Investment Banking in U.S. and Foreign Countries
Table of Contents
Purpose of this report is to elaborate
trends that are followed today in investment banking around the globe. This
report will put light on investment banking in US and foreign countries, how
they raise capital for their clients and instruments that they popularly use. We
will make discussion about trends, their pros and cons etc.
Introduction to investment
banking:
Investment banks are financial
institutions that help individuals, corporations and governments in raising
capital by underwriting or issuing securities on behalf of them. They also assist
companies whom are involved in merger or acquisition with any other authority
and provide them with services of market making, equity securities, foreign
exchange and fixed income instruments etc. These banks are mainly involved in two
services, one is trading securities by exchanging them with cash or other
securities and other is promoting securities in order to sell them to public. In
this ways investment banking involves buying and selling side components, so
that they can increase client’s annual turnover and make huge profits for them.
Investment banks hold two kinds
of information, one that is provided to public as helping tool in dealing with
stock analysis; other is private and secure information and is kept secret
within internal staff members with help of information barriers. Information
barriers also separate these two kinds of information from each other and let
banks deal with their tasks more easily. With help of public information companies
acquire fund, and maximize their portfolios.
History of investment banking
in the United States:
In America first modern or investment
bank was established by a Philadelphia financier Jay Cooke. This was although
not the first bank there, but pure functions of investment were started with
bank established by this man. Before it many banks were associated in
operations of investment directly or indirectly but none was purely
working for this purpose only, some were turned from foreign exchange operations
to banking while others were turned from merchandise to investment. Some famous
names at that time that converted to private banks include Thomas Biddle and
Co., Alexander Brothers, Prime, Thayer
and Brother and , Ward and King and John E etc.
During civil war, banks were
unable to meet all needs of government, in order to supply funds for war at
that time idea of raising funds by offering bonds or shares was proposed by Jay
Cooke. In this why at that time federal government collect about $830 million.
But this process did not stopped there; it was even used after war as well in
America by government and other private bodies as well. Later on to expand
British and American capital market industries were need of funds, instead of
borrowing money from international market, they issue shares and make local
people there partners in business. In this ways dramatically trend of
investment banking started growing in America and different projects emerged
under this fund raising trend.
People were satisfied with this
kind of debt; because they were assure that they will receive their investments
with some profits In future. This satisfaction also brings ownership to them,
although part of ownership was small for those shareholders but this feeling
was much bigger for a common person. In 19th century every American
was aware about investment banking and their trends that they use for
collection of funds. At government level great achievement like metro, highways
and roads were constructed by using common men money.
What investment banks do?
When corporations hire an
investment banking firm, then he want it to work as distributor and adviser.
For corporations they are underwriters or middle men, which work for
establishment and listing the securities. Before actual process of selling or buying take
place, some agreements are made between investment bank and corporation. First
is negotiated underwriting, in which these two parties sign an agreement to
surrender concerns related to funds that a corporation needs, type of
securities going to be issued, price of each security with features and actual
cost that firm in bearing for issuance etc. In this scenario investment banking
plays important role as they help organizations to market securities in form of
stocks and bonds to their customers.
On the other hand, competitive
bidding is preferred by organizations over negotiated underwriting, because it creates
option for organizations to choose best possible investment bank for issuance
of securities. Bidding takes place by competing underwriting syndicates and
bank which offers best deal is selected for public utility issuance.
If investment bank somehow choose
to buy complete series of securities from organization to offer it to general
public, then a commitment takes place between them which is known as firm
commitment. This commitment covers all risks related to selling securities; it
also states risk is purely linked with underwriter (investment bank) and
issuing corporation has not link with risk after handing it over to bank.
Besides this investment banks
also agree to try their level best in order to sell all the securities of their
client or corporation, in this scenario agreement that take place is known as
best effort agreement. Here no guarantees are made about selling all securities
and capturing specific amount in return to issuer. Once agreements are
finalized now next important phase comes, which is offering securities to
general public.
When organization made first
offer to public, it is known as Initial Public offering (IPO), further second
offering takes place to sell out outstanding stock. Owners of outstanding stocks
are usually more than one investors, as these include those securities which
are being offered for second time or re-sold by stockholders. These reoffered
securities can include primary and secondary shares as combined or split offer.
