The Business of Investment Banking: A Comprehensive Overview

By K. Thomas Liaw

A comprehensive overview of investment banking for professionals and students

The investment banking industry has changed dramatically since the 2008 financial crisis. Three of the top five investment banks in the United States have disappeared, while Goldman Sachs and Morgan Stanley have converted to commercial banking charters. This Third Edition of The Business of Investment Banking explains the changes and discusses new opportunities for students and professionals seeking to advance their careers in this intensely competitive field.

The recent financial regulation overhaul, including the Dodd-Frank legislation, is changing what investment banks do and how they do it, while the Volcker rule has shaken up trading desks everywhere.

• This new edition updates investment banking industry shifts in practices, trends, regulations, and statistics
• Includes new chapters on investment banking in BRIC countries, as Brazil, Russia, India, and China now account for a quarter of the global economy
• Explains the shift in the listing of securities away from New York to various financial centers around the world, and how major exchanges compete for the same business

This new edition, reflecting the current state of the investment banking industry, arrives in time to better serve professionals wanting to advance their careers and students just beginning theirs.

• Language: English
• Publisher: Wiley
• Release date: Oct 4, 2011
• ISBN: 9781118127650

Book preview

CHAPTER 1

INTRODUCTION TO INVESTMENT BANKING: HOW THE FINANCIAL CRISIS AND REFORMS CHANGED THE INDUSTRY

The investment banking market has experienced dramatic changes since 2008. Three of the top five investment banks in the United States have disappeared, while Goldman Sachs and Morgan Stanley have converted to commercial banking charter. The bankruptcy of Lehman Brothers has also brought about unprecedented quantitative easing in monetary policies in many countries. Recent financial regulation overhaul will have significant impact on what investment banks do and how they operate those activities. The Volcker rule will shake up trading desks. Investment banks such as Goldman Sachs, Morgan Stanley, JPMorgan, Deutsche Bank, and Credit Suisse have reshuffled proprietary trading. Therefore, the investment banking market is very different today.

THE NEW INVESTMENT BANKING

One important lesson from the financial crisis is the need for more effective regulation. The recent financial reform legislation, most notably the Dodd-Frank bill, aims at setting standards for financial operations and preventing another crisis. The reforms focus on several essential areas. The first is to end ``too big to fail.'' Taxpayers should not be protecting the shareholders and bondholders of even the most systemically important financial firms. Instead, these firms should be required to structure themselves so that they can be recapitalized without taxpayer money, and before local problems can spiral into a systemic crisis. Second, financial firms are required to practice consistency. Regulators should require that all assets across financial institutions be similarly valued. Within each financial firm, there needs to be greater consistency and rigor in the way assets are valued and accounted for. Firms should no longer be allowed to move risk around to areas where it will be less rigorously monitored or more generously valued. Third, the regulatory system has more dynamic regulation. Across the board, the regulatory system should be comprehensive and strong enough to identify and constrain excesses in markets, before they can threaten the broader economy.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) is a comprehensive regulatory overhaul. Certain portions of the Act were effective immediately; other portions follow an extended transition period. Implementation of the Act will be accomplished through numerous rulemakings by multiple governmental agencies. The Act also mandates the preparation of studies on a wide range of issues, which could lead to additional regulatory changes.

In addition, legislative and regulatory initiatives continue outside the United States that will affect investment banking business. Basel III, the new global regulation on bank capital adequacy and liquidity, introduces new capital, leverage, and liquidity standards. It is designed to improve the banking sector's ability to deal with financial and economic stress. A provision of the Dodd-Frank Act (the Volcker rule) will over time prohibit investment banks from engaging in proprietary trading. The rule will also require banking entities to either restructure or unwind certain relationships with hedge funds and private equity funds. The rule is expected to become effective in July 2012, and banking entities will then have a two-year period to come into compliance with the Volcker rule.

Through the Dodd-Frank Act, investment banks face a comprehensive regulatory regime in over-the-counter derivatives. The regulation of swaps and security-based swaps in the United States will be effected and implemented through the CFTC, SEC, and other agency regulations. The Act requires central clearing of certain types of swaps and also mandates that trading of such swaps be done on regulated exchanges or execution facilities. As a result, investment banks will have to centrally clear and trade on an exchange or execution facility certain swap transactions that are uncleared and executed bilaterally. The Act further requires registration of swap dealers and major swap participants with the CFTC and security-based swap dealers and major security-based swap participants with the SEC.

