Investment Banking Paradigm

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Unit 1 - Investment Banking Paradigm: Concepts And Definitions,Evolution Of American Investment Banks, Evolution Of IndianInvestment Banking, Conflict Of Interest In Investment Banking,Regulatory Framework For Investment Banking

An investment bank is a financial institution that assists individuals,corporations and governments in raising capital by underwritingand/or acting as the client's agent in the issuance of securities. Aninvestment banker may not accept deposits or make commercialloans. Investment bankers are the people who do the grunt work forIPOs and bond issues. Its a specific division of banking related to the

creation of capital for other companies. Investment banks underwritenew debt and equity securities for all types of corporations.Investment banks also provide guidance to issuers regarding the issueand placement of stock. They may also assist companies involved inmergers and acquisitions, and provide ancillary services such asmarket making, trading of derivatives, fixed income instruments,foreign exchange, commodities, and equity securities.

At a very macro level, Investment Banking as the term suggests, isconcerned with the primary function of assisting the securities marketin its function of capital intermediation, i.e. the movement of financialresources from those who have them (the investors), to those whoneed to make use of them for generating GDP (the Issuers).

Banking & financial institutions and securities markets are the twobroad platforms of institutional intermediation for capital flows in theeconomy. Investment banks are the counterparts of banks in financialmarkets in the function of intermediation in resource allocation.

The term investment banking is of American origin. Their

counterparts in UK were termed as merchant banks and they had

confined themselves to security market intermediation whereasAmerican investment banks undertook both fund-based and advisoryroles. American investment banks entered the UK and Europeanmarkets and extended the scope of merchant banking to investment

banking.
http://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Mergers_and_acquisitionshttp://en.wikipedia.org/wiki/Market_makinghttp://en.wikipedia.org/wiki/Derivative_%28finance%29http://en.wikipedia.org/wiki/Fixed_incomehttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Commoditieshttp://en.wikipedia.org/wiki/Equity_securitieshttp://en.wikipedia.org/wiki/Equity_securitieshttp://en.wikipedia.org/wiki/Commoditieshttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Fixed_incomehttp://en.wikipedia.org/wiki/Derivative_%28finance%29http://en.wikipedia.org/wiki/Market_makinghttp://en.wikipedia.org/wiki/Mergers_and_acquisitionshttp://en.wikipedia.org/wiki/Securities


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Investment banking

Core business portfolio

Fund based

Equity: Underwriting, market makingDebt: Underwriting, market makingM & A: Investing in Private Equity, Leveraged Buyout(LBO) andManagement Buyout (MBO)

Non-fund based

Equity: Merchant banking (Public issue management), PrivateplacementDebt: Public issue management, Private placement, Securitization forfinance companies and banksM&A: M&A advisory, Corporate Advisory, Project Advisory

Support business portfolio

Fund based

Equity: Proprietary trading and portfolio investing, private equityfunds and asset management fundsDebt: Proprietary trading and investing, asset management fundsDerivatives: Proprietary trading, hedge fund investments

Non-fund based

Equity: Equity broking, distribution, asset management, custodialservices, wealth management (private banking), research and analysis.Debt: Debt market broking, distribution, asset management, researchDerivatives: Derivative broking, risk management services, custodialservices


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Evolution Of American Investment Banks

In the mid-20th century, large investment banks were dominated bythe dealmakers. Advising clients on mergers and acquisitions and

public offerings was the main focus of major Wall Street partnerships.These bulge bracket firms included Goldman Sachs, MorganStanley, Lehman Brothers, First Boston and others.

That trend began to change in the 1980s as a new focus on tradingpropelled firms such as Salomon Brothers, Merrill Lynch and DrexelBurnham Lambert into the limelight. Investment banks earned anincreasing amount of their profits from proprietary trading. Advances

in computing technology also enabled banks to use more sophisticatedmodel driven software to execute trades and generate a profit on smallchanges in market conditions.

In the 1980s, financier Michael Milken popularized the use of highyield debt (also known as junk bonds) in corporate finance andmergers and acquisitions. This fuelled a boom in leverage buyoutsand hostile takeovers (see History of Private Equity). FilmmakerOliver Stone immortalized the spirit of the times with his movie, WallStreet, in which Michael Douglas played the role of corporate raiderGordon Gekko and epitomized corporate greed.

