9781906096236 chapter-1-overview-of-investment-banking


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9781906096236 chapter-1-overview-of-investment-banking

  1. 1.   Career GuideBook for IT in Investment Banking by Essvale Corporation Limited Essvale Corporation Limited. (c) 2010. Copying Prohibited.    Reprinted for Ramakanth Prerepa, Cognizant Technology Solutions ramakanth.prerepa@cognizant.com Reprinted with permission as a subscription benefit of Skillport, http://skillport.books24x7.com/All rights reserved. Reproduction and/or distribution in whole or in part in electronic,paper or other forms without written permission is prohibited.
  2. 2. Career GuideBook for IT in Investment Banking Chapter 1: Overview of Investment Banking What is Investment Banking? In finance theory, investment means the process of buying securities or other financial assets. Thus, a simple way of defining what investment banks do is to say that they invest, i.e. purchase new securities from corporate issuers and resell them to the public, in addition to their activities (trading of securities) on capital markets. Investment banks differ from commercial banks in that they facilitate companies’ direct access to the capital markets, as opposed to an intermediary role between customers who save money and those who borrow it. Core functions of the investment banks include: a) transferring economic resources, b) management of risk, and c) clearance and settlement of transactions across different time zones beyond national borders. Investment banks significantly expand the menu of products and services which are: a) cash money lending, b) structured finance, c) fund management, and d) securities transactions to retail and institutional clients (Liaw, 2006). The cost of entering the investment banking industry is high, because new entrants need to establish cross-border information and communication networks and hire bright and energetic specialists. The profitability of the investment banking business depends on its ability to reduce operational costs in the continuous flow of a large number of transactions. It is important for investment banks to: a) obtain a high market share in the key business functions such as mergers and acquisitions (M&A), advisory and securities issuance, and b) develop a broad range of products in order to activate cross-selling to various clients (Roberts, 2004). In the wake of the recent financial crisis, which has seen some big names in investment banking, such as Bear Stearns and Lehman Brothers, disappear from the scene, the traditional view of investment banking has been slightly altered. This is because in 2008, banking giants such as Morgan Stanley and Goldman Sachs, who were model standalone investment banks and the two remaining major investment banks in the USA, had to change their status to bank holding companies.[1] The move allowed both banks to have permanent access to emergency funding from the US Federal Reserve but also meant changes to the ways they were regulated. The conversion to commercial bank status will also allow Goldman Sachs and Morgan Stanley to bolster their funding through deposits. [1]Banking Times. ‘Goldman Sachs and Morgan Stanley convert to commercial banks’. 22 September, 2008. Available from http://www.bankingtimes.co.uk/22092008-goldman-sachs- and-morgan-stanley-convert-to-commercial-banks/. The Business of Investment Banking The business of investment banking involves the core functions of: n Capital raising; n Securities trading; n Advisory on corporate mergers and acquisitions. In addition to the above, it entails all major capital activities such as underwriting, private placement, mergers and acquisitions, venture capital, private equity, proprietary trading, market making, clearing and settlement, financing and money management and also financial engineering. Investment banking also entails research in a division which reviews companies and writes reports about their prospects, often with ‘buy’ or ‘sell’ ratings. Despite the fact that the research division generates no revenue, its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. There is, however, a potential conflict of interest between the investment bank and its analysis, in that published analysis can impact the profits of the bank. Thus in recent years, the relationship between investment banking and research has become highly regulated, requiring a Chinese wall between public and private functions. Classification of Investment Banks n Bulge bracket – The term ‘bulge bracket’ frequently refers to the group of investment banks considered to be the Page 2 / 4Reprinted for CTS/108802, Cognizant Technology Solutions Essvale Corporation Limited, Essvale Corporation Ltd. (c) 2010, Copying Prohibited
  3. 3. Career GuideBook for IT in Investment Banking largest and most profitable in the world. Bulge bracket banks provide the full spectrum of investment banking services for large-cap (more than $10 billion) and increasingly mid-cap firms ($2 billion to $10 billion). They usually offer both advisory and financing banking services, as well as the sale, market making and research of a broad array of financial products including equities, credit, rates, commodities and their derivatives. They are also heavily involved in the invention of new financial products, such as mortgage-backed securities in the 1980s, credit default swaps in the 1990s and today, carbon emission trading and insurance-linked products. There is regular debate over which banks are considered to belong to the bulge bracket, given that membership implies prestige, because there are no precise criteria for inclusion and because financial power is transitory. The 10 bulge bracket firms on Wall Street prior to late 2008 were, alphabetically: Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, and UBS. This list has changed as a result of the credit crunch, with Bear Stearns being purchased by JPMorgan Chase; Lehman