Investment banking
Encyclopedia
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions
, and provide ancillary services such as market making, trading of derivatives
, fixed income
instruments, foreign exchange
, commodities, and equity securities.
Unlike commercial bank
s and retail banks, investment banks do not take deposits. From 1933 (Glass–Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States
maintained a separation between investment banking and commercial bank
s. Other industrialized countries, including G8
countries, have historically not maintained such a separation.
There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting
, research, etc.) is the "sell side
", while dealing with pension fund
s, mutual fund
s, hedge fund
s, and the investing public (who consume 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.
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.
An advisor who provides investment banking services in the United States must be a licensed broker-dealer
and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory Authority
(FINRA) regulation.
, middle office
, and back office
. While large service investment banks offer all of the lines of businesses, both sell side
and buy side
, smaller ones sell side investment firms such as boutique investment bank
s and small broker-dealer
s focus on investment banking and sales/trading/research, respectively.
Investment banks offer services to both corporations issuing securities and investors buying securities. For corporations, investment bankers offer information on when and how to place their securities on the open market, an activity very important to an investment bank's reputation. Therefore, investment bankers play a very important role in issuing new security offerings.
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 City of London
, New York City
, Hong Kong
and Tokyo
.
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 the hope of winning over clients and developing trading know-how in new markets. However, since these can usually not be patent
ed or copyright
ed, 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 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.
s. Glass–Steagall was effectively repealed for many large financial institutions 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 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.
of the investment bank no longer worked without the regulation imposed on it by Glass-Steagall. Once Robert Rubin
, a former co-chairman of Goldman Sachs
became part of the Clinton
administration and deregulated banks, the previous conservatism of underwriting established companies and seeking long-term gains was replaced by lower standards and short-term profit. Formerly, the guidelines said that in order to take a company public, it had to be in business for a minimum of five years and it had to show profitability for three consecutive years. After deregulation, those standards were gone, but small investors did not grasp the full impact of the change.
Investment banks Bear Stearns
, founded in 1923 and Lehman Brothers
, over 100 years old, collapsed; Merrill Lynch
was acquired by Bank of America, which remained in trouble, as did Goldman Sachs
and Morgan Stanley
. The ensuing financial crisis of 2008 saw Goldman Sachs
and Morgan Stanley
"abandon their status as investment banks" by converting themselves into "traditional bank holding companies", thereby making themselves eligible to receive billions of dollars each in emergency taxpayer-funded assistance. By making this change, referred to as a technicality, banks would be more tightly regulated. Initially, banks received part of a $700 billion Troubled Asset Relief Program (TARP) intended to stabilize the economy and thaw the frozen credit markets. Eventually, taxpayer assistance to banks reached nearly $13 trillion dollars, most without much scrutiny, lending did not increase and credit markets remained frozen.
A number of former Goldman-Sachs top executives, such as Henry Paulson
and Ed Liddy moved to high-level positions in government and oversaw the controversial taxpayer-funded bank bailout. The TARP Oversight Report released by the Congressional Oversight Panel found, however, that the bailout tended to encourage risky behavior and "corrupt[ed] the fundamental tenets of a market economy
".
Under threat of a subpoena
by Senator Chuck Grassley
, Goldman Sachs revealed that through TARP bailout of AIG
, Goldman received $12.9 billion in taxpayer aid (some through AIG), $4.3 billion of which was then paid out to 32 entities, including many overseas banks, hedge funds and pensions. The same year it received $10 billion in aid from the government, it also paid out multi-million dollar bonuses to 603 employees and hundreds more received million-dollar bonuses. The total paid in bonuses was $4.82 billion.
Morgan Stanley received $10 billion in TARP funds and paid out $4.475 billion in bonuses. Of those, 428 people received more than a million dollars and of those, 189 received more than $2 million.
. 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 to prevent communication between investment banking on one side and equity research and trading on the other.
Some of the conflicts of interest that can be found in investment banking are listed here:
World's biggest banks are ranked for M&A advisory, syndicated loan
s, equity
capital market
s and debt
capital market
s.
For more information on investment banking revenues, please visit Financial Times
and Wall Street Journal
websites or see Bloomberg
M&A and Capital Market
s League Tables:
Mergers and acquisitions
Mergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
, and provide ancillary services such as market making, trading of derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
instruments, foreign exchange
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
, commodities, and equity securities.
