Investment banking assists in capital intermediation by moving funds from investors to those who need capital to generate economic growth. It pools and allocates funds in capital markets like banks do in traditional banking. Investment banks also provide services like advising on financial matters, selling securities, facilitating mergers and acquisitions, and trading for their own accounts. In the future, full service investment banks and financial conglomerates providing a wide range of banking, investment, and insurance products are likely to dominate the industry.
2. Concepts and definitions
Investment banking is concerned with the primary function of assisting
the capital market, in its function of capital intermediation, i.e. the
movement of financial resources from the investors to those who need to
make use of them for generating GDP.
It can be inferred that investment banks are the counterparts of banks in
the capital market in discharging the critical function of pooling and
allocation of funds.
Investment bank, is a term used in the US to mean a bank which deals
with the underwriting of new issues and advices corporations on their
financial affairs.
Its termed in UK as an ‘issue house’
3. An investment bank is also defined as, a financial intermediary that
performs a variety of services including aiding in the sale of securities,
facilitating mergers and other corporate re-organizations, acting as
brokers to both individual and institutional clients and trading for its
own account.
4. Merchant banking
The Dictionary of banking and finance defines a Merchant Bank as,
‘a bank which arranges loans to companies, deals in international
finance, buys and sells shares and launches new companies on the
stock exchange, but does not provide normal banking services to the
general public’.
In US Merchant Banking is the activity of making direct investments
of the investment bank’s own funds, in some assets not directly
related to traditional investment banking business. Thus in addition to
underwriting obligations, it also takes its own exposure to securities.
When the investment bank is primarily an advisor, merchant banking
involves transactions such ass buyouts and acquisitions.
In India MB connotes ‘Issue Management’ of various types provided
under law and activities therewith.
5. Evolution of investment banks in US
The earlier stage is traced to the end of WW 1, by which the commercial
banks in the US were preparing for an economic recovery and
consequently, to the significant demand for corporate finance.
American co’s were expected to shift their dependence to stock and bond
markets, where funds were available at cheaper rates and longer terms.
In preparation for the boom in the capital markets in the 1920’s,
commercial banks started to acquire the stock broking businesses in a bid
to have a presence in such markets.
The stock and bond market boom in 1920’s was an opportunity that
banks could not miss. But since they could not underwrite and sell
securities directly, they owned security affiliates through holding
companies. They were financed by the parent banks for their
underwriting and other business obligations.
6. The IB affiliates started making huge profits as the boom lasted. The Mc
Fadden Act of 1927, allowed bank subsidiaries to underwrite stock
issues as well.
The stock market got over-heated with investment banks borrowing
money from the parent banks in order to speculate in the bank’s stocks,
mostly for short-selling.
Later the price earning ratios reached absurd limits and the bubble
eventually burst in October 1929 wiping out millions of dollars of bank
depositors’ funds and bringing down with it banks such as the Bank of
United States.
7. Regulation of the industry
It starts with Glass-Steagall Act or the Banking act of 1933, that
restricted commercial banks from engaging in securities underwriting
and taking positions or acting as agents for others in securities
transactions.
The exclusive domain of Investment Banking were segregated.
Other regulations include:
The securities act of 1933- preparations of offer documents and
registrations of new securities with the federal government.
The securities exchange act of 1934- formation of Securities Exchange
Commission.
The Maloney act of 1938- formation of NASDAQ
The investment company act of 1940- brought mutual funds within
regulatory orbit.
The investment advisors act of 1940-nregulated the businesses of
investment advisors and wealth managers.
8. Global industry structure
The IB industry on a global scale is oligopolistic in nature ranging
from global leaders to ‘ Pure Investment banks’ and ‘Boutique
investment banks’.
The global bulge group leaders include 8 investment banks that has
global presence.
League tables’- a word taken too seriously in the IB as they define
their position in the industry and send a strong message to their clients
about their performance and capabilities.
Pure investment banks are those which do not have commercial
banking connections. Eg: Merrill Lynch, Goldman Sachs etc.
9. Business portfolio of Investment Banks.
Investment banks handle significant fund-based businesses of their own in
the capital market along with their non-fund service portfolio, which is
offered to clients.