How a corporation can issue
securities:
Corporation which wants to raise
funds for business must follow some guidelines before making public offering of
their stock. It has to follow guideline set by Securities and Exchange
Commission (SEC), it has to get registered with it and follow its rules and
regulation. First step in this step is filing registration statement, this
statement describes about purpose of business, need for which capital is
required, biographical information of directors and list of people who already
own more than 10% of firms total issuing. These people can be directors,
officers or any other stockholder. This registration statement also holds
information about financial history of firm, with separately defined current
debts, assets and processing for raising funds.
When investment bank files
registration statement with SEC on behalf of client, then twenty days “Cooling
off Period” is needed by commission to review provided information. In this
time period commission check that provided information is validate or not, in
practice this process takes more than 20 days. If SEC finds any fault on part
of corporation then effective date get postpone, therefore it is important for
business to add following disclaimer inside and in front of prospectus.
“THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE
SECURITIES AND EXCHANGE COMMISSION NOR HAS THE COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.”
In this period investment bank
can issue primary prospectus on behalf of client to improve marketability of
new securities. This prospectus is known as Red Herring, and its cost if bear
by investment bank, it includes information about clients current business,
firm’s financial statements, information about regulatory bodies, major
competitors in industry, management information about business and how new
raised capital will be used in company etc. in this report price offered to
public for each security and effective date is not mentioned because these two
are determined after getting registration certificate. Mostly price depends on
current market situations; therefore it is announced on effective date after
noticing current market trends.
During pre-filing period
negotiation made between issuer and underwriter cannot be disclosed, if it
happens then it would be considered as a criminal act. In this period SEC also
restrict to send research reports, recommendations about market situations and
sales forecasts to clients. Only allowable thing during this time period is description
about interest rates and advertisements about upcoming share or bond offers. There
are ways to inform public about benefits of new issue, expected date of new
issue, number of shares that are coming for public and name of investment bank,
from where they can buy shares and prospectus etc.
When cooling period ends, meeting
is conducted between client and bank, which is known as Diligence Meeting. In
this meeting these parties can make some changes in registration statement to
complete it with accuracy, but after these amendments it is civil liability of
officers and both parties to sign and register amendments with SEC. If they
fail in doing so then they would be criminally liable for fraud and
manipulation in statement.
After completing all these
procedure and getting effective date by commission, bank can begin sales and
accept cash from clients as well. For confirmation of trade final prospectus
and registration statement must send to clients and SEC. it is important for
all business that are registered with SEC, to update their prospectus quarterly
and file it to commission, in order to let them know about current financial
condition of business.
Underwriter or investment can
distribute its risk by including some other investment banks as partners. But
here with risk they would also share profits, there partners are called as
managing underwriters and they sign a non-binding agreement. This is also known
as letter of intent, which indicates that all partners are ready to share
profit and loss equally. Almost in all public offerings three agreements must
signed, including Agreement among
underwriters, the Underwriting Agreement and Dealers Agreement.
1. Agreement among
Underwriters (AAU):
AUA describes relationship
between underwriters and underwriting managers. This manager work on behalf of
group of people but is not included as active part of prospectus. Each
underwriter in this agreement agrees to buy described portion of total
securities and manager work to establish offering price. He also decides time
to begin offering with price of each share and commission that he will charge
for each sale and marketing through advertisement.
2. Underwriting
Agreement (AU):
AU is used to clear relation between issuer and underwriter. It
makes a legal obligation on them about sale and purchase of shares or bonds.
Here all partners or investment banks agree to sell, their portion of stocks
but none of them is responsible to sell anyone else’s unsold allotments.
Therefore this agreement is also recommended as divider. But if all investment
banks are responsible to sell others stock as well, then same agreement will be
called as undivided agreement.
