The term " investment bank " does not have a precise definition, but is generally applied to financial houses which, starting from trading as merchants, expanded their role to financing the trading and commercial activities of others, especially in the international market place. Generally, investment banks act as a bridge between those who need capital and those who can provide it, i.e. a Financial Intermediary.
There is understood and agreed upon that companies need capital funding from time to time. To solve this capital funding issue, a company may decide to authorize an issue of shares and bonds. The problem now of selling these securities to the public would loom as almost in surmountable to a company unversed in this field of finance. The distribution of any important volume of stock or bonds requires the services of specialists who have the offices and sales personnel to handle it. Their function is similar to that of a departmental store, which buys goods from manufacturers and sells them to customers.
More specific, an investment banking group provides world-wide some or all of the following services, either in divisions of the bank or in associated companies within this group:
Corporate finance and advisory work
Banking, for governments, institutions and companies
Treasury dealing
Investment management
Securities trading
Only a few investment banks provide services in all these areas. Most others tend to specialize to some degree and concentrate on a few product lines. A number of banks have diversified their range of services by developing businesses such as:
Principal Investing and Proprietary Trading
Research
The following sections will describe each of the services an investment bank may offer to its customers in a somewhat detailed manner.
What do investment banks do?
Corporate finance and advisory work
Corporate finance is the field of finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. Investment banks do corporate finance normally in connection with new issues of securities for raising finance, takeovers, mergers and acquisitions.
Their services include arranging equity and debt offerings, providing credit facilities and "selling" securities to investors. They also advise institutions on a wide range of transactions, notably mergers and acquisitions. The clients of an investment bank benefit from the bank's access to investors, expertise in valuing assets and experience in executing transactions.
The Investment banking division (IBD) helps its clients to raise funds through debt and equity offering. This includes raising funds through an Initial Public Offering (IPO), offering a credit facility with the bank, selling shares to sophisticated investors through private placements, or issuing and selling bonds on behalf of the client. The division functions as an intermediary and earns its revenue by charging a fee. Clients benefit from the bank's access to investors, expertise in valuing assets and experience in executing these transactions.
Often the bank will buy shares directly from the company and try to sell it at a higher price to investors. This process is known as underwriting, and is riskier than simply advising clients -- since the bank assumes the risk of the stock selling for a lower price than it had expected. Underwriting an offering requires the division to work with Sales & Trading to sell shares to the public markets.
The division also earns revenue by advising clients on mergers and acquisitions (M&A), which involves evaluating the target company, negotiation the terms of the agreement and arranging the financing for the deal.
The Corporate Finance division is normally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry such as retail, oil, or technology. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance and equity.
Banking, for governments, institutions and companies
Investment banks are offering the widest range of financial services to some governments, large institutions and companies. Investment banks usually have a large international network and are therefore a natural provider of banking for these players.
Treasury dealing
Treasury services are the function of investment banks where they provide transaction, investment, and information services for chief financial officers or treasurers. Treasury services concentrates and invests client money, and provides trade finance and logistics solutions as well as safeguards, values, clears and services securities and portfolios for investors and broker-dealers.
Investment management
Investment management is the professional management of various securities (shares, bonds and other securities) and assets (e.g., real estate) in order to meet specified investment goals for the benefit of the investors. Investment banks perform these services either for corporate pension funds, charities, private clients, either via direct investment for the more wealthy or via unit and investment trusts. In the larger firms, the value of funds under management runs into many billions of pounds.
The buy side of investment banking is dealing with various funds and other groups that have put money into the investment bank with the interest of seeing returns from their investment, such as hedge funds and mutual funds, as well as individuals and other small investment groups.
Securities trading
On behalf of the bank and its clients, the primary function of a large investment bank is buying and selling products. In 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. Structuring has been a relatively recent activity 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.
Principal Investing and Proprietary Trading
Investment banks have attempted to increase their return on equity by investing their own capital into certain ventures. The bank invests its own capital by taking a equity or debt stake in corporations with the aim of influencing the management. The motive is very similar to that private equity investors -- the bank tries to profit by turning around companies.
