Investment Banking Paradigm: Concepts And Definitions,

Evolution Of American Investment Banks, Evolution Of Indian

Investment Banking, Conflict Of Interest In Investment Banking,
Regulatory Framework For Investment Banking

An investment bank is a financial institution that assists individuals,

corporations and governments in raising capital by underwriting
and/or acting as the client's agent in the issuance of securities. An
investment banker may not accept deposits or make commercial
loans. Investment bankers are the people who do the grunt work for
IPOs and bond issues. Its a specific division of banking related to the
creation of capital for other companies. Investment banks underwrite
new debt and equity securities for all types of corporations.
Investment banks also provide guidance to issuers regarding the issue
and placement of stock. They may also assist companies involved in
mergers and acquisitions, and provide ancillary services such as
market making, trading of derivatives, fixed income instruments,
foreign exchange, commodities, and equity securities.

At a very macro level, ‘Investment Banking’ as the term suggests, is

concerned with the primary function of assisting the securities 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 generating GDP (the Issuers).

Banking & financial institutions and securities markets are the two
broad platforms of institutional intermediation for capital flows in the
economy. Investment banks are the counterparts of banks in financial
markets in the function of intermediation in resource allocation.

The term ‘investment banking’ is of American origin. Their

counterparts in UK were termed as ‘merchant banks’ and they had
confined themselves to security market intermediation whereas
American investment banks undertook both fund-based and advisory
roles. American investment banks entered the UK and European
markets and extended the scope of merchant banking to investment
banking.
Responsibility of Merchant Banker: Merchant banking is not merely
about marketing of securities in an agency capability. The regulatory
authorities require the merchant banking firms to promote quality
issues, maintain integrity and ensure compliance with the law on own
account and on behalf of the issuers as well.

Heart of investment banking consists of advising corporations on how

best to configure their balance sheets – with the aim of maximizing
shareholder value and executing the transactions that flow from that
advice.

The title “investment banker” is usually reserved for those individuals

within an investment banking firm who are responsible for the firm’s
relationship with the issuer, as opposed to the investor clients, i.e.,
with clients who engage investment banks to issue new securities,
restructuring existing liabilities; either increasing or decreasing
leverage, moving from public to private ownership.

Business Portfolio of Investment Banks

Globally, investment banks handle significant fund-based business of

their own in the capital market along with their non-fund service
portfolio which is offered to clients. However, various services or
segments of services are handled either on the same balance sheet or
through subsidiaries and affiliates depending upon the regulatory
requirements in the operating environments of each country. All these
activities are segmented across three broad platforms-equity market
activity, debt market activity, and mergers and acquisitions (M&A)
activity.
Investment banking

Core business portfolio

Fund based

Equity: Underwriting, market making

Debt: Underwriting, market making
M & A: Investing in Private Equity, Leveraged Buyout (LBO) and
Management Buyout (MBO)

Non-fund based

Equity: Merchant banking (Public issue management), Private

placement
Debt: Public issue management, Private placement, Securitization for
finance companies and banks
M&A: M&A advisory, Corporate Advisory, Project Advisory

Support business portfolio

Fund based

Equity: Proprietary trading and portfolio investing, private equity

funds and asset management funds
Debt: Proprietary trading and investing, asset management funds
Derivatives: Proprietary trading, hedge fund investments

Non-fund based

Equity: Equity broking, distribution, asset management, custodial

services, wealth management (private banking), research and analysis.
Debt: Debt market broking, distribution, asset management, research
Derivatives: Derivative broking, risk management services, custodial
services
Evolution Of American Investment Banks

In the mid-20th century, large investment banks were dominated by

the dealmakers. Advising clients on mergers and acquisitions and
public offerings was the main focus of major Wall Street partnerships.
These “bulge bracket” firms included Goldman Sachs, Morgan
Stanley, Lehman Brothers, First Boston and others.

That trend began to change in the 1980s as a new focus on trading

propelled firms such as Salomon Brothers, Merrill Lynch and Drexel
Burnham Lambert into the limelight. Investment banks earned an
increasing amount of their profits from proprietary trading. Advances
in computing technology also enabled banks to use more sophisticated
model driven software to execute trades and generate a profit on small
changes in market conditions.