3. Dealers or Selling
Agreement:
This agreement is used when an
investment bank select some dealers, whom are not acting as participating
underwriters and ask them to purchase shares for purpose of distribution. These
dealers are not partners, therefore they do not cover same rate of risk with
bank. Their duties are just to buy some shares at discount and then sell them
after effective date announced by SEC. If they failed in selling all purchased
shares after their best efforts then there is no risk on their part, else it is
mentioned in the contract. Two variations available for best underwriting
efforts include all-or-none and mini-max, where all-or-none offering means all
shares have to be distributed within fixed time period. But in mini-max
offering, specific amount is must to sold otherwise offer would be eliminated
from that bank. For both these offers, a minimum amount is must to set, because
at the end of this period some returns are must to provide to buyers of
securities. For this purpose Escrow account is established which keep bank to
protect purchaser’s rights.
If somehow till end, some
securities remain unsold, then standby underwriters perform their duties to
purchase those remaining securities. These unclaimed issues can be reoffered by
them to general public, and no one can restrict them from doing this. Agent and
broker also plays important role in working or investment bank, they buy and
sell issues and charge commission for these services. Principal also works for organization
and buy or sell securities on his own risk. He basically buys stock at discount
rates and then sells it to public later in higher prices.
The price on which bank offer
shares is called public offering price, but underwriters always pay less to
organizations when they purchase stocks from them. Difference between discount
price and actual offered price to public is profit for banks and underwriters.
Core Investment Banking
Activities:
Discussion made in this paper
earlier is enough to explain duties and responsibilities of investment banking.
Those details will also help readers in determining the process that
underwriters and firms follow, to register themselves before offering securities
to general public and raise funds through those securities. Now in this section
we will put light on core activities of an investment bank, how operations take
place actually in investment banking. Mainly an investment bank is divided into
three section, front office, middle office and back office.
1. Front Office
Activities In Investment Banking:
Front office
activities are most important and variant in overall scenario of investment
banking. Here operations of cooperate finance, research, sales and traders take
place. Each of these is highly important for banking sector. Diagram given
bellow is showing complete activities of front office in investment banking.
I.
Cooperate
Finance: It is counted as traditional aspect of
investment banking because this is the first stage for customer, when he enters
in bank for purpose of raising funds. People work in this section help them by
providing knowledge to them about current market trends, capital market and
mergers or acquisitions. Here customers from all fields, such as investors,
bidders and merger targets are facilitated. Corporate finance or investment
banks generate information book for clients to give them detailed knowledge
about this sector and activities that take place here in everyday routine. Two
group work under this head, industry coverage group and product coverage group.
Industry coverage group facilitate clients related to some special industries
like healthcare, technology, education etc.
They maintain
long term relationships with them to bring business to bank. Other group that
is product coverage group, keep eye on merger and acquisition activities with
leveraged finance, public finance, leasing, equity, restructuring and debt
issues. They work more closely to clients which are interested in collaboration
with other groups and need specialized guidance.
II.
Sales and trading:
To help clients which are individuals or banks, investment
banking industry buy and sell products on their behalf. This is now counted as
major activity performed by investment banks, because they have developed now
as profitable and successful market. They act like traders now and perform
duties of buying and selling of financial products, goal of these activities is
to earn money for themselves as well as for their clients.
Term sales here is especially covering investment bank
sales force, this team works to call those institutions which are worthy and
well established in their fields. Banks suggest them, trading ideas and capture
orders from them in return. Once order is captured, then it is moved to senior
officers for purpose of execution. These experts set accurate price and trades
for new or existing products of client, in order to fulfill their needs. Banks
are now working on structuring highly technical and numerate employees, so that
they can create those products which can fulfill needs of customers accurately.
They are making strategies to compel new customers and diverse their services
to different markets. In this ways they are diversifying their risks and
maximizing profit ratios. This leads higher rate of trade towards company and stability
in sale and purchase activities.
Investment banking is adopting some qualitative and
quantitative techniques as well in business, only purpose of using these
techniques is to satisfy customers and improving their worth in industry.
III.
Research:
Research is an important activity in front office, as it
provides help to investment banks and clients in determining financial
stability of bank. This division reviews companies which are registered with
SEC and collect their reports and prospectus to know about their selling and
buying ratings. Activities of this division are not to generate profits
directly, but resources used by them provide results that are beneficial for
investment banks. On basis of reports, decision of working with clients is
finalized. This team helps in generating ideas for privileged customers, bankers
and other major sources, it is research that give clear description about
current market trends and best available stocks. This is not only helpful for
internal clients but it also server many purposes of external clients as well.