The bank can also take short-term positions in the market with its own capital. This is known as proprietary trading, and the bank attempts to earn a profit by correctly predicting market movements. Proprietary trading is very different from normal sales and trading operations -- where the banks revenue is primarily dependent on the volume of trade it executes on behalf of its client.
In proprietary trading, banks seek to maximize profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and trading has created jobs for physics, math and engineering Ph.D.s who act as quantitative analysts.
The notion of the bank risking its own capital can be traced back ever since banking was invented. J.P. Morgan, founder of J P Morgan Chase, was an extremely successful investor. However, in recent years, Goldman Sachs has been the leader in this field -- in 2007, the bank profited greatly from the proprietary trades that it made against the sub-prime market.
In many cases, the banks allow other investors to invest in such ventures (and charge a management fee). This puts them in direct competitor with hedge funds and private equity firms for both investors and investing opportunities.
Research
Research is the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While the research division may or may not generate revenue (based on policies at different banks), its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. Research also serves outside clients with investment advice (such as institutional investors and high net worth individuals) in the hopes that these clients will execute suggested trade ideas through the Sales & Trading division of the bank, thereby bringing in revenue for the firm.
Strategists advise 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. This strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products.
There is a potential conflict of interest between the investment bank and its analysis in that published analysis can affect the profits of the bank. Therefore in recent years the relationship between investment banking and research has become highly regulated requiring a Chinese wall between public and private functions.
The investment banking sector
Investment banks are commonly identified as bulge bracket firms such as Morgan Stanley or Goldman Sachs. However, investment banks vary both in terms of services they offer and the way they are organized.
Smaller investment banks, such as Lazard, focus on financial advisory and do not have significant sales and trading operations. Others, such as KBW Inc. (which specializes in advising financial companies), focus only on a certain sector.
On the other side of the spectrum, institutions such as Citigroup and Bank of America, commonly identified by their retail operations, have in-house investment banking divisions which compete for business with pure-play firms like Goldman Sachs. Banks in this category are known as Money Center Banks (or Universal bank) -- a term used by institutions that offer a wide range of financial services.
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. 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 retains higher margins in good times-and the risk of large losses in difficult market conditions, such as the credit crunch that began 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 Chicago Board Option Exchange (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 segment 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.
The structure of Investment banking
Investment banks are typically split into several divisions, which are either "front office" or "middle/back office". The bulge bracket firms and financial conglomerates each have all of the divisions listed below, even if they sometimes use different names. The other investment banks may only have particular front office divisions, such as only an investment banking division (as well as certain middle and back office divisions). Front office divisions are essentially the most exciting in which to work, and come with the best compensation and prospects. Middle/back office divisions are sometimes seen as low-risk and boring, but some people try to start off there hoping to eventually switch into a front office division. For example, Jérôme Kerviel started off in risk management at Société Générale before becoming a trader!
Front office divisions
Investment banking
Investment banking is the traditional business of investment banks. Many salespeople, traders, asset managers, private bankers, and other employees of investment banks call themselves investment bankers. However, investment banking is strictly a particular type of business, undertaken by a particular division, Investment Banking. This division is variously known as the Investment Banking Division (IBD), Corporate Finance, or Mergers & Acquisitions (M&A).
Investment bankers advise companies, governments, and other institutions, on any deal they want to perform. Deals are mostly mergers or acquisitions, but can also be privatizations, nationalizations, etc. In a deal, each party will use the services of one or more investment banks. For example, in an acquisition, the acquiring company will use one or more investment banks, and the target company will recruit one or more investment banks. The bankers to the acquiring party will pitch acquisition ideas, calculate how much to pay for the target, prepare documents for the deal, raise the necessary funds, and conduct due diligence. The bankers to the target company will calculate how much money the target should hold out for, coordinate bids, and prepare documents on its side of the deal. Roles differ slightly in mergers, privatizations, nationalizations, etc.
Capital markets
The capital markets division makes money by trading on the financial markets, which also conveniently creates the markets themselves ("market making"). It is also sometimes called sales & trading or financial markets. Capital markets include groups known as Equity Capital Markets (ECM), which raises equity, and Debt Capital Markets (DCM), which raises debt. Four types of people work in capital markets:
Salespeople call institutional and private investors to suggest trading ideas, take orders, and communicate these orders to the traders.