Unlike commercial bank
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...
s and retail banks, investment banks do not take deposits. From 1933 (Glass–Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
maintained a separation between investment banking and commercial bank
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...
s. Other industrialized countries, including G8
G8
The Group of Eight is a forum, created by France in 1975, for the governments of seven major economies: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. In 1997, the group added Russia, thus becoming the G8...
countries, have historically not maintained such a separation.
There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
, research, etc.) is the "sell side
Sell side
Sell side is a term used in the financial services industry. It is a general term that indicates a firm that sells investment services to asset management firms, typically referred to as the buy side, or corporate entities...
", while dealing with pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
s, mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s, hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s, and the investing public (who consume the products and services of the sell-side in order to maximize their return on investment) constitutes the "buy side
Buy side
Buy-side is a term used in investment banking to refer to advising institutions concerned with buying, rather than selling, assets or securities...
". Many firms have buy and sell side components.
An investment bank can also be split into private and public functions with a Chinese wall
Chinese wall
In business, a Chinese wall or firewall is an information barrier implemented within a firm to separate and isolate persons who make investment decisions from persons who are privy to undisclosed material information which may influence those decisions...
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.
An advisor who provides investment banking services in the United States must be a licensed broker-dealer
Broker-dealer
A broker-dealer is a term used in United States financial services regulations. It is a natural person, a company or other organization that trades securities for its own account or on behalf of its customers....
and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory Authority
Financial Industry Regulatory Authority
In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization . FINRA is the successor to the National Association of Securities Dealers, Inc. ...
(FINRA) regulation.
Main activities
Investment banking is split into the so-called front officeFront office
Front office is a business term that refers to a company's departments that come in contact with clients, including the marketing, sales, and service departments...
, middle office
Middle office
The middle office comprises departments of a financial services company that manage position-keeping . These divisions make sure these transaction representations properly capture profit flows given the technological resources...
, and back office
Back office
A back office is a part of most corporations where tasks dedicated to running the company itself takes place. The term "Back office" comes from the building layout of early companies where the front office would contain the sales and other customer-facing staff and the back office would be those...
. While large service investment banks offer all of the lines of businesses, both sell side
Sell side
Sell side is a term used in the financial services industry. It is a general term that indicates a firm that sells investment services to asset management firms, typically referred to as the buy side, or corporate entities...
and buy side
Buy side
Buy-side is a term used in investment banking to refer to advising institutions concerned with buying, rather than selling, assets or securities...
, smaller ones sell side investment firms such as boutique investment bank
Boutique investment bank
A boutique investment bank is a small investment bank that specializes in primarily investment banking. Usually they work on smaller deals, typically less than a billion dollars, and usually assist on the sell-side in M&A transactions. In addition they sometimes specialize in certain industries...
s and small broker-dealer
Broker-dealer
A broker-dealer is a term used in United States financial services regulations. It is a natural person, a company or other organization that trades securities for its own account or on behalf of its customers....
s focus on investment banking and sales/trading/research, respectively.
Investment banks offer services to both corporations issuing securities and investors buying securities. For corporations, investment bankers offer information on when and how to place their securities on the open market, an activity very important to an investment bank's reputation. Therefore, investment bankers play a very important role in issuing new security offerings.
Front office
- Investment banking (corporate financeCorporate financeCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
) is the traditional aspect of investment banks which also involves helping customers raise funds in capital markets and giving advice on mergers and acquisitionsMergers and acquisitionsMergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
(M&A). This may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Another term for the investment banking division is corporate financeCorporate financeCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
, and its advisory group is often termed mergers and acquisitionsTakeoverIn business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...
. A pitch bookPitch BookA pitch book is a marketing device used by investment banks around the world. It consists of a careful arrangement and analysis of the investment considerations of a potential or current client, and/or a reference for comparison for an employee in an investment or commercial bank...
of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. 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, project finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt and generally work and collaborate with industry groups on the more intricate and specialized needs of a client.
- Sales and tradingSales and tradingSales and trading is one of the key functions of an investment bank. The term refers to the various activities relating to the buying and selling of securities or other financial instruments...
