Chapter 16 - Securities Firms and Investment Banks

6th Edition

Chapter Sixteen
Securities Firms and Investment Banks

I. Chapter Outline
1. Services Offered by Securities Firms versus Investment Banks: Chapter Overview
2. Size, Structure, and Composition of the Industry
3. Securities Firm and Investment Bank Activity Areas
a. Investment Banking
b. Venture Capital
c. Market Making
d. Trading
e. Cash Management
f. Mergers and Acquisitions
g. Other Service Functions
4. Recent Trends and Balance Sheets
a. Recent Trends
b. The Balance Sheet
5. Regulation
6. Global Issues

II. Learning Goals

1. Know the different types of securities firms and investment banks.
2. Understand the major activity areas in which securities firms and investment banks
engage.
3. Differentiate among the major assets and liabilities held by securities firms.
4. Know the main regulators of securities firms and investment banks.

III. Chapter in Perspective

Investment bankers assist borrowers in raising capital in debt and equity markets and
provide advice about mergers and acquisitions, corporate restructuring and general
assistance in finance. Bankers also provide many creative over the counter derivative
products. Securities firms provide brokerage and market making services. The
investment banking and securities industries are complementary and many firms provide
a broad range of services. Some specialized entities with advantages in certain market
niches remain less diversified. The industry underwent tremendous consolidation in the
last decade due to increasing scale and scope economies and the need for greater capital.
The face of the industry was changed forever during the financial crisis of 2007-2008
with forced buyouts of Merrill-Lynch and Bear-Stearns, failure of Lehman Brothers and
Goldman-Sachs and Morgan Stanley becoming commercial banks. Nevertheless, working
for many of these firms is often considered the penultimate finance career, with prestige
and remuneration to match. With industry profits down, firms on the Street are having a
difficult time maintaining their large salaries and bonuses. A very significant portion of

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profits are paid out in the form of remuneration to executives. The chapter presents an
overview of the size of the industry and the general strategies of the participants, major
activities, primary assets and liabilities on the balance sheet, recent in the news events
concerning breaches of ethics and the trend toward globalization. There is some overlap
with Chapter 8, The Stock Market.

IV. Key Concepts and Definitions to Communicate to Students

Brokers and dealers Best efforts underwriting

Underwriting Firm commitment offering

Discount broker Cash management account

Private placement Shelf registration

Venture capital Block or Position Trading

Pure arbitrage Risk arbitrage

Program trading Cash management accounts

Mergers & Acquisitions SIPC

Sarbanes-Oxley Ethical problems on Wall Street

Tombstone ad Market making

Front running Price fixing

V. Teaching notes

1. Services Offered by Securities Firms versus Investment Banks: Chapter

Overview
Investment banking involves market analysis, advising, securities pricing, underwriting,
distribution of newly created securities and venture capital. Investment banks often
create formal or informal syndicates to assist in sharing risk and expertise. Some bankers
are stronger in distribution, such as Bank of America (via former Merrill Lynch), some
are stronger in corporate negotiations, such as Morgan Stanley, and some are stronger in
certain industries or in certain aspects of restructurings such as Goldman Sachs.
Corporate finance activities such as spin-offs, divestitures, mergers and acquisitions,
tender offers, and other financial restructurings are often undertaken with the advice and
assistance of investment bankers. Securities firms provide brokerage, research and
advising services and trade securities for their own account. Full line firms provide both
investment banking and brokerage services. Specialized firms may concentrate on firms
in a given region, focus on a trading method, such as over the Internet, or specialize in a

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particular type of financing such as providing capital for startups and small firms (venture
capital).

2. Size, Structure and Composition of the Industry

Total assets in 2012 comprised $4.77 trillion. Equity capital, the more traditional
measure for this industry, was $223 billion.1 The industry underwent shakeouts in the
1970s after “May Day” and again after the 1987 crash.2 The number of firms fell from
9,515 in 1987 to 5,063 in 2010. Ever larger firms have also been created via intra and
inter industry mergers. The amount of capital firms employ has also grown dramatically
and probably now represents a valid entry barrier.