Investment Banking Business

Investment banks engage in public and private market transactions for corporations, governments, and investors. These transactions include mergers, acquisitions, divestitures, and the issuance of equity or debt securities, or a combination of both. Investment bankers advise and assist clients with specialized industry expertise. The industry or sector grouping often includes industrial, consumer, health care, financial institutions, real estate, technology, media and telecommunications, and others. As noted throughout the book, investment banks today go far beyond investment banking to also include other securities businesses such as trading, securitization, financial engineering, merchant banking, investment management, and securities services. For those activities, investment banks earn fees, commissions, and gains from principal transactions.

Investment banking includes capital raising and merger and acquisition (M&A) advisory services. Investment banks help clients raise capital through underwriting in which investment banks purchase the whole block of new securities from the issuer and distribute them to institutional and individual investors. For the service, investment bankers earn an underwriting spread, the difference between the price they receive from investors and the amount they pay to the issuing firm. The underwriting spread has been in the range of 6 to 7 percent of the total proceeds raised for equity offerings. The competitive pressure has forced bankers to charge less, especially for a large deal in which the spread could go much lower. In debt offerings, the spread is much lower, often less than 100 basis points. Several chapters in this book describe the relevant regulatory issues and the processes investment banks and issuers go through to offer the new securities.

Another major line in investment banking is strategic advising on mergers and acquisitions. Services offered include structuring and executing domestic and international transactions in acquisitions, divestitures, mergers, joint ventures, corporate restructurings, and defenses against unsolicited takeover attempts. Fees are usually negotiable. As the size of transactions gets larger and larger, the M&A advisory fees are generally less than 100 basis points and often much lower. M&A bankers still take in large sums of money, as the value of transactions grows larger. This line of business is attractive, because, win, lose, or draw, bankers earn fee income.

Other Securities Businesses

Full-service investment banks offer a service menu that goes beyond just investment banking. Principal transactions have accounted for a very significant portion of total net revenues at many Wall Street houses. These transactions include proprietary trading and merchant banking. In proprietary trading, the investment bank trades on its own capital. Under the Dodd-Frank Reform Act, investment banks are permitted to operate proprietary trading only on a restricted and limited basis. Merchant banking invests the firm's own capital as well as funds raised from outside corporate and real estate investors.

Investment management is an integral part of investment banks. Major houses such as Morgan Stanley, Goldman Sachs, and JPMorgan each manage hundreds of billions of dollars for their clients. This is an attractive segment of the financial services industry. The income stream is less volatile than trading or underwriting and, hence, contributes to the stability of earnings.

Another line of business is securities services that include prime brokerage, securities lending, and financing. Prime brokerage offers tools and services desired by clients looking to support their operations in trading and portfolio management. In security lending services, investment banks find securities for clients to make good delivery so as to cover their short positions. Alternatively, financing services provide funds to finance clients’ purchases of securities.

CAUSES OF THE FINANCIAL CRISIS

During the recent global financial crisis, the world stock markets declined, large financial institutions collapsed or were bought out, and governments in even the wealthiest nations had to come up with rescue packages to bail out their financial systems. In its reports, the Financial Crisis Inquiry Commission concluded that factors contributing to the financial crisis included widespread failures in financial regulation, dramatic breakdowns in corporate governance, excessive borrowing and risk-taking by households and Wall Street, the poor preparation of policy makers for the crisis, and systemic breaches in accountability and ethics at all levels. The following lists the commission's principal findings.

This financial crisis was avoidable. The crisis was the result of human action and inaction. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.

There were widespread failures in financial regulation and supervision that proved devastating to the stability of the nation's financial markets.

Dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis. There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding.

A combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. Clearly, this vulnerability was related to failures of corporate governance and regulation, but it is significant enough by itself to warrant our attention here.

The government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. As part of our charge, it was appropriate to review government actions taken in response to the developing crisis, not just those policies or actions that preceded it, to determine if any of those responses contributed to or exacerbated the crisis.

