6.      INTERNATIONAL INVESTMENT BANKING   

 

Financial institutions may generally either operate as commercial banks or investment firms. The essence of commercial banking is the taking in of deposits from the general public and advancing loans or credits although many large commercial banks will now also provide a number of other financial services. Investment banking is principally concerned with raising capital for corporate bodies, governments or other organisations or institutions, market making and trading in securities, managing financial assets for various investors (especially institutional investors and mutual funds) and providing financial advice to private companies and governments. Commercial banking is money market and corporate and retail banking based with investment banking being securities and capital markets based.  

 

The distinction between these two principal types of financial activity is nevertheless not equally maintained in all countries. On Continental Europe, large universal banks can conduct commercial and security related activities from within the same corporate entity. Even in such other countries as the US and UK where separate subsidiaries are commonly used for each type of activity (either for legal reasons or simply as a matter of corporate practice), the distinctions are become increasingly unclear as many cross-sector products and services are developed.

 

The modern financial environment is now characterised by the emergence of increasingly large complex financial groups which are active in all major areas of financial business at the same time as financial products themselves are dissolving into essentially fungible and substitutable alternative and investment media.     

 

 

 

(1)    Investment Banking Business

 

In considering the nature of modern investment banking, the following main types of activities can be identified.

 

(i)   Equity and Debt Underwriting

 

Investment banks principally assist companies raise capital through the underwriting of issues of new equity or debt (bond) instruments. In acting as an underwriter in the issue of such securities, the investment bank undertakes to ensure that the company will receive the full issue price irrespective of whether the securities are bought by retail or other public investors or are left with the underwriter. The underwriter will receive a fee, commission or discount in return for the commitment to structure, manage and market the issue.

 

New issues of both debt and equities can either be structured through an initial public offering (IPO) or a private placement with the issue being sold on privately to a smaller group of institutional investors. Other options include Preliminary Prospectus Offerings (provisional price and coupon are set using exploratory documents) and Impact Day Offerings (public announcement of price and coupon with subscription being left open for a particular period.). These new issues are then initially sold to investors through the ‘primary market’ while the subsequent buying and selling of the securities being conducted in the ‘secondary market’.

 

(ii) Market Making and Trading

 

Market making involves undertaking to act as a broker or dealer for the purchase and sale of specific securities at all times. This ensures market trading and liquidity in all of the stock covered with the market makers generating profits from the differences in the values that the securities are bought and sold. Trading refers to the more general buying and selling of securities on the secondary market. This can either can be conducted as principal on the bank’s own account (proprietary or ‘prop desk’ trading) or as agent on behalf of one or more clients. Such dealing can then either be conducted on an instruction (execution only) or discretionary basis.

 

(iii)          Asset Management

 

Most investment banks provide asset management services, often on a discretionary basis, with the aim of generating the maximum return for their clients. The major users of asset management services are institutional investors (especially pension funds and insurance companies) and investment funds (mutual funds, unit trusts and investment trusts) which may either operate on an in-house or independent basis. The fund managers will charge a fee for management of the fund in addition to the broker’s commissions charged for each transaction carried out.

 

(iv)          Advisory Services

 

Investment banks will provide advice to governments on raising funds or to corporations on such matters as mergers and acquisitions, restructuring and privatisation. Corporate restructuring work may involve any major organisational changes or transfers of ownership including management buy-outs (MBIs), management buy-ins (MBIs), share repurchases, asset sales, divestitures, ‘spin-offs’ and other strategic reviews. With regard to privatisation work, the investment banks may either act as an adviser to the government or the privatised industry or entity on the privatisation and sale strategy to be adopted or on underwriting of the sale of the equities to the public.

 

(v) Trade Finance

 

Specialist banking services are traditionally concerned with the trade finance through the provision of bills of exchange for importers and exporters. These may, in particular, involve accepting the bills (adding the bank’s credit to the bill through endorsement) or discounting (purchasing the bills less a discount calculated having regard to the outstanding time before payment is due on the bill). Trade finance also includes providing letters of credit or any other form of trade related finance such as forfaiting.

 

Since the 1980s, investment banks have also become involved in a number of other more specialist areas including, ‘project finance’ (the arrangement of large and complex financial packages for infrastructure projects such as airports, bridges and power stations), ‘structured finance’ (the design and implementation of sophisticated and tax efficient financial packages such as securitization), and ‘private finance initiatives’ (specific arrangements launched by the government in the UK to raise private-sector funds for public-sector capital projects such as schools, hospitals or museums).

 

 

(vi) Foreign Exchange and Financial Derivatives

 

Investment banks will be engaged in foreign exchange trading either for their own account or on behalf of client positions. They are also often key players in the financial derivatives markets in designing and setting-up one-off OTC products or in dealing in OTC or exchange traded products for hedging or speculative purposes and either for their own or client account purposes.