: On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products. In market makingMarket makerA market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
, traders will buy and sell financial products with the goal of making money on each trade. Sales is the term for the investment bank's sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on a caveat emptorCaveat emptorCaveat emptor is Latin for "Let the buyer beware". Generally, caveat emptor is the property law doctrine that controls the sale of real property after the date of closing.- Explanation :...
basis) and take orders. Sales desks then communicate their clients' orders to the appropriate trading desks, which can price and execute trades, or structure new products that fit a specific need. Structuring has been a relatively recent activity as derivativesDerivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
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. In 2010, investment banks came under pressure as a result of selling complex derivatives contracts to local municipalities in Europe and the US. 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. Banks also undertake risk through proprietary tradingProprietary tradingProprietary trading occurs when a firm trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments, with the firm's own money as opposed to its customers' money, so as to make a profit for itself...
, performed 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. The necessity for numerical ability in sales and trading has created jobs for physics, mathematics and engineering Ph.D.Ph.D.A Ph.D. is a Doctor of Philosophy, an academic degree.Ph.D. may also refer to:* Ph.D. , a 1980s British group*Piled Higher and Deeper, a web comic strip*PhD: Phantasy Degree, a Korean comic series* PhD Docbook renderer, an XML renderer...
s who act as quantitative analystQuantitative analystA quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
s.
- ResearchSecurities researchSecurities research is a discipline within the financial services industry. Securities research professionals are known most generally as "analysts," "research analysts," or "securities analysts;" all the foregoing terms are synonymous...
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 ideaTrade ideaTrade ideas are investment ideas which are sent by institutional stockbrokers to their clients. They typically propose a trade in a specific stock and are developed by the individual idea author’s Trade ideas (or trading ideas) are investment ideas ("long" i.e. buy, or "short" i.e. sell) which...
s through the sales and trading division of the bank, and thereby generate revenue for the firm. There is a potential conflict of interest between the investment bank and its analysis, in that published analysis can affect the bank's profits. Hence in recent years the relationship between investment banking and research has become highly regulated, requiring a Chinese wallChinese wallIn business, a Chinese wall or firewall is an information barrier implemented within a firm to separate and isolate persons who make investment decisions from persons who are privy to undisclosed material information which may influence those decisions...
between public and private functions.
Other businesses that an investment bank may be involved in
- Global transaction banking is the division which provides cash management, custody services, lending, and securities brokerage services to institutions. Prime brokeragePrime brokeragePrime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return...
with hedge funds has been an especially profitable business, as well as risky, as seen in the "run on the bank" with Bear StearnsBear StearnsThe Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
in 2008.
- Investment managementInvestment managementInvestment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
is the professional management of various securities (shares, bondsBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, etc.) and other assets (e.g., real estateReal estateIn general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
), to meet specified investment goals for the benefit of 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 schemeCollective investment schemeA collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
s e.g., mutual funds). The investment managementInvestment managementInvestment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
division of an investment bank is generally divided into separate groups, often known as Private Wealth Management and Private Client Services.
- Merchant banking can be called "very personal banking"; merchant banks offer capital in exchange for share ownership rather than loans, and offer advice on management and strategy. Merchant banking is also a name used to describe the private equity side of a firm.Merchant Banking: Past and Present Current examples include Defoe Fournier & Cie.Defoe Fournier & Cie.Defoe Fournier & Cie. is an investment and merchant banking company. As part of its traditional business the firm and its partners are a source of financial advice for high net worth individuals, specifically large stockholders and "family trusts" of listed family businesses.Additionally, the firm...
and JPMorgan's One Equity PartnersOne Equity PartnersOne Equity Partners is a private equity firm focused on leveraged buyout and growth capital investments in middle-market companies across a range of industries....
and the original J.P. Morgan & Co.J.P. Morgan & Co.J.P. Morgan & Co. was a commercial and investment banking institution based in the United States founded by J. Pierpont Morgan and commonly known as the House of Morgan or simply Morgan. Today, J.P...
Rothschilds, Barings, Warburgs and Morgans were all merchant banks. (Originally, "merchant bank" was the British English term for an investment bank.)
- Commercial banking: see commercial bankCommercial bankAfter the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...
.
Middle office
- Risk managementRisk managementRisk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
involves analyzing the marketMarket riskMarket risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
and credit riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty 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 on a desk overall. Another key Middle Office role is to ensure that the economic risks are captured accurately (as per agreement of commercial terms with the counterpartyCounterpartyA counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
), 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 riskOperational riskAn operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
" 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.
