CONCEPT OF INVESTMENT BANKING

What is an Investment Bank? 

It is neither Investment banking nor I-banking, as it is often called. It is the term used to describe the business of raising capital for companies. 

Capital essentially means money. Companies need cash in order to grow and expand their businesses; Investment banks sell securities to public investors in order to raise the cash. These securities can come in the form of stocks or bonds. Thus, Investment banks are essentially financial intermediaries, who assist their clients in raising capital either by underwriting their shares or bonds or by acting as an agent in the issuance of securities. 

Please note that Investment banking isn't one specific service or function. It is an umbrella term for a range of activities including underwriting, selling, and trading securities (stocks and bonds); providing financial advisory services, such as mergers and acquisition advice; divestitures, private equity syndication, IPO advisory and managing assets.

The Players 

The biggest investment banks in global scenario include Goldman Sachs, Bank of America, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, Donaldson, Lufkin & Jenrette, Credit Suisse, Deutsche Bank, Citi, Barclays Capital, J.P. Morgan and Barings (Lehman Brothers), among others. 

The Components of Investment Bank 

Generally, the breakdown of an investment bank includes the following areas: 

Corporate Finance 

The bread and butter of a traditional investment bank, corporate finance, generally perform two different functions: 

1) Mergers and acquisitions advisory and 

2) Underwriting. 

On the mergers and acquisitions (M&A) advising side of corporate finance, bankers assist in negotiating and structuring a merger between two companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price by coordinating with the bidders, performing due diligence, structuring the deal, negotiating with the merger target and generally ensuring a smooth transaction. 

Mergers and acquisition advice include buy-side and sell-side advice where competent buy-side analysts and sell-side analysts are appointed by the Investment banking companies to advice their clients on lucrative merger targets in case a firm wants to buy another firm and potential purchasing companies if a firm wants to sell its assets. 

The traditional investment banking world is considered the sell-side of the securities industry. Why? Investment banks create stocks and bonds, and sell these to investors. Sell is the key word, as I-banks continually sell their firms' capabilities to generate corporate finance business. Who are the buyers of public stocks and bonds? They are individual investors (you and me) and institutional investors, firms like Fidelity and Vanguard. The universe of institutional investors is appropriately called the buy-side of the securities industry. 

The underwriting function within corporate finance involves spearheading the process of raising capital for a company. In the investment banking world, capital can be raised by selling either stocks or bonds to the investors. 

When a corporation wishes to issue new securities and sell them to the public, it makes an arrangement with an investment banker whereby the investment banker agrees to purchase the entire issue at a set price, known as underwriting. Underwriting can be done either through negotiations between underwriter and the issuing company (called negotiated underwriting) or by

competitive bidding. A negotiated underwriting is a negotiated agreed arrangement between the issuing firm and its investment banker. Most large corporations work with investment bankers with whom they have long-term relationship. In competitive bidding, the firm awards offering to investment banker that bid the highest price.

Sales

Sales are another core component of any investment bank. The primary job of the sales force of an Investment bank is to call on high net worth individuals and institutions to suggest trading ideas (on a caveat emptor basis) and take orders. Salespeople take the form of:

1) The Classic Retail Broker,

2) The Institutional Salesperson, or

3) The Private Client Service Representative.

Brokers develop relationships with individual investors and sell stocks and stock advice to them.

Institutional salespeople develop business relationships with large institutional investors. Institutional investors are those who manage large groups of assets, for example pension funds or mutual funds.

Private Client Service (PCS) representatives lie somewhere between retail brokers and institutional salespeople, providing brokerage and money management services for extremely wealthy individuals.

Salespeople make money through commissions on trades made through their firms.

Trading

Traders also provide a vital role for the investment bank. The salespeople communicate the client’s orders to the trading people. Traders facilitate the buying and selling of stock, bonds, or other securities such as currencies, either by carrying an inventory of securities for sale or by executing a given trade for a client.

Traders deal with transactions large and small and provide liquidity (the ability to buy and sell securities) for the market. (This is often called making a market.) Traders make money by purchasing securities and selling them at a slightly higher price. This price differential is called the "bid-ask spread."

Sales and trading can also engage in proprietary trading. Proprietary trading involves a special group of traders who do not work with clients. These traders take on "principal risk", which involves buying or selling a product and does not hedge his total exposure. By managing the amount of risk on its balance sheet, an investment bank can maximize its profitability.

An investment bank’s sales and trading department also interacts with the corporate finance department on the issuance of IPOs and follow-on offerings. It is the sales and trading department that builds a book for a particular stock by calling up institutional and retail investors to judge the interest for the offering. They then price the initial sales value on the day of the offering and begin selling the new shares to their clients. 

Research 

Research analysts study stocks and bonds and make recommendations on whether to buy, sell, or hold those securities. Research analysts review companies and write reports on their prospectus often with buy or sell ratings. Stock analysts (known as equity analysts) typically focus on one industry and will cover up to 20 companies' stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as high yield bonds or Govt. Treasury bonds. The research department on its own does not generate a lot of income. What it does is influence trading volume, which results in more fees for sales and trading. When a research analyst changes his or her recommendation on a stock, many investors will then act on that recommendation and the sales and trading team earns more in trading fees. Salespeople within the I-bank utilize research published by analysts to convince their clients to buy or sell securities through their firm. Corporate finance bankers rely on research analysts to be experts in the industry in which they are working. Reputable research analysts can generate substantial corporate finance business as well as substantial trading activity, and thus are an integral part of any investment bank. 