 

(vii)         Prime Brokerage

 

Many investment banks act as prime brokers on behalf of other financial institutions such as hedge funds. Prime brokerage involves the provision of a range of completion services not involving trade execution directly. Prime brokers are principally responsible for the clearing and settling of executed trades although they may also act as central global custodians on behalf funds as well as provide other margin financing (lending against the collateral of the securities purchased) and stock lending services (providing securities to market counterparties for short periods of time such a for short selling). Prime brokers may provide other research, reporting or reconciliation services.

 

(viii)        Other Activities

 

Apart from the principal activities discussed above, investment banks may generate income through gold or commodities trading, such as in oil or gas, either directly or through derivatives contracts. Investment banks have often become involved more recently in other activities such as insurance broking, life assurance, leasing, property development and real estate agency. These may be conducted through separate subsidiaries. With these new areas of business and the growing overlap between investment and commercial banking activities, the traditional distinctions between these types of firms are becoming less important.

 

(2)    Development of Investment Banking

 

In terms of historical development, a number of principal types of investment banks or banking can be identified. These include US investment banks and brokerage houses, British merchant banks, Continental European universal banks and Japanese securities houses. A number of these have already been referred to.

 

 

 

(i)   US Investment Banks and Brokerage Houses

 

The legal separation between commercial banking and investment banking in the United States originated under the Glass-Steagall Act of 1933 (or more specifically the provisions of the Banking Act 1933 sponsored by Congressman Carter Glass and Henry B Steagall). This separation resulted in the creation of a number of leading investment banks such as Morgan Stanley, Lehman Brothers, Kuhn Loeb & Co (acquired by Lehman Brothers in 1977), and Dillon Read (later SBC Warbugh Dillon read and then part of UBS) which dominated during the Wall Street in 1940s and 1950s. The pre-eminence of these firms in the securities underwriting business was then challenged in the 1960s by other leading brokerage houses and newly formed investment banks such as Merrill Lynch, Salomon Brothers and Goldman Sachs.

 

The abolition of the New York Stock Exchange’s fixed brokerage commission rates on 1 May 1975 subsequently led to a number of further amalgamations between brokers and the emergence of a more limited number of large leading firms and set of smaller ‘boutique’ houses. Since 1980s, the larger Wall Street investment banks attempted to expand their international operations partly due to the further deregulatory eventsin other major financial centres across the world and significant growth in international capital market activity. By the late 1990s, most of the firms had established presences in all of the main financial cities across the world as well as in the leading emerging markets. Further consolidations have also since taken place between the Wall Street investment banks and between the banks and brokerage houses which has allowed a considerably more comprehensive and complementary range of services to be provided.

 

A two-tier hierarchy has also emerged among the leading US investment banks dominated by a limited number of firms with strong US capital markets and corporate finance operations and large US securities retail capacities as well as extended global operational networks. These were referred to as ‘bulge-bracket’ firms and the first to be listed on a public ‘tombstone’ announcement of a major securities issue. The largest Wall Street investment firms before the 200 crisis were (in order of size and influence) Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. Bear Stearns was acquired by JP Morgan Chase in March 2008 and Merrill Lynch by Bank of American on 14 September 2008. Lehman Brothers was forced to file for bankruptcy on 15 September 2008 with Goldman Sachs and Morgan Stanley reregistering as bank holding companies which ended the dominance of Watt Street by powerful independent investment banks.         

 

As the investment banking industry has continued to consolidate again after the financial crisis, the separation between the investment banking and commercial banking has again broken down further as increasingly large complex groups have emerged that have significant presences in both areas. This was specifically facilitated with the adoption of the Financial Services Modernization Act in 1999 (sponsored by Phil Gramm, Jim Leach and Thomas J Bliley) which allowed firms from more than one key financial sector to be owned by new Financial Holding Companies (FHCs). The most notable restructuring that occurred in anticipation of this relaxation of the ownership rules in the US was the merger in 1998 between the international commercial bank Citicorp and Travellers Group owner of Salomon Smith Barney. Continuing consolidation within the US financial industry is expected while the authorities have adopted a number of further re-regulatory measures following the financial crisis and especially with the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (renamed after Barney Frank, Chairman of the House Financial Services Committee and Chris Dodd, Chairman of the Senate Banking Committee).   

 

(ii) British Merchant Banks

 

British merchant banks have historically specialised in trade finance areas including the provision of bills of exchange and letters of credit facilities for merchants engaged in international trade. (Letters of credit allowed merchants to purchase goods abroad using correspondent banks on each side who would exchange the bills of lading (carrying legal title to the goods) for payment on behalf of their clients which ensured quality of the goods and security of payment.) Trade finance developed during the nineteenth and early twentieth centuries at a time when the international trade was denominated in sterling and London was the main centre for international finance. With the expansion of the international economy in the nineteenth century and an enormous demand for the transfer of capital from European savers to borrowers in the Americas, Asia and elsewhere, the British merchant banks began to offer international bonds into the London capital markets. The main objective of these new securities was to fund overseas governments as well as railway and other large project financing. Early forms of asset management and investment as well as and corporate finance were also developed in the early twentieth century.