Investment banks profited handsomely during the boom years of the1990s and into the tech boom and bubble. When the tech bubbleburst, it precipitated a string of new legislation to prevent conflicts ofinterest within investment banks. Investment banking researchanalysts had been actively promoting stocks to investors while

privately acknowledging they were not attractive investments. Inother instances, analysts gave favourable stock ratings to corporateclients in the hopes of attracting them as investment banking clientsand handling potentially lucrative initial public offerings.

These scandals paled by comparison to the financial crisis that hasenveloped the banking industry since 2007. The speculative bubble inhousing prices along with an overreliance on sub-prime mortgage

lending trigged a cascade of crises. Two major investment banks,Bear Stearns and Lehman Brothers, collapsed under the weight of


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failed mortgage-backed securities. In March, 2008, the Federalgovernment began using a variety of taxpayer-funded bailoutmeasures to prop up other firms. The Federal Reserve offered a $30billion line of credit to J.P. Morgan Chase to that it could acquire BearSterns. Bank of America acquired Merrill Lynch. The last two bulgebracket investment banks, Goldman Sachs and Morgan Stanley,elected to convert to bank holding companies and be fully regulatedby the Federal Reserve.

Moving forward, the recent financial crisis has weakened both thereputation and the dominance of U.S. investment bankingorganizations throughout the world. The growth of foreign capital

markets along with an increase in pools of sovereign capital ischanging the landscape of the industry.

The growing international flow of capital has also opened upopportunities for investment banking in new financial centres aroundthe world, including those in developing countries such as India,China and the Middle East

Evolution Of Indian Investment Banking

The origin of investment banking in India can be traced back to the19

thcentury when European merchant banks set-up their agency

houses in the country to assist in the setting of new projects. In theearly 20

thcentury, large business houses followed suit by establishing

managing agencies which acted as issue house for securities,promoters for new projects and also provided finance to Greenfieldventures. The peculiar feature of these agencies was that their services

were restricted only to the companies of the group to which theybelonged. A few small brokers also started rendering Merchantbanking services, but theirs was limited due to their small capitalbase.

In 1967, ANZ Grindlays bank set - up a separate merchant bankingdivision to handle new capital issues. It was soon followed byCitibank, which started rendering these services. The foreign banks

monopolized merchant banking services in the country. The bankingcommittee, in its report in 1972, took note of this with concern and


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recommended setting up of merchant banking institutions bycommercial banks and financial intuitions. State bank of Indiaventured into this business by starting a merchant banking bureau in1972. In 1972, ICICI became the first financial institution to offermerchant banking services. JM finance was set-up by Mr. NimeshKampani as an exclusive merchant bank in 1973. The growth of theindustry was very slow during this period. By 1980, the number ofmerchant banks rose to 33 and was set-up by commercial banks,financial institutions and private sector. The capital market witnessedsome buoyancy in the late eighties. The advent of economic reformsin 1991 resulted in sudden spurt in both the primary and secondarymarket. Several new players entered into the field. The securities

scam in may, 1992 was a major set back to the industry. Severalleading merchant bankers, both in public and private sector werefound to be involved in various irregularities. Some of the prominentpublic sector players involved in the scam were Can bank financialservices, SBI capital markets, Andhra bank financial services, etc.leading private sector players involved in the scam includedFairgrowth financial services and Champaklal investments andfinance (CIFCO).

The market turned bullish again in the end of 1993 after the taintedshares problem was substantially resolved. There was a phenomenalsurge of activity in the primary market. The registration norms withthe SEBI were quite liberal. The low entry barriers coupled withlucrative opportunities lured many new entrants into this industry.Most of the new entrants were undercapitalized with little or noexpertise in merchant banking. These players could hardly afford to

be discerning and started offering their services to all and sundryclients. The market was soon flooded with poor quality paper issuedby companies of dubious credentials. The huge losses suffered byinvestors in these securities resulted in total loss of confidence in themarket. Most of the subsequent issues started failing and companiesstarted deferring their plans to access primary markets. Lack ofbusiness resulted in a major shake out in the industry. Most of thesmall firms exited from the business. Many foreign investment banks

started entering Indian markets. These firms had a huge capital base,


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global distribution capacity and expertise. However, they were new toIndian markets and lacked local penetration. Many of the top rungIndian merchant banks, who had string domestic base, started enteringinto joint ventures with the foreign banks. This energy resulted insynergies as their individual strength complemented each other.