- Corporate treasuryTreasury managementTreasury management includes management of an enterprise's holdings, with the ultimate goal of maximizing the firm's liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm's collections, disbursements, concentration, investment and funding...
is responsible for an investment bank's funding, capital structure management, and liquidity riskLiquidity riskIn finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
monitoring.
- Financial controlInternal controlIn accounting and auditing, internal control is defined as a process effected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives. It is a means by which an organization's...
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 via dedicated trading desk product controlProduct controlWithin banking, Product Control are a team responsible for the accounting and financial reporting of a trading desk. They are responsible for the bookkeeping of trades in the portfolios they look after, and act as a primary control function; monitoring trading activity to ensure it is within a...
teams. In the United States and United Kingdom, a Financial ControllerComptrollerA comptroller is a management level position responsible for supervising the quality of accounting and financial reporting of an organization.In British government, the Comptroller General or Comptroller and Auditor General is in most countries the external auditor of the budget execution of the...
is a senior position, often reporting to the Chief Financial Officer.
- Corporate strategy, along with risk, treasury, and controllers, also often falls under the finance division.
- ComplianceCompliance (regulation)In general, compliance means conforming to a rule, such as a specification, policy, standard or law. Regulatory compliance describes the goal that corporations or public agencies aspire to in their efforts to ensure that personnel are aware of and take steps to comply with relevant laws and...
areas are responsible for an investment bank's daily operations compliance with government regulations and internal regulations. Often also considered a back-office division.
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 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 refers to the information technologyInformation technologyInformation technology is the acquisition, processing, storage and dissemination of vocal, pictorial, textual and numerical information by a microelectronics-based combination of computing and telecommunications...
department. Every major investment bank has considerable amounts of in-house software, created by the technology team, who are also responsible for technical supportTechnical supportTechnical support or tech support refers to a range of services by which enterprises provide assistance to users of technology products such as mobile phones, televisions, computers, software products or other electronic or mechanical goods...
. Technology has changed considerably in the last few years as more sales and trading desks are using electronic tradingElectronic tradingElectronic trading, sometimes called etrading, is a method of trading securities , foreign exchange or financial derivatives electronically...
. Some trades are initiated by complex algorithms for hedgingHedge (finance)A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
purposes.
Size of industry
Global investment banking revenue increased for the fifth year running in 2007, to a record US$84.3 billion, which was up 22% on the previous year and more than double the level in 2003. Subsequent to their exposure to United States sub-prime securities investments, many investment banks have experienced losses since this time.The United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
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 City of London
City of London
The City of London is a small area within Greater London, England. It is the historic core of London around which the modern conurbation grew and has held city status since time immemorial. The City’s boundaries have remained almost unchanged since the Middle Ages, and it is now only a tiny part of...
, New York City
New York City
New York is the most populous city in the United States and the center of the New York Metropolitan Area, one of the most populous metropolitan areas in the world. New York exerts a significant impact upon global commerce, finance, media, art, fashion, research, technology, education, and...
, Hong Kong
Hong Kong
Hong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...
and Tokyo
Tokyo
, ; officially , is one of the 47 prefectures of Japan. Tokyo is the capital of Japan, the center of the Greater Tokyo Area, and the largest metropolitan area of Japan. It is the seat of the Japanese government and the Imperial Palace, and the home of the Japanese Imperial Family...
.
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 the hope of winning over clients and developing trading know-how in new markets. However, since these can usually not be patent
Patent
A patent is a form of intellectual property. It consists of a set of exclusive rights granted by a sovereign state to an inventor or their assignee for a limited period of time in exchange for the public disclosure of an invention....
ed or copyright
Copyright
Copyright is a legal concept, enacted by most governments, giving the creator of an original work exclusive rights to it, usually for a limited time...
ed, 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
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
retains higher margins in good times—and the risk of large losses in difficult market conditions, such as the credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
that began in 2007. Each over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
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 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
Bulge bracket
The bulge bracket comprises the "big banks," the world's largest and most profitable multi-national investment banks.- Technical meaning :The term 'bulge bracket' refers to the first group of investment banks listed on the "tombstone" notifying the public of a financial transaction or deal...
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.
Vertical integration
In the U.S., 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, and led to segregation of investment banks from commercial bankCommercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...
s. Glass–Steagall was effectively repealed for many large financial institutions by the Gramm–Leach–Bliley Act in 1999.
