in 344D, to a record $*M/J.' billion,
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which
was up 33F on the previous year and more than double the level in 344'. *ubseuent to their e#posure to $nited
*tates sub8primesecurities investments, many investment banks have e#perienced losses. As of late 34%3, global
revenues for investment banks were estimated at M3J4 billion, down about a third from 344&, as companies pursued
less deals and traded less.
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0ifferences in total revenue are likely due to different ways of classifying investment
banking revenue, such as subtracting proprietary trading revenue.
!n terms of total revenue, *;" filings of the ma9or independent investment banks in the $nited *tates show that
investment banking (defined as @:A advisory services and security underwriting) only made up about %G834F of
total revenue for these banks from %&&E to 344E, with the ma9ority of revenue (E4NF in some years) brought in by
7trading7 which includes brokerage commissions and proprietary tradingB the proprietary trading is estimated to
provide a significant portion of this revenue.
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6he $nited *tates generated JEF of global revenue in 344&, down from GEF in %&&&. ;urope (with @iddle
;ast and Africa) generated about a third while Asian countries generated the remaining 3%F.
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6he industry is
heavily concentrated in a small number of ma9or financial centers, including "ity of +ondon, <ew Oork
"ity, Frankfurt, Hong Long and 6okyo.
According to estimates published by the !nternational Financial *ervices +ondon, for the decade prior to the
financial crisis in 344/, @:A was a primary source of investment banking revenue, often accounting for J4F of such
revenue, but dropped during and after the financial crisis.
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;uity underwriting revenue ranged from '4F to '/F
and fi#ed8income underwriting accounted for the remaining revenue.
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1evenues have been affected by the introduction of new products with higher marginsB however, these innovations
are often copied uickly by competing banks, pushing down trading margins. For e#ample, brokerages commissions
for bond and euity trading is a commodity business but structuring and trading derivatives has higher margins
because each over8the8counter contract has to be uniuely structured and could involve comple# pay8off and risk
profiles. -ne growth area isprivate investment in public euity (2!2;s, otherwise known as 1egulation 0 or
1egulation *). *uch transactions are privately negotiated between companies and accredited investors.
,anks also earned revenue by securiti.ing debt, particularly mortgage debt prior to the financial crisis. !nvestment
banks have become concerned that lenders are securiti.ing in8house, driving the investment banks to
pursue vertical integration by becoming lenders, which is allowed in the $nited *tates since the repeal of the (lass8
*teagall Act in %&&&.
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Top "# banks=edit>
Further information: List of inestment !anks
6he ten largest investment banks as of 0ecember '%, 34%', are as follows (by total fees from all advisory).
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6he
list is 9ust a ranking of the advisory arm of each bank and does not include the generally much larger portion of
revenues from sales and trading and asset management.
Rank Company Fees ($m)
1. J.P. Morgan & Co. 6,271.74
2. Bank of America Merrill Lynch 5,65.5!
". #ol$man %ach& 5,'5".21
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4. Morgan %(anley 4,452.
5. Ci(igro)* ",!52.'!
6. +e)(&che Bank ",616.12
7.
Cre$i( %)i&&e
",545.45
. Barclay& ",454.7"
!. ,ell& -argo 2,277.
1'. .BC Ca*i(al Marke(& 2,'41.'
World's biggest banks are ranked for @:A advisory, syndicated loans, euity capital markets and debt capital
markets.
The Financial Times, The Wall Street Journal and "loom!erg often cover mergers and acuisitions and capital
markets. +eague tables are also availableA
!nvestment ,anking 1eview, The Financial Times.
!nvestment ,anking *corecard, The Wall Street Journal.
(lobal @:A Financial Advisory 1ankings, "loom!erg.
(lobal "apital @arkets +eague 6ables, "loom!erg.
Financial crisis of 2008=edit>
6he 344/ financial credit crisis led to the notable collapse of several banks, notably including the bankruptcy of large
investment bank +ehman ,rothers and the hurried sale of @errill +ynch and the much smaller ,ear *tearns to banks
which effectively rescued them from bankruptcy. 6he entire financial services industry, including numerous
investment banks, was rescued by government loans through the 6roubled Asset 1elief 2rogram (6A12). *urviving
$.*. investment banks such as (oldman *achs and @organ *tanley converted to traditional bank holding
companies to accept 6A12 relief.
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*imilar situations occurred across the globe with countries rescuing their
banking industry. !nitially, banks received part of a MD44 billion 6A12 intended to stabili.e the economy and thaw the
fro.en credit markets.
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;ventually, ta#payer assistance to banks reached nearly M%' trillion, most without much
scrutiny,
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lending did not increase
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and credit markets remained fro.en.
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6he crisis led to uestioning of the business model of the investment bank
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without the regulation imposed on it by
(lass8*teagall.
=neutralit# is dis$uted>
-nce 1obert 1ubin, a former co8chairman of (oldman *achs, became part of
the "lintonadministration and deregulated banks, the previous conservatism of underwriting established companies
and seeking long8term gains was replaced by lower standards and short8term profit.
