1 Investment Banking Process and Profit Measurement Return on Assets ROA An indicator of how profitable a company is relative to its total assets Gives an idea as to how efficient management is at using its assets to generate earning Calculated by dividing a company s net income by total assets Return on Equity ROE The amount of net income returned as a percentage of shareholders equity Measures a corporation s profitability by revealing how much profit a company generates with the money shareholders have invested ROE Net Income Shareholders Equity 2 Investment Banking Organization and Types of Investment Banking Trading Investment banking is concerned with the following activities 1 Providing advice on new security issues Firms usually turn to investment banks for advice on how to raise funds by issuing stock or bonds or by taking out loans 2 Underwriting new security issues In underwriting investment banks typically guarantee a price to the issuing firm sell the issue in financial markets or directly to investors at a higher price and keep the difference known as the spread When groups of investments banks called syndicated underwrite large issues there is a syndicate sale The lead investment bank acts as a manager and keeps part of the spread and the remainder of the spread is divided among the syndicates members and brokerage firms that sell the issue to the public Once a firm has chosen the investment bank it will underwrite its securities the bank carries out a due diligence process during which it researches the firm s value Then prepares a prospectus which is all the information a potential investor may find relevant Then the investment bank goes on a road show involving visits to institutional investors such as mutual funds and pension funds that might be interested in buying securities 3 Providing advice and financing for mergers and acquisitions Investment banks advise both the buyers and sellers Typically investment banks take the initiative in contacting firms about potential purchases sales or mergers When advising a firm seeking to be acquired investment banks attempt to find a buyer willing to pay significantly more than the book value of the firm M A is particularly profitable because an investment bank does not have to invest its own capital The only significant costs are the salaries of the bankers involved 4 Financial engineering including risk management Financial engineering typically involves developing new financial securities or investment strategies using sophisticated mathematical models Investment banks use these financial engineering strategies such as derivatives to hedge risk by creating risk management strategies 5 Research Investment banks uses some of the research material compiled to identify merger or acquisition targets for clients and it makes some of the research material public through the financial media as research notes The opinions of senior analysts at large investment bans can have a significant impact on the market Some analyst specialize in offering opinions on the current state of the financial markets sometimes minute by minutes during the hours the market is open This information can be useful for investment bank trading desks 6 Proprietary Trading In 1990 proprietary trading or buying and selling securities for the bank s own account rather than for clients became a major part of the operations and an important source of profits for many investment banks 7 Repo Financing Investment banks borrowed to finance their investments in securities and their direct loans to firms Financing investments by borrowing rather than by using capital increases a bank s leverage Using leverage in investing is a double edged sword Profits from the investment are increased but so are losses 3 Various Types of Securities Risks and their emergence as an effect on markets and securities Proprietary trading exposes banks to both interest rate risk and credit risk 1 Interest rate risk If investment banks hold long term securities such as U S Treasury bonds or many mortgage backed securities the banks are exposed to the risk of an increase in market interest rates that will cause the prices of their long term securities to decline 2 Credit risk Is the risk that borrowers might default on their loans Many of the large investment banks were highly leveraged so when the financial market crashed many investment banks lost a lot of money They were forced to reduce leverage in a process know as deleveraging Another way investment banks were vulnerable during the financial crisis was because of the ways in which they financed their investments They borrowed primarily by either issuing commercial paper or by using repurchase agreements Repurchase agreements are short term loans backed by collateral Both are short term loans If the funds raised are used to invest in mortgage backed securities or to make long term loans investment banks face a maturity mismatch because the maturity of their liabilities is shorter than the maturity of their short term assets Maturity mismatch leaves investment banks vulnerable to bank runs Counterparty risk or the risk that the party on the other side of a financial transaction will not fulfill its obligations played in important role in the financial crisis 4 Major Legislative and major components impacts of those legislation Glass Steagall Act of 1933 Legally separated investment banking from commercial banking Also contained a provision for a system of federal deposit insurance If the federal government was going to insure deposits it should not allow banks to use the deposits to engage in what it saw as risky investments banking activities Graham Leach Bliley Act of 1999 Repealed the Glass Steagall Act It allowed commercial banks to participate in securities insurance and real estate activities Troubled Asset Relief Program TARP Allowed Goldman Sachs Morgan Stanley to become financial holding companies which are regulated by the Federal Reserve and eligible for discount loans through their bank subsidiaries Commodity Futures Trading Commission CFTC Regulates the futures markets Federal Deposit Insurance Corporation FDIC By reassuring depositors that they would receive their money back even if their bank failed deposit insurance effectively ended the era of bank panics in the United States On September 18 2007 the Fed began aggressively driving down short term interest rates by cutting its target for the federal funds rate the
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