1 Investment Banking Process Profit Margin a b Investment Banking Financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions IB Main Activities i Providing advice on new security issues ii Underwriting new security issues iii Providing advice and financing on mergers and acquisitions iv Financial engineering and risk management v Research vi Proprietary Trading First three are central to IB while the last three have recently emerged c d Providing advice on new security issues i Firms usually turn to IB on how to raise funds by issuing stock or bonds or by ii taking out loans IB have info About the current willingness of investors to buy different types of securities and on the prices investors are likely to require iii This info would be difficult for firms to gather for themselves but is essential if they are to raise funds at a lower cost e Underwriting new securities i Underwriting an activity in which an investment bank guarantees to the issuing corp the price of a new security and then the resells the security for a profit IB typically earn 6 8 profit on IPO s and 2 4 on second offerings ii iii This is one way IB earn a profit iv Syndicates group of investment banks that jointly underwrite a security issue v Process to Underwriting 1 Once a firm chooses an IB IB engages in Due Process IB researches firms value IB prepares a Prospectus should contain all info about the firm that a potential investor would find relevant to making a decision to buy the firm s stocks or bonds including the firm profitability and net worth as well as risks associated with them such as pending laws IB conducts a road show involving visits to institutional investors who might be interested IB sets price of the stock 2 3 4 vi Underwriting can Lower info costs because IB put their reputation behind the firms they underwrite vii During 07 crisis investor confidence shaken when IB wrote mortgage backed securities that turned out to be poor investments f Providing advice and financing on mergers and acquisitions i IB take initiative in contacting firms about potential purchases sales or mergers ii iii IB attempt to find an acquiring firms to pay significantly more than the book value of the firm IB help arrange financing for firms raising funds who are raising funds by issuing stocks and bonds iv Advising on MAs are particularly profitable an IB bank does not have its own capital Only significant costs are the salaries of the bankers involved in the MA g Financial Engineering Risk Management i Financial Engineering process of designing new securities ii Develop new strategies by using sophisticated mathematical models Use these derivatives to hedge or reduce risk iii Construct risk management strategies for firms for a fee h Research i Proprietary Trading i IB analyst gather info on firms and sometimes visit a firms facilities and interview their managers i Proprietary Trading buying and selling securities for the banks own account rather than for clients ii Important source of revenue for IB iii Short term borrowing another important source of funds iv Leverage ratio of IB assets to its capital 1 By borrowing rather than using capital for proprietary trading increases 2 IB Organization Types of IB Trading a bank s leverage IB do not take in deposits so they must finance their investments in other ways IB Capital source of funds funds from shareholders plus profits bank has retained a b c When IB banks converted from partnerships to publicly traded corporations they began d Proprietary Trading buying and selling securities for the banks own account rather than to use proprietary trading for clients Important source of profit i ii Exposed to interest rate risk and credit risk e Short term borrowing Repurchase repo financing sell treasury bill and buy back in short period of time without interest and Commercial Paper short term loans backed by capital 3 Various Types of Security Risks Their Emergence as an Effect on Markets Securities a Interest Rate Risks Long term bonds or securities such as a U S Treasury bonds or mortgage backed securities that are exposed to the risk of an increase in market interest rates that will cause the prices of the long term securities to decline b Credit Risk Most significant risk that investment banks faced from proprietary trading c Credit Risk risk borrowers might default on their loans i Mortgage backed securities subprime or Alt A much higher risk than expected Many borrowers defaulted d Maturity Mismatch maturity of liabilities is shorter than the maturity of their assets i When banks use short term deposits to make long term deposits e Counter Party Risk played an important role in the 07 crisis f Counter Party Risk risk that the party on the other side of the financial transaction will not satisfy its obligations i EX AS investment banks suffered from heavy losses on mortgage backed securities lenders refused to buy their commercial paper or enter into repo refinancing agreements with them g Systematic Risk Risk to the entire financial system rather than to individual firms or investments h Roll Over risk in MMMF firms using commercial paper to fund their operations faced the risk that they might have difficulty selling new commercial paper when their existing commercial paper matured 4 Major Legislation Major Components Impact of the Legislation a Federal Reserve Act Divided US into 12 districts each with its own Fed Reserve Bank Required all national banks to join but gave state banks the option Allowed creation of the Federal Reserve b Glass Stegall Act legally separated investment banks from commercial banks c Graham Leach Bailey Act repealed glass Steagall act Authorized new financial holding companies which would permit securities and insurance firms to own commercial banks d TARP Troubled Assets Relief Program allowed financial holding companies to borrow from the Fed SEC regulate stock and bond market e Federal Deposit Insurance Corporation FDIC insured deposits in commercial banks f g Commodity Futures Trading Commission CFTC regulate futures markets h Too Big to Fail a policy under which the federal government does not allow large i financial firms to fail for fear of damaging the financial system Federal Deposit Insurance Corporation Improvement Act FDICIA created to counter the unfairness and increased moral hazard resulting from the too big to fail policy Deal with failed banks using a method
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