There was a systemic breakdown in accountability and ethics. The integrity of our financial markets and the public's trust in those markets are essential to the economic well-being of our nation. The soundness and the sustained prosperity of the financial system and our economy rely on the notions of fair dealing, responsibility, and transparency. In our economy, we expect businesses and individuals to pursue profits, at the same time that they produce products and services of quality and conduct themselves properly.

Collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis. When housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street. This report catalogues the corrosion of mortgage-lending standards and the securitization pipeline that transported toxic mortgages from neighborhoods across America to investors around the globe.

Over-the-counter derivatives contributed significantly to this crisis. The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis.

The failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seals of approval. Investors relied on them, often blindly. In some cases, investors were obligated to use them, or regulatory capital standards were hinged on them. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.

THE DODD-FRANK ACT AND THE VOLCKER RULE

The purpose of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) is to … promote the financial stability of the United States by improving accountability and transparency in the financial system, to end too big to fail, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. In addition, the Volcker rule imposes restrictions on proprietary trading for banks.

The Dodd-Frank Act

The Dodd-Frank Act significantly restructures the regulatory regimes under which investment banks operate. The implications of the Act on investment banks depend on the provisions of future rulemaking by the Board of Governors of the Federal Reserve System, the SEC, the Commodity Futures Trading Commission (CFTC), and other agencies, as well as the development of market practices and structures under the regime by the legislation and the rules adopted. However, the principal impacts on investment banks include:

The prohibition on proprietary trading and the limitation on the sponsorship of, and investment in, hedge funds and private equity funds (the Volcker rule).

Increased regulation of and restrictions on over-the-counter derivatives markets and transactions.

The Dodd-Frank Act, enacted in July 2010, significantly alters the framework within which investment banks operate. Under the Act, the newly created Financial Stability Oversight Council (FSOC) oversees and coordinates the efforts of the primary U.S. financial regulatory agencies in establishing regulations to address financial stability issues. The act directs the FSOC to make recommendations to the Federal Reserve Board as to supervisory requirements and prudential standards. Those include risk-based capital, leverage, liquidity, and risk management. The Act mandates that those standards be more stringent for systematically important financial institutions than for other financial companies.

The Act contains derivative pushout provisions that prevent investment banks such as Goldman Sachs and Morgan Stanley from conducting swaps-related activities through their insured depository institution subsidiaries. There are exceptions for certain interest rate and currency swaps and for hedging and risk mitigation activities directly related to banking business.

The Act also calls for the imposition of expanded standards of care by market participants in dealing with clients and customers. It provides the SEC with authority to adopt rules establishing fiduciary duties for broker-dealers and directs the SEC to examine and improve sales practices and disclosure by broker-dealers and investment advisors. The Act also contains provisions designed to increase transparency in over-the-counter derivatives markets by requiring registration of all swap dealers, and the clearing and execution of swaps through regulated facilities. Under the Act, federal banking agencies are required to develop rules whereby anyone who organizes or initiates an asset-back security transaction must retain a portion, generally at least 5 percent, of the credit risk.

Volcker Rule

The Volcker rule prohibits proprietary trading (other than certain risk mitigation activities) and limits the sponsorship of, and investment in, hedge funds and private equity funds by banks. Proprietary trading, defined mainly as engaging in short-term trading, is subject to several exceptions that allow a banking entity significant leeway to engage in some short-term trading, including trading:

In U.S. government, state, and municipal obligations

In connection with underwriting or activities related to market-making

In connection with certain risk-mitigating hedging activities

In any security or instrument on behalf of customers

The exception for regulation on hedge funds and private equity funds is for funds that are organized or offered by the banking entity, subject to:

The banking entity owning no more than 3 percent of the fund

An overall limit of 3 percent of the entity's Tier 1 capital invested in private funds

CONCLUSIONS

This chapter reviewed the causes of the financial crisis and the subsequent regulatory reforms afterward. The chapter also discussed the changing environment under the new regulatory regime, including capital requirements, leverage, proprietary trading, and hedge funds and private equity funds–related operations.

