MN50412

Investment Banking

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General information

Lecturer: Dr Richard Fairchild

Office: Wessex House 8.52

Email: mnsrf@bath.ac.uk

Lecture time: Thursdays 9.15 – 11.15 am

Office hours: Tuesday 14.15pm- 15.15pm

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What is investment banking?

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The banking function

The banking function can be decomposed into:

– Central banking: • Monetary policy (interest rates, money supply)• In the UK: Bank of England

– Commercial banking:• Lending to the public (businesses, individuals, banks)• Receiving deposits from businesses and individuals• In the UK: HSBC, RBS, Barclays, HBOS

– Investment banking

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Investment banking activities

Investment banking activities include:

• Mergers and acquisitions (+ divestitures)

– Advise potential buyers on which companies to target– Help sellers screen potential buyers– Suggestions about what price to offer/accept– Negotiation support– Structuring the deal ( pay in cash vs. pay in stock)

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• Debt underwriting

– IB help companies and governments raise money by issuing corporate or government bonds

– Underwriting: IB act as intermediate between the issuer and investors (individuals, banks, mutual funds, hedge funds, sovereign funds etc.)

• Act as primary dealers for the government• Have a certification role for companies that want to issue bonds

• Proprietary trading: Trading with the bank own money

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• Equity underwriting

- Evaluate the issuer- Determine the offering price- Buy the shares from the issuer- Find investors and sell the shares- Initial public offering (IPOs)

• Asset management

- Managing short-term cash flows of corporate clients

- Management of long-term bonds and equity portfolios of investors

- Institutional investors: insurance companies, pensions funds etc.

- Private investors7

• Asset securitization

- Issuance of securities using a pool a similar assets as collateral

- Mortgage-backed securities, asset-backed securities

• Private equity: refers to shares in companies that are not publicly traded

- Venture capital- LBOs: using borrowed money for a substantial

portion of the purchase price of the buyout company

- IB can raise funds for private equity funds or manage these funds themselves

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Investment banks

• Investment banks are financial institutions that engage primarily in IB activities

• Investment banks engage in public and private market transactions with corporations, governments and

institutional investors.

• Main differences with commercial banks:- IB have a marginal role in deposits and loan activities.- IB usually take short-term positions, i.e. few days (except in the non-core business of venture capital). Commercial banks take longer term positions.

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• Investment banks are intermediary between those needing funds and those having them:

– Need funds: Corporations, government– Have funds: Corporations, investment vehicles such

as mutual funds, pension funds etc.

• How do they make money?

– Fees (underwriting, M&A, asset management)– Trading revenues

• Main IB up to early 2008: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns

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• Commercial banks Institutions whose current operations consist mostly in granting loans and receiving deposits from businesses and customers

• Universal banks

Banks that combine commercial and investment bankingExample: UBS, Citibank, Bank of America

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Content of the course

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Content of the course

• Introduction

• Equity underwriting

– Why go public?– The IPO process– Syndicates in IPOs– Market shares in IPOs– Underwriting spread in IPOs– Underpricing of IPOs– Long-run performance of IPOs

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• Debt underwriting– Pricing of bonds– Yield curve– Corporate vs. government bonds– Callable bonds, convertible bonds

• Derivatives products– Futures– Options– SWAPS, CDO, CDS

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• Mergers and acquisitions– M&A valuation– Determinants of market shares– Who gains from mergers?– Financing: cash vs. stock– Why use IB? Investment banks vs. commercial banks

• Role of IB in the financial and economic crisis

• Asset management:- Active vs. passive management- Performance measurement

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Contribution of financial services to the UK economy

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Sectors' share in UK GDP

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Financial services jobs in central London

City of London Canary Wharf City-type UK

Fin. servs Total Fin. servs Total

2000 158 330 11 46 325 1069

2001 134 309 24 62 312 1089

2002 143 312 22 57 305 1113

2003 145 311 26 61 317 1105

2004 127 292 40 78 316 1075

2005 135 306 47 87 327 1063

2006 131 303 54 96 342 1048

2007 --- --- --- --- 353 1045

2008 --- --- --- --- 325 1029

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UK sector trade balances

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Tax contribution of UK financial services