From last few decades, relationship between investment banking and research has
grown in private as well as public areas.
2. Middle Office
Activities In Investment Banking:
Like first office activities middle office activities are
also very essential for successfully established investment business. This area
or division covers different issues that a business can face. This separates
front and back office by bringing gab between them. It is office that avoids
all negativity that can affect bank’s performance. These issues include treasury
management, risk management, corporate strategy, and Internal controls. Figure
2 explains all these activities as well.
I.
Risk management:
Biggest and main responsibility of middle office is to
avoid all risks that can affect business. This team is specialized in managing
activities that can lead performance towards risk. People working behind this
team put extra efforts to make sure that trader are not taking extra burden of
risk, and they are not leaving their positions because of these factors. To
maintain trust level and promise of high return of profits this team need to
work hard. They also predict about
upcoming trends in market, so that traders put less amount as investment.
II.
Corporate Treasury:
Key important role that this division has to perform is to
ensure that economic risks are under consideration all the time, and everyone
is updated with accurate information on right time. Most this right time is
considered as at least 30 minutes before execution of trade. Now days many
errors also occur in operations, that is why a new type is introduces which is
known as operational risk. To cover this risk middle officer guarantee to take
measures and address this part to ensure market penetration issue, credit risk
and all manipulations.
.
III.
Compliance:
Additionally now cooperate treasury is liable for all funds
that an investment bank put. Here influence is put on each trade and account
individually, because each one of them is trading here for earning some money
and receiving some benefits. Therefore it is important for bank not to overlook
at some of the major accounts only. Each one should get proper attention.
IV.
Financial Control:
To track inflow and outflow of capital from investment bank
financial tracks and analysis are done. This division is responsible to advise
top management about tricks to maintain equilibrium between these two sides. In
this ways they are save their business from global risk and earn high profits by
putting control on their team members. Financial controllers are counted as
senior advisories for controlling financial position and forwarding results to
chief financial officer.
3. Back Office
Activities In Investment Banking:
Roles that are performed by back officers make smooth
execution of operations successful. Duties that are performed at backend in
investment bank are also shown in Fig 3.
I.
Operations:
People who are involved in operations keep check on every single
trade that is taking place in bank or market. This helps them in rechecking
number of executions or sales that they have received from trading desk.
Editors and proofreaders together carry these operations and make sure that
there is not flaw in execution. People who work in this division are
specialized and highly qualified as they hold professional degree and deep
understanding of their work.
Figure
3: Back Office Activities
II.
Technology:
Today everything is working with technology, records are kept on
computers and their backups are then saved in secure places. To help in these things
IT team work for investment banks. They create in-house software to handle day
to day activities accurately and efficiently. Behind every software complete
technical support is provided, because of help of technology now electrical
trading is taking place.
With help of technology now in investment banks computer models
are changed, advance communication systems have been introduced and better
security options have been developed. It is difficult for hackers now to touch
sensitive information or monitor any transaction or record from banks database.
Investment Banking: Past,
Present, and Future:
Now when we are aware about basic
structure of investment banks, their functions, core activates and history of
their existence in US, we can more easily discuss about its past, present and
future. With passage of time investment banks their trading methods are
changing. In last four decades many new trends have taken place in this
industry all over the world, here we are not considering investment industry in
US, we are talking about global investment industry here.
Few years back there were just few small
partnerships and they were enjoying all the benefits in form of heavy profits,
by offering securities to general public. But today many amendments have taken
place, although basics are still same but art of performing those basics differ
now. Investment banks are earning more now, overall estimations tell us that
their profits rise to $194 billion from $1 billion in just four decades. Here we will put light on some aspects that
have changed this industry a lot.
1. Relationships,
Reputations, and Skills in Investment Banking:
Long term relations are
very important part for growth of a bank, as they always feel threat of losing
their valuable relations due to tough competition now. On basis of their
relations they create their missions and distribute price-relevant information
to clients at that time when they are actually in need of it. Mostly they offer
these privileges before initial public offering so that public can enjoy some
incentives. Therefore it is said that relations are important for them to
maintain, for there and publics benefits.