Another development in recent years has been the vertical integration
Vertical integration
In microeconomics and management, the term vertical integration describes a style of management control. Vertically integrated companies in a supply chain are united through a common owner. Usually each member of the supply chain produces a different product or service, and the products combine to...
of debt securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
. Previously, investment banks had assisted lenders in raising more lending funds and having the ability to offer longer term fixed interest rates by converting 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
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
beginning in 2007, by making risky loans less apparent to investors.
2008 Financial crisis
The 2007 credit crisis proved that the business modelBusiness model
A business model describes the rationale of how an organization creates, delivers, and captures value...
of the investment bank no longer worked without the regulation imposed on it by Glass-Steagall. Once Robert Rubin
Robert Rubin
Robert Edward Rubin served as the 70th United States Secretary of the Treasury during both the first and second Clinton administrations. Before his government service, he spent 26 years at Goldman Sachs eventually serving as a member of the Board, and Co-Chairman from 1990-1992...
, a former co-chairman of Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
became part of the Clinton
Bill Clinton
William Jefferson "Bill" Clinton is an American politician who served as the 42nd President of the United States from 1993 to 2001. Inaugurated at age 46, he was the third-youngest president. He took office at the end of the Cold War, and was the first president of the baby boomer generation...
administration and deregulated banks, the previous conservatism of underwriting established companies and seeking long-term gains was replaced by lower standards and short-term profit. Formerly, the guidelines said that in order to take a company public, it had to be in business for a minimum of five years and it had to show profitability for three consecutive years. After deregulation, those standards were gone, but small investors did not grasp the full impact of the change.
Investment banks Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
, founded in 1923 and Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
, over 100 years old, collapsed; Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
was acquired by Bank of America, which remained in trouble, as did Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
and Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
. The ensuing financial crisis of 2008 saw Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
and Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
"abandon their status as investment banks" by converting themselves into "traditional bank holding companies", thereby making themselves eligible to receive billions of dollars each in emergency taxpayer-funded assistance. By making this change, referred to as a technicality, banks would be more tightly regulated. Initially, banks received part of a $700 billion Troubled Asset Relief Program (TARP) intended to stabilize the economy and thaw the frozen credit markets. Eventually, taxpayer assistance to banks reached nearly $13 trillion dollars, most without much scrutiny, lending did not increase and credit markets remained frozen.
A number of former Goldman-Sachs top executives, such as Henry Paulson
Henry Paulson
Henry Merritt "Hank" Paulson, Jr. is an American banker who served as the 74th United States Secretary of the Treasury. He previously served as the Chairman and Chief Executive Officer of Goldman Sachs.-Early life and family:...
and Ed Liddy moved to high-level positions in government and oversaw the controversial taxpayer-funded bank bailout. The TARP Oversight Report released by the Congressional Oversight Panel found, however, that the bailout tended to encourage risky behavior and "corrupt[ed] the fundamental tenets of a market economy
Market economy
A market economy is an economy in which the prices of goods and services are determined in a free price system. This is often contrasted with a state-directed or planned economy. Market economies can range from hypothetically pure laissez-faire variants to an assortment of real-world mixed...
".
Under threat of a subpoena
Subpoena
A subpoena is a writ by a government agency, most often a court, that has authority to compel testimony by a witness or production of evidence under a penalty for failure. There are two common types of subpoena:...
by Senator Chuck Grassley
Chuck Grassley
Charles Ernest "Chuck" Grassley is the senior United States Senator from Iowa . A member of Republican Party, he previously served in the served in the United States House of Representatives and the Iowa state legislature...
, Goldman Sachs revealed that through TARP bailout of AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
, Goldman received $12.9 billion in taxpayer aid (some through AIG), $4.3 billion of which was then paid out to 32 entities, including many overseas banks, hedge funds and pensions. The same year it received $10 billion in aid from the government, it also paid out multi-million dollar bonuses to 603 employees and hundreds more received million-dollar bonuses. The total paid in bonuses was $4.82 billion.
Morgan Stanley received $10 billion in TARP funds and paid out $4.475 billion in bonuses. Of those, 428 people received more than a million dollars and of those, 189 received more than $2 million.
Possible conflicts of interest
Conflicts of interest may arise between different parts of a bank, creating the potential for market manipulationMarket manipulation
Market manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
. Authorities that regulate investment banking (the FSA
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
in the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
and the SEC
United States Securities and Exchange Commission
The U.S. Securities and Exchange Commission is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the United States...
in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
) require that banks impose a Chinese wall to prevent communication between investment banking on one side and equity research and trading on the other.