Corporation Income Total Corporation(share)

Income (share)

2001 10.9 12.5 23.4 34.9 14.0

2002 7.3 12.2 19.6 25.8 13.3

2003 7.4 11.2 18.6 26.7 11.9

2004 7.7 11.9 19.6 25.7 11.7

2005 8.8 13.5 22.2 25.4 12.4

2006 11.4 14.8 26.2 27.0 13.0

2007 12.4 --- --- 27.1 ---

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International financial markets in the UK

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IB revenues

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Funds under management

2006 2007

Institutional 2,400 2,556

- Insurance 840 838

- Corporate pension funds 870 979

- Other (local authority, charity, etc) 690 737

Retail 650 769

- Hedge funds 150 180

- Property funds 202 174

- Private Equity funds 34 29

Private client funds 376 412

Total funds under management in the UK 3,812 4,118

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Sovereign wealth funds under management (global)

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Global private equity

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UK market shares

% share UK US Japan France Germany

Cross-border bank lending (Mar 2008) 20 9 7 9 11

Foreign exchange turnover (Apr 2007) 34 17 6 3 3

Exchange-traded derivatives turnover 6 40 2 1 13

Over-the-counter derivatives turnover 43 24 4 7 4

International bonds - secondary market 70 ... ... ... ...

Fund management (as a source of funds, end-2007)

9 48 6 6 4

Hedge funds assets (end-2007) 20 66 2 1 -

Private equity - investment value (2007) 7 71 - 2 1

IPOs (Jan-Sep 2008)5 9 7 - - -

Securitisation - issuance (2007) 6 76 2 - 126

Turnover of London based derivativesexchanges

ICE FuturesEurope

Liffe LME EDX Total

1997 14.7 209.3 57.4 4.4 285.81998 19.4 149.8 53.1 7.3 229.61999 23.0 117.8 61.5 10.4 212.72000 25.5 131.1 66.4 11.6 234.62001 26.4 619.1 59.4 15.9 720.82002 30.4 697 58.6 14.1 800.12003 33.3 695.1 72.3 14.8 815.52004 35.5 787.8 71.9 21.5 916.72005 42.1 759.3 78.6 20.3 900.32006 92.7 730.3 86.9 28.8 938.82007 138.5 949 92.9 43.1 1,223.50

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UK vs. US (1929-2007)

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Investment banking in the US

• The modern concept of “Investment Bank” was created by the Glass-Steagall act (Banking Act of 1933). Following the 1929 stock market crash, large banks went bankrupt.

• Glass-Steagall separated commercial banks, investment banks, and insurance companies.

• In 1999 the Glass-Steagall Act was waived (Graham-Leach-Bliley Act).

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Investment banking in the UK

• In the past, separation between:

1. Brokers: Rout the orders of customers to the stock exchange, give advices on investments. They cannot take positions in the stocks that act as brokers for.

2. Jobbers: Market makers that could trade only with the brokers, not with the general public.

3. Merchant banks: Commercial banks that offer corporate finance services (M&A advisory, underwriting etc.). Did not own the brokers.

• In 1986: Big bang:1. Abolition of fixed commission to increase competition2. Dual capacity: Jobbers, brokers and merchant banks can

integrate 30

1990s: The failure of UK investment banks

• Problems

– The US had deregulated fees in 1975– Business became much more complex, more difficult to manage– Lack of managerial experience– Clash of cultures brokers/jobbers/merchant banks

• Markets became volatile after the 1987 crash

• Results became volatile and UK banks made substantial losses

• 1995 saw many UK banks fail amid losses

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Reasons for US success since the 1990s

• Large financial and management resources, meaning that they were less exposed

• Huge profits in the US market allowed cross-subsidisation in Europe

• Economies of scale for underwriting activities

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