Investment banking involves raising money (capital) for companies and governments, usually by issuing securities. Securities or financial instruments include equity or ownership instruments such as stocks where investors own a share of the issuing concern and therefore are entitled to profits. They also include debt instruments such as bonds, where the issuing concern borrows money from investors and promises to repay it at a certain date with interest. Companies typically issue stock when they first go public through initial public offerings (IPOs), and they may issue stock and bonds periodically to fund such enterprises as research, new product development, and expansion. Companies seeking to go public must register with the Securities and Exchange Commission and pay registration fees, which cover accountant and lawyer expenses for the preparation of registration statements. A registration statement describes a company's business and its plans for using the money raised, and it includes a company's financial statements.
Before stocks and bonds are issued, investment bankers perform due diligence examinations, which entail carefully evaluating a company's worth in terms of money and equipment (assets) and debt (liabilities). This examination requires the full disclosure of a company's strengths and weaknesses. The company pays the investment banker after the securities deal is completed and these fees often range from 3 to 7 percent of what a company raises, depending on the type of transaction.
Investment banks aid companies and governments in selling securities as well as investors in purchasing securities, managing investments, and trading securities. Investment banks take the form of brokers or agents who purchase and sell securities for their clients; dealers or principals who buy and sell securities for their personal interest in turning a profit; and broker-dealers who do both.
The primary service provided by investment banks is underwriting, which refers to guaranteeing a company a set price for the securities it plans to issue. If the securities fail to sell for the set price, the investment bank pays the company the difference. Therefore, investment banks must carefully determine the set price by considering the expectations of the company and the state of the market for the securities. In addition, investment banks provide a plethora of other services including financial advising, acquisition advising, divestiture advising, buying and selling securities, interest-rate swapping, and debt-for-stock swapping. Nevertheless, most of the revenues of investment banks come from underwriting, selling securities, and setting up mergers and acquisitions.
When companies need to raise large amounts of capital, a group of investment banks often participate, which are referred to as syndicates. Syndicates are hierarchically structured and the members of syndicates are grouped according to three functions: managing, underwriting, and selling. Managing banks sit at the top of the hierarchy, conduct due diligence examinations, and receive management fees from the companies. Underwriting banks receive fees for sharing the risk of securities offerings. Finally, selling banks function as brokers within the syndicate and sell the securities, receiving a fee for each share they sell. Nevertheless, managing and underwriting banks usually also sell securities. All major investment banks have a syndicate department, which concentrates on recruiting members for syndicates managed by their firms and responding to recruitments from other firms.
A variety of legislation, mostly from the 1930s, governs investment banking. These laws require public companies to fully disclose information on their operations and financial position, and they mandate the separation of commercial and investment banking. The latter mandate, however, has been relaxed over the intervening years as commercial banks have entered the investment banking market.
Investment banking began in the United States around the middle of the 19th century. Prior to this period, auctioneers and merchants—particularly those of Europe—provided the majority of the financial services. The mid-1800s were marked by the country's greatest economic growth. To fund this growth, U.S. companies looked to Europe and U.S. banks became the intermediaries that secured capital from European investors for U.S. companies. Up until World War I, the United States was a debtor nation and U.S. investment bankers had to rely on European investment bankers and investors to share risk and underwrite U.S. securities. For example, investment bankers such as John Pierpont (J. P.) Morgan (1837-1913) of the United States would buy U.S. securities and resell them in London for a higher price.
During this period, U.S. investment banks were linked to European banks. These connections included J.P. Morgan & Co. and George Peabody & Co. (based in London); Kidder, Peabody & Co. and Barling Brothers (based in London); and Kuhn, Loeb, & Co. and the Warburgs (based in Germany).
Since European banks and investors could not assess businesses in the United States easily, they worked with their U.S. counterparts to monitor the success of their investments. U.S. investment bankers often would hold seats on the boards of the companies issuing the securities to supervise operations and make sure dividends were paid. Companies established long-term relationships with particular investment banks as a consequence.
In addition, this period saw the development of two basic components of investment banking: underwriting and syndication. Because some of the companies seeking to sell securities during this period, such as railroad and utility companies, required substantial amounts of capital, investment bankers began under-writing the securities, thereby guaranteeing a specific price for them. If the shares failed to fetch the set price, the investments banks covered the difference. Underwriting allowed companies to raise the funds they needed by issuing a sufficient amount of shares without inundating the market so that the value of the shares dropped.
Because the value of the securities they underwrote frequently surpassed their financial limits, investment banks introduced syndication, which involved sharing risk with other investment banks. Further, syndication enabled investment banks to establish larger networks to distribute their shares and hence investment banks began to develop relationships with each other in the form of syndicates.