Investment bankers

Investment bankers play an important role in the issue managementprocess. Lead managers (category I merchant bankers) have to ensurecorrectness of the information furnished in the offer document. They

have to ensure compliance with SEBI rules and regulations as alsoguidelines for disclosures and investor protection. To this effect, theyare required to submit to SEBI a due diligence certificate conformingthat the disclosures made in the draft prospectus or letter of offer aretrue, fair and adequate to enable the prospective investors to make awell informed investment decision. The role of merchant bankers inperforming their due diligence functions has become even moreimportant with the strengthening of the disclosure requirements and

with the SEBI giving up the vetting up of prospectus. SEBIs variousoperational guidelines issued during the year to merchant bankersprimarily addressed the need to enhance the standard of disclosures.It was felt that a further strengthening of the criteria for registration ofmerchant bankers was necessary, primarily through an increase in thenet worth requirements, so that the capital would be commensuratewith the level of activities undertaken by them. With this in view, thenet worth requirement or category I merchant bankers was raised in

1995-96 to Rs.5 crore. In 1996-96, the SEBI (merchant bankers)regulations, 1992 were amended to require the payment of fees foreach letter of offer or draft prospectus that is filed with SEBI.


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Underwriters

Underwriters are required to register with SEBI in terms of the EBI(Underwriters) Rules and Regulations, 1993. In addition tounderwriters registered with SEBI in terms of these regulations, allregistered merchant bankers in categories I, II and III and stockbrokers and mutual funds registered with SEBI can function asunderwriters.

Conflict Of Interest In Investment Banking

Conflicts of interest may arise between different parts of a bank,creating the potential for market manipulation. Authorities thatregulate investment banking (the FSA in the United Kingdom and theSEC in the United States) require that banks impose a Chinese wall toprevent communication between investment banking on one side andequity research and trading on the other.

Some of the conflicts of interest that can be found in investment

banking are listed here:

Historically, equity research firms have been founded andowned by investment banks. One common practice is for equityanalysts to initiate coverage of a company in order to developrelationships that lead to highly profitable investment bankingbusiness. In the 1990s, many equity researchers allegedly tradedpositive stock ratings for investment banking business. On the

flip side of the coin: companies would threaten to divertinvestment banking business to competitors unless their stockwas 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 largeextent following the 2001 stock market tumble.

Many investment banks also own retail brokerages. Also duringthe 1990s, some retail brokerages sold consumers securitieswhich did not meet their stated risk profile. This behavior may
http://en.wikipedia.org/wiki/Market_manipulationhttp://en.wikipedia.org/wiki/Financial_Services_Authorityhttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/United_States_Securities_and_Exchange_Commissionhttp://en.wikipedia.org/wiki/Chinese_wall_%28financial%29http://en.wikipedia.org/wiki/Chinese_wall_%28financial%29http://en.wikipedia.org/wiki/United_States_Securities_and_Exchange_Commissionhttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/Financial_Services_Authorityhttp://en.wikipedia.org/wiki/Market_manipulation


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have led to investment banking business or even sales of surplusshares during a public offering to keep public perception of thestock favourable.

Since investment banks engage heavily in trading for their ownaccount, there is always the temptation for them to engage insome form of front running the illegal practice whereby abroker executes orders for their own account before fillingorders previously submitted by their customers, there benefitingfrom any changes in prices induced by those orders.

Regulatory Framework For Investment Banking

Investment Banking in India is regulating in its various facets underseparate legislations or guidelines issued under statute. TheRegulatory powers are also distributed between different regulatorsdepending upon the constitution and status of Investment Bank. Pureinvestment banks which do not have presence in the lending orbanking business are governed primarily by the capital marketregulator (SEBI). However, Universal banks and NBFC investmentbanks are regulated primarily by the RBI in their core business of

banking or lending and so far as the investment banking segment isconcerned, they are also regulated by SEBI. An overview of theregulatory framework is furnished below:

1. At the constitutional level, all invest banking companiesincorporated under the Companies Act, 1956 are governed by theprovisions of that Act.

2. Investment Banks that are incorporated under a separate statutesuch as the SBI or IDBI are regulated by their respective statute. IDBIis in the process of being converted into a company under theCompanies Act.

3. Universal Banks that are regulated by the Reserve Bank of Indiaunder the RBI Act, 1934 and the Banking Regulation Act which putrestrictions on the investment banking exposures to be taken by

banks.
http://en.wikipedia.org/wiki/Front_runninghttp://en.wikipedia.org/wiki/Front_running


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Investment Banking Paradigm