CHAPTER 2

NEW INVESTMENT BANKING STRUCTURE: FINANCIAL HOLDING COMPANIES, FULL-SERVICE, AND BOUTIQUE INVESTMENT BANKS

Full-service investment banks offer cli-ents a range of services including underwriting, merger and acquisition advice, trading, merchant banking, and prime brokerage. Goldman Sachs and Morgan Stanley are examples of such investment banks. Some of the large financial holding companies such as Citigroup, HSBC, Credit Suisse, JPMorgan Chase, Bank of America, and Nomura operate full-service investment banking as well. These financial holding companies have a major advantage over other investment banks because they can offer clients large sums of credit. All these large, full-service investment banks are known as the Wall Street bulge bracket. The so-called boutique investment banks specialize in particular segments of the market. This chapter describes the lines of business offered by those institutions.

TYPES OF INVESTMENT BANKS

There are two basic types of investment bank: full-service and boutique. Full-service institutions engage in all kind of activities, including underwriting, trading, merger and acquisition (M&A), merchant banking, securities services, investment management, and research. In contrast, boutique houses focus on particular segments. Some specialize in M&As, some in financial institutions, and some in Silicon Valley business.

Before the Gramm-Leach-Bliley Act of 1999 (GLB), there were large full-service investment banks and smaller boutiques that specialized in a particular segment of the market. Section 20 of the Glass-Steagall Act of 1933 prohibits the affiliation of a member bank of the Federal Reserve System with a company that is engaged principally in underwriting or dealing in securities. In 1987, the Federal Reserve Board of Governors interpreted that phrase to allow bank subsidiaries—so-called Section 20 subsidiaries or underwriting subsidiaries—to underwrite and deal in securities. The Board approved applications by three bank holding companies to underwrite and deal in Tier 1 securities, such as commercial paper, municipal revenue bonds, mortgage-backed securities, and securities related to consumer receivables. In 1988, the Board approved applications by five bank holding companies to underwrite and deal in Tier 2 securities (all debt and equity securities).

Initially, a Section 20 subsidiary could not derive more than 5 percent of its total revenue from activities involving bank-ineligible securities. The Board increased the limit to 10 percent of total revenue in 1989 and raised it to 25 percent in 1997. Finally, with the passage of the GLB, the limit was effectively eliminated. Under the Act, a bank holding company that elects to become a financial holding company may engage in securities underwriting, dealing, or market-making activities through its subsidiaries (called securities subsidiaries).

The GLB has enabled a financial services firm such as a commercial bank or a securities house to become a one-stop shop that can supply all its customers’ financial needs. By allowing banks, insurance companies, and securities firms to affiliate with each other, the Act has opened the way for financial services supermarkets that offer a vast array of products and services including savings and checking accounts, credit cards, mortgages, stock and bond underwriting, insurance (homeowners, auto, and life), mergers and acquisitions advice, commercial loans, derivative securities, and foreign exchange trading.

The GLB has not only opened up new opportunities for banks but has also provided significant protection for investors and consumers while striving to create a level playing field for all financial services firms. It established a new system of functional regulation, whereby banking regulators oversee banking activities, state insurance regulators supervise insurance business, and securities regulators supervise securities activities. In this new regulatory environment, investment-banking houses are able to offer a full menu of financial services to meet client demand. At the same time, commercial banks can engage in formerly forbidden activities such as stock underwriting and dealing. Citigroup, JPMorgan Chase, Bank of America, HSBC, Deutsche, UBS, and ICBC all operate under this format.

The traditional full-service firms like Goldman Sachs and Morgan Stanley offer clients a full menu of investment banking services. Niche players are smaller in general, but are creative in specializing in a particular type of client or service. Sandler O’Neill works on the financial institutions segment. Lazard specializes in asset management and mergers and acquisitions.

FINANCIAL HOLDING COMPANIES

Large financial holding companies now include investment banking in their menu of services. Under the universal banking scheme, large banks in Europe and Japan have operated in commercial banking and investment banking. In the United States, since the Gramm-Leach-Bliley Act of 1999 took effect, investment banking has become an integral part of their businesses. Furthermore, these global financial holding companies all have operations in most financial centers and are competing on nearly every continent of the world. The advancement of technology has enabled these financial services giants to offer a complete menu of services on a global basis. Table 2.1 provides a summary of business categories that form major financial holding companies.¹

Table 2.1 Business Categories of Financial Holding Companies

Table 2-1

HSBC Holdings PLC

The HSBC Group provides personal banking, business and commercial banking, global banking and markets, and private banking. It has operations in Europe, Asia-Pacific, the Americas, the Middle East, and Africa. The slogan of its marketing campaign The world's local bank emphasizes that it has local knowledge along with international experience and expertise.