The syndicate structure typically included three to five tiers, which handled varying degrees of shares and responsibilities. The structure is often thought of as a pyramid with a few large, influential investment banks at the apex and smaller banks below. In the first tier, the "originating broker" or "house of issue" (now referred to as the manager) investigated companies, determined how much capital would be raised, set the price and number of shares to be issued, and decided when the shares would be issued. The originating broker often handled the largest volume of shares and eventually began charging fees for its services.
In the second tier, the purchase syndicate took a smaller number of shares, often at a slightly higher price such as I percent or 0.5 percent higher. In the third tier, the banking syndicate took an even smaller amount of shares at a price higher than that paid by the purchase syndicate. Depending on the size of the issue, other tiers could be added such as the "selling syndicate" and "selling group." Investment banks in these tiers of the syndicate would just sell shares, but would not agree to sell a specific amount. Hence, they functioned as brokers who bought and sold shares on commission from their customers.
From the mid-i800s to the early 1900s, J. P. Morgan was the most influential investment banker. Morgan could sell U.S. bonds overseas that the U.S. Department of the Treasury failed to sell and he led the financing of the railroad. He also raised funds for General Electric and United States Steel. Nevertheless, Morgan's control and influence helped cause a number of stock panics, including the panic of 1901.
Morgan and other powerful investment bankers became the target of the muckrakers as well as of inquiries into stock speculations. These investigations included the Armstrong insurance investigation of 1905, the Hughes investigation of 1909, and the Money Trust investigation of 1912. The Money Trust investigation led to most states adopting the so-called blue-sky laws, which were designed to deter investment scams by start-up companies. The banks responded to these investigations and laws by establishing the Investment Bankers Association to ensure the prudent practices among investment banks. These investigations also led to the creation of the Federal Reserve System in 1913.
Beginning about the time World War I broke out, the United States became a creditor nation and the roles of Europe and the United States switched to some extent. Companies in other countries now turned to the United States for investment banking. During the 1920s, the number and value of securities offerings increased when investment banks began raising money for a variety of emerging industries: automotive, aviation, and radio. Prior to World War 1, securities issues peaked at about $ 1 million, but afterwards issues of more than $20 million were frequent.
The banks, however, became mired in speculation during this period as over 1 million investors bought stocks on margin, that is, with money borrowed from the banks. In addition, the large banks began speculating with the money of their depositors and commercial banks made forays into underwriting.
The stock market crashed on October 29, 1929, and commercial and investment banks lost $30 billion by mid-November. While the crash only affected bankers, brokers, and some investors and while most people still had their jobs, the crash brought about a credit crunch. Credit became so scarce that by 1931 more than 500 U.S. banks folded, as the Great Depression continued.
As a result, investment banking all but frittered away. Securities issues no longer took place for the most part and few people could afford to invest or would be willing to invest in the stock market, which kept sinking. Because of crash, the government launched an investigation led by Ferdinand Pecora, which became known as the Pecora Investigation. After exposing the corrupt practices of commercial and investment banks, the investigation led to the establishment of the Securities and Exchange Commission (SEC) as well as to the signing of the Banking Act of 1933, also known as the Glass-Steagall Act. The SEC became responsible for regulating and overseeing in-vesting in public companies. The Glass-Steagall Act mandated the separation of commercial and investment banking and from then—until the late 1980—banks had to choose between the two enterprises.
Further legislation grew out of this period, too. The Revenue Act of 1932 raised the tax on stocks and required taxes on bonds, which made the practice of raising prices in the different tiers of the syndicate system no longer feasible. The Securities Act of 1933 and the Securities Exchange Act of 1934 required investment banks to make full disclosures of securities offerings in investment prospectuses and charged the SEC with reviewing them. This legislation also required companies to regularly file financial statements in order to make known changes in their financial position. As a result of these acts, bidding for investment banking projects became competitive as companies began to select the lowest bidders and not rely on major traditional companies such as Morgan Stanley and Kuhn, Loeb.
The last major effort to clean up the investment banking industry came with the U.S. v. Morgan case in 1953. This case was a government antitrust investigation into the practices of 17 of the top investment banks. The court, however, sided with the defendant investment banks, concluding that they had not conspired to monopolize the U.S. securities industry and to prevent new entrants beginning around 1915, as the government prosecutors argued.
By the 1950s, investment banking began to pick up as the economy continued to prosper. This growth surpassed that of the 1920s. Consequently, major corporations sought new financing during this period. General Motors, for example, made a stock offering of $325 million in 1955, which was the largest stock offering to that time. In addition, airlines, shopping malls, and governments began raising money by selling securities around this time.