Some of the conflicts of interest that can be found in investment banking are listed here:
- Historically, equity research firms have been founded and owned by investment banks. One common practice is for equity analysts to initiate coverage of 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 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. Laws were passed to criminalize such acts, and 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 for them to engage in some form of front runningFront runningFront running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers...
– the illegal practice whereby a broker executes orders for their own account before filling orders previously submitted by their customers, there benefiting from any changes in prices induced by those orders.
Top 10 banks
The ten largest global investment banks as of December 31, 2010, are as follows (by total fees):| Rank | Company | Fees ($m) |
|---|---|---|
| 1. | J.P. Morgan J.P. Morgan & Co. J.P. Morgan & Co. was a commercial and investment banking institution based in the United States founded by J. Pierpont Morgan and commonly known as the House of Morgan or simply Morgan. Today, J.P... |
$5,533.85 |
| 2. | Bank of America Merrill Lynch Bank of America Merrill Lynch Bank of America Merrill Lynch is the corporate and investment banking division of Bank of America. It provides services in mergers and acquisitions, equity and debt capital markets, lending, trading, risk management, research, and liquidity and payments management... |
$4,581.59 |
| 3. | Goldman Sachs Goldman Sachs The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients... |
$4,386.52 |
| 4. | Morgan Stanley Morgan Stanley Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000.... |
$4,055.48 |
| 5. | Credit Suisse Credit Suisse The Credit Suisse Group AG is a Swiss multinational financial services company headquartered in Zurich, with more than 250 branches in Switzerland and operations in more than 50 countries.-History:... |
$3,379.12 |
| 6. | Deutsche Bank Deutsche Bank Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets... |
$3,286.80 |
| 7. | Citi | $3,238.67 |
| 8. | Barclays Capital Barclays Capital Barclays Capital is a global British investment bank. It is the investment banking division of Barclays plc which has a balance sheet of over £1.2 trillion . Barclays Capital provides financing and risk management services to large companies, institutions and government clients. It is a primary... |
$2,864.44 |
| 9. | UBS | $2,614.44 |
| 10. | BNP Paribas BNP Paribas BNP Paribas S.A. is a global banking group, headquartered in Paris, with its second global headquarters in London. In October 2010 BNP Paribas was ranked by Bloomberg and Forbes as the largest bank and largest company in the world by assets with over $3.1 trillion. It was formed through the merger... |
$1,433.89 |
World's biggest banks are ranked for M&A advisory, syndicated loan
Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....
s, equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
capital market
Capital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
s and debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
capital market
Capital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
s.
For more information on investment banking revenues, please visit Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
and Wall Street Journal
The Wall Street Journal
The Wall Street Journal is an American English-language international daily newspaper. It is published in New York City by Dow Jones & Company, a division of News Corporation, along with the Asian and European editions of the Journal....
websites or see Bloomberg
Bloomberg L.P.
Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
M&A and Capital Market
Capital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
s League Tables:
- Investment Banking Review, Financial TimesFinancial TimesThe Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
. - Investment Banking Scorecard, Wall Street JournalThe Wall Street JournalThe Wall Street Journal is an American English-language international daily newspaper. It is published in New York City by Dow Jones & Company, a division of News Corporation, along with the Asian and European editions of the Journal....
. - Global M&A Financial Advisory Rankings, BloombergBloomberg L.P.Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
. - Global Capital Markets League Tables, BloombergBloomberg L.P.Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
.
External links
- Bloomberg: Wall Street Bonuses Hit Record $39 Billion for 2007
- Bloomberg: Wall Street Executives Made $3 Billion Before Crisis
Further reading
- Fleuriet Michel Investment Banking Explained: An Insider's Guide to the Industry Mc Graw-Hill New York NY 2008 ISBN 978-0-07-149733-6
See also
- List of investment banks
- Merchant bankMerchant bankA merchant bank is a financial institution which provides capital to companies in the form of share ownership instead of loans. A merchant bank also provides advisory on corporate matters to the firms they lend to....
- History of investment banking in the United StatesHistory of investment banking in the United StatesPhiladelphia financier Jay Cooke established the first modern American investment bank during the Civil War era. However, private banks had been providing investment banking functions since the beginning of the nineteenth century and many of these evolved into investment banks in the post-bellum...