How do they operate Commercial banks operate by financing investments primarily from deposits The banks make a profit through interest payments Commercial Banks Investment Banks Unlike commercial banks investment banks do not take in deposits Rather they have traditionally been involved in three major activities 1 Providing advice on new securities Investment banks have information about the current willingness of investors to buy different types of securities and the price that will likely be required of investors This information may be difficult and costly for firms to acquire on their own making this aspect of investment banks essential to firms to enable raising funds at the lowest cost 2 Underwriting new security issues The process of underwriting is one of the most important ways investment banks earn income The process works by investment banks guaranteeing a price of a security to an issuing firm and then reselling that same security for a higher price than they paid the issuing firm and keeping the difference Underwriting can lower information costs between lenders and borrowers because investment banks put their reputation behind the firms they deem to be profitable Note that the difference between the buying price and the selling price is called the spread Initial Public Offering IPO The first time a firm sells stock to the public Secondary seasoned Offering Security sales by a firm that has sold securities previously A single investment banks will typically underwrite small issues of stocks and bonds However for larger issues underwriting is typically handled by groups of investment banks called syndicates Each investment bank or syndicate caries out a period of concentrated research of an issuing firms value This process is called the due diligence process From this process a prospectus is generated which contains all information that potential investors might find relevant when deciding whether to invest with a firm Examples of info contained in prospectus Firms Profitability Firms Net Worth Risks Pending Lawsuits etc While waiting for the registration statement s SEC approval prospective investors may receive a preliminary prospectus called a red herring because the notice printed in red indicates the tentative nature of the offer The lead or originating investment banker and the syndicate members put together a selling group made up of themselves and a large number of brokerage firms And each member is responsible for selling a certain portion of the issue and is paid a commission on the securities it sells Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of securities Recall from chapter 3 one of the problems with individual investing is that it may be difficult to distinguish low risk borrowers from high risk borrowers Adverse Selection this issue applies to investment banks as well 3 Providing advice and financing for Mergers and Acquisitions Distinguishing Merger When two firms typically about the same size agree to go forward as a single new company rather than two separately owned and operated firms In this case the stocks of each individual firm are voided and new stocks are created for the newly created firm Acquisition Occur when one firm is bought out or acquired by another firm The purchasing firm in this case will clearly establish itself as the new owner and continue operation as it had Only the stock of the purchasing firm continues to be traded Investment banks provide advice to both the buyers and the sellers buy side mandate v sell side mandate Investment banks take the initiative in contacting firms about potential purchases sales and mergers The investment bank will estimate the value of the firm s assets minus liabilities and then can prepare negotiations Investment banks will always seek to match sellers with buyers who are willing to pay more than the book value of the firm As part of the advising process investments banks help arrange the financing of these deals Mergers and acquisitions are particularly profitable because the investment bank does not have to invest its own capital so the only real cost of the transaction is the salaries of the bankers involved More recently investment banks have become involved in other activities such as 1 Financial Engineering Risk Management Financial engineering is the process of designing and developing new financial securities and new investment strategies 2 Research Investment banks conduct several types of research on issuing firms to ensure they are legitimate The investment banks will then make some research material public through the financial media as research notes Analysts use the terms overweight for stock they recommend and underweight for stock they do not recommend Trading desk where traders buy and sell securities 3 Proprietary Trading the buying and selling of securities for an investment banks own account rather than for clients This is an important source of profit for many investment banks Leverage Financing investments by borrowing rather than using capital equity increase banks leverage Leverage ratio Value of assets Value of equity Repurchase agreements repos short term loans backed by collateral Ex an investment banks might borrow buy selling treasury bills to another banks and agrees to buy the treasury bills back at a later date for a slightly higher price representing interest This process is called repo financing Mutual Funds financial intermediaries that allow savers to purchase shares in a portfolio of financial assets stocks bonds mortgages money market securities etc Mutual funds offer savers the advantage of reducing transaction costs Provide risk sharing benefits by offering a diversified portfolio of assets and liquidity benefits so savers can easily sell their shares Money Market Mutual Fund a mutual fund that invests exclusively in high quality short term assets treasury bills negotiable certificates of deposit and commercial paper Have become a popular alternative to commercial bank checking and savings accounts for savers those typically pay lower interest rates Roll over risk the risk firms assume when using commercial paper to fund their operations when there may be difficulty selling new commercial paper when the existing commercial paper matures Finance Companies a non bank financial intermediary that raises money through sales of commercial paper and other securities and uses the funds to make
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