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
buy side is a term used to refer to advising institutions concerned with buying investment services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the most common types of buy side entities.
An investment bank can also be split into private and public functions with an
information barrier 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.
Organizational structure[edit]
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.
[2]
Core investment banking activities[edit]
The traditional service of underwriting security issues has declined as a percentage of revenue. As far back as 1960, 70% of
Merrill Lynch's revenue was derived from transaction commissions while "traditional investment banking" services accounted for 5%. However, Merrill Lynch was a relatively "retail-focused" firm with a large brokerage network.
[2]
Front office[edit]
Investment banking[edit]
Corporate finance is the traditional aspect of investment banks which also involves helping customers raise
funds in
capital markets and giving advice on
mergers and acquisitions (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 finance, and its advisory group is often termed
mergers and
acquisitions. A
pitch book 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, public finance (governments), FIG (financial institutions group), industrials, TMT (technology, media, and telecommunication) – and maintains relationships with corporations within the industry to bring in business for the bank. Product coverage groups focus on financial products – such as mergers and acquisitions, leveraged finance, public 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.
The Wall Street Journal, in partnership with Dealogic, publishes figures on investment banking revenue such as M&A in its Investment Banking Scorecard.
[4]
Sales and trading[edit]
On behalf of the bank and its clients, a large investment bank's primary function is
buying and selling products. In
market making, 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 emptor 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
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. In 2010, investment banks came under pressure as a result of selling complex derivatives contracts to local municipalities in Europe and the US.
[5] 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 trading, 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.s who act as
quantitative analysts.
Research[edit]
The
equity research division reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. Investment banks typically have
sell-side analysts which cover various industries. Their sponsored funds or proprietrary trading offices will also have buy-side research. 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 and trading division of the bank, and thereby generate revenue for the firm. However, research does not directly bring in revenue through commission or profit, which arguably places research in a middle office role. Research also covers credit research, fixed income research, macroeconomic research, and quantitative analysis, all of which are used internally and externally to advise clients but do not directly affect revenue. All research groups, nonetheless, provide a key service in terms of advisory and strategy. 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 wall between public and private functions.
Front office/Middle office[edit]
Risk Management[edit]
Risk management involves analyzing the market and credit risk that an investment bank or its clients take onto their balance sheet during transactions or trades. Credit risk focuses around capital markets activities, such as loan syndication, bond issuance, restructuring, and leveraged finance. Market risk conducts review of sales and trading activities utilizing the VaR model and provide hedge-fund solutions to portfolio managers. Other risk groups include country risk, operational risk, and counterparty risks which may or may not exist on a bank to bank basis. Credit risk solutions are key part of capital market transactions, involving debt structuring, exit financing, loan amendment,
project finance, leveraged buy-outs, and sometimes portfolio hedging. Front office market risk activities provide service to investors via derivative solutions, portfolio management, portfolio consulting, and risk advisory. Well-known risk groups in
JPMorgan Chase,
Goldman Sachsand
Barclays engage in revenue-generating activities involving debt structuring, restructuring, loan syndication, and securitization for clients such as corporates, governments, and hedge funds. J.P. Morgan IB Risk works with investment banking to execute transactions and advise investors, although its Finance & Operation risk groups focus on middle office functions involving internal, non-revenue generating, operational risk controls.
[6][7][8] Credit default swap, for instance, is a famous credit risk hedging solution for clients invented by J.P. Morgan's
Blythe Masters during the 1990s. The Loan Risk Solutions group
[9] within Barclays' investment banking division and Risk Management and Financing group
[10] housed in Goldman Sach's securities division are client-driven franchises. However, risk management groups such as operational risk, internal risk control, legal risk, and the one at
Morgan Stanley are restrained to internal business functions including firm balance-sheet risk analysis and assigning trading cap that are independent of client needs, even though these groups may be responsible for deal approval that directly affects capital market activities. Risk management is a broad area, and like research, its roles can be client-facing or internal.
Middle office[edit]
This area of the bank includes treasury management, internal controls, and internal corporate strategy.
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 via dedicated trading desk
product control teams. In the United States and United Kingdom, a
Financial Controller is a senior position, often reporting to the Chief Financial Officer.
Internal corporate strategy tackling firm management and profit strategy, unlike corporate strategy groups that advise clients, is non-revenue regenerating yet a key functional role within investment banks.
This list is not a comprehensive summary of all middle-office functions within an investment bank, as specific desks within front and back offices may participate in internal functions.
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Back office[edit]
Operations[edit]
This involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. 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.
[citation needed] 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[edit]
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.
Firms are responsible for compliance with government regulations and internal regulations.
Other businesses[edit]
- 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.[12] Current examples include Defoe Fournier & Cie. and JPMorgan's One Equity Partners and the originalJ.P. Morgan & Co. Rothschilds, Barings, Warburgs and Morgans were all merchant banks. (Originally, "merchant bank" was the British English term for an investment bank.)
Industry profile[edit]
Global size and revenue mix[edit]
Global investment banking revenue increased for the fifth year running in 2007, to a record US$84.3 billion,
[15] 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. As of late 2012, global revenues for investment banks were estimated at $240 billion, down about a third from 2009, as companies pursued less deals and traded less.
[16] Differences in total revenue are likely due to different ways of classifying investment banking revenue, such as subtracting proprietary trading revenue.
In terms of total revenue, SEC filings of the major independent investment banks in the United States show that investment banking (defined as M&A advisory services and security underwriting) only made up about 15-20% of total revenue for these banks from 1996 to 2006, with the majority of revenue (60+% in some years) brought in by "trading" which includes brokerage commissions and
proprietary trading; the proprietary trading is estimated to provide a significant portion of this revenue.