There are distinct segments which are handled either on the same B/S or
through subsidiaries and affiliates.
The activities are segmented along 3 broad segments:
1. Equity market activity
2. Debt market activity
3. Mergers and acquisitions activity.
US investment banking, the main sources of revenue comprises of
Core investment banking- underwriting, issue management, marketing
and research.
Securities portfolio
Brokerage
Asset management
Advisory services.
10. Core Business Portfolio
Non-fund based
Equity PF- underwriting primary market
security issues and private placements, Fund Based
issue management and security business( Equity PF- Underwriting bought deals,
market, distribution and research) secondary market making and proprietary
Debt PF- Fixed income underwriting and trading, derivatives and arbitrage.
placement structures financing and Debt PF- underwriting, secondary market
securitization, junk bonds and debt making and proprietary trading.
finance advisory. M&A PF- participation as lead/ co-
M&A PF- corporate restructuring, M&A investor in buyouts, LBO’s/MBO’s.
transaction services, Corporate finance
advisory.
Allied Businesses
Asset management
•Mutual Funds
•Hedge Funds
•Venture capital, private equity, buyout funds.
•Stock broking and investment advisory.
•Risk advisory and management.
•Custodial services.
11. Investment Banking in India
Its existence has been traced to over 3 decades.
IB was largely confined to MB services.
The forerunners of Merchant banking in India were mostly foreign
banks.
In 1972 T he Banking commission Report asserted the need for
Merchant banking Services in India.
Here merchant banking was meant to provide advisory services and
manage investments.
By the mid eighties and early nineties, most of the merchant
banking divisions of public sector banks were spun-off as separate
subsidiaries. This includes SBI’s SBI capital markets Ltd in 1986 and
IDBI’s IDBI capital markets in 1992.
12. Growth:
Merchant banking activity was regulated by SEBI in 1992 following
a sever downturn due to phases of hectic activity in business.
Majority of those registered under SEBI were either in Issue
management or advisory services.
Based on their net-worth, SEBI had 4 categories of Merchant
banks.
The number of registered merchant banks with SEBI at the end of
march 2003 was 124 from a high of almost a thousand in nineties.
In 2002-03 the number further decreased by 21.
13. Constraints to IB
Over dependence in the Issue management activity in the initial
years led the merchant banks to perish in the primary market
downturn. Later they diversified to offer a broad spectrum of capital
market services.
Only few industry leaders other than merchant banks could not
turn themselves into full service investment banks.
Indian industry has seen more or less similar developments to that
of its western counterparts, though the breadth available there is still
not present in India.
Due to lower availability of institutional financing to fund the
capital market activity, its only the bigger industry players who are in
full service investment banking.
The main constraint is the inadequate breadth in the secondary
market, especially in the corporate debt segment.
14. Risk aversion, characteristics and structure of Indian Investment Banking
Industry
Indian regulatory regime does not allow all investment banking functions to
be performed under one legal entity as its structure over the years has
evolved due to business realities and the regulatory regime. The reasons for
this are:
1. To prevent excessive risk exposure to business risk under one entity &
2. To prescribe and monitor capital adequacy and risk mitigation
mechanisms.
Thus Indian investment banks follow a conglomerate structure by keeping
their business segments in different corporate entities to meet regulatory
norms.
Indian investment banking industry also has a heterogeneous structure, as
bigger investment banks have several group entities in which the core and
non-core business segments are distributed. Others have one or more
entities depending upon the activity profile.
15. CORE BUSINESS PORTFOLIO
Non-Fund based Fund Based
Merchant Banking services for • Underwriting
• Management of public offers of equity and debt • Market making
instruments • Bought out deals
• Rights issue •Proprietary investments and trading in equities, bonds
• Open offers under the takeover code and derivatives
• Buyback offers
• De-listing offers
ALLIED BUSINESSES
Advisory and Transaction services in
• Project financing
• Syndicated loans Asset management services
• Structured finance and Securitization • Mutual funds, Portfolio management
• Private equity / Venture capital • Venture capital funds, Private equity funds
• Preferential issues Secondary market services
• Qualified institutional placements • Securities business
• Business Advisory -Broking, Sales and distribution, Equity research
• Financial restructuring • Investment advisory
• Corporate re-organizations such as mergers and de- •Derivatives
mergers, hive-offs, asset sales and divestitures. Support services
• Acquisitions, strategic sale, buyouts and takeovers • Registrars and share transfer agents
• Government disinvestments and privatization • Custodial services
• Asset recovery agency services. • Other capital market services.