Traders structure, price, and execute these orders; they are the people who actually buy and sell the financial products.
Structuring specialists will help if the trades are particularly complex, often because they involve derivatives.
Researchers review companies, write "broker reports" about them, and usually attach an essentially meaningless "buy", "hold" or "sell" rating to their report.
Asset management
Asset management is the professional management of securities and other assets (real estate, etc.) on behalf of investors. Investors may be institutions (insurance companies, pension funds, corporations, etc.), or private investors (individuals or groups of individuals, such as mutual funds). The Asset Management division is sometimes called Investment Management. The business is divided into three sub-divisions.
Fund management: This division manages a number of funds, each with a different focus and strategy. For example: the asset management division may have three funds, one focused on private equity investments in emerging markets, another dealing with arbitrage trades, and yet another that buys and holds corporate debt. Clients can choose to place their money with either of these funds. Some banks, such as Bank of New York Mellon, manage exchange-traded funds that are accessible to retail investors. The bank earns revenue by charging a fee for assets under management, and sometimes by charging a commission based on returns.
Private Banking and Wealth Management: The division manages banking activities of extremely wealthy individuals. Apart from providing regular banking services, such as check clearing, the division also advises such individuals on tax strategy and investments. They work closely with other parts of the asset management division to provide a comprehensive service, e.g. work with fund management to invest in different strategies.
Prime Brokerage: The division deals with professional asset managers, such as mutual funds and hedge funds. Their services include executing trades on behalf of these clients, holding custody of their assets, and advising them on potential opportunities. For example: When Berkshire Hathaway (BRK) needs to buy a certain security from public markets, it uses a prime broker to buy and hold the security on its behalf. The division works closely with the Sales and Trading division. Additionally, the prime brokerage can also help its clients (hedge funds) to find investors.
Prime brokerage with hedge funds has been an especially profitable business, as well as risky, as seen in the "run on the bank" with Bear Stearns in 2008.
Non-investment banking divisions
The following types of banking divisions are sometimes wrongly thought to be investment banking divisions:
Private wealth management (a combination of private banking, estate planning, asset management, etc., for high net worth individuals)
Private banking, including offshore banking (retail banking for high earners)
Retail banking (checking, savings, loans, mortgages, credit cards, etc.)
Commercial banking (bank accounts and loans for businesses rather than individuals)
Middle Office divisions
Middle office investment banking services include compliance with government regulations and restrictions for professional clients such as banks, insurance companies, finance divisions, etc. This is sometimes considered a back office function. It also includes capital flows. These are the people that watch money coming into and out of the firm to determine the amount of liquidity the company needs to keep on hand so that it doesn't get into financial trouble. The team in charge of capital flows can use that information to restrict trades by reducing the buying / trading power available for other divisions.
Risk management
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. Risk management involves limiting the investment bank's risk, mainly from the activities of the Sales & Trading division. For example, people in the risk management division:
Analyze the risk taken on by traders, and limit the amount of capital they can play with, in order to limit the potential damage from bad trades.
Attempt to limit "economic risks".
Attempt to limit "operational risk", the risk of errors.
Corporate treasury
Corporate treasury is responsible for an investment bank's funding, capital structure management, and liquidity risk monitoring.
Cash managers are the subcategory of corporate treasury personnel who focus on balancing incoming payments from customers with outgoing payments to suppliers and for taxes. Cash managers also seek appropriate investment opportunities for excess cash, normally in short-term debt or bank deposits, giving the field an aspect of money management.
Additionally, corporate treasury has many similarities to investment banking, since it also involves monitoring and forecasting the company's needs for outside funding, both long-term and short-term, utilizing bank loans, commercial paper, bond issues and stock issues to meet these needs for cash. Corporate treasury personnel work in close concert with outside investment bankers.
Financial control
Financial control tracks and analyzes 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. In the United States and United Kingdom, a Financial Controller is a senior position, often reporting to the Chief Financial Officer.