Figure 4 in this
report, is showing investment banks relationships and how these relations
effect the position of bank in marketplace. It is important for banks to
maintain relationships with counterparties, to get sufficient liquidity and
best discount price. Liquidity is very important for investment banks so that
they can fit in best place in market. Counterparties which offer their
securities to investment banks for purpose of issuance are famously known as
bank’s information network and liquidity network. As fig 4 is showing that some
members here also generate price relevant information to ease financial
institutions.
Some banks use to maintain large
network of retail investors, these investors provide them with alternate
sources of liquidity. There accurate information about values of new issues is
not meaningful but demand information that they provide is always valuable for
banks. To get this kind of information banks never rely on one source only,
they creates some links in secondary market s well for many purpose. Some of
those purposes are
·
This link provide investors of prime market with
execution route in case of loss, so that their liquidity remain same
·
Secondly these networks provide information
about current market sentiments, this help banks in working with trading
activities in primary market.
·
Further when investment banks put their money in
secondary markets, there are high chances for them to get return from these
investments through information network that they are following
·
Last but not the least, investments in secondary
markets is creating more trading opportunities in new stocks and issues.
Issuers of new securities always
take active part in information market place in order to buy current market
trends information from there, this information always help them in selling
securities at some profits.
To avoid threat of losing
clients, investment banks are trying to ensure that all counterparties are
earning enough profits that can carry long relationships between them. If somehow
they are failing in this part, then they try to use some sufficient alternates
that can carry relations longer and add credibility to break this threat. This
is one new technique that has been adopted now by investment banks to process
adequate deal flow.
For minimum deal flow in any
corporation successful information and liquidity networks are essential, these
networks work best in those situations when member are sure about positive
returns on investment. Sometime best results are difficult to compute due to
leaded information, as it damages the overall network. Using this information
is considered as a criminal act today, but in past it was not a big issue for
traders as they just try to sell securities by any mean. But today use of
leaked information can diminish value and destroy overall reputation of
investment bank, therefore it is tried today to avoid overlap between networks
of information.
2. The Power of
Networks:
Frequent traders
are part of investment bank network, as they provide them with important
information and necessary details about new securities to maintain liquidity. If,
bank put some effort in composition of network then it can bring higher
incentives for members. When banks directly invest in information production
then it can also influence the behavior of members of network. For this purpose
now new trend of developing large information departments within banks is
established by large firms. These departments work on same problems now which
were tackled by network members in past. Getting best solution for problem
through these information departments serve in two ways.
·
Information that is computed by department of
bank stays within bank; there is less risk of leakage of information now.
·
Clients feel more secure as there trading
records are now discussed between bank and them only.
In this scenario relationship
with network members become weaker as information is not exchanged between them
and investment bank now. To keep information related to trade a secret also
effect on reputation of bank. If banks information department is not so secure
to keep secret information as secret then reputation of bank can come at stake in
eyes of client, it will also end relationship between these two parties. Counterparties
never trust those banks which break their past promises, therefore bank that renege,
lose his ability to establish contact with counterparty again.
Reputation is important because in
risks trade and make investment credible for agreement that he made with all
its clients. That is why today banks design their deals and networks, to
increase reputational cost in front of their clients and agree that he will pay
back to them in case of dishonoring agreement. With these words of bank, if
become easy for them to deal with frequent trader, because loss from these
parties effect upon investment bank but to deal with retail investors and
security issuers become difficult here. Its reason is that they mostly deal infrequently;
profit form ripping off one of these will easily outweigh future business.
3. Technological Change
and Investment Banking:
Technological
needs raise with passage of time in investment banking; these changes establish
efficient and accurate means to complete tasks in investment banks.
Technological changes those areas where entrepreneurs and capitalists required
more informal laws for investment banking market. It took 40 years to this
industry, in adopting these changes and staying with them in future. Figure 5
shows that how technological changes bring increase in capitalization of
banks.