16. Inter-dependence between different verticals in investment banking
There are different verticals in investment banking and they do enjoying synergies
with one another. The service or business segments form the core of investment
banking, others provide invaluable support. It is important to understand and the
inter-dependence and complementary existence of all these business segments.
Merchant banking largely relates to management of public floatation of
securities/ reverse floatation like buy backs and open offers, underwriting is an
inherent part of MB for public issues.
Advisory and transaction services have a close linkage with MB in public issue
and reverse floatation.
Venture capital enables identification of potential IPO candidates which leads
to generation of fee income from MB services and good capital gain for the VC
invested at the earlier rounds of financing in such companies.
Stock broking and primary dealership in debt markets nurture- institutional,
corporate and retail clients who can be tapped effectively for asset management,,
PF management, and private equity business.
17. Presence in the equity derivative and foreign exchange derivative segments
can help in offering solutions in treasury management to clients.
All these verticals are driven by support services such as sales and distribution
and equity research and analysis, where the capability of S&D determines the
success of MB vertical.
Thus IB is a business that is very sensitive to the economic and capital market
scenario and therefore, the broader the platform of operations, the more is the
likelihood of an IB, surviving business cycles and sudden shocks from the
market.
18. Conflict of interest in IB
The most burning global issue in the IB industry at the beginning of the 21st
century became the conflict of interest between the investment banks and their
research analysis divisions.
The securities and exchange commission in the US initiated investigations into
instances of investment banks issuing over-optimistic research and steering in hot
IPO’s for important clients in vested interests.
In such investigations some banks were also fined.
19. How does the conflicts arise?
Most investment banks have in-house research divisions as a support
function. The research divisions perform vital functions of tracking
corporate and making recommendations to their clients in the secondary
market operations or to their own dealing rooms. They also issue reviews
and ratings to the new issuances hitting the market.
The conflict could arise if the analyst would promote a share, the public
offering for which is being handled by the MB.
Alternatively , it could also be that the analyst is prone to insider
information from the merchant banking division and there upon issue
recommendations that could amount to fraudulent deceit of investors or
gain for select few.
20. The corporate scandals of US led to precautionary amendments in India by
SEBI.
SEBI amended the regulations that were in place for merchant bankers and
Underwriters and for prohibition of insider trading . As a result analysts are
barred from private trading in shares they analyze.
There is rule for more regulation in this area of importance for the survival of
the IB industry.
21. Full service investment banks and financial conglomerates of the future.
The business of IB is under-going rapid changes in response to the growing
sophistication in the financial markets and the need of clients.
Consolidation and globalization is the ‘Mantra’ for success and growth.
Financial conglomerates with equal presence and reach in commercial
banking, IB, insurance and financial advisory are the way to go for one-step
shopping for all financial needs.
Emerging areas of investment banks have been retail and institutional fund
management, trust services and thrift charters etc.
The share of revenue from core investment banking has been declining
steadily and is being replaced by proprietary trading, asset management and
advisory services.
22. Investment banks are buying into asset management companies and also
setting up private equity to tap the available opportunity.
The future therefore lies in ‘full service investment banking’ comprising
of core investment banking, asset management, private equity, venture
capital, brokerage, S&D, research and analysis, proprietary trading and
investment, primary dealing in fixed income securities, structured
financing and corporate advisory services.
Universal banks can add all their banking products in both corporate and
retail banking segments to the long list of services offered as full service
investment banks.
A step forward would be the financial conglomerates for the future that
can even add on insurance and pension products to make them one-stop
financial shops, large financial conglomerates such as Citygroup/ ING
would be the models of growth in years to come.