The industry can be broken down into three major subdivisions and a group of smaller
specialized firms:
 Commercial bank holding companies that operate diversified national full line
firms that serve both retail and corporate customers such as Bank of America and J.P.
Morgan Chase. These firms’ income comes primarily from brokerage, lending, and
underwriting and trading activities.
 National full line firms specializing in corporate finance such as Goldman Sachs.
Their income is primarily from underwriting, placement, mergers and acquisitions
other consulting services and trading income.
 Large investment banks such as Lazard Ltd and Greenhill and Company
 Specialized firms such as
 regional investment bankers (D.A. Davidson, Raymond James), (sometimes
labeled ‘boutiques’)
 discount brokers (Schwab),
 Internet brokers (E-Trade),
 venture capital firms (New Enterprise) &
 exchange floor specialists (LaBranche & Co.)
 dealers in off exchange trading (KCG or Knight Capital Group)

3. Securities Firm and Investment Bank Activity Areas

a. Investment Banking
Investment banking is underwriting and distributing new issues of debt and equity. The
top 5 underwriters are listed in Text Table 16-3. The top firms represented about 32.9%
of the total underwriting volume. A key factor of success in the investment banking
industry is reputation and bankers guard their firm’s name jealously.

Teaching Tip: One can see the pecking order in the banking industry in a tombstone ad.
The lead or managing underwriter(s)’ names will appear at the top of the list of bankers

1
The size of investment banking and securities trading is not properly measured by industry assets
because, unlike bank or insurance financing, investment bankers and securities firms need not
permanently hold securities. Their purpose is to turn them over quickly. Equity capital measures a
firm’s ability to turnover large issues since firms will only risk limited amounts of their capital at one
time. Underwriting volume is also used to measure activity.
2
In May of 1975 brokerage commission rates were deregulated leading to reduced commission revenue.
Lower commission revenue translated into lower profitability and caused a major industry shakeout of
less competitive firms.

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involved in the issue. Where the bankers’ name appears in this list is very important to
the banker’s reputation.

U.S. corporate underwriting activity for debt issues is almost always many times larger
than the volume of equity underwriting though equity deals usually dominate the
headlines. Investment banking strategy elements can be discussed with the help of Text
Table 16-3 which contains the top underwriters for different security types. In 2012
Morgan Stanley was tops for IPOs and Goldman Sachs for equity, Bank of America for
syndicated loans and J. P. Morgan for global debt. After declining precipitously during
the financial crisis, $6.19 trillion of debt and equity was underwritten in 2012 and $4.76
trillion in the first nine months of 2013.

Placement methods:
 Firm commitment: In a firm commitment the underwriter buys the issue from
the issuer at a set price called the bid price and then attempts to sell the issue to
the final buyers at a slightly higher amount called the offer price. The banker acts
as a principle in this transaction and the banker bears the risk of a failed issue if it
does not sell. The banker may not raise the offer price during the offer period
once it is announced. In this sense the banker has a profit profile similar to a
written put option with limited upside gains and unlimited downside loss
potential. Bankers slightly underprice issues and charge fees to offset the risk of
underwriting. A significant amount of pre-selling activity occurs (the so called
“road show”) to limit the investment banker’s risk of selling the issue. An
excellent interactive CD-ROM on the mechanics of going public (and secondary
market mechanics) is available from NASDAQ (for free) titled Market
MechanicsSM which you can order from academic@nasdaq.com.
 Best efforts: The investment banker agrees to market and distribute the issue and
use their ‘best efforts’ to sell the issue to the public, but the banker does not buy
the issue outright and is not at risk if buyers do not want the securities offered.
 Private placements: Issues sold to a few large primarily institutional investors
are termed private placements and are exempt from SEC registration
requirements. Private placements can now be traded among institutional and high
net worth investors.

b. Venture Capital
It can be difficult for small firms to obtain sufficient capital to grow. Many banks are not
willing to lend to small firms who do not have a sufficient record of profitability and may
not have sufficient collateral. An alternative source of financing is through venture
capital (VC) or angel investors. Venture capitalists are typically limited partnership
organizations that specialize in financing and assisting in the management of small
startup entities. VC investors purchase an equity stake in the enterprise and usually are
actively involved in the business management of the firm in which they invest. The VC
firm will have a well defined exit strategy and an exit timeline. The exit strategy is
usually to take the firm public or to find a buyer for the firm, usually within 10 years.
VC firms usually invest money in stages to limit their capital at risk. VC capital is not
uniformly distributed among different industries. A VC investor is looking for the ‘next

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big idea’ and is often concentrated in whatever industry is ‘hot’ at the time, often in
technology and bioengineering firms. The typical VC investor has traditionally been
looking for a 20% to 30% annualized return on invested capital although in recent years
returns on the NVCA index have been less than returns on major stock indices.

Many small investors obtain funding from angel investors. Angel investors can range
from wealthy individuals who are willing to put up capital without requiring such a high
return on investment nor providing active management to professional investment firms
that specialize in smaller deals than VC firms.