Figure 5: Top Banks Capitalization
PORTER’S SIX FORCES:
After taking
look at past, present and future of investment banking, now we need to perform
analysis of this industry. For this purpose PORTER’S SIX FORCES work best.
Figure 6: PORTER’S SIX FORCES
I.
Rivalry:
II.
Supplier Bargaining Power:
Traditionally
bargaining power of supplier was higher, but it was neglecting effects of new
competitive challenges. Investment banking carries long term relationships with
their clients as well as general public, this is the only reason that why a
strong network is still working as investment banking in 21st
century. New trends tell us that more critical investors a bank will carry,
more supplier power would be offered to it with huge revenues. Besides this,
some banks offer their services to limited industries only; this feature makes
them prominent in eyes of some clients.
III.
Buyer Bargaining Power:
In
investment banking buyers always want to get more profits and spend fewer
amounts for services that bank is offering. To reduce cost of services they
switch form one bank to another and bargain with them to get most sufficient
price. Although it seem tough thing to do, but studies has shown that banks
always love to serve these kind of difficult clients, because they bring more loyalty
with them which last for longer.
Today as
well bargaining power is considered important, but with that another important
thing is giving innovations to industry. These innovations did not let clients
to follow process of bargaining and increase profits in this industry.
IV.
Substitutes:
In history substitute to investment
banking are not described but technology is changing now and it is providing
some option to general public now. It is creating some un-expectable
alternatives, like information department and specially designed software etc.
V.
Threat of New Entrants:
In every
industry there are few threats, and one of the major is merging of one industry
with another industry. From quite long securities firms and commercial banks
are earning high profits as they never met any tough competitor in industry but
after Glass-Steagall Act, different industries like foreign exchange and other
financial organizations started trying to enter in this industry. Many of
domestic banks succeed in their efforts and they enter foreign banks market
very easily. This creates tough completion and reduce profit share among
existing traders.
Today they
are again facing competitors, but they belong to some other category and that
is IPO over internet. These are brokers working over internet; they are earning
huge turnovers with less effort and capital.
VI.
Complementary Services:
One new factor that has been added to
Poter’s five factors and it has been converted into six is Complementary
Services. Under this head discussion is made to know, whether it is feasible
for an investment bank to merger with a commercial bank or any other financial
institution, to earn some extra profit or not. Recent data and research tells
us that although banks are moving towards consolidation of services, but found
features that an investment owns cannot be in other institution after merger
with investment banks.
Global investment-banking
revenue:
If we put consideration on data that
is available to us in year 2012, showing revenues generated worldwide through
investment banking, we will be surprised.
Figure 7: Global investment-banking revenue
The graph shows that for first nine
months of year 2012, total revenues generated were of about $44.9 billion which
are 19% more than amount of last year. In total of global revenues more than
50% are owned by Americans, and rest are distributed among other nations around
the globe. The total loss that is faced in revenues due to mergers and
acquisition is 18%, which makes total of $12.6 billion. Total equity market
earning also fell this year by 29% and earning that are made through debts or
loans are third part of all revenues generated in this time period.
References:
1.
Economist.com, 29 September 2012. “Global
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2.
John Spacey, Simplicable, 8 Feb 2011. “investment banking at 50,000 feet(online)”,
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3.
Bharat N. Anand, Alexander Galetovic. Feb
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4.
Lamin Leigh and Richard Podpiera, Dec 2006,
“The rise of foreign investment
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5.
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Shiromi Nassreen, “Investing in Foreign
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11.
Tacit skill was christened by M. Polanyi
(1966) The Tacit Dimension,
Garden City, NY: Doubleday.
12.
The first merger wave is documented by N. R.
Lamoreaux (1985) The Great Merger
Movement in American Business, 1895–1904, Cambridge, UK: Cambridge
University Press.
13.
Equity receiverships and the involvement of
investment banks in contemporary corporate reorganizations are studied by D. A.
Skeel, Jr. (2001) Debt’s Dominion, Princeton: Princeton University
Press, and by P. Tufano (1997) “Business Failure, Judicial Intervention, and
Financial Innovation: Restructuring U.S. Railroads in the Nineteenth Century,” Business
History Review 71: 1–40.
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