Investment banking services provide tailored financial solutions to major government, corporate, and institutional clients. They segregate clients by sector, and their service teams combine relationship managers and product specialists to develop financial solutions to meet individual client needs. Services include capital raising, corporate finance and advisory services, as well as project and export finance. Capital raising includes debt and equity capital, structured finance, and syndicated finance. In corporate finance and advisory services, HSBC offers services in the fields of mergers and acquisitions, stock exchange listings, privatizations, and capital restructurings. Project and export finance services provide non-recourse finance to exporters, importers, and financial institutions.

Deutsche Bank

Deutsche Bank groups its products and services into Corporate and Investment Banking and Private Clients and Asset Management. Deutsche Bank's investment banking operates under the Corporate and Investment Banking division. Corporate and Investment Banking provides equities, fixed income, foreign exchange, commodities, corporate finance, asset finance and leasing, cash management, trade finance, and trust and securities services. The Private Clients and Asset Management comprises Deutsche Bank's investment management business for both private and institutional clients, together with its traditional banking activities for private individuals and small and medium-sized businesses. Asset Management comprises four businesses: the retail mutual funds business (DWS Investments), alternatives (RREEF Alternative Investments), institutional asset management (DB Advisors), and asset management for insurance companies (Deutsche Insurance Asset Management). Private Wealth Management serves high net worth individuals and families worldwide. It provides these clients with a fully integrated wealth management service, encompassing portfolio management, tax advisory, inheritance planning, and philanthropic advisory services.

UBS AG

UBS is a global financial services firm serving a diverse client base that includes affluent individuals, corporations, institutions, and governments. Its business segments include Wealth Management, Asset Management, Investment Bank, and Banking in Switzerland.

UBS Investment Bank provides securities products and research in equities, fixed income, rates, foreign exchange, and metals. It also provides advisory services as well as access to the world's capital markets. UBS Investment Bank services its clients’ needs through investment banking, equities, fixed income, interest rates, and currencies. The specific services provided to each target clientele are:

Corporations: Covers M&A, equity, and debt capital markets.

Institutions: Provides equities, fixed income, interest rate and foreign exchange, research, sales, trading, execution, and eCommerce services.

Hedge funds: Offers prime brokerage services of global clearing, custody, financing, and full accounting support, as well as access to its foreign exchange and fixed-income platforms. It provides settlement and clearing of securities and cash balances for all transactions in more than 30 markets. UBS's integrated back office provides hedge funds access to a full range of operational and financing options through a single point of contact, allowing hedge funds to operate all over the world.

Governments: Offers governments and central banks services in raising capital and privatization.

Bankers, brokers, and advisors: Serves as bank for banks. It offers banks, brokers, and advisors its global infrastructure to enhance efficiency gains and improve client service without the associated development costs.

Citigroup

Citi is organized into two major segments: Citicorp and Citi Holdings. Citicorp has two major divisions, including Regional Consumer Banking and Institutional Clients Group. Citi Holdings is divided into Brokerage and Asset Management and Local Consumer Lending.

The services offered by the four groups are:

Regional Consumer Banking: Offers retail banking, local commercial banking, and Citi personal wealth management. It provides services in Citi-branded cards and Latin America asset management as well.

Institutional Clients Group: In securities and banking areas, it offers services to clients in investment banking, debt and equity markets, lending, private equity, hedge funds, real estate, structured products, and equity and fixed income research. The transactions services division provides clients with cash management, trade services, custody and fund services, and clearing services.

Brokerage and Asset Management: Offers include investment in and associated earnings from Morgan Stanley Smith Barney joint venture as well as retail alternative investments.

Local Consumer Lending: Provides banking services in consumer finance lending, retail partner cards, and certain international consumer lending.

JPMorgan

JPMorgan offers products and services in asset management, commercial banking, investment bank, private banking, securities services, and treasury services. The following is a brief description of lines of businesses operated by JPMorgan:

Asset Management: Provides U.S., non-U.S., and global investment management products ranging from traditional cash management, equity, fixed income, and asset allocation to alternative asset classes such as private equity and real estate. It also provides administrative, investment, and communication services for corporate retirement plans.

Commercial Banking: Provides banking services to corporate and individual customers.