In the 1980s, financier Michael Milken popularized the use of high

yield debt (also known as junk bonds) in corporate finance and
mergers and acquisitions. This fuelled a boom in leverage buyouts
and hostile takeovers (see History of Private Equity). Filmmaker
Oliver Stone immortalized the spirit of the times with his movie, Wall
Street, in which Michael Douglas played the role of corporate raider
Gordon Gekko and epitomized corporate greed.

Investment banks profited handsomely during the boom years of the

1990s and into the tech boom and bubble. When the tech bubble
burst, it precipitated a string of new legislation to prevent conflicts of
interest within investment banks. Investment banking research
analysts had been actively promoting stocks to investors while
privately acknowledging they were not attractive investments. In
other instances, analysts gave favourable stock ratings to corporate
clients in the hopes of attracting them as investment banking clients
and handling potentially lucrative initial public offerings.

These scandals paled by comparison to the financial crisis that has

enveloped the banking industry since 2007. The speculative bubble in
housing prices along with an overreliance on sub-prime mortgage
lending trigged a cascade of crises. Two major investment banks,
Bear Stearns and Lehman Brothers, collapsed under the weight of
failed mortgage-backed securities. In March, 2008, the Federal
government began using a variety of taxpayer-funded bailout
measures to prop up other firms. The Federal Reserve offered a $30
billion line of credit to J.P. Morgan Chase to that it could acquire Bear
Sterns. Bank of America acquired Merrill Lynch. The last two bulge
bracket investment banks, Goldman Sachs and Morgan Stanley,
elected to convert to bank holding companies and be fully regulated
by the Federal Reserve.

Moving forward, the recent financial crisis has weakened both the
reputation and the dominance of U.S. investment banking
organizations throughout the world. The growth of foreign capital
markets along with an increase in pools of sovereign capital is
changing the landscape of the industry.

The growing international flow of capital has also opened up

opportunities for investment banking in new financial centres around
the world, including those in developing countries such as India,
China and the Middle East

Evolution Of Indian Investment Banking

The origin of investment banking in India can be traced back to the
19th century when European merchant banks set-up their agency
houses in the country to assist in the setting of new projects. In the
early 20th century, large business houses followed suit by establishing
managing agencies which acted as issue house for securities,
promoters for new projects and also provided finance to Greenfield
ventures. The peculiar feature of these agencies was that their services
were restricted only to the companies of the group to which they
belonged. A few small brokers also started rendering Merchant
banking services, but theirs was limited due to their small capital
base.

In 1967, ANZ Grindlays bank set - up a separate merchant banking

division to handle new capital issues. It was soon followed by
Citibank, which started rendering these services. The foreign banks
monopolized merchant banking services in the country. The banking
committee, in its report in 1972, took note of this with concern and
recommended setting up of merchant banking institutions by
commercial banks and financial intuitions. State bank of India
ventured into this business by starting a merchant banking bureau in
1972. In 1972, ICICI became the first financial institution to offer
merchant banking services. JM finance was set-up by Mr. Nimesh
Kampani as an exclusive merchant bank in 1973. The growth of the
industry was very slow during this period. By 1980, the number of
merchant banks rose to 33 and was set-up by commercial banks,
financial institutions and private sector. The capital market witnessed
some buoyancy in the late eighties. The advent of economic reforms
in 1991 resulted in sudden spurt in both the primary and secondary
market. Several new players entered into the field. The securities
scam in may, 1992 was a major set back to the industry. Several
leading merchant bankers, both in public and private sector were
found to be involved in various irregularities. Some of the prominent
public sector players involved in the scam were Can bank financial
services, SBI capital markets, Andhra bank financial services, etc.
leading private sector players involved in the scam included
Fairgrowth financial services and Champaklal investments and
finance (CIFCO).

The market turned bullish again in the end of 1993 after the tainted
shares problem was substantially resolved. There was a phenomenal
surge of activity in the primary market. The registration norms with
the SEBI were quite liberal. The low entry barriers coupled with
lucrative opportunities lured many new entrants into this industry.
Most of the new entrants were undercapitalized with little or no
expertise in merchant banking. These players could hardly afford to
be discerning and started offering their services to all and sundry
clients. The market was soon flooded with poor quality paper issued
by companies of dubious credentials. The huge losses suffered by
investors in these securities resulted in total loss of confidence in the
market. Most of the subsequent issues started failing and companies
started deferring their plans to access primary markets. Lack of
business resulted in a major shake out in the industry. Most of the
small firms exited from the business. Many foreign investment banks
started entering Indian markets. These firms had a huge capital base,
global distribution capacity and expertise. However, they were new to
Indian markets and lacked local penetration. Many of the top rung
Indian merchant banks, who had string domestic base, started entering
into joint ventures with the foreign banks. This energy resulted in
synergies as their individual strength complemented each other.