 

Despite of the strength of the British merchant banks during 1960s and early 1970s, they failed to develop a leading position in the expanding Eurobond and Eurocurrency markets in 1970s mainly due to the competition from the larger and more dynamic US investment banks. Their position was also affected by the deregulation of the London Stock Exchange between 1983 and 1986 which permitted the entry of foreign firms into the UK markets by relaxation of the earlier restrictions on ownership of Stock Exchange firms. By the late 1980s, the top of the British merchant banks consisted of a number of leading independent firms including Barings (purchased by ING in 1995 after suffering £827 losses of by Nick Leeson in Singapore), Flemings (sold to Chase Manhattan in 2000), Hambros (sold to Société Generale in 1998), Kleinwort Benson (acquired by RHJ International following a forced disposal by Commerzbank in 2009 which had earlier purchased Dresdner Kleinwort), Morgan Grenfell (bought by Deutsch bank in 1990), NM Rothschild & Sons, Schroders and S G Warburg & Co (acquired by Swiss Bank Corporation in 1995) and divisions of the main UK clearing banks such as Barclays and Royal Bank of Scotland (which acquired NatWest in 2000).

 

Although a further boom in international investment banking was experienced in the 1990s, the British merchant banks were not able to realise the full potential benefits of this growth. Five of the top independent merchant banks were then acquired by foreign banks and any ambition of competing with the US bulge-bracket firms in the global investment banking market place was abandoned. By the beginning of the 21st century, the UK investment banking industry only comprised three major independent firms with Flemings, Rothschilds and Schroders with Flemings acquired by Chase Manhattan in 2000 (which also merged with JP Morgan & Co in 2000 to create JP Morgan Chase).

 

(iii)          Continental European Universal Banks

 

On Continental Europe, the historical practice is that of ‘universal banking’ which allows commercial and investment banking to be combined with no restrictions being imposed on the conduct of securities business by such institutions. The leading European investment banks now include such large operators as Deutsche Bank, Banque Paribas, Credit Suisse. As one of original developers of international investment banking services, Banque Paribas formed an early alliance with the London merchant bank Warburgs in 1973. Other major continental European banks have also subsequently strengthened their presence in London through the acquisition of British merchant banks taking specific advantage of the relaxation of the ownership rules with the deregulation of the Stock Exchange in 1986.

 

By the late 1980s and early 1990s, European banks had expanded their securities activities across the Continent and into Asia with the deregulation of the continental bourses and the opening up of the Tokyo Stock Exchange. In spite of this, most European banks experienced great difficulty in establishing any significant presence on Wall Street with only four major banks being able to develop any substantial expertise in the US, Credit Suisse, UBS, Deutsche Bank and Schroders.

 

(iv)          Japanese Securities Houses

 

A strict legal separation of commercial and investment banking was also adopted in Japan on a US model after the Second World War. The domestic business was then dominated by the ‘Big Four’ securities firms of Nomura, Daiwa Securities, Nikko (later Nikko Cordial under Citigroup) and Yamaichi Securities (later closed down in 1999). Japanese securities houses were able to expand substantially in the 1980s especially with the growing use of the capital markets by corporate borrowers. They had also secured become highly successful in London and New York until a turn around in economic conditions in the 1990s led to the collapse of several large securities houses including Yamaichi. Financial crisis and scandals as well as a stagnant deflationary economy have subsequently restricted any substantial expansion of the Japanese securities industry until recently.

 

 

 

(3)    International Investment Banking and the Financial Crisis

 

International investment banking had grown substantially immediately before the global financial crisis. This had been referred to as being a period of ‘Great Moderation’ or ‘Great Stability’. Investment banking had become a global business with the cross-border and complex nature of modern international capital market activity. Margins had earlier become increasingly tighter and business more competitive although the massive levels in global liquidity that arose especially with the recycling of Asian surplus assets lead to huge expansion in activity. This had been particularly noticeable in a number of specialist also market sectors including structured finance, with the growth in the use of CDSs, CDOs and CLNs and other structured products. This expansion ended with the contraction in global interbank credits which began in summer 2007 and led to the closure of many structured finance markets. Bear Stearns had to be purchased by JP Morgan Chase in February 2008 with Bank of America acquiring Merrill Lynch in September 2008 following the closure of Lehman Brothers 15 September 2008 (above). As noted, the other two largest Wall Street investment firms, Goldman Sachs and Morgan Stanley, were forced to be registered as bank holding companies to obtain Federal discount window lending facilities. This led to the demise of international investment banking as an independent sector with most of this activity now been carried on within universal banks or larger banking and financial groups. 

.