Private equity (PE) differs from VC in funds sources and in types of investments. PE
firms raise funds by selling securities rather than commingling private funds as many VC
firms do. Second, PE firms often acquire established existing firms rather than purchase
start ups. During and after the crisis however there have been fewer promising startups
so VC firms have begun engaging in PE type investments.

The federal government provides funding through the Small Business Administration
(SBA) to assist in venture financing. The SBA licenses privately organized Small
Business Investment Companies (SBICs) to help finance entrepreneurs. SBICs can
obtain funds from the Treasury so they have a cost advantage over private VC firms.
Some banks operate VC firms (financial VCs) and some corporations such as Intel
operate VC firms as well.

Implementation of the Volcker Rule in July 2014 continues to lead to reduced investment
in all forms of private equity by banks. Bank of America has eliminated its private equity
fund and Goldman Sachs and Citigroup are reducing their investments. This may reduce
the supply of funds available to VC and private equity, at least temporarily.

c. Market Making
Market making is creating a secondary market for securities or contracts. These involve
both agency (brokerage) and principle (dealer) functions. Brokerage is typically
remunerated with commissions and dealers profit from the bid-ask spread. Dealers buy at
the bid (low) and sell at the ask (high). Dealers incur the risk of price changes on the
stock since they must maintain an inventory and bear inventory financing costs. On the
NYSE, specialists are designated market makers that have an affirmative obligation to
ensure ongoing market liquidity and price continuity. If the majority of investors wish
to sell the stock, the specialist is charged with buying in order to provide market liquidity.
In the event of a large market move the exchange’s circuit breakers may halt trading,
relieving specialists of their obligation. In addition specialists may petition the exchange
to halt trading in a given security.

Teaching Tip: The size of the spread is determined by the security’s volatility, inventory
financing costs, the amount of trading and competition between non-colluding dealers
and regulations. Decimalization reduced the minimum stock spread from about 6 cents
(1/16) to 1 cent. To the extent that reduced spreads encourage more trading volume,
specialists and other brokers could see an increase in commission revenue. Increased

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competition from ECNs and other markets have led to an erosion of specialist profits
however.

Goldman Sachs managed $43 trillion in derivatives in 2013 (about 18% of the total held
by FIs). The profit for the first six months of 2013 was $392 million. This is a major
source of income for banks and illustrates why they don’t like the new restrictions in the
Dodd-Frank bill. Losses from subprimes and derivatives were over $1 trillion as of 2009
so these are risky investments. Implementation of Dodd-Frank rules on OTC derivatives
came were phased in in 2013. The main changes are that OTC derivative positions such
as swaps must be traded on an exchange and cleared through a clearing agency. This
change will probably reduce profits per deal and may lead to increased capital
commitments to meet margin requirements. However over the long run, one would
expect a pickup in trading activity and perhaps volume which may create opportunities
for banks to generate profits.

d. Trading
Trading activities include:
 Position trading: Holing a position for weeks or months
 Pure arbitrage; arbitrage is taking advantage of a mispricing between two
markets by simultaneously buying and selling the same commodity. Spot futures
arbitrage is a common example.
 Risk arbitrage; taking advantage of a real or perceived mispricing based on some
information the trader possesses without perfectly covering or eliminating all the
risk.
 Program trading; defined as simultaneous buying and selling of a portfolio of at
least 15 different stocks valued at more than $1 million in total using a computer
program to initiate the trade. Some forms of program trading are either pure or
risk arbitrage, such as stock index futures arbitrage trades. Portfolio insurance is
another form of program trading.
 Stock brokerage; processing buy and sell orders from the public. Many firms
either buy or lease seats on the NYSE and/or are NASDAQ members.

Teaching Tip: Full service brokers offer research and advice about which stocks to buy,
discount brokers process public orders for a reduced fee.
 Electronic brokerage offers investors direct access to the trading floor, bypassing
normal brokers and offering even lower fees than discount brokers. Examples
include E-Trade and Ameritrade. Most large firms now offer clients a choice of
full service brokerage or reduced cost electronic trading.

e. Cash Management
Securities firms have long offered accounts called Cash Management Accounts
(CMAs) that were similar to bank checking accounts. As of 1999 securities firms were
allowed to offer federally insured deposits. These accounts have normally been checking
accounts written on mutual fund investments. Many of these accounts now offer ATM
and debit card services. CMAs make it easier and cheaper for brokers to process
payments for security buy and sell orders. Note that since the FSMA securities firms can

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also offer loans, credit cards and other banking type services to customers and banks can
offer traditional brokerage services. New rules that will soon be in place are likely to
force these accounts to change. Currently money market investments have a fixed $1 net
asset value (NAV). As part of increased oversight from the Dodd-Frank bill these
accounts will soon be forced to trade at varying NAV so that investors can understand the
risks they face in these investments. It remains to be seen whether investors will no
longer consider these accounts as close substitutes for bank deposits.

f. Mergers and Acquisitions (M&A)

Investment bankers help find merger partners, underwrite new securities to be issued as a
result of a restructuring or acquisition, assess the value of a potential target, recommend
takeover terms, or assist in fighting off a hostile takeover.

