Management of Financial Institutions

Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest

<< Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters >>
Management of Financial Institutions - MGT 604
Lecture # 28
Role of Investment Banks
Investment banks
It helps companies and governments (or their agencies) raise money by issuing and selling
securities in the capital markets (both equity and debt).
Almost all investment banks also offer strategic advisory services for mergers, acquisitions,
divestiture, or other financial services for clients, such as the trading of derivatives, fixed
income, and foreign exchange, commodity, and equity securities.
Trading securities for cash or securities (i.e., facilitating transactions, market-making), or
the promotion of securities (i.e., underwriting, research, etc.) is referred to as "sell side."
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.
Organizational structure of an investment bank
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.
An investment bank is split into the so-called Front Office, Middle Office and Back
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 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 & Acquisitions (M&A) and
Corporate Finance (often pronounced "corpfin").
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) .
Sales and Trading is often the most profitable area of an investment bank,
responsible for the majority of revenue of most investment banks 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
Management of Financial Institutions - MGT 604
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 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. 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
standardized 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 includes
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. While some believe it
provides the greatest job security with the bleakest career prospects of the divisions
within an investment bank, many have outsourced operations. It is however a critical
part of the bank that involves managing the financial information of the bank and
ensures efficient capital markets through the financial reporting functions. In recent
years due to increased competition in finance related careers, college degrees are
now mandatory at most Tier 1 investment banks. A finance degree has proved
significant in understanding the depth of the deals and transactions that occur across
all the divisions of the bank.
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.
Management of Financial Institutions - MGT 604
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 time period.
Recent evolution of the business
New products
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, 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 but
structuring and trading derivatives is highly profitable. Each OTC 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).
Vertical Integration
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 which led
to segregation of Investment Banks from Commercial Banks. Glass-Steagall was repealed
by the Gramm-Leach-Bliley Act in 1999.
Another development in recent years has been the vertical integration of debt securitization .
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
Management of Financial Institutions - MGT 604
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 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 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 in
order to make money securitizing the loans, causing them to be a very popular financing
option for commercial property investors and developers.
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
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. Front running is the illegal practice of a stock broker executing orders on a
security for their own account (and thus affecting prices) before filling orders
previously submitted by their customers.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday