Investment banking
(Redirected from Investment bank)
Investment banks help companies and governments and their agencies to raise money by issuing and selling securities in the primary market. The sector takes the North American Industry Classification System (NAICS) code 523110. They assist public and private corporations in raising funds in the capital markets (both equity and debt), as well as in providing strategic advisory services for mergers, acquisitions and other types of financial transactions.
Investment banks also act as intermediaries in trading for clients. Investment banks differ from commercial banks, which take deposits and make commercial and retail loans. In recent years, however, the lines between the two types of structures have blurred, especially as commercial banks have offered more investment banking services. In the US, the Glass-Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities; Glass-Steagall was repealed by the Gramm-Leach-Bliley Act in 1999. Investment banks may also differ from brokerages, which in general assist in the purchase and sale of stocks, bonds, and mutual funds. However some firms operate as both brokerages and investment banks; this includes some of the best known financial services firms in the world.
In the strictest definition [citation needed], investment banking is the raising of funds, both in debt and equity, and the division handling this in an investment bank is often called the "Investment Banking Division" (IBD). However, only a few small boutique firms solely provide this - such as Greenhill Bank. Almost all investment banks are heavily involved in providing additional financial services for clients, such as the trading of fixed income, foreign exchange, commodity, and equity securities. It is therefore acceptable to refer to both the "Investment Banking Division" and other 'front office' divisions such as "Fixed Income" as part of "investment banking," and any employee involved in either side as an "investment banker." Furthermore, one who engages in these activities in-house at a non-investment bank is also considered an investment banker.
More commonly used today to characterize what was traditionally termed "investment banking" is "sell side." This is trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e. underwriting, research, etc.).
The "buy side" constitutes the pension funds, mutual funds, hedge funds, and the investing public who consume the products and services of the sell-side in order to maximize their return on investment. Many firms have both buy and sell side components.
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Raising capital in the capital markets
The main activities and units
The primary function of an investment bank is buying and selling products both on behalf of the bank's clients and also for the bank itself. 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 or she buys or sells a product to a client and does not hedge his or her total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet[citation needed].
An investment bank is split into the so-called Front Office, Middle Office and Back Office. The individual activities are described below:
Front Office
- Investment Banking is the traditional aspect of investment banks which involves helping customers raise funds in the Capital Markets and advising on mergers and acquisitions. Investment bankers prepare idea pitches that they bring to meetings with their clients, with the expectation that their effort will be rewarded with a mandate when the client is ready to undertake a transaction. Once mandated, an investment bank is responsible for preparing all materials necessary for the transaction as well as the execution of the deal, which 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 & Acquisitions (M&A) and Corporate Finance.
- Financial Markets is split into four key divisions: Sales, Trading, Research and Structuring.
- Sales and Trading is often the most profitable area of an investment bank[citation needed], responsible for the majority of revenue of most investment banks[citation needed]. In the process of market making, traders will buy and sell financial products with the goal of making an incremental amount of money on each trade. Sales is the term for the investment banks sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales desks then communicate their clients' orders to the appropriate trading desks, who can price and execute trades, or structure new products that fit a specific need.
- Research is the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While the research division generates no revenue, its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. In recent years the relationship between investment banking and research has become highly regulated, reducing its importance to the investment bank.
- 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.
Middle Office
- Risk Management involves analysing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent 'bad' trades having a detrimental effect to a desk overall. Another key Middle Office role is to ensure that the above mentioned economic risks are captured accurately (as per agreement of commercial terms with the counterparty) correctly (as per standardised booking models in the most appropriate systems) and on time (typically within 30 minutes of trade execution). In recent years the risk of errors has become known as "operational risk" and the assurance Middle Offices provide now include measures to address this risk. When this assurance is not in place, market and credit risk analysis can be unreliable and open to deliberate manipulation.
Back Office
- Operations involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. Whilst it provides the greatest job security [citation needed] of divisions within an investment bank, it is a critical part of the bank that involves managing the financial information of the bank and ensures efficient capital markets through the financial reporting function. The staff in these areas are often highly qualified [citation needed] and need to understand in depth the deals and transactions that occur across all the divisions of the bank. [1].
