Investment Banking

I INTRODUCTION

Investment Banking, a branch of finance concerned with the underwriting, distribution, and maintenance of markets in securities issued by business firms and public agencies. Investment bankers are primarily merchants of securities; they perform three basic economic functions: (1) providing capital for corporations and local governments by underwriting and distributing new issues of securities; (2) maintaining markets in securities by trading and executing orders in secondary market transactions; (3) providing advice on the issue, purchase, and sale of securities, and on other financial matters such as mergers and acquisitions. In contrast to commercial banks, whose chief functions are to accept deposits and grant short-term loans to businesses and consumers, investment bankers engage primarily in long-term financing.

II UNDERWRITING

When a corporation needs to obtain funds by issuing stock or bonds, an investment banker may buy the entire issue and resell the securities in smaller amounts to investors, a procedure known as underwriting. Investors include individuals, insurance companies, pension funds, trust companies, investment companies, and other institutions. Sometimes a corporate issuer sells an entire issue of securities directly to one or more institutional buyers, such as insurance companies, without registering the issue for public sale. These sales are known as private placements.

The buying of a new issue may be handled by a single investment house, but large issues often are underwritten by syndicates or groups of firms. The risk-sharing thus provided has become increasingly appealing in recent decades. The originating firm conducts a thorough investigation of the issuing corporation, analysing financial, marketing, and production matters involved in the proposed transaction. It then enlists the participation of other firms in a syndicate; each syndicate member agrees to take a specified part of the issue.

The typical underwriting transaction involves a commitment by an investment house to buy a whole issue. In some cases, the firm acts only as an agent and attempts to sell the securities on a commission basis. In most cases, however, the investment house or syndicate guarantees the sale of an entire issue by buying the whole issue at a set price and assuming the risk of being able to sell the securities at a higher price.

In many countries—such as the United Kingdom—this risk is reduced by inviting other institutions to sub-underwrite an issue. Each sub-underwriter guarantees a portion of the issue and the main underwriter guarantees any remaining securities not sub-underwritten.

III OTHER SERVICES

In addition to departments handling the purchase and resale of new issues, an investment-banking house often has a trading department, a brokerage department, and a research or statistical department. The trading department buys and sells securities when profitable opportunities arise. Sometimes it may have to buy back securities it is marketing in order to prevent a decline in