Brothers having filed for bankruptcy (later having their core US investment bank acquired by Barclays); and Merrill Lynch being purchased by Bank of America. Barclays Capital and Bank of America Merrill Lynch gained bulge bracket status after their acquisitions. Wells Fargo’s recent acquisition and growth could allow the bank to qualify for bulge bracket status. n Tier one – These are also known as major bracket. These firms are large, full-service firms that do not qualify for bulge bracket status. n Boutiques – These are usually small banks that focus on a class of service offerings. People most commonly cite the size of deals as the difference between a boutique investment bank and bulge bracket bank. While Goldman Sachs may advise on multibillion-dollar acquisitions, a boutique will usually stick to deals under a billion dollars and often far less than that. Typical examples of boutique investment banks are Rothshild, Lazard, Seymour Pierce and Close Brothers, which specialise in mergers and acquisitions. The Range of Investment Banking Operations Investment banks are essentially intermediaries that match sellers of securities with buyers of securities. They act as intermediaries for their clients such as companies, individuals, institutions and governments. These clients can assume the role of investors or issuers. The latter are issuers of securities and are on the sell side while the former, despite the name, are not investors as such – they may be either sellers or buyers. Investment banks can work on both the buy side and the sell side. Hence, it could be said that investment banks act as intermediaries either between investors (buying and selling) or between investors and issuers. They also provide advisory services to their clients. The following describes two of the roles assumed: n Offering services to clients: The range of activities that a typical investment bank provides will depend on the types of client. However, the following are some of the services that investment banks provide for some types of client: ¡ Investors – Investment banks usually use their selling abilities to provide advice on the attractiveness of a financial product. Private-client representatives (brokers) liaise with individual investors while institutional sales teams provide investors with opportunities for portfolio diversification, risk management and boosting their returns. Investors are also offered services from the research departments of investment banks, which communicate information to them about fiscal matters as well as provide advice on future prospects of listed securities. ¡ Issuers of securities – Investment banks offer their capital market services to institutional investors such as governments, agencies, corporations and investment houses. To enhance their service offerings, banks keep inventing and underwriting new financing structures to adjust the issuers’ cash flow to the requirements of investors. ¡ Buyers and sellers of securities – Investment banks also use their expertise to execute trades in bonds, currencies (FX), equities, bonds and derivatives such as futures, options and swaps. Their counterparties in these trades are usually other investment banks, commercial banks and big institutional investors. ¡ Commodities dealers – Banks make markets in commodity products such as wheat futures on behalf of their clients, who may be speculators taking a position (long or short) or industrial corporations hedging their risks. As market makers, banks act as principals that take the other side of customer trades. Page 3 / 4Reprinted for CTS/108802, Cognizant Technology Solutions Essvale Corporation Limited, Essvale Corporation Ltd. (c) 2010, Copying Prohibited
  4. 4. Career GuideBook for IT in Investment Banking ¡ For companies involved in a merger or acquisition – Investment banks can offer strategic advice and valuation services to clients in an advisory capacity for companies involved in mergers and acquisitions. n Financial role:This could be described as a trading role that investment banks assume, which involves trading either as a principal investor or as an agent. Proprietary trading, whereby investment banks trade as principal investors, involves buying and selling for their own accounts. They also act as intermediaries in transactions, known as agency transactions. Investment banks can also act as counterparties in a trade. In this role, they stand willing to buy (or sell) the security and in essence create a market. Despite the fact that they facilitate clients’ trades, investment banks risk their own capital in doing so. Sources of Revenue Like any other business, investment banks need to generate revenue, and the following are some of the sources of revenue streams for these banks: n Trading income– This is the realised and unrealised profits and losses from the market-making activities of banks. The term ‘PnL’ is commonly used in these banks and is a term that potential candidates for investment banking IT jobs should take note of. n Underwriting revenues – These are derived from underwriting of security issues. n Commission –This is revenue derived from the different types of agency transactions (i.e. in the investment bank’s capacity as an intermediary) specified as a percentage of the value of the transaction. n Interest – This could be revenue generated from margin interest (i.e. the interest charged to customers that borrow against the value of their securities to finance purchases) or from interest on investment accounts (including repo and reverse repos). n Asset management fees – These are derived from the sale of mutual funds and management of portfolios. n Other securities-related revenues – These include revenue from interest on investment accounts and fees from advisory work on mergers and acquisitions. Page 4 / 4Reprinted for CTS/108802, Cognizant Technology Solutions Essvale Corporation Limited, Essvale Corporation Ltd. (c) 2010, Copying Prohibited