Private Banking: Offers wealthy individuals and their families private banking services including investing, wealth structuring, capital advisory, philanthropy, and banking.

Investment Banking: Provides advice on corporate strategy and structure, equity and debt capital raising, risk management, research, and market-making in cash securities and derivative instruments. It also operates proprietary investing and trading.

Securities Services: Offers an integrated platform for the delivery of financial services globally. Securities Services helps institutional investors, alternative asset managers, broker dealers, and equity issuers optimize efficiency, mitigate risk, and enhance revenue. It also serves as a strategic advisor to clients by way of delivering solutions tailored to meet clients’ needs.

Treasury Services: Treasury services provide treasury and cash management, trade finance, payment, and liquidity management services for multinational corporations, banks and non-bank financial institutions, and governments. The institutional trust services area provides services to debt and equity issuers, intermediaries, and investors in the global capital markets. Investor services (custody and related services) are for mutual funds, investment managers, pension funds, insurance companies, and banks.

Bank of America

Bank of America groups its services under the Personal, Small Business, Wealth Management, and Corporate and Institutional categories. The Corporate and Institutional group is mainly serviced by Bank of America Merrill Lynch.

Personal Banking: It covers online services, checking and savings, cards, investment management, specialized banking (such as military bank and student banking), and additional services.

Small Business: Bank of America provides services in account access, checking and savings, loans and credit lines, leasing, cards, merchant services, payroll and tax, and investment and retirement. Additional services include treasury management, insurance, wholesale mortgage lending, and trade services.

Wealth Management: Offers services from investment, banking, and retirement products to college savings and estate-planning services.

Corporate and Institutional: Services to corporate and institutional clients include capital markets, capital raising, and capital management. Capital markets cover mortgage-backed securities, convertibles, emerging markets, energy derivatives, equities, equity derivatives, fixed income, foreign exchange, interest-rate derivatives, and structured credit products. Capital raising services raise capital for clients through debt issuance, equity issuance, equity-linked products, leasing, mergers and acquisitions advisory, and private equity. Finally, capital management offers asset management, business capital, investment solutions, trade services, and treasury management services.

FULL-SERVICE INVESTMENT BANKS

This section describes the businesses of Goldman Sachs and Morgan Stanley, the two U.S. independent full-service investment banks. These two firms converted to commercial bank charter during the financial crisis after the bankruptcy of Lehman Brothers, but continue to operate as full-service providers and are not part of a financial holding company. Table 2.2 summarizes the business categories offered by those two Wall Street houses.²

Table 2.2 Business Categories of Full-Service Investment Banks

Goldman Sachs

Goldman Sachs is a global investment banking, securities, and investment management firm, providing services to corporations, financial institutions, governments, and high-net-worth individuals. Its revenue-producing activities are divided into four segments: Investment Banking, Institutional Client Services, Investing and Lending, and Investment Management.

The Investment Banking segment is organized along regional, product, and industry groups. The main services are underwriting and financial advisory. Underwriting includes public offerings and private placements of equity and debt securities. Financial advisory covers mergers and acquisitions, divestitures, corporate defense activities, restructuring, and spin-offs.

The Institutional Client Services segment facilitates trades on behalf of clients and invests Goldman's own capital using various debt and equity instruments. There are three subdivisions in the Trading and Principal Investments segment:

Fixed-income, Currency, and Commodities: Facilitates trades in fixed-income instruments, currencies, and commodities contracts. This group seeks opportunities to profit from movements in interest rates and credit products.

Equities: Facilitates trades in equities. This segment is also involved in proprietary trading and derivatives.

Securities Services: Earns fees by providing financing, lending, as well as clearing and settlement of securities for clients.

Investing and Lending segments are generally long term investments and loans to large organizations. This portfolio consists of privately negotiated transactions such as acquisitions, equity and debt securities, buyouts, and investments in external funds.

The Investment Management division manages assets for large institutional investors such as pension plans, endowments, and trusts. This includes providing a range of investment strategies and advice to these organizations.

Morgan Stanley

Morgan Stanley divides its services into Institutional Securities, Global Wealth Management, and Asset Management. Institutional Securities include investment banking, equities, and fixed income. Investment banking covers securities underwriting, institutional sales and trading in equity and debt securities, advisory services in M&As, corporate finance, and real estate.