There exists, however, a conflict of interest between research and other parts on the investment bank. If an investment bank were about to issue new shares of stock for a company, for example, the research analyst could put out a strong recommendation for the stock just prior to the offering, and the bank could get a better price and potentially earn more fees. 

Likewise, if the proprietary trading division wanted to boost the return on their holdings, they could have research analysts recommend some of the stock they held as a buy. There are a number of areas where the research department could be used to mislead investors and earn more profit for the investment bank. 

To circumvent these conflicts of interests, regulators have insisted that investment banks implement a “Chinese wall” in their firms. The Chinese wall keeps information about the investment bank’s corporate finance and sales and trading activities from passing through to the research department. 

A Chinese wall also exists between the corporate finance and sales and trading divisions because many corporate finance activities involve non-public information that could be used to profitably execute trading strategies.

Syndicate 

The hub of the investment banking wheel, syndicate provides a vital link between salespeople and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering, a knock-down drag-out affair between and among buyers of offerings and the investment banks managing the process. In a corporate or municipal debt deal, syndicate also determines the allocation of bonds. 

In certain cases, for large or risky issues a number of investment bankers get together as a group, they are referred to as syndicate. A syndicate is a temporary association of investment bankers brought together for the purpose of selling new securities. One investment banker is selected to manage the syndicate called the originating house, which does underwriting of the major amount of the issue. There are two types of underwriting syndicates, divided and undivided. In a divided syndicate, each member group has liability of selling a portion of offerings assigned to them. However, in undivided syndicate, each member group is liable for unsold securities up to the amount of its percentage participation irrespective of the number of securities that group has sold. 

The breakdown of these fundamental areas differs slightly from firm to firm, but typically an investment bank will have these areas. 

Commercial Banking vs. Investment Banking 

Commercial and investment banking share many aspects, but also have many fundamental differences. After a quick overview of commercial banking, we will build up to a full discussion of what I-banking entails. 

We’ll begin examining what this means by taking a look at what commercial banks do. 

Commercial Banks 

A commercial bank may legally take deposits for current and savings accounts from consumers. Commercial banks must follow a myriad of regulations. The typical commercial banking process is fairly straightforward. You deposit money into your bank, and the bank loans that money to consumers and companies in need of capital (cash). You borrow to buy a house, finance a car, or finance an addition to your home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the dry cleaner on the corner to a multinational conglomerate. 

Private Contracts 

Importantly, loans from commercial banks are structured as private legally binding contracts between two parties - the bank and you (or the bank and a company). Banks work with their clients to individually determine the terms of the loans, including the time to maturity and the interest rate charged. Your individual credit history (or credit risk profile) determines the amount you can

borrow and how much interest you are charged. 

Commercial banks thus collects funds and loan them to its customers for taking advantage of the large spread between their cost of funds (1 percent, for example) and their return on funds loaned (ranging from 5 to 14 percent). 

Investment Banks 

An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds). Because commercial banks already have funds available from their depositors and an investment bank does not, an I-bank must spend considerable time finding investors in order to obtain capital for its client. 

Public Securities 

Investment banks typically sell public securities (as opposed private loan agreements). Technically, securities such as Microsoft stock or Tata Steel AAA bonds, represent a high degree of safety and are traded either on a public exchange or through an approved dealer. The dealer is the investment bank. 

Let’s look at an example to illustrate the difference between private debt and bonds. Suppose ITC Ltd, the FMCG conglomerate needs capital, and estimates its need to be ` 20 million. ITC has two choices 

(a) It could obtain a commercial bank loan from State Bank of India for the entire ` 20 million, and pay interest on that loan. 

(b) It could sell bonds publicly using an investment bank such as Merrill Lynch. The ` 20 million bond issue raised by Merrill would be broken into many bonds and then sold to the public. (For example, the issue could be broken into 20,000 bonds, each worth 1,000.) Once sold, the company receives its ` 20 million and investors receive bonds worth a total of the same amount. Over time, the investors in the bond offering receive coupon payments (the interest), and ultimately the principal (the original ` 1,000) at the end of the life of the loan, when ITC buys back the bonds (retires or redeem the bonds). Thus, we see that in a bond offering, while the money is still loaned to ITC, it is actually loaned by numerous investors, rather than a single bank. 

As the investment bank involved in the offering does not own the bonds but merely placed them with investors at the outset, it earns no interest - the bondholders earn this interest in the form of

regular coupon payments. The investment bank makes money by charging the client (in this case, ITC) a small percentage of the transaction upon its completion. Investment banks call this upfront fee the "underwriting discount." In contrast, a commercial bank making a loan actually receives the interest and simultaneously owns the debt. 

Thus, the fundamental differences between an investment bank and a commercial bank can be outlined as follows:

Investment Banks	Commercial Banks
1. Investment Banks help their clients in raising capital by acting as an intermediary between the buyers and the sellers of securities (stocks or bonds)	1. Commercial Banks are engaged in the business of accepting deposits from customers and lending money to individuals and corporates
2. Investment Banks do not take deposits from customers	2. Commercial banks can legally take deposits from customers.
3. The Investment Banks do not own the securities and only act as  an  intermediary for smooth transaction of buying and selling securities.	3. Commercial Banks own the loans granted to their customers.
4. Investment Banks earn underwriting commission	4. Commercial banks earn interest on loans granted to their customers.