Corporate strategy, along with risk, treasury, and controllers, often falls under the finance division as well.
Human resources
Human resources relates to department with the individuals who comprise the workforce of an organization.
In simple terms, an Investment bank's human resource management strategy should maximize return on investment in the organization's human capital and minimize financial risk. Human Resources seeks to achieve this by aligning the supply of skilled and qualified individuals and the capabilities of the current workforce, with the organization's ongoing and future business plans and requirements to maximize return on investment and secure future survival and success. In ensuring such objectives are achieved, the human resource function purpose in this context is to implement the organization's human resource requirements effectively but also pragmatically, taking account of legal, ethical and as far as is practical in a manner that retains the support and respect of the workforce.
Back office
Operations
Operations involve data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While some believe that operations provides the greatest job security and the bleakest career prospects of any division within an investment bank, many banks have outsourced operations. It is, however, a critical part of the bank. 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
Technology or IT involves creating and maintaining in-house software, as well as implementing commercial software and hardware solutions. Technology divisions are rising in importance with the continuing development of electronic trading platforms.
Technology refers to the information technology department. Every major investment bank has considerable amounts of in-house software, created by the technology team, who are also responsible for technical support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading. Some trades are initiated by complex algorithms for hedging purposes.
Compliance
Compliance areas are responsible for an investment bank's daily operations' compliance with government regulations and internal regulations.
Potential 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 equity research and trading on the other.
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 - the illegal practice of a stock broker executing orders on a security for their own account before filling orders previously submitted by their customers, thereby benefiting from any changes in prices induced by those orders.
Reputation - Investment banks' lifeline
Investment banks act as a bridge between those who need capital and those who can provide it. In this regard they act as a "certification" company. Investors who purchase securities buy it under the assumption that that these securities are "fairly" valued. Similarly, the company that issues these securities depend on the bank to provide them a "fair" price for these securities.
While the bank can use sell securities for an "unfair" price and make quick short-term gains, it is unlikely they can sustain such practices in the long run. Moreover, given that their service includes providing advice to institutions, their business depends on the quality of these advices. In other words, banks with a reputation for providing good advice are likely to retain their clients and get more clients in future. Major investment banks, such as Morgan Stanley and Lazard, have built their reputation over decades, making it extremely difficult for new players to gain advantage in the industry.
Certain banks choose to focus on a particular market and build its reputation in that segment. For example, while KBW Inc. is known for its expertise in advising companies in the financial sector. According to research by the Wharton School, there is a correlation between advisory fees and reputation of the bank. Indicating that, everything else being equal, investment banks with a better reputation earn higher revenue from fees.
On the other hand, highly ranked employees of a bank have their own reputation and industry connections -- in some instances, overshadowing the reputation of the bank. For example, in Mergers & Acquisitions, names such as Joseph Perella and Bruce Wasserstein stand independent of their firm's reputation. As a result, there is fierce competition between banks to hire and retain top bankers.
History
Regulation
As a result of more than 9,000 banks failing during the Great Depression years of 1930-1933, bank regulation was greatly tightened in the United States. The legislature felt the unethical actions from the integration of commercial and investment banking aided in these failures for three main reasons: banks invested their own assets in risky securities, unsound loans were made to boost the price of securities of companies whom the bank had invested in, and the commercial banks interests in the price of securities tempted bank managers to pressure customers to purchase risky securities that the bank was trying to sell. As a result, President Roosevelt felt that the best remedy to the situation was to pass the Banking Act of 1933, which established two new provisions to financial regulation: deposit insurance and the separation of commercial and investment banking activities. Sections 16, 20, 21, and 32 of the act are referred to as the Glass-Steagall Act. These sections forbid deposit-taking institutions from engaging in the issuing, underwriting, selling, or distributing of securities. Since the provisions of the Glass-Steagall Act did not apply to foreign banks operating in the United States, they could engage in insurance and securities activities. This put the American banks at a disadvantage.
