Investment banking

An investment bank is a financial institution that assists corporations and

governments in raising capital by underwriting and acting as the agent in the
issuance of securities. An investment bank also assists companies involved in
mergers and acquisitions, derivatives, etc. Further it provides ancillary
services such as market making and the trading of derivatives, fixed income
instruments, foreign exchange, commodity, and equity securities.

Unlike commercial banks and retail banks, investment banks do not take
deposits.

To provide investment banking services in the United States an advisor must

be a licensed broker-dealer. The advisor is subject to Securities & Exchange
Commission (SEC) (FINRA) regulation. Until 1999, the United States
maintained a separation between investment banking and commercial banks.
Other industrialized countries, including G7 countries, have not maintained
this separation historically. Trading securities for cash or securities (i.e.,
facilitating transactions, market making), or the promotion of securities (i.e.,
underwriting, research, etc.) was referred to as the "sell side".

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

Organizational structure of an investment bank

Main activities and units

An investment bank is split into the so-called front office, middle office, and
back office. While large full-service investment banks offer all of the lines
of businesses, both sell side and buy side, smaller sell side investment firms
such as boutique investment banks and small broker-dealers will focus on
investment banking and sales/trading/research, respectively.

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 in the market. To the
investor, the responsible investment banker offers protection against
unsafe securities. The offering of a few bad issues can cause serious loss to
its reputation, and hence loss of business. Therefore, investment bankers
play a very important role in issuing new security offerings.

Core investment banking activities

Front office

• Investment banking is the traditional aspect of the investment banks

which also involves helping customers raise funds in the capital
markets and giving advice on M&A's aka mergers and acquisitions.
Investment banking may involve subscribing investors to a security
issuance, coordinating with bidders, or negotiating with a merger
target. Another term for the investment banking division is corporate
finance, and its advisory group is often termed mergers and
acquisitions (M&A). A pitch book of financial information is generated
to market the bank to a potential M&A client; if the pitch is
successful, the bank arranges the deal for the client. The investment
banking division (IBD) is generally divided into industry coverage and
product coverage groups. Industry coverage groups focus on a specific
industry such as healthcare, industrials, or technology, and maintain
relationships with corporations within the industry to bring in business
for a bank. Product coverage groups focus on financial products, such
as mergers and acquisitions, leveraged finance, project finance, asset
finance and leasing, structured finance, restructuring, equity, and
high-grade debt and generally work and collaborate with industry
groups in the more intricate and specialized needs of a client.

• Sales and trading: On behalf of the bank and its clients, the primary
function of a large investment bank is buying and selling products. In
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. Structuring has been a relatively recent activity 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. 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, 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 necessity for numerical ability in sales and trading has
created jobs for physics, math and engineering Ph.D.s who act as
quantitative analysts.

• Research is the division which reviews companies and writes reports

about their prospects, often with "buy" or "sell" ratings. While the
research division may or may not generate revenue (based on policies
at different banks), 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 (such as institutional investors
and high net worth individuals) in the hopes that these clients will
execute suggested trade ideas through the Sales & Trading division of
the bank, thereby bringing in revenue for the firm. There is a
potential conflict of interest between the investment bank and its
analysis in that published analysis can affect the profits of the bank.
Therefore in recent years the relationship between investment
banking and research has become highly regulated requiring a Chinese
wall between public and private functions.
Other businesses that an investment bank may be involved in

• Global transaction banking is the division which provide cash

management, custody services, lending, and securities brokerage
services to institutions. Prime brokerage with hedge funds has been
an especially profitable business, as well as risky, as seen in the "run
on the bank" with Bear Stearns in 2008.

• 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 e.g.
mutual funds). The investment management division of an investment
bank is generally divided into separate groups, often known as Private
Wealth Management and Private Client Services.

• Merchant banking is a private equity activity of investment banks.[2]

Current examples include Goldman Sachs Capital Partners and
JPMorgan's One Equity Partners. (Originally, "merchant bank" was the
British English term for an investment bank.)

• Commercial banking see article commercial bank.