[3]
The
United States generated 46% of global revenue in 2009, down from 56% in 1999. Europe (with Middle East and Africa) generated about a third while Asian countries generated the remaining 21%.
[15]:8 The industry is heavily concentrated in a small number of major financial centers, including
City of London,
New York City,
Hong Kong and
Tokyo.
According to estimates published by the International Financial Services London, for the decade prior to the financial crisis in 2008, M&A was a primary source of investment banking revenue, often accounting for 40% of such revenue, but dropped during and after the financial crisis.
[15]:9 Equity underwriting revenue ranged from 30% to 38% and fixed-income underwriting accounted for the remaining revenue.
[15]:9
Revenues have been affected by the introduction of new products with higher margins; however, these innovations are often copied quickly by competing banks, pushing down trading margins. For example, brokerages commissions for bond and equity trading is a commodity business but structuring and trading
derivatives has higher margins because each
over-the-counter contract has to be uniquely structured and could involve complex pay-off and risk profiles. One growth area is
private investment in public equity (PIPEs, otherwise known as Regulation D or Regulation S). Such transactions are privately negotiated between companies and
accredited investors.
Banks also earned revenue by securitizing debt, particularly mortgage debt prior to the financial crisis. Investment banks have become concerned that lenders are securitizing in-house, driving the investment banks to pursue
vertical integration by becoming lenders, which is allowed in the United States since the repeal of the Glass-Steagall act in 1999.
[citation needed]
Financial crisis of 2008[edit]
The 2008 financial credit crisis led to the notable collapse of several banks, notably including the bankruptcy of large investment bank
Lehman Brothers and the hurried sale of
Merrill Lynch and the much smaller
Bear Stearns to banks which effectively rescued them from bankruptcy. The entire financial services industry, including numerous investment banks, was rescued by government loans through the
Troubled Asset Relief Program (TARP). Surviving U.S. investment banks such as Goldman Sachs and Morgan Stanley converted to traditional bank holding companies to accept TARP relief.
[18] Similar situations occurred across the globe with countries rescuing their banking industry. Initially, banks received part of a $700 billion
Troubled Asset Relief Program (TARP) intended to stabilize the economy and thaw the frozen credit markets.
[19] Eventually, taxpayer assistance to banks reached nearly $13 trillion, most without much scrutiny,
[20] lending did not increase
[21] and credit markets remained frozen.
[22]
The crisis led to questioning of the
business model of the investment bank
[23] without the regulation imposed on it by Glass-Steagall.
[neutrality is disputed] 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.
[24] 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.
[24]
Under threat of a
subpoena, Goldman Sachs revealed that it received $12.9 billion in taxpayer aid, $4.3 billion of which was then paid out to 32 entities, including many overseas banks,
hedge funds and pensions.
[26] The same year it received $10 billion in aid from the government, it also paid out multi-million dollar bonuses; the total paid in bonuses was $4.82 billion.
[27][28] Similarly, Morgan Stanley received $10 billion in TARP funds and paid out $4.475 billion in bonuses.
[29]
Criticisms[edit]
The investment banking industry, and many individual investment banks, have come under criticism for a variety of reasons, including perceived conflicts of interest, overly large pay packages, cartel-like or oligopolic behavior, taking both sides in transactions, and more.
[30] Investment banking has also been criticised for its opacity.
[31]
Conflicts of interest[edit]
Conflicts of interest may arise between different parts of a bank, creating the potential for
market manipulation, according to critics. 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. Critics say such a barrier does not always exist in practice, however.
Conflicts of interest often arise in relation to investment banks' equity research units, which have long been part of the industry. A 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. Alternatively, companies may 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 after the
dot-com bubble.
Philip Augar, author of The Greed Merchants, said in an interview that: "You cannot simultaneously serve the interest of issuer clients and investing clients. And it’s not just underwriting and sales; investment banks run proprietary trading operations that are also making a profit out of these securities."
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Many investment banks also own retail brokerages. 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 running – 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.
Documents
under seal in a decade-long lawsuit concerning
eToys.com's IPO but obtained by
New York Times Wall Street Business columnist
Joe Nocera alleged that IPOs managed by
Goldman Sachs and other
investment bankers involved asking for
kickbacks from their institutional clients who made large profits flipping IPOs which Goldman had intentionally undervalued. Depositions in the lawsuit alleged that clients willingly complied with these demands because they understood it was necessary in order to participate in future hot issues.
[32] Reuters Wall Street correspondent
Felix Salmon retracted his earlier, more conciliatory, statements on the subject and said he believed that the depositions show that companies going public and their initial consumer stockholders are both defrauded by this practice, which may be widespread throughout the IPO
finance industry.
[33] The case is ongoing, and the allegations remain unproven.
Compensation[edit]
Investment banking is often criticized for the enormous pay packages awarded those who work in the industry. According to Bloomberg Wall Street's five biggest firms paid over $3 billion to their executives from 2003 to 2008, "while they presided over the packaging and sale of loans that helped bring down the investment-banking system."
[34]
The highly generous pay packages include $172 million for Merrill Lynch & Co. CEO Stanley O'Neal from 2003 to 2007, before it was bought by Bank of America in 2008, and $161 million for Bear Stearns Co.'s James Cayne before the bank collapsed and was sold to JPMorgan Chase & Co. in June 2008.
[34]
Such pay arrangements have attracted the ire of Democrats and Republicans in Congress, who demanded limits on executive pay in 2008 when the U.S. government was bailing out the industry with a $700 billion financial rescue package.
[34]
Writing in the Global Association of Risk Professionals, Aaron Brown, a vice president at Morgan Stanley, says "By any standard of human fairness, of course, investment bankers make obscene amounts of money."
[30]
