Investment Banks

Investment banks assist public and private corporations in raising funds in the capital markets (both equity and debt), as well as in providing strategic advisory services for mergers, acquisitions and other types of financial transactions.They also act as intermediares in trading for clients. Investment banks differ from commercial banks which take deposits and make commercial and retail loans. In recent years, however, the lines between the two types of structures have blurred, especially as commercial banks have offered more investment banking services. In the US, 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Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities; Glass-Steagall was repealed by the Gramm-Leach-Bliley Act in 1998. Investment banks may also differ from brokerages, which in general assist in the purchase and sale of stocks, bonds, and mutual funds. In some cases, brokerages and investment banks are integrated into single firms.

Role of Modern Investment Banks

The original purpose of an investment bank was to raise capital and advise on mergers and acquisitions and other corporate financial strategies. As banking firms have diversified, investment banks have come to fill a variety of roles (list taken from the Swiss Banking Institute):

• Underwriting and distributing new security issues
• Offering brokerage services to public & institutional investors
• Providing financial advice to corporate clients, especially on security issues, M&A deals
• Providing financial security research to investors and corporate customers
• Market-Making, in particular securities.

Investment banks have also moved into foreign exchange markets, private banking, asset management and bridge financing.

Raising capital in the Capital Markets

A key role of investment banks is to help companies raise capital in the capital markets by arranging the issuance of new securities. There are two ways to do this: through a public offering or through a private placement.

A public offering involves selling securities to a wide range of investors. The investment bank can sell the company's stock in an initial public offering (IPO) or secondary offering, or they can arrange a bond issue. As these securities can end up with many investors, including unsophisticated ones, these sales are tightly regulated by bodies such as the U.S. Securities and Exchange Commission (SEC) and the Financial Services Authority in the United Kingdom.

A private placement is an offering of securities to a small group of sophisticated investors. There are fewer rules to comply with, though the investment bank must show that the investors comply with certain criteria. The distribution of other types of investment, other than securities, is usually also done through a private placement. This could include investments in venture capital or private equity, acquisitions and other strategic investments by companies.

The main activities and units

Large, global investment banks typically have several business units, including Investment Banking, concerned with advising public and private corporations; Research, concerned with producing reports on valuations of financial products; and Sales and Trading, concerned with buying and selling products both on behalf of the bank's clients and also for the bank itself. Banks undertake risk through Proprietary Trading, done 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 individual activities are described below:

• Investment Banking, is the traditional aspect of investment banks which involves helping customers raise funds in the Capital Markets and advising on mergers and acquisitions. Investment bankers prepare idea pitches that they bring to meetings with their clients, with the expectation that their effort will be rewarded with a mandate when the client is ready to undertake a transaction. Once mandated, an investment bank is responsible for preparing all materials necessary for the transaction as well as the execution of the deal, which may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target.

• Research, is the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While 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. In recent years the relationship between investment banking and research has become highly regulated, reducing its importance to the investment bank.

• Sales and Trading, is often the most profitable area of an investment bank, responsible for the majority of revenue of most investment banks. In the process of market making, traders will buy and sell financial products with the goal of making an incremental amount of money on each trade. Sales is the term for the investment banks sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales desks then communicate their clients' orders to the appropriate trading desks, who can price and execute trades, or structure new products that fit a specific need.

Investment banks create value for their clients primarily through their:

• extensive network of industry and financial contacts, so they can distribute newly issued securities
• market making and research activities, which allows them to create a liquid environment for the client's securities
• superior knowledge about transaction structuring, legal processes and comparable market events.

Recent evolution of the business

Investment Banking is constantly evolving. One main course of evolution is with investment banking products. Investment banks constantly invent new products, which are usually accompanied by very high profit margins since buyers are not sure how to value them. However, since these cannot be patented or copyrighted, they are very often copied quickly by other Investment Banks, and margins are forced downward as the pricing approaches commodity pricing. Throughout Investment Banking history, many have theorized that all investment banking products and services would be commoditized, and the concentration of power in the bulge bracket would be eliminated. This has failed to happen, because while many products became commoditized, new ones were constantly being invented. For example, trading stocks for customers is now a commodity style business, but creating stock derivative contracts is now a very high margin business since the contracts are difficult to evaluate. In addition, while many products have been commoditized, an increasing amount of investment bank profit 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, allowing it to theoretically make better trades).