During the 1960s, high-tech electronics companies spurred on investment banking. Companies such as Texas Instruments and Electronic Data Systems led the way in securities offerings. Established investment houses such as Morgan Stanley did not handle these issues; rather, Wall Street newcomers such as Charles Plohn & Co. did. The established houses, however, participated in the conglomeration trend of the 1950s and 1960s by helping consolidating companies negotiate deals.
The stock market collapse of 1969 ushered in a new era of economic problems which continued through the 1970s, stifling banks and investment houses. The recession of the 1970s brought about a wave of mergers among investment brokers. Investment banks began to expand their services during this period, by setting up retail operations, expanding into international markets, investing in venture capital, and working with insurance companies.
While investment bankers once worked for fixed commissions, they have been negotiating fees with investors since 1975, when the SEC opted to deregulate investment banker fees. This deregulation also gave rise to discount brokers, who undercut the prices of established firms. In addition, investment banks started to implement computer technology in the 1970s and 1980s in order to automate and expedite operations. Furthermore, investment banking became much more competitive as investment bankers could no longer wait for clients to come to them, but had to endeavor to win new clients and retain old ones.
In the early 1980s, the SEC introduced and made law a rule that permits well-known companies to register securities without a set sale date and delay the sale of the securities until the issuers expect their securities will have strong prices in the market. These registrations are known as "shelf registrations and have become an important part of investment banking.
Shelf financing also contributed to the decline of the historic connections between specific corporations and investment banks. Nevertheless, it did not change the basic structure of the industry, which has retained the pyramid shape. The apex investment houses before the introduction of shelf financing by and large remained the apex houses afterwards.
Contemporary investment banking is also influenced by the growth of institutional investors as key players in the securities market. Whereas institutional investors accounted for 25 percent of securities trade in the 1960s, they accounted for over 75 percent in the 1990s. In addition, the securities market has become more global. For example, U.S. companies raised more money in London in the early 1980s than in New York. Moreover, U.S. investors are buying more European and Asian securities than in previous decades.
New technology—including telecommunications technology, computers, and computer networks—has enabled investment bankers to receive, process, organize, and circulate large amounts of diverse information. This technology has helped investment banks become more efficient and complete transactions more quickly.
The increased competition within the investment banking arena has further quelled the establishment of long-term relationships between corporations and investment houses. Company executives receive offers from a variety of investment banks and they compare the offers, choosing the ones they believe will benefit their company the most. Large corporations generally have transactions with four or more investment banks. Nevertheless, corporations still favor their traditional investment banks and about 70 percent of the executives surveyed in a study said they do most of their business with their traditional investment banks, according to The Investment Banking Handbook.
In the 1980s and 1990s, the investment banking industry continued to consolidate. As a result, a few investment banks with large amounts of capital dominated the industry and offered a wide array of services, earning the name "financial supermarkets." This trend also altered the structure of the industry, affecting the size and roles of syndicates. Syndicates became dependent on the type and volume of the securities being offered as a result. For small offerings, syndicates are usually small and the managing banks sell the majority of the securities. In contrast, for large offerings, the managing banks may create a syndicate including more than 100 investment banks.
Investment houses continued to be innovative and introduce new financial instruments for both issuers and investors. Some of the most significant innovations include fixed-income and tax-exempt securities, which have grown in popularity since their inception in the 1980s. Some key fixed-income securities have been debt warrants, which are bonds sold with warrants to buy more bonds at a specific time; and debt-equity swaps, where companies offer stock to existing bondholders.
With a growing number of mergers and acquisitions as well as corporate restructurings, investment banks have become increasingly involved in the process of arranging these transactions as part of their primary services. Because of changing economic, competitive, and market conditions, several thousand small and mid-sized companies as well as a handful of large corporations agree to merger and acquisition deals each year. Investment banks facilitate this process by providing advice on such transactions, negotiating on behalf of their clients, and guaranteeing the purchase of bonds for acquisitions that rely on debt, known as leveraged buyouts.
The rapid expansion of the Internet in the mid-to-late 1990s provided an impetus for stockbrokers to begin offering trading services through the Internet. Because of the popularity of online trading, brokers began offering investment banking services. Early in 1999, E-Trade established the online investment bank "E-Offering," which provides online initial public offering services.
Since the passage in 1933 of the Glass-Steagall Act, the U.S. banking industry has been closely regulated. This act requires the separation of commercial banking, investment banking, and insurance. In contrast to investment banks, commercial banks focus on taking deposits and lending. Nevertheless, there have been recent endeavors to repeal the act and to relax its measures. While the act has not been overturned even with efforts continuing in 1999, the Federal Reserve, which oversees commercial banking, has allowed commercial banks to sell insurance and issue securities. Consequently, investment banks and insurers support the latest round of activity to overturn the act. Japan and the United States are the only major industrial countries that require the separation of commercial and investment banking.
SEE ALSO : Banks and Banking
[ Karl Heil ]
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