Investment banking
Investment banking is an advisory-based financial service for institutional investors, corporations, governments, and similar clients. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client's agent in the issuance of debt or equity securities. An investment bank may also assist companies involved in mergers and acquisitions and provide ancillary services such as market making, trading of derivatives and equity securities, FICC services or research. Most investment banks maintain prime brokerage and asset management departments in conjunction with their investment research businesses. As an industry, it is broken up into the Bulge Bracket, Middle Market, and boutique market.
Unlike commercial banks and retail banks, investment banks do not take deposits. The revenue model of an investment bank comes mostly from the collection of fees for advising on a transaction, contrary to a commercial or retail bank. From the passage of Glass–Steagall Act in 1933 until its repeal in 1999 by the Gramm–Leach–Bliley Act, the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G7 countries, have historically not maintained such a separation. As part of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, the Volcker Rule requires some institutional separation of investment banking services from commercial banking.
All investment banking activity is classed as either "sell side" or "buy side". The "sell side" involves trading securities for cash or for other securities, or the promotion of securities. The "buy side" involves the provision of advice to institutions that buy 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 a screen separating 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 U.S. Securities and Exchange Commission and Financial Industry Regulatory Authority regulation.
History
Early history
The Dutch East India Company was the first company to issue bonds and shares of stock to the general public. It was also the first publicly traded company, being the first company to be publicly listed.Further developments
Investment banking has changed over the years, beginning as a partnership firm focused on underwriting security issuance, i.e., initial public offerings and secondary market offerings, brokerage, and mergers and acquisitions, and evolving into a "full-service" range including securities research, proprietary trading, and investment management. In the 21st century, the SEC filings of the major independent investment banks such as Goldman Sachs and Morgan Stanley reflect three product segments:- investment banking,
- asset management, and
- trading and principal investments and brokerage trading ).
After the 2008 financial crisis and the subsequent passage of the Dodd-Frank Act of 2010, regulations have limited certain investment banking operations, notably with the Volcker Rule's restrictions on proprietary trading.
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.
Organizational structure
Core investment banking activities
Investment banking is split into front office, middle office, and back office activities. While large service investment banks offer all lines of business, both "sell side" and "buy side", smaller sell-side advisory firms such as boutique investment banks and small broker-dealers focus on niche segments within investment banking and sales/trading/research, respectively.For example, Evercore acquired ISI International Strategy & Investment in 2014 to expand their revenue into research-driven equity sales and trading.
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, a highly regulated process by the SEC to ensure transparency is provided to investors. Therefore, investment bankers play a very important role in issuing new security offerings.
Front office
Front office is generally described as a revenue-generating role. There are two main areas within front office: investment banking and markets.- Investment banking involves advising organizations on mergers and acquisitions, as well as a wide array of capital raising strategies.
- Markets is divided into "sales and trading", and "research".
Corporate finance
transactions in which capital is raised for the corporation include those listed aside.
This work may involve, subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target.
A pitch book, also called a confidential information memorandum, is a document that highlights the relevant financial information, past transaction experience, and background of the deal team to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client.
Recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions.
Sales and trading
On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products.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 and take orders. Sales desks then communicate their clients' orders to the appropriate bank department, which can price and execute trades, or structure new products that fit a specific need.
Sales make deals tailored to their corporate customers' needs, that is, their terms are often specific. Focusing on their customer relationship, they may deal on the whole range of asset types.
Structuring has been a relatively recent activity as derivatives have come into play, with highly technical and numerate employees working on creating complex financial products which typically offer much greater margins and returns than underlying cash securities, so-called "yield enhancement". 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 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.
Here, and in general, banks seek to maximize profitability for a given amount of risk on their balance sheet.
Note here that the FRTB framework has underscored the distinction between the "Trading book" and the "Banking book"
- i.e. assets intended for active trading, as opposed to assets expected to be held to maturity -
and market risk capital requirements will differ accordingly.
The necessity for numerical ability in sales and trading has created jobs for physics, computer science, mathematics, and engineering PhDs who act as "front office" quantitative analysts.
Research
The securities research division reviews companies and writes reports about their prospects, often with "buy", "hold", or "sell" ratings. Investment banks typically have sell-side analysts which cover various industries. Their sponsored funds or proprietary trading offices will also have buy-side research.Research also covers credit risk, fixed income, macroeconomics, and quantitative analysis, all of which are used internally and externally to advise clients; alongside "Equity", these may be separate "groups".
The research group typically provide a key service in terms of advisory and strategy.
While the research division may or may not generate 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. Research also serves outside clients with investment advice 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.
With MiFID II requiring sell-side research teams in banks to charge for research, the business model for research is increasingly becoming revenue-generating. External rankings of researchers are becoming increasingly important, and banks have started the process of monetizing research publications, client interaction times, meetings with clients etc.
There is a potential conflict of interest between the investment bank and its analysis, in that published analysis can impact the performance of a security or influence the relationship between the banker and its corporate clients, and vice versa regarding material non-public information, thereby affecting the bank's profitability.
See also.