Compensation

Investment bankers are competitively compensated through a base salary that is paid through the year and a large year-end bonus, in July for junior bankers and in November for senior bankers. Recent graduates, typically of top universities, are hired to fill analyst positions and are commonly paid for their first year a $60,000 salary, a $10,000 sign-on bonus, and a bonus that ranges with the reputation and the profitability of the firm but is usually between $40,000 to $60,000. While the base salary stays the same, the size of the bonus increases by about $15,000 a year. Although the analyst contract expires after 2 years, the best analysts are asked to stay on for a third year, and can be promoted to the Associate level after the 3rd year. MBA graduates usually start at the Associate level. Associate salaries start with a $95,000 base salary, a sign-on bonus, and expected bonus of around $100,000. Vice presidents usually command all-in compensation of half a million dollars. Bankers more senior get paid according to the revenue they produce, but a typical managing director earns $1.5-$2.0 million while a group head might earn $3.0-5.0 million.

Compensation for bankers who work in the Sales & Trading division varies much more than in actual investment banking. Because compensation is closely attached to the profit generated by each trader, a star Associate with a good relationship with his Managing Director can sometimes earn more than other (presumably less profitable) Managing Directors at the Firm!

It is also interesting that the most big banks, like Goldman Sachs and Morgan Stanley, pay lower bonuses than the rest because a short tenure at one of these can drastically increase a banker's value to future employers. Bankers who work outside the major financial centers such as London and New York. typically earn significantly smaller bonuses for various reasons, including the usually better lifestyle abroad, lower cost of living, and in the case of a branch office, the geographic distance from key individuals at head office who may divert money to compensate their own employees.

The big picture of compensation is that ultimately about 50% of total revenues is paid out as compensation to employees (Lazard Freres PLC goes as far as setting a target level for compensation as 57.5% of total revenue). In their 3Q 2005 earnings release, Goldman Sachs earmarked an average of $420,000 per employee per year for compensation (this includes everyone from janitors to the CEO).

Possible conflicts of interest

Because potential conflicts of interest may arise between different parts of a bank, the authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall which prohibits communication between Investment Banking on one side and Research and Equities on the other.

These are some of the conflicts of interest involved in investment banking:

• Historically, most equity research firms are owned by investment banks. It is common practice for equity analysts to initiate coverage on a company in order to develop a relationship with that company that will lead to highly profitable investment banking business. In the 1990s, many equity researchers allegedly traded positive stock ratings directly for investment banking business. The practice went the other way as well: companies would threaten to divert investment banking business to competitors unless an analyst rated their stock favorably. No one is sure how widespread these criminal acts were. 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 allegedly occurred, much like with equity researchers, to clinch investment banking business or even to sell surplus shares during a public offering to keep public perception of the stock favorable.

• Since investment banks engage heavily in trading for their own account, there is always the temptation or possibility that they might engage in some form of front running.

Investment banks

Some of the major global public and private investment banks include:

• ABN AMRO
• Bank of America
• Barclays Capital
• Bear Stearns
• BMO Nesbitt Burns
• BNP Paribas
• Bulltick Capital Markets
• Brown Brothers Harriman
• CIBC World Markets
• Calyon
• Cazenove
• Citigroup
• Credit Suisse First Boston
• Deutsche Bank
• Dresdner Kleinwort Wasserstein
• Ferris, Baker Watts, Inc.
• Friedman Billings Ramsey
• Goldman Sachs
• Houlihan Lokey Howard & Zukin
• Jefferies & Co.
• JPMorgan Chase
• Lazard
• Lehman Brothers
• Macquarie Bank
• Merrill Lynch
• Morgan Stanley
• Piper Jaffray
• Pricewaterhousecoopers
• RBC Capital Markets
• Robert W. Baird & Company
• Rothschild
• Scotia Capital
• SG Cowen
• TD Securities
• Thomas Weisel Partners
• TSG Partners
• UBS AG
• Wachovia Securities

See also

• Bank
• Private equity
• Thomson Financial League Tables
• Underwriting