Investment Banking Demystified

Investment banks play an important role in the economy. They help to channel country's wealth into productive activities making economic growth possible, creating more jobs.

In recent times, their role and contribution to economic growth is being questioned post-financial crisis in 2008. Markets have become more regulated.

Many key stakeholders are brought together along with investors in the process of value addition. In the West, investment banks have roots since 17th century with Rothschild as one of the nascent names dealing in investment banking businesses.

The origin of investment banks in India can be traced back to 19th century when European merchant banks set up agency houses for new projects and provide finance for green field ventures. In 1967, with the objective to handle new capital issues, ANZ Grindlays bank set up a separate merchant banking. Citibank soon started rendering these services. Many foreign banks started entering the Indian market.

With huge capital base, global distribution and expertise, they were expected to dominate the Indian market. But these investment banks lacked local penetration. The Indian and foreign investment banks started entering joint venture where synergies played an important role in gaining the market share and profitability.

The investment bank play a custodian role in the issue management process. The top executives have to ensure that right set of information is furnished in compliance with SEBI. Their role in offering due diligence service is indispensable.

Here the question arises what are the objectives of investment banks. In contrast to commercial banks that lend money to corporations, investment banks rather raise it through IPO (Initial Public Offering). They also trade securities on behalf of clients. Their major roles comes in the form of advisors in M& A deals.

Investment banks act as intermediary and match sellers of securities with potential buyers of securities. The scope extends to capital market activities as they are involved in Private Placement, Venture Capital, Market Marking, Proprietary Trading, Underwriting, Financial Engineering, Clearing and Settlement, Financing and Money Management.

Investment bank products include Treasury bill, repurchase agreements, Mortgage Backed Securities, Bond Syndication and financial derivatives like options. The revenue mix of investment bank comes from five different sources - Commissions, underwriting revenue, interest, trading income and advisory from M&A deals.

The underwriting revenue includes the gross profits from underwriting security issues. The interest can be the margin interest when customers borrow against the value of the securities in order to finance purchase. Or interest from the investment accounts including repurchase agreements or reverse repurchase agreement Asset management fees from sale of mutual funds and management of portfolios. Another source of revenue is through the equity research.

Let us take the example of two US-based investment banks Morgan Stanley and Goldman Sachs. If we analyze their core competencies - areas of expertise that provide customer benefit which are hard to imitate and can be leveraged widely to many products. This can be extended to many markets and products. Both the banks have unique value proposition in terms of service offerings.

Morgan Stanley provides capital market services, investment insurance, banking related products and services on the global scale. Their client pool includes individual and institutional investors, business of all sizes, financial institution, and government agencies. Let's analyze the global investment bank Goldman Sachs. They offer wide range of services worldwide to a substantial and diversified client base that includes corporations and financial institutions, government and high net worth individuals.

Both investment banks offer wide range of services which includes raising capital and providing strategic advice simultaneously to the same client base. There is a practice of cross selling their services. If we look into their value system it is clear that client focus, excellence, integrity entrepreneurial spirit, teamwork and meritocracy tops the list.

Investment bank has a responsible financial role to play to make a world a better place and create value for customers. They can trade as a principal investor or as an agent. When involved in trade as principal investor so called proprietary trading the bank is either buying or selling for its own account. Acting as an intermediary they are involved in agency transaction. They have a role to play as a counter party. The investment bank stand willing to buy or sell the security and hence create a market. There is a great element of risk to their own capital even when they facilitate the client trade.

Some of their products include credit focused products which are further extended to trading and investing in credit derivatives, bank loans, high yield securities and municipal securities either in developed market or any other emerging market debt and other distressed debt and equity securities.

In addition to the above other products include interest rate products, including interest rate derivatives, global government securities and the money market instruments, currencies and currency derivatives commodities and commodity related derivatives.

The credibility of the investment banks have been questioned recently since they caused the financial crisis 2007-2009. The negative effects were felt globally resulting in unemployment and great loss to wealth. The complex structured instruments like CDS /CDO need to be used with robust risk management strategies because they operate in highly leveraged business model, capricious markets and there can be liquidity issues.