Technology
- Every major investment bank has considerable amounts of in-house software, created by the Technology team, who are also responsible for Computer and Telecommunications-based support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading platforms. These platforms can serve as auto-executed hedging to complex model driven algorithms...
Size of industry
Global investment banking revenue increased for the third year running in 2005, to $52.8bn. This was up 14% on the previous year, but 7% below the 2000 peak. The recovery in the global economy and capital markets resulted in an increase in M&A activity, which has been the primary source of investment banking revenue in recent years. Credit spreads are tightening and intense competition within the field has ensured that the banking industry is on its toes.
The US was the primary source of investment banking income in 2005, with 51% of the total, a proportion which has fallen somewhat during the past decade. Europe (with Middle East and Africa) generated 31% of the total, slightly up on its 30% share a decade ago. Asian countries generated the remaining 18%. Between 2002 and 2005, fee income from Asia increased by 98%. This compares with a 55% increase in Europe, and a 46% increase in the US, during this period. [2]
Recent evolution of the business
Investment banking is one of the most global industries [citation needed], and is hence continuously challenged to respond to new developments and innovation in the global financial markets. Throughout the history [citation needed] of investment banking, many have theorized [citation needed] that all investment banking products and services would be commoditized. New products with higher margins are constantly invented [citation needed] and manufactured by bankers in hopes of winning over clients and developing trading know-how in new markets. However, since these cannot be patented or copyrighted [citation needed], they are very often copied quickly by competing banks [citation needed], pushing down trading margins.
For example, trading bonds and equities for customers is now a commodity business [citation needed], but structuring and trading derivatives is highly profitable [citation needed]. Each contract has to be uniquely structured to match the client's need, may involve complex pay-off and risk profiles, and is not listed on any market.
In addition, while many products have been commoditized, an increasing amount of investment bank profit has come from proprietary trading [citation needed], 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).
Vertical IntegrationAnother trend in Investment Banking at the dawn of the 21st century has been the vertical integration of debt securitization [citation needed]. Previously, investment banks had assisted lenders in raising more lending funds and having the ability to offer longer term fixed interest rates by converting the lenders' outstanding loans into bonds. For example, a mortgage lender would make a house loan, and then use the investment bank to sell bonds to fund the debt, the money from the sale of the bonds can be used to make new loans, while the lender accepts loan payments and passes the payments on to the bondholders. This process is called securitization. However, lenders have begun to securitize loans themselves [citation needed], especially in the areas of mortgage loans. Because of this, and because of the fear that this will continue, many Investment Banks have focused on becoming lenders themselves [citation needed], making loans with the goal of securitizing them. In fact, in the areas of commercial mortgages, many Investment Banks lend at loss leader interest rates [citation needed] in order to make money securitizing the loans, causing them to be a very popular financing option for commercial property investors and developers [citation needed].
Possible conflicts of interest
Potential conflicts of interest may arise between different parts of a bank, creating the potential for financial movements that could be market manipulation. Authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall which prohibits communication between investment banking on one side and research and equities on the other.
Some of the conflicts of interest that can be found in investment banking are listed here:
- Historically, equity research firms were founded and owned by investment banks. One common practice is for equity analysts to initiate coverage on a company in order to develop relationships that lead to highly profitable investment banking business. In the 1990s, many equity researchers allegedly traded positive stock ratings directly for investment banking business. On the flip side of the coin: companies would threaten to divert investment banking business to competitors unless their stock was rated favorably. Politicians acted to pass laws to criminalize such acts. Increased pressure from regulators and a series of lawsuits, settlements, and prosecutions curbed this business to a large extent following the 2001 stock market tumble.
- Many investment banks also own retail brokerages. Also during the 1990s, some retail brokerages sold consumers securities which did not meet their stated risk profile. This 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.
- Since investment banks engage heavily in trading for their own account, there is always the temptation or possibility that they might engage in some form of front running.
Investment banks
See also
External links
- Advisory Firms - Online, searchable database of M&A firms
- Investment Banking A concise, illustrated guide to investment banking.
- Summer Investment Bank Programs For Australian undergraduates
- ibankingoasis.com An investment banking community website
Categories
Cleanup from November 2006 | Wikipedia articles needing factual verification | Articles with unsourced statements | Investment banks