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Investment banking

2007 Schools Wikipedia Selection. Related subjects: Business

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   v d e

   Investment banks help companies and governments and their agencies to
   raise money by issuing and selling securities in the primary market.
   They 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.

   Investment banks also act as intermediaries 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   underwriting securities; Glass-Steagall was repealed by the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 1999. Investment banks may also differ from
   brokerages, which in general assist in the purchase and sale of stocks,
   bonds, and mutual funds. However some firms operate as both brokerages
   and investment banks; this includes some of the best known financial
   services firms in the world.

   In the strictest definition, investment banking is the raising of
   funds, both in debt and equity, and the division handling this in an
   investment bank is often called the "Investment Banking Division"
   (IBD). However, only a few small firms solely provide this service.
   Almost all investment banks are heavily involved in providing
   additional financial services for clients, such as the trading of fixed
   income, foreign exchange, commodity, and equity securities. It is
   therefore acceptable to refer to both the "Investment Banking Division"
   and other 'front office' divisions such as "Fixed Income" as part of
   "investment banking," and any employee involved in either side as an
   "investment banker." Furthermore, one who engages in these activities
   in-house at a non-investment bank is also considered an investment
   banker. That said, many if not most IBD employees consider the title of
   Investment Banker reserved to them alone and bristle at
   self-referential use of this title by employees of other IB divisions,
   especially those engaged in Sales & Trading.

   More commonly used today to characterize what was traditionally termed
   "investment banking" is "sell side." This is trading securities for
   cash or securities (i.e., facilitating transactions, market-making), or
   the promotion of securities (i.e. underwriting, research, etc.).

   The "buy side" constitutes the pension funds, mutual funds, hedge
   funds, and the investing public who consume the products and services
   of the sell-side in order to maximize their return on investment. Many
   firms have both buy and sell side components.

   Generally speaking, those on the sell side are engaged in persuading
   those on the buy side. As such, it is sometimes considered to be more
   desirable to be on the buy side, since discretionary control over
   decisions lies with them. This said, it is not necessarily the case
   that the buy side is more personally lucrative than the sell side. As
   with most other endeavors, financial rewards await those who through
   luck or skill identify opportunity, regardless of whether they are
   selling or buying.

Organizational structure of an investment bank

The main activities and units

   The primary function of an investment bank is 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 or she buys or
   sells a product to a client and does not hedge his or her total
   exposure. Banks seek to maximize profitability for a given amount of
   risk on their balance sheet.

   An investment bank is split into the so-called Front Office, Middle
   Office and Back Office. The individual activities are described below:

   Front Office
     * 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. Other terms for the Investment Banking Division include
       Mergers & Acquisitions (M&A) and Corporate Finance (often
       pronounced "corpfin").
     * Investment management is the professional management of various
       securities (shares, bonds etc) and other assets (e.g. real estate),
       to meet specified investment goals for the benefit of the
       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 schemes eg. mutual funds) .

     * Financial Markets is split into four key divisions: Sales, Trading,
       Research and Structuring.
          + 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.
          + 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.
          + Structuring has been a relatively recent division 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.

   Middle Office
     * Risk Management involves analysing the market and credit 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 to a desk overall. Another key Middle Office role is to
       ensure that the above mentioned economic risks are captured
       accurately (as per agreement of commercial terms with the
       counterparty) correctly (as per standardised 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 risk" and the assurance Middle Offices
       provide now include 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.

   Back Office
     * Operations involves data-checking trades that have been conducted,
       ensuring that they are not erroneous, and transacting the required
       transfers. While it provides the greatest job security of the
       divisions within an investment bank, it is a critical part of the
       bank that involves managing the financial information of the bank
       and ensures efficient capital markets through the financial
       reporting function. The staff in these areas are often highly
       qualified and need to understand in depth the deals and
       transactions that occur across all the divisions of the bank. .

   Technology
     * Every major investment bank has considerable amounts of in-house
       software, created by the Technology team, who are also responsible
       for Computer and Telecommunications-based support. Technology has
       changed considerably in the last few years as more sales and
       trading desks are using electronic trading platforms. These
       platforms can serve as auto-executed hedging to complex model
       driven algorithms...

Size of industry

   Global investment banking revenue increased for the third year running
   in 2005, to $52.8bn. This was up 14% on the previous year, but 7% below
   the 2000 peak. The recovery in the global economy and capital markets
   resulted in an increase in M&A activity, which has been the primary
   source of investment banking revenue in recent years. Credit spreads
   are tightening and intense competition within the field has ensured
   that the banking industry is on its toes.

   The US was the primary source of investment banking income in 2005,
   with 51% of the total, a proportion which has fallen somewhat during
   the past decade. Europe (with Middle East and Africa) generated 31% of
   the total, slightly up on its 30% share a decade ago. Asian countries
   generated the remaining 18%. Between 2002 and 2005, fee income from
   Asia increased by 98%. This compares with a 55% increase in Europe, and
   a 46% increase in the US, during this time period.

Recent evolution of the business

New products

   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. Throughout the history of investment
   banking, many have theorized that all investment banking products and
   services would be commoditized. New products with higher margins are
   constantly invented and manufactured by bankers in hopes of winning
   over clients and developing trading know-how in new markets. However,
   since these can usually not be patented or copyrighted, 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 is highly
   profitable. Each OTC 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).

Vertical Integration

   Another trend in Investment Banking at the dawn of the 21st century 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 the 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.

Possible conflicts of interest

   Potential conflicts of interest may arise between different parts of a
   bank, creating the potential for financial movements that could be
   market manipulation. 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.

   Some of the conflicts of interest that can be found in investment
   banking are listed here:
     * Historically, equity research firms were founded and owned by
       investment banks. One common practice is for equity analysts to
       initiate coverage on 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 directly 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.
       Politicians acted to pass laws to criminalize such acts. 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 behaviour 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 or possibility that they
       might engage in some form of front running.

Investment banks

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