Middle office

• Risk management involves analyzing 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 standardized 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 includes 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.

• Corporate treasury is responsible for an investment bank's funding,

capital structure management, and liquidity risk monitoring.

• Financial control tracks and analyzes the capital flows of the firm,
the Finance division is the principal adviser to senior management on
essential areas such as controlling the firm's global risk exposure and
the profitability and structure of the firm's various businesses. In
the United States and United Kingdom, a Financial Controller is a
senior position, often reporting to the Chief Financial Officer.

• Corporate strategy, along with risk, treasury, and controllers, often

falls under the finance division as well.

• Compliance areas are responsible for an investment bank's daily

operations' compliance with government regulations and internal
regulations. Often also considered a back-office division.

Back office

• Operations involves data-checking trades that have been conducted,

ensuring that they are not erroneous, and transacting the required
transfers. While some believe that operations provides the greatest
job security and the bleakest career prospects of any division within
an investment bank,[3] many banks have outsourced operations. It is,
however, a critical part of the bank. Due to increased competition in
finance related careers, college degrees are now mandatory at most
Tier 1 investment banks.[citation needed] A finance degree has proved
significant in understanding the depth of the deals and transactions
that occur across all the divisions of the bank.

• Technology refers to the information technology department. Every

major investment bank has considerable amounts of in-house
software, created by the technology team, who are also responsible
for technical support. Technology has changed considerably in the last
few years as more sales and trading desks are using electronic
 trading. Some trades are initiated by complex algorithms for hedging
purposes.

Chinese wall

An investment bank can also be split into private and public functions with a
Chinese wall which separates 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.

Size of industry

Global investment banking revenue increased for the fifth year running in
2007, to $84.3 billion.[4] This was up 22% on the previous year and more than
double the level in 2003. Despite a record year for fee income, many
investment banks have experienced large losses related to their exposure to
U.S. sub-prime securities investments.

The United States was the primary source of investment banking income in
2007, with 53% of the total, a proportion which has fallen somewhat during
the past decade. Europe (with Middle East and Africa) generated 32% of
the total, slightly up on its 30% share a decade ago.[citation needed]Asian countries
generated the remaining 15%. Over the past decade, fee income from the
US increased by 80%.[citation needed] This compares with a 217% increase in
Europe and 250% increase in Asia during this period.[citation needed] The industry
is heavily concentrated in a small number of major financial centers,
including London, New York City, Hong Kong and Tokyo.

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. 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,[citation needed] but structuring and trading derivatives retains higher
margins in good times—and the risk of large losses in difficult market
conditions, such as the credit crunch that began in 2007. Each over-the-
counter 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).

The fastest growing segment of the investment banking industry are private
investments into public companies (PIPEs, otherwise known as Regulation D
or Regulation S). Such transactions are privately negotiated between
companies and accredited investors. These PIPE transactions are non-rule
144A transactions. Large bulge bracket brokerage firms and smaller
boutique firms compete in this sector. Special purpose acquisition companies
(SPACs) or blank check corporations have been created from this industry.
[citation needed]

Vertical integration

In the U.S., 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, and led to segregation of investment banks from
commercial banks. Glass–Steagall was effectively repealed for many large
financial institutions by the Gramm–Leach–Bliley Act in 1999.

Another development in recent years has been the vertical integration of

debt securitization.[citation needed] 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,[5] 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[citation needed] in order to
make money securitizing the loans, causing them to be a very popular
financing option for commercial property investors and developers.[citation needed]
Securitized house loans may have exacerbated the subprime mortgage crisis
beginning in 2007, by making risky loans less apparent to investors.

2008 Financial Crisis

The financial crisis of 2008 saw the last of the largest bulge-bracket US
investment banks which hadn't gone bankrupt or been acquired in a
bankrupt-like state convert over to 'bank holding companies' which are
eligible for emergency government assistance.[6]

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 equity 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 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.[citation needed]

• 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 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. Front running is the illegal
practice of a stock broker executing orders on a security for their
own account before filling orders previously submitted by their
customers, thereby benefiting from any changes in prices induced by
those orders..