U.S. and global M&A activity boomed in the late 1990s and through 2000 topping out at
$1.83 trillion in 2000, but activity declined substantially after that. In 2001 U.S. M&A
activity totaled $819 billion, down 53% from the prior year, and declined again in 2002
to $458 billion. M&A activity picked up slightly in 2003 to $465 billion, but grew rapidly
again in 2004 when the total value hit $748 billion, led by mergers of financial
institutions. M&A activity in 2007 was $1.59 trillion. While M&A activity brings large
fees to bankers, this type of business remains very cyclical and it declined during the
financial crisis, picking up in 2011. See below:

M&A activity by year

US Global
2008 $903 billion $2.90 trillion
2009 713 1.70
2010 687 1.80
2011 861 2.33
2012 882 2.04
2013* 594 1.45
* First nine months

Teaching Tip: According to a very interesting piece by Michael Jensen, “Agency Costs
of Overvalued Equity,” M. Jensen, Spring 2005, Financial Management, pp, 5-19, many
if not most of the large number of acquisitions in the late 1990s destroyed shareholder
value. He argues that overpriced equity led to too low cost of capital and encouraged
managers to engage in poor investments such as acquisitions in order to meet analysts’
earnings expectations. Given that a high P/E ratio predicts rapid earnings growth and/or
low risk, too high a stock price then predicts an impossibly high growth rate (and/or an
unrealistically low level of risk). The manager, expected to hit ever growing earnings
targets, faces an impossible task, because with overvalued equity management cannot
deliver the expected level of performance except by chance. Hence firms look for ways
to keep the fiction of improving performance alive, even resorting to illegal accounting
practices and poor acquisitions. This is a very interesting argument. It helps explain why
there were extreme pressures on managers to produce short term performance. It is not
that managers suddenly decided to ‘lie, cheat and steal.’ The pressure to perform has

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been very high, and brought about in part by too close a tie between Wall Street analysts
and corporate executives, a conflict of interest. With overvalued equity, stock price
signals are faulty and cannot be relied upon as indicators of long term value of the firm.
Trying to do so when those signals are wrong must lead to suboptimal decisions for long
term shareholder wealth. Several firms enlisted their professional consultants in
accounting and finance to help them find ways to hit performance targets, which of
course could not continue to occur without some form of ‘cheating’ such as accounting
manipulations. This argument does not excuse managers. They should have known
better. We have seen a major breakdown of corporate governance at the board level.
Too many managers had ethical failures even though they were highly paid to act in
shareholders interests.

g. Other Service Functions

In addition to the above functions, investment bankers and securities firms also provide
security custodian services, clearance and settlement services, escrow services, research
and advice on divestitures and asset sales. Fees for these services are often bundled
together and allocated for different activities. Some of these ‘soft dollar’ allocations
have come under scrutiny as alleged conflicts of interest have arisen between the
underwriting and security selling functions of investment bankers (see the ethics
discussion below).

4. Recent Trends and Balance Sheets

a. Recent Trends
As goes the stock market, so goes securities firms’ profitability. Industry profits are
strongly cyclical. Extended bull markets are good for profits, employment and growth;
crashes and downturns hurt trading volume and hence commission income (a mainstay of
revenue at most firms). Fewer firms seek to issue new equity during a bear market, and
debt issuance drops off as coverage ratios decline so underwriting income is also cyclical.
Both underwriting and brokerage income recovered dramatically in the 1990s after
dropping off precipitously subsequent to the 1987 crash. Profitability remained strong
with the bull market of the 1990s. Industry profits were at a record high $21 billion in
2000, but fell 50% in 2001. Reasons for the profit problems included the weak stock
market, the September 11, 2001 attacks, the drop in M&A activity, and the loss of
confidence by investors due to the many ethical violations by some corporations, bankers
and auditors. Profitability remained poor in 2002 at $6.9 billion, but increased in 2003,
hitting a record $22.5 billion and remained high at $19.5 billion in 2004 on large
increases in underwriting activity and hefty cuts in interest and operating expenses. ROE
for 2004 was 13.04%. Domestic underwriting activity was $3,358.3 billion in 2006.
Profits would have been up in 2005 but interest expense on financing securities
inventories increased as interest rates rose. Interest expense rose from $43 billion in
2003 to $136 billion in 2005 to almost $216 billion in 2006. Pre-tax profits fell to $17.6
billion in 2005 but recovered to $33.1 billion in 2006 due to additional revenue growth.
The year 2007 was as bad a year for these firms as it was for most of the financial
services industry due to the subprime crisis. UBS wrote down $10 billion of subprime
related assets in 2007. Likewise, Morgan Stanley wrote down $9.4 billion, Merrill Lynch
wrote down $5 billion. Two hedge funds of Bear Stearns collapsed and went bankrupt