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Formerly, the guidelines said
that in order to take a company public, it had to be in business for a minimum of five years and it had to show
profitability for three consecutive years. After deregulation, those standards were gone, but small investors did not
grasp the full impact of the change.
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A number of former (oldman8*achs top e#ecutives, such as Henry 2aulson and ;d +iddy were in high8level
positions in government and oversaw the controversial ta#payer8funded bank bailout.
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6he 6A12 -versight 1eport
released by the"ongressional -versight 2anel found that the bailout tended to encourage risky behavior and
7corrupt=ed> the fundamental tenets of a market economy7.
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$nder threat of a subpoena, (oldman *achs revealed that it received M%3.& billion in ta#payer aid, MJ.' billion of
which was then paid out to '3 entities, including many overseas banks, hedge funds and pensions.
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6he same
year it received M%4 billion in aid from the government, it also paid out multi8million dollar bonusesB the total paid in
bonuses was MJ./3 billion.
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*imilarly, @organ *tanley received M%4 billion in 6A12 funds and paid out MJ.JDG
billion in bonuses.
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Criticisms=edit>
6he investment banking industry, and many individual investment banks, have come under criticism for a variety of
reasons, including perceived conflicts of interest, overly large pay packages, cartel8like or oligopolic behavior, taking
both sides in transactions, and more.
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!nvestment banking has also been criticised for its opacity.
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$onflicts of interest=edit>
"onflicts of interest may arise between different parts of a bank, creating the potential for market manipulation,
according to critics. Authorities that regulate investment banking (the F*A in the $nited Lingdom and the *;" in the
$nited *tates) reuire that banks impose a 7"hinese wall7 to prevent communication between investment banking
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on one side and euity research and trading on the other. "ritics say such a barrier does not always e#ist in
practice, however.
"onflicts of interest often arise in relation to investment banks' euity research units, which have long been part of
the industry. A common practice is for euity analysts to initiate coverage of a company in order to develop
relationships that lead to highly profitable investment banking business. !n the %&&4s, many euity researchers
allegedly traded positive stock ratings for investment banking business. Alternatively, companies may threaten to
divert investment banking business to competitors unless their stock was rated favorably. +aws were passed to
criminali.e such acts, and increased pressure from regulators and a series of lawsuits, settlements, and
prosecutions curbed this business to a large e#tent following the 344% stock market tumble after the dot8com
bubble.
2hilip Augar, author of The %reed &erchants, said in an interview that, 7Oou cannot simultaneously serve the
interest of issuer clients and investing clients. And itPs not 9ust underwriting and salesB investment banks run
proprietary trading operations that are also making a profit out of these securities.7
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@any investment banks also own retail brokerages. 0uring the %&&4s, some retail brokerages sold consumers
securities which did not meet their stated risk profile. 6his 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.
*ince investment banks engage heavily in trading for their own account, there is always the temptation for them to
engage in some form of front running ) the illegal practice whereby a broker e#ecutes orders for their own account
before filling orders previously submitted by their customers, there benefiting from any changes in prices induced by
those orders.
0ocuments under seal in a decade8long lawsuit concerning e6oys.com's !2- but obtained by 'e( )ork Times* Wall
*treet ,usiness columnist Coe <ocera alleged that !2-s managed by (oldman *achs and other investment
bankers involved asking for kickbacks from their institutional clients who made large profits flipping !2-s which
(oldman had intentionally undervalued. 0epositions in the lawsuit alleged that clients willingly complied with these
demands because they understood it was necessary in order to participate in future hot issues.
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+euters Wall
*treet correspondent Feli# *almon retracted his earlier, more conciliatory, statements on the sub9ect and said he
believed that the depositions show that companies going public and their initial consumer stockholders are both
defrauded by this practice, which may be widespread throughout the !2- finance industry.
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6he case is ongoing,
and the allegations remain unproven.
$ompensation=edit>
!nvestment banking is often critici.ed for the enormous pay packages awarded to those who work in the industry.
According to ,loomberg Wall *treet's five biggest firms paid over M' billion to their e#ecutives from 344' to 344/,
7while they presided over the packaging and sale of loans that helped bring down the investment8banking
system.7
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6he highly generous pay packages include M%D3 million for @errill +ynch : "o. ";- *tanley -'<eal from 344' to
344D, before it was bought by ,ank of America in 344/, and M%E% million for ,ear *tearns "o.'s Cames
"ayne before the bank collapsed and was sold to C2@organ "hase : "o. in Cune 344/.
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*uch pay arrangements have attracted the ire of 0emocrats and 1epublicans in the $nited *tates "ongress, who
demanded limits on e#ecutive pay in 344/ when the $.*. government was bailing out the industry with a MD44 billion
financial rescue package.
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Writing in the (lobal Association of 1isk 2rofessionals, Aaron ,rown, a vice president at @organ *tanley, says 7,y
any standard of human fairness, of course, investment bankers make obscene amounts of money.7
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History=edit>
&ain article: ,istor# of inestment !anking in the -nited States
6he first company to issue publicly traded stock was the 0utch ;ast !ndia "ompany (.erenigde /ostindische
0om$agnie, or 75-"7), which traded on the Amsterdam *tock ;#change.
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