The Investment Management line includes several important business areas. The traditional investments cover mutual funds, separately managed accounts, unit investment trusts, and variable annuities. Alternative investments offer private equity, hedge funds, fund of funds, managed futures, and real estate. Retirement services cover both defined contribution as well as defined benefit. In addition, this line provides advice in financial and estate planning, trust services, and securities transfer.

Global wealth management is one of the largest wealth management firms globally. Fees and commissions are the two large revenue sources for this division.

BOUTIQUE INVESTMENT BANKS

Boutique investment banks do not offer a range of services and are not part of a larger financial institution that serves many competing interests. The following provides a brief description of several boutiques with different specializations, as summarized in Table 2.3.³

Table 2.3 Specializations of Boutique Investment Banks

Table 2-3

Sandler O’Neill

Sandler O’Neill specializes in the financial services sector. It is a partnership, and different by design. Since the firm's founding in 1988, the firm's partners have aimed at providing financial services companies with an alternative to large Wall Street banking firms. The company raises capital, provides research coverage, acts as a market maker, advises on mergers and acquisitions, and trades securities. Its services cover mutual-to-stock conversion (from a mutual ownership structure to a public company), loan portfolio restructuring, strategic planning, and balance-sheet interest rate risk management.

The investment banking team focuses on demutualization, M&A advice, fairness opinion, leveraged and management buyout, and strategic issues. The capital markets group specializes in convertible securities for financial institutions and in pooled trust preferred transactions for banks, thrifts, and insurance companies.⁴In balance sheet management, it offers clients techniques to enhance earnings and manage interest rate risk, and it underwrites and trades all types of fixed-income securities. Its research covers financial services companies. In addition to covering large issuers, it is positioned to offer value to smaller issuers that are not widely followed by bulge bracket Wall Street houses. Furthermore, its mortgage finance group covers performing and non-performing loan portfolios. It engages in trading the whole loans as well. Finally, Sandler O’Neill equity trading centers on financial institutions to enhance liquidity and distribution.

Greenhill

Greenhill is a boutique house focused on mergers and acquisitions, financial restructuring, and merchant banking. Its focus is on advisory work. It does not have research, trading, lending, or related activities. In contrast to many competitors, it is not part of a larger financial institution that serves many competing interests.

Greenhill's M&A practice covers buy-side, sell-side, merger, special, and cross-border transactions. Sell-side advisory provides advice about the merit of the received bids to the target companies, special board committees, or selling shareholders. In buy-side advisory assignments, it advises principally on stock or asset purchases. Special committee advisory involves advising a Special Committee of the Board of Directors that has been formed due to the conflicts in relation to a possible transaction. Often its role involves not only assisting with a transaction process, but also delivering a fairness opinion.

Another area of practice is advice on restructuring. It advises debtors, creditors, and prospective acquirers of companies that are faced with or going through reorganization, recapitalizations, or out-of-court restructurings.

The merchant banking services are to identify private investment opportunities and partner with strong management teams. During 2009, Greenhill announced its separation from its historical merchant banking business in order to focus entirely on the client advisory business. Specifically, it sold to senior members of the existing investment team the right to launch successor funds to its three current merchant banking funds. The existing funds continue to be managed by the current investment team, through a new, independent entity, GCP Capital Partners (GCP).

Lazard

Lazard has two core businesses: One specializing in financial advisory and the other in asset management. Its mergers and acquisitions services include general strategic advice and transaction-specific advice in domestic and cross-border M&As, divestitures, privatizations, takeover defenses, strategic partnerships, and joint ventures. Lazard also receives special committee assignments. Lazard's industry focus includes consumer, financial institutions, healthcare and life science, industrial, power and energy, technology, media, and telecommunications. By contrast, the financial restructuring practice specializes in advising companies in financial distress. The asset management business provides investment management and advisory services to institutions, financial intermediaries, and private clients. Furthermore, Lazard operates two wholly owned subsidiaries: One is a private equity operation and the other is a bank in France.

CONCLUSIONS

This chapter provided a brief description of bulge bracket houses and boutique investment banks. Some of the bulge bracket houses are part of larger financial holding companies. These large investment banks offer clients a full menu of investment banking and securities services. In contrast, the so-called boutiques tend to specialize in the industry or the service.