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due to their subprime holdings as well. This was the setup to the Federal Reserve
assisted bailout of Bear in March 2008 where J.P. Morgan Chase agreed to purchase Bear
for $2 a share or $236 million.3 J.P. Morgan Chase also received guarantees on parts of
Bear’s mortgage portfolio.

In 2008 the industry reported net losses of $34.1 billion as revenues fell 38.7%.
Expenses fell as well particularly because with the lower interest rates, interest expense
declined. Trading and investment account losses for the industry were $65 billion. As a
result employment in the industry fell from 869,000 to 840,800. Employment kept
falling to 779,800 in September 2009. Profits rebounded sharply in 2009 reaching a
record $61.4 billion. Commissions, fee income and trading profits all rebounded and
interest expense remained very low as the Fed kept interest rates down. High profits
helped in rebuilding capital and efforts to raise external equity.

The years 2010 through 2012 brought many new challenges. The threat of a ‘fiscal cliff’
as U.S. government debt levels grew rapidly while Congress could not decide whether to
increase the debt ceilings, the problems in the Euro area, increasing regulations and
generally weak U.S. economic growth limited profitability for many firms. In May
2010 the ‘flash crash’ brought more scrutiny to trading activities as did the collapse in
October 2011 of MF Global along with the trading glitch at Knight Capital in August
2012. Pretax profits fell from 2010 levels of $34.8 billion to $10.6 billion in 2011 and
$12.4 billion in 2012. The fiscal cliff problem was resolved in January 2013 and after the
European Central Bank pumped about $1 trillion into euro area banks the euro crisis
subsided. In 2013, trading activity, and municipal bond and equity underwriting began to
grow once more and profitability improved.

b. The Balance Sheets

Selected major assets include: (2012)
 Receivables from other broker-dealers 26.19%
 Long positions in securities and commodities 24.38%
 Reverse repurchase agreements 34.21%

Selected major liabilities and equity include: (2012)

 Payables to other broker-dealers 14.23%
 Payables to customers 15.35%
 Short positions in securities and commodities 7.74%
 Repurchase agreements 45.83%
 Other nonsubordinated liabilities 7.56%
 Equity 4.68%

Securities firms finance much of their securities inventory used in market making with
repos. Notice the high levels of repurchase agreement liabilities. This is one reason why
the Fed reacted quickly to ensure liquidity to securities firms when the repo market
briefly ceased functioning on collateral worries during the subprime crisis. These firms
can hold lower capital than banks because they are subject to lower capital requirements
3
The sale price was subsequently raised when shareholders complained.

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and because their assets are more liquid than banks. Nevertheless, securities firms’
balance sheets are subject to high levels of both market and interest rate risk.

Non-commercial bank firms in this industry must maintain a minimum 2% capital ratio.
This level is probably too low for the risks they take. Indeed Bear-Stearns probably
failed because of its excessive leverage. During the crisis, these firms employed leverage
ratios greater than 30 to 1. This means if the firm loses 3% of the value of their assets,
they are bankrupt. Rumors of large losses at Bear in relation to their capital base led
investors to stop lending and forced a liquidity crisis and a lack of confidence that led to
the firm’s demise. J.P. Morgan Chase purchased the firm for $236 million even though
Bear’s offices in New York were valued at over $2 billion.

5. Regulation
The Securities Investor Protection Corporation (SIPC) insures losses of funds
deposited with securities firms up to $500,000 per investor in the event of the failure of a
securities firm. Losses to security values due to adverse market moves are not insured.

