Investment Banking

INVESTMENT BANKING Brief Overview of the sector: An investment bank is a specialized organization that takes in your money and after analyzing the possible risks and economic conditions gives you advice to convert it into more money. Investment Banks profit from companies and governments by raising money through issuing and selling securities in the capital markets (both equity and bond), as well as providing advice on transactions such as mergers and acquisitions. To perform these services in the United States, an adviser must be a licensed broker-dealer, and is subject to SEC (FINRA) regulation. Until the late 1980s, the United States maintained a separation between investment banking and commercial banks. Other developed countries (including G7 countries) have not maintained this separation historically. They offer: 1) 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. 2) 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". 3) 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 On behalf of the bank and its clients, the primary function of the bank is buying and selling products. Banks undertake risk through proprietary trading, done by a special set of traders who do not interface with clients and through "principal risk", risk undertaken by a trader after he 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. An investment bank is split into the so-called front office, middle office, and back office.

Front office • Investment banking may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Other terms for the investment banking division include mergers and acquisitions (M&A) and corporate finance. 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.

• Investment management is the professional management of various securities (shares, bonds, etc.) and other assets (e.g. real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes eg. mutual funds). The investment management division of an investment bank is generally divided into separate groups, often known as Private Wealth Management and Private Client Services. • Structuring has been a relatively recent division as derivatives have come into play, with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities. • Merchant banking is a private equity activity of investment banks. Current examples include Goldman Sachs Capital Partners and JPMorgan's One Equity Partners. • Investment Research is the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. • Investment Strategy is the division which advises 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.

Middle office • Risk management involves analyzing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent 'bad' trades having a detrimental effect to a desk overall. • Finance areas are responsible for an investment bank's capital management and risk monitoring. By tracking and analyzing 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. • Compliance areas are responsible for an investment bank's daily operations' compliance with government regulations and internal regulations.

Back office • Operations involve data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. •

Technology refers to the IT department.

The Concept of Chinese wall 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

Market Structure (Globally): Global investment banking revenue increased for the fifth year running in 2007, to $84.3 billion. This was up 21% on the previous year and more than doubles 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 centers, including New York City, London and Tokyo.

Major players in the sector: The last two major bulge bracket firms on Wall Street were Goldman Sachs and Morgan Stanley until both banks elected to convert to traditional banking institutions on September 22, 2008, as part of a response to the U.S. financial crisis. Barclays, Citigroup, Credit Suisse, Deutsche Bank, HSBC, JP Morgan Chase, and UBS AG are "universal banks" rather than bulge-bracket investment banks, since they also accept deposits (though not all of them have U.S. branches). There are some small, specialized banks called boutiques which might be oriented towards a specific aspect of investment banking like bond-trading, M&A advisory or technical analysis e.g., Allen & Co. , Lazard.

Challenges & Future Ahead: Challenges: 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 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 begin 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 segments 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.

Future prospects: Universal banks appear to offer clear advantages to both shareholders and regulators. Yet some of those advantages are illusory. For regulators, larger, diversified institutions may be more stable than investment banks but they pose an even greater systemic risk. And deposit funding is cheaper than wholesale funding in part because those deposits are insured. Measures to protect customers may end up allowing banks to take on risks that endanger customers. For shareholders, too, the universal bank may offer false comfort. A model that looks appealing in part because assets are not valued at market prices ought to ring alarm bells. Sprawling conglomerates are just as hard to manage as turbo-charged investment banks. And shareholders at UBS and Citigroup will derive little comfort from the notion that the model has been proven because their institutions are still standing. If the independent investment banks survive, they will clearly need to change. But they are not the only ones.

References: http://Wikipedia.org http://site.securities.com/ www.crisilresearch.com

http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12274054

Compiled By: Amit Agarwal (B08005)