Deregulation
As a result of the pressure on the legislature and the constant talks of overturning the act, it was finally repealed. On November 12, 1999, President Clinton signed the Gramm-Leach-Bliley Financial Services Modernization Act, which repealed the Glass-Steagall Act. This allowed securities firms and insurance companies to purchase banks and commercial banks to underwrite insurance and securities. From this repeal, the financial services industry has undergone a consolidating phase of commercial banks and investment banks becoming one. However, this has not always proved beneficial for these companies. The culture clash stemming from the different risk tolerance levels between investment banks and commercial banks is the main reason why such mergers and acquisitions have not resulted in the expected synergies the financial markets were anticipating.
Investment banks, by nature, have higher risk tolerance levels than do commercial banks. The principal reason for this is that investment banks are not financial intermediaries in the sense that they take deposits and lend them out. Therefore, default risk is not a concern for these institutions. They focus on assisting corporations in the issuance of securities, principally stocks and bonds. Since investment banks receive fees for their service at the issuance of these securities, the future successes or failures of these corporations is not a large concern of these banks. Indeed, the reputation of investment banks will be hindered when they assist companies that perform poorly, but the receipt of revenue not being tied to the performance after issuance makes these firms relatively risk tolerant. This risk tolerance was quite visible during the dot.com crash, in which economists argue that investment banks were responsible for creating the dot.com bubble in the first place.
These institutions took underperforming firms public that no longer exist and took in millions in revenue. In fact, nvestment banks bagged a total of more than $600 million directly related to IPO's involving just the companies whose stocks are now under $1." (Sorkin, Andrew Ross, "Just Who Brought Those Duds to Markets?" NYTimes.com)
Commercial banks, on the other hand, are more risk averse. They are greatly concerned about default risk since their traditional line of business is accepting deposits and making loans with the profits resulting in the interest rate spreads between the deposits and loans. These banks will only receive profit if the borrowing corporations repay. If the borrowing corporations struggle financially, there is a much smaller likelihood of the commercial bank receiving its interest and principal payments. Therefore, the risk tolerance of these banks will be significantly lower than for investment banks.
With these differences in risk tolerance, it comes as no surprise that the cultures of these banks do not mix. While most firms involved with mergers and acquisitions go through a temporary transition phenomenon where performance is below expectations, the large difference in risk tolerance between commercial and investment banks will result in the water and oil occurrence: they will not mix. The examples of the J.P.Morgan Chase & Co. merger and the embarrassing failure of the FleetBoston Financial Corporation with Robertson Stephens investment banking will demonstrate instances of the Glass-Steagall repeal failing to result in financial powerhouse conglomerates due to the risk and culture differences of investment banks versus commercial banks.
Mergers between commercial banks and investment banks
The most well documented example of a commercial bank and an investment bank merging together as a result of the repeal is J.P.Morgan and Chase Manhattan Bank merging together in late 2000. At the time of the merger, it was believed by many analysts that the merger would prove beneficial for the newly created firm of J.P.Morgan Chase & Co. "It's a good potential fit because there are quite a lot of areas where the two are complementary," said Ron Mandle, a banking analyst at Sanford C. Bernstein & Co. ("Morgan, Chase Dance Ends With Merger." 18 Sept. 2000. http://www.clubs.org/jpm.merger.htm)
Douglas Warner, former J.P.Morgan chief executive and chairman and now current chairman of J.P.Morgan Chase & Co, was very optimistic about the merger. In his words: "This merger is a breakthrough for J.P.Morgan and Chase that will position the new firm as a global powerhouse. With a formidable client franchise and a potent array of capabilities to address the full spectrum of clients' needs, we see exceptional prospects for sustained growth and profitability."("Morgan, Chase Dance Ends With Merger." 18 Sept. 2000. http://www.clubs.org/jpm.merger.htm)
Despite the support of many analysts, there were plenty of critics, who felt that the clash of styles would prevent the company from performing to its potential. Critics believe the culture clash is related to the risk tolerance differentiation between the two firms by the nature of their businesses. Based on the results of J.P.Morgan Chase & Co. since the merger, the critics are correct as the company's stock price has lost over a third of its value, a total of 10,000 people have been laid off, and the company has only been able to post one quarter of positive earnings. While one could argue the transition period phenomenon, critics argue that that the difference in the risk tolerance levels will prevent the new firm from ever achieving the synergies the financial world was expecting.