The daily activities of the securities industry are primarily regulated via the New York
Stock Exchange and the Financial Industry Regulatory Authority (FINRA). Thus, to a
large extent these firms are self-regulated according to rules promulgated by the SEC.
The Federal Reserve regulates margin requirements on stocks and occasionally suggests
rules changes involving securities trading and underwriting. Recently the Fed suggested
shortening securities settlement from the current three days to one day because securities
are often used as collateral for bank loans.

Since the passage of the National Securities Markets Improvement Act of 1996 removed
state oversight of securities firms, the SEC has the primary jurisdiction over securities
firms and sets standards for their activities. The SEC regulates underwriting and trading
activities and promulgates a series of rules such as Rule 144A regulating private
placements, Rule 415 allowing shelf registrations,4 etc. Under Rule 144A security
issuers may avoid the registration process (and the considerable expense) if they are sold
to a few qualified buyers. The buyers are typically institutional investors but certain high
net worth individuals can qualify. These securities may now be re-traded among the
qualified investors but may not be sold to the public.

Teaching Tip: Very few equities are privately issued; the private market is mostly for
debt. Privately placed debt issues will have lower flotation costs but often carry higher
interest rates.

In the early 2000s certain states began to take a much more active role in regulations of
the markets. Former New York State General Attorney Spitzer led in this process. These
prosecutions led to SEC rules changes to help ensure fewer conflicts of interests between
analysts and investment bankers and better methods of allocating IPO shares.
4
To help speed up the process issuers sometimes pre-register securities using a procedure termed a shelf
registration. After the registration is approved the issuer may then market the issue at any time within
the subsequent two years after filing a short form with the SEC that is normally approved within a day or
two.

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Investment bankers paid large fines as a result (fines totaled $1.4 billion, see Chapter 8).
In particular, analysts have been barred from attending/participating in the ‘road shows’
and may not receive compensation based on the amount of underwriting business the firm
generates. Within days of the settlement however, Bear Stearns allegedly violated the
new rules. Morgan Stanley allegedly withheld emails pertinent to hundreds of arbitration
cases, falsely claiming the email were lost in the September 11, 2001 terrorist attacks
when they were not.

Teaching Tip:
Interestingly, Bear Stearns (and I am sure the rest) had a very explicit code of ethics
requiring employees to treat customers fairly and to report all ethical violations. The
corporate culture on Wall Street, including compensation schemes, needs an overhaul.
Moreover, these violations matter. They impede growth by raising the cost of funds to
everyone. How much value was destroyed by unethical behavior of managers at Enron,
WorldCom, HealthSouth, Tyco, Parmalat, etc.? How much spillover to other firms’
stock prices occurred as a result of the loss of confidence in management? What did this
do to our cost of funds, or reliance on foreign funds if you prefer. What has/will this cost
us in the future in terms of costly contracting? Already a class action lawsuit against
bankers that underwrote WorldCom debt has resulted in payments of $6 billion by
bankers (with the largest payment of $2.85 billion by Citigroup). Citigroup also paid $2
billion to settle a class action suit over Enron and $75 million to settle a similar suit over
its involvement with Global Crossing. Citi has now instituted mandatory ethics training
for all employees.5 The long jail sentences that Ebbers (WorldCom CEO), Rigas
(Adelphia CEO), Dennis Kozlowski and others received should also help deter some of
the more egregious fraud schemes. I believe that at some point increased sentences may
be needed to rein in unethical investment banking practices as well.

The markets themselves have not been immune to scandal. In 1996 the SEC charged the
NASD (the regulatory body of the NASDAQ stock market) with ignoring evidence of
price fixing by NASDAQ market makers or dealers. The dealers were allegedly
colluding to keep bid-ask spreads artificially high by refusing to quote odd eighths and
blackballing dealers who did not comply (at that time many stock prices traded in
minimum increments of one eighth). The NASD agreed to spend $100 million to
improve rules enforcement. Subsequently, 30 brokerage firms agreed to pay $900
million to settle a civil suit alleging they engaged in price fixing of NASDAQ securities.
In 2003 the NYSE fined a trader of Fleet Specialist Inc $25,000 for front running. Front
running occurs when a specialist executes orders for their own account ahead of public
orders. The trader sold GM stock from the specialist’s own account on rumors of
accounting problems at GM ahead of a public sell order.