1. The following descriptions of business lines for financial holding companies are taken from their annual reports and materials published on their websites.

2. The following descriptions are from annual reports of those two investment banks.

3. The descriptions are taken from their publications. Note that Sandler O’Neill is a private company.

4. A trust preferred security is a security with characteristics of both equity and debt. A company first creates a trust and issues debt to the new entity, then the trust issues the trust preferred securities.

CHAPTER 3

THE STRUCTURE OF INVESTMENT BANKS: DIVISIONS AND SERVICES

Most people use the term investment banking to include underwriting and advisory services for mergers and acquisitions. Morgan Stanley described its investment banking in this way: Morgan Stanley offers its investment banking clients, including corporations, governments and other entities, underwriting and distribution services for debt and equity offerings in addition to financial advisory services regarding key strategic matters, such as mergers and acquisitions, restructuring, real estate and project finance. Today, investment banks are facing an intensely competitive environment, fostered by regulatory changes, by globalization, and by technological advances. As a result, most investment banks have expanded to comprise major capital market activities. In this chapter, we describe Morgan Stanley and Goldman Sachs to review the typical organizational structure of an investment bank.

MORGAN STANLEY

The organizational structure at Morgan Stanley (MS) is divided into three broad areas: business units, company management, and operations and technology. Six business units provide institutions and individuals with a full spectrum of products and services across the world's major markets. Eleven management units provide information and strategic analysis to the firm's management committee, help ensure efficient daily operations and long-term growth, and serve the well-being of shareholders, employees, and clients. Operations and technology provide infrastructure and controls for the firm.

Business Units

There are six business units, including Morgan Stanley Smith Barney, Sales and Trading, Investment Banking, Global Capital Markets, Investment Management, and Research.

Morgan Stanley Smith Barney provides a range of products and services to individuals, businesses, and institutions, including brokerage and investment advisory services, financial and wealth planning, credit and lending, cash management, annuities and insurance, and retirement and trust. In Sales and Trading, Morgan Stanley provides services in sales, trading, market making in most types of financial instruments, including stocks, bonds, derivatives, foreign exchange, and commodities. It also provides analytics to clients as well. The Investment Banking group provides services in underwriting of equity and equity-related transactions, high-yield debt financing, corporate debt issuance, and in mergers and acquisitions.

The Global Capital Markets group works with clients to arrange financing and risk management solutions. This group provides guidance as to size, structure, timing, and marketing of transactions. The Investment Management division offers individual and institutional clients a diverse array of equity, fixed income, and alternative investments. In the Research division, equity analysts provide research coverage for investment recommendations. Economists, strategists, and fixed-income analysts cover all major regions and other asset classes around the world. Many investors, institutional and individual, consider such recommendations in their investment and trading decisions.

Company Management

There are 11 departments in Company Management, including legal and compliance, corporate services, finance, government relations, human resources, internal audit, corporate communications, community affairs, strategy and execution, firmwide marketing, and risk management. All those departments together provide information and strategic thinking to the company's management committee and help ensure long-term growth and efficient day-to-day functioning of businesses.

Operations and Technology

Operations and Technology provide the global infrastructure and controls for the firm. Technology provides quantitative trading systems, modeling and simulation software, comprehensive risk and security systems, and infrastructure supporting these systems and tools. Operations is the backbone for sales, trading, and other business activities. It ensures that the firm is aware of all operational risks, makes sure transactions are settled and recorded correctly, and supports new markets and products.

GOLDMAN SACHS

Goldman Sachs (GS) has a flat organizational structure, comprising 12 divisions. Those divisions are finance, global compliance, global investment research, human capital management, investment banking, investment management, legal and internal audit, merchant banking/private equity, operations, securities, services, and technology. Those divisions together provide a full spectrum of services to meet clients’ needs and to enhance shareholder value. Goldman Sachs groups its revenue-producing activities into investment banking, investing and lending, institutional client service, and investment management.

Finance

Finance is responsible for the firm's capital management and risk monitoring. The teams act as advisors to senior management on essential areas such as controlling the firm's global risk exposure and the profitability and structure of its various businesses. Finance division carries out these responsibilities by: tracking and analyzing the firm's capital flows; managing the firm's relationship with external regulators; preparation of the firm's statutory financial information and statements in accordance with the applicable accounting principles of each region; working closely with all of the