The examples of J.P.Morgan Chase & Co. illustrate how the Gramm-Leach-Bliley Financial Services Modernization Act has not always resulted in the synergies that the financial markets were hoping for because the risk tolerance differentiation between commercial banks and investment banks do not allow for a good mix. With the example as evidence, it is clear that the risk tolerance variation between commercial banks and investment banks create culture clashes that are undefeatable, which results in a lack of synergy when the two come together.
New trend
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 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. Securitized house loans may have exacerbated the subprime mortgage crisis beginning in 2007, by making risky loans less apparent to investors.
The credit crunch
There have been big changes in investment banking since the credit crunch started in 2007. Many investment banks have gone bankrupt while others have expanded rapidly. However, as the financial crisis of 2008 unfolded, we saw the last of the largest bulge-bracket US investment banks which hadn't gone bankrupt or been acquired in a bankrupt-like state convert over to 'bank holding companies' which are eligible for emergency government assistance.
Some companies are no longer present. For example Lehman Brothers, which was one of the top investment banks of the late twentieth century, went bankrupt in a move that was seen as the height of the credit crunch, and later had its North American operations brought by the British bank Barclays Capital, with the other operations brought by the large Japanese bank Nomura Securities. Similarly the once enormous securities house of Merrill Lynch was taken over by Bank of America, while Citigroup was forced to sell its stock broker to Morgan Stanley, creating Morgan Stanley Smith Barney. Similarly Wachovia Securities had to rename itself as Wells Fargo Advisors after being sold to the massive Wells Fargo bank.
In Britain the enormous RBS Group had to be largely taken over by the British government after a disastrous takeover of ABN AMRO. Similarly the Dutch government had to take a substantial stake in the ING Group.
Some investment banks flourished, such as Goldman Sachs, which still continued paying enormous bonuses. Other banks such as JPMorgan Chase became more prominent while unknown banks such as the southern based BB&T Capital Markets were catapulted into the top of the banking league tables when small but well capitalized regional investment banks were asked to take over less stable rivals.
Many of the international headlines concerned British or American banks, where local banks in large markets showed some more stability. In Canada the big five banks kept to their respective strategies with RBC Capital Markets and CIBC World Markets still keeping a high international presence in London and New York, while Scotia Capital concentrated on an internal Canadian base. The other two banks concentrated their activities on the investment management side with TD Securities continuing to build an international stock broking organization and BMO Nesbitt Burns offering an award winning full service offering, but concentrating on Canada.
In Europe, the Swiss banks faced increased scrutiny due to their private banking operations, with Credit Suisse and UBS AG having to face allegations that they aided tax evasion through creative measures such as smuggling diamonds in toothpaste tubes. In France BNP Paribas CIB was named as a potential bidder in many takeover operations, while Societe Generale was one of the first institutions to almost go bankrupt when a rogue trader lost it billions. The small credit union based banks such as Calyon Credit Agricole CIB and the relatively new Natixis tended to grow, like their Dutch equivalent Rabo Securities.
In Germany the market leader Deutsche Bank CIB faced a strong challenge from the second place Commerzbank who had merged with the Dresdner Bank. German banking has been opening up recently with its largest Bavarian bank being bought by the Italian lender Unicredit. The Italian operation MPS Finance (a sub-division of the third largest Italian bank Monte dei Paschi di Siena) kept its stranglehold on the Italian bond market.
India has seen the growth of the aggressively marketed Kotak Securities, a division of the fast growing Kotak Mahindra Bank. In Japan Nomura securities, the largest Japanese brokerage has moved its headquarters to London in order to become more international, while Daiwa Securities has been bought out entirely by its parent company the Daiwa bank. In South Korea Daewoo Securities still maintains its market leading position. In Australia the news was of a bankruptcy that did not happen as Macquarie Group, a global specialist in infrastructure finance, did not go under.