In July 2002, Congress passed the Sarbanes-Oxley Act seeking to improve corporate
governance and accounting oversight. This bill created an independent auditing oversight
board run by the SEC, increased penalties for corporate malfeasance, and gave
disgruntled shareholders more options to pursue lawsuits. The law restricts accounting

5
Citgroup data from “Evening Wrap Up, Citi Settles,” Mark Congoloff, The Wall Street Journal
Online, June 10, 2005.

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firms’ ability to provide non-audit services to audit clients and no longer allow the
AICPA to set accounting and auditing standards. These will be set by the Public
Company Accounting Oversight Board. The act requires that the CEO and CFO prepare
and sign a statement certifying the reasonableness of the firm’s financial statements. The
NYSE and the NASD have also changed their listing requirements with respect to
corporate governance. Details may be obtained from their websites (see the list of
websites at the end and in Chapter 8).

Anti-money laundering activities:

The USA Patriot Act added three new requirements to securities firms as of October
2003. The new rules included:
1. Firms must verify the identity of any person seeking to open an account.
2. Firms must keep records of the information used to verify the client’s identity.
3. Firm must determine whether the client appears on any lists of known or
suspected terrorists or terrorist organizations.

The industry is subject to Congressional oversight, but this usually takes the form of ex-
post investigations after problems have emerged. For instance, Goldman Sachs (GS) was
investigated by a congressional panel in 2010 concerning GS’ creation of mortgage
backed CDOs which they had shorted to limit their risk. GS was accused of knowingly
creating and selling risky mortgage investments after they knew they were likely to be
riskier than the rating indicated and put themselves in a position to profit from a decline
in the securities’ values. This is an obvious conflict of interest. Under the Dodd Frank
Act, the Financial Services Oversight Council (FSOC) has oversight of systemic risk of
the industry. More investment advisors will have to be registered with either the SEC or
state advisors. Securitization markets should now have more oversight and originators
will have to retain a greater interest in loans that will be resold. More derivatives
regulation over time can be expected as well. FINRA is increasing oversight and
reporting requirements for dark pools and for flash trading. As of this writing no formal
limits have been proposed on these activities but they are suspected to increase volatility
and of being used in market manipulation strategies.

The government can also mandate higher capital requirements for larger and for
interconnected firms. Government oversight of industry practices has increased as a
result of the bill. Executive compensation restrictions were also promulgated by the
Obama administration which tried to strengthen the independence of the compensation
committee from senior management. Shareholders now also have a non-binding vote on
executive compensation packages and Obama’s pay czar, Kenneth Feinberg, has a say on
executive pay for firms that accepted bailout money.

Teaching Tip:
Ask students whether limits on executive pay are appropriate or not. What would be the
pros and cons? The industry argues that they will be unable to attract top talent without
large performance type bonuses. Executive pay would seem to be very high however and
it is higher than is typical in much of the rest of the world. Many in the public would
argue that executives in firms that took taxpayer dollars have no business receiving any

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performance bonuses. AIG executives received bonuses even as the firm was on the
verge of bankruptcy.

The Scandals Continue

Date Firm/Principal Activity Settlement

Primary Global Soliciting information for inside Payment
January 2011
Research LLC, Bob trading
June 2012 Nguyen Bank
Barclays LIBOR manipulation $450 million
Peregrine Financial, Misallocating and misreporting usage
July 2012
Russell Wassendorf , of $215 million in client funds
December Goldman Sachs trader
Concealed $8.3 billion futures position
2012 Matthew Taylor $1.5 million
December Senior banker influenced analyst and
Morgan Stanley
2012 share allocation of Facebook IPO
December
UBS LIBOR manipulation
2012 $1.5 billion
December
HSBC Money laundering
2012 $1.9 billion
February 2013 Royal Bank of Scotland LIBOR manipulation $610 million
Bad mortgage practices origination
October 2013 J. P. Morgan
and sale $13 billion
Trade error in London cost firm $6
October 2013 J. P. Morgan
billion $920 million
October 2013 J. P. Morgan Excessive credit card charges $ 80 million
October 2013 J. P. Morgan Manipulating energy markets $410 million
December
Deutsche Bank Euribor manipulation
2013 $981 million
Bad mortgage practices origination
February 2014 Morgan Stanley
and sale $1.25 billion
Bad mortgage practices origination
July 2014 Citigroup
and sale $7.00 billion
July 2014 Lloyds Banking Group LIBOR manipulation $370 million
Sources: Text, Wall Street Journal and Bloomberg, various dates

This list is not complete. Charges of the same banks as involved in LIBOR fixing of
manipulating ISDAfix, a rate used for swaps, are also emerging as of July 2014. Also as
of this writing, evidence is emerging of allegations that the Bank of England, the British
central bank, knew of manipulations of currency rate quotes for as long as eight years
without taking action. The currency markets involve over $5.3 trillion in daily trading
volume.6 The SEC is investigating whether traders distorted prices for currency options
and exchange traded funds. Reports are emerging that traders shared information about
client orders in order to manipulate prices. As of June 2014 about 20 traders at the top
three banks (Deutsche, Citi and Barclays) involved in currency trading had been fired.
6
Carney Faces Grilling as Currency Scandal Snares BOE. Bloomberg, By Scott Hamilton and Suzi
Ring Mar 10, 2014 8:37 AM MT, http://www.bloomberg.com/news/2014-03-10/carney-faces-
leadership-test-as-currency-scandal-snares-boe.html.