Investment bankers

Investment bankers play an important role in the issue management

process. Lead managers (category I merchant bankers) have to ensure
correctness of the information furnished in the offer document. They
have to ensure compliance with SEBI rules and regulations as also
guidelines for disclosures and investor protection. To this effect, they
are required to submit to SEBI a due diligence certificate conforming
that the disclosures made in the draft prospectus or letter of offer are
true, fair and adequate to enable the prospective investors to make a
well informed investment decision. The role of merchant bankers in
performing their due diligence functions has become even more
important with the strengthening of the disclosure requirements and
with the SEBI giving up the vetting up of prospectus. SEBIs various
operational guidelines issued during the year to merchant bankers
primarily addressed the need to enhance the standard of disclosures.
It was felt that a further strengthening of the criteria for registration of
merchant bankers was necessary, primarily through an increase in the
net worth requirements, so that the capital would be commensurate
with the level of activities undertaken by them. With this in view, the
net worth requirement or category I merchant bankers was raised in
1995-96 to Rs.5 crore. In 1996-96, the SEBI (merchant bankers)
regulations, 1992 were amended to require the payment of fees for
each letter of offer or draft prospectus that is filed with SEBI.
Underwriters

Underwriters are required to register with SEBI in terms of the EBI

(Underwriters) Rules and Regulations, 1993. In addition to
underwriters registered with SEBI in terms of these regulations, all
registered merchant bankers in categories I, II and III and stock
brokers and mutual funds registered with SEBI can function as
underwriters.

Conflict Of Interest In Investment Banking

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

Some of the conflicts of interest that can be found in investment

banking are listed here:

 Historically, equity research firms have been founded and

owned by investment banks. One common practice is for equity
analysts to initiate coverage of 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 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. Laws were passed to criminalize such acts,
and 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 favourable.

 Since 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 executes orders for their own account before filling
orders previously submitted by their customers, there benefiting
from any changes in prices induced by those orders.

Regulatory Framework For Investment Banking

Investment Banking in India is regulating in its various facets under
separate legislations or guidelines issued under statute. The
Regulatory powers are also distributed between different regulators
depending upon the constitution and status of Investment Bank. Pure
investment banks which do not have presence in the lending or
banking business are governed primarily by the capital market
regulator (SEBI). However, Universal banks and NBFC investment
banks are regulated primarily by the RBI in their core business of
banking or lending and so far as the investment banking segment is
concerned, they are also regulated by SEBI. An overview of the
regulatory framework is furnished below:

1. At the constitutional level, all invest banking companies

incorporated under the Companies Act, 1956 are governed by the
provisions of that Act.

2. Investment Banks that are incorporated under a separate statute

such as the SBI or IDBI are regulated by their respective statute. IDBI
is in the process of being converted into a company under the
Companies Act.

3. Universal Banks that are regulated by the Reserve Bank of India

under the RBI Act, 1934 and the Banking Regulation Act which put
restrictions on the investment banking exposures to be taken by
banks.
4. Investment banking companies that are constituted as non-banking
financial companies are regulated operationally by the RBI under
sections 45H to 45QB of Reserve Bank of India Act, 1934. Under
these sections RBI is empowered to issue directions in the areas of
resources mobilization, accounts and administrative controls.

5. Functionally, different aspects of investment banking are regulated

under the Securities and Exchange Board of India Act, 1992 and
guidelines and regulations issued there under.

6. Investment Banks that are set up in India with foreign direct

investment either as joint ventures with Indian partners or as fully
owned subsidiaries of the foreign entities are governed in respect of
the foreign investment by the Foreign Exchange Management Act,
1999 and the Foreign Exchange Management (Transfer or issue of
Security by a person Resident outside India) Regulations, 2000 issued
there under as amended from time to time through circulars issued by
the RBI.

7. Apart from the above specific regulations relating to investment

banking, investment banks are also governed by other laws applicable
to all other businesses such as – tax law, contract law, property law,
local state laws, arbitration law and the other general laws that are
applicable in India

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