Change in operating atmosphere
Investment banks have found that the operating atmosphere has changed considerably. Before the credit crunch it was a golden period for these banks as there was a wave of takeovers and structured fundraising. Private equity was very popular, where a management team buys out a company division on the back of a large amount of debt. Many publicly traded companies were also encouraged to take out a large amount of debt as they found that the historically low interest rates were now affordable and by leveraging and buying back shares they could radically increase their profit per share. This was somewhat of a change to the usual role for investment banks which was to take private companies that wanted to broaden their ownership and funding on to a stock market, what is known as "floatation" or an Initial Public Offering (IPO).
One of the more controversial areas where investment banks were involved was the growth of the residential mortgage backed securities (RMBS) market. This market involved the pooling together of mortgages, and their segmentation into various areas that would be paid off in different orders. The tranches that would be paid off first were regarded as highly safe and often attracted the highest credit ratings, the AAA rating meaning that many investment funds could treat them as equivalent to government bonds. The market naturally led to the rapid growth of the mortgage market, with good borrowers getting low rates, first time buyers needing low deposits and bad borrowers getting offered mortgages for the first time. This led to increased perceived prosperity and rising house prices, which led to fewer defaults and a higher return on the mortgage securities. This virtuous cycle could not continue forever and instead it broke when a number of the less trustworthy borrowers stopped repaying their mortgages and a number of investment banks found themselves exposed to these funds, including the Royal Bank of Scotland, Lehman Brothers and Bear Stearns.
Another area of investment bank activity has been proprietary trading, where an investment bank maintains its own traders who buy and sell securities either for the clients or for the banks. These tend to be short term traders, who aim to take advantage of differences in the prices of various securities. Although they are often seen as a source of risk, particularly the trading that is done on the firm's own account, this is in fact a major source of profit for the investment banks.
One area of controversy was with bonuses. As investment bankers make a large amount of money for their banks, and can easily measure their results the successful ones have tended to be paid very generously. This increased with the growth of hedge funds, which like the in-house trading operations of merchant banks would trade on short term price movements. They paid multi-million bonuses to star traders. Investment banks felt that they had to match these bonuses to retain the clients.
This led to moves to restrict bonuses, or tax them at penal rates. This has been attacked by some economic commentators and bankers as being self destructive as many bankers left for lower tax jurisdictions such as Switzerland and Hong Kong. Many bonuses stopped being guaranteed and were paid in more long term ways and were held back for a number of years.
The controversy over bonuses was exaggerated due to an international government rescue of the banking system. This could either involve direct support such as the nationalization of the Royal Bank of Scotland or American Insurance Group (AIG) or indirect support such as the American government's Troubled Assets Relief Program and cheap government loans to the distressed institutions. This was a considerable burden to the taxpayer, and led many commentators to call for more regulation and higher taxation of merchant banks.
Regulations after crisis
Investment banks were once considered solely institutional investors, bankers and financiers to high-end individuals and groups, much like Goldman Sachs. But in recent years, financial giants with large retail operations like Citigroup have eaten into their territory, which in recent time has also meant sharing investment-bank losses in the subprime mortgage-backed securities sector. An agreement in mid-2008 between U.S. market and banking overseers will in future give the Federal Reserve more regulatory control over investment banking, which will in turn likely accelerate the recent trend towards investment banks allying with traditional bankers to expand their financial range.
Congressional reaction
Securities industry regulator the SEC and retail banking regulator the Federal Reserve agreed in mid-2008 to give the Fed greater regulatory oversight of investment banking following the recent credit crunch, which some blamed on poor judgment by investment banks. That means the Fed could enforce stricter capital ratios on investment banks, which have typically resisted such change, and could force them to merge with deposit-taking institutions that already comply with Fed regulations, one analyst predicted.
The decision could also create moral hazard if investors believe the U.S. government effectively stands behind investment banks in fear of heavy market losses, another argued. This would likely erode market discipline even further, the piece argued, and encourage even more risk-taking in markets - something the regulations are intended to discourage, he added.
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Investment banking revenue in different regions
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Top Investment banks in US
Here is a list of the ten best investment banks in the US
This is based on the financial solidity of their investment firm, the diversity of their investments, and the rate of return and amount of dividends they earn for their clients.
Most of these can be found in New York City, and they are still strong and striving even in the current mortgage crisis and economic downfall.
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