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Teaching Tip:
These firms are regulated but we continue to have ethical problems. Ask students
whether regulations are sufficient to prevent these problems. If not, then what else
should be done? As of January 1, 2013 Dutch bankers are required by law to swear an
oath to act ethically, details can be found at:
http://www.nibc.com/investor-relations/dutch-banking-code.html. Should the U.S. do
something similar?

6. Global Issues
Investment banking activities are highly globalized. For instance, in 2012 Deutsche Bank
was the number one underwriter of convertible debt and mortgage debt. Foreign
transactions in U.S. stocks increased from $211.2 billion in 1991 to $12,037.9 billion in
2008. This represents a compound average annual growth rate of 26.85%. U.S.
transactions in foreign stocks increased from $152.6 billion in 1991 to $5,410.9; an
annual compound growth rate of over 23%. The financial crisis deterred the rate of
growth. In 2013 foreign transactions in U.S. stocks were $7,571.68 billion and U.S.
trading in foreign stocks was $3,969.5 billion. International offerings have also grown
rapidly, but recent scandals, the U.S. stock market weakness, disclosure requirements and
the decline in the value of the dollar has probably deterred foreign investors and foreign
issuers from participating in the U.S. markets. U.S. firms are seeking a greater presence
in fast growing markets such as China and India.

The financial crisis has increased the need for capital at banks. Many firms are now
engaging in strategic alliances with foreign partners. For instance, Morgan Stanley sold a
21% stake of its firm to Mitsubishi UFJ in 2008. Citigroup took a different tact and sold
some of its foreign businesses such as Nikko Asset Management and Nikko Citi Trust to
increase capital. The industry continues to restructure as a result of the crisis.

Teaching Tip: Investment bankers can help U.S. institutions gain exposure to
international markets. Banks have created structured derivative debt products that allow
an institution to earn higher overseas interest rates while limiting exchange rate risk.
Bankers can also sometime help improve the marketability of foreign bonds that are
difficult to sell because they are denominated in a foreign currency. Many U.S. financial
institutions are limited as to how much currency risk they can incur. Bankers have at
times securitized these foreign currency denominated bonds by placing them in a trust
and issuing dollar denominated claims to U.S. buyers.7 Hedge funds engage in risk
arbitrage strategies on a global basis. The most famous of these (or infamous), Long
Term Capital Management, engaged in risk arbitrage on an unprecedented global scale.

VI. Web Links

http://www.federalreserve.gov/ Website of the Board of Governors of the Federal

Reserve

7
These claims are usually overcollateralized to help limit exchange rate risk.

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http://www.wsj.com/ Website of the Wall Street Journal Interactive

edition. The web version of the well known
financial newspaper can be personalized to meet
your own needs. The Wall Street Journal Online
‘Scandal Scorecard’ provides readers with a fast
way to keep track of the large number of scandals
and what has happened to the players.

http://www.sifma.com/ The Securities Industry Association website.

Industry information, the SIA Factbook (other than
the current annual version) and discussions on key
industry issues may be found here.

http://www.sec.gov/ The Securities Exchange Commission

http://www.nyt.com/ The New York Times, from time to times the NYT
has excellent articles on financial topics.

http://www.tfibcm.com/ Thompson Reuters website. This site has the latest

updates on U.S. and global underwriting volume
and M&A activity.

http://www.nyse.com/ The website of the NYSE, exchange rules are

online.

http://www.nasdaq.com/ The National Association of Securities Dealers

website.

http://www.sipc.org/ The Securities Investor Protection Corporation

website.

VII. Student Learning Activities

1. Go to the website of the SIPC and summarize the answers to the ‘7 most
asked questions about the SIPC.’

2. At the NASD’s website, read the study outline for the Series 7 exam. What is
the purpose of the Series 7 exam? What are the seven critical functions of a registered
representative?

3. Go to the SIFMA website and read about the complexity of the new Dodd
Frank law. How many new regulations are proposed? Will this law help or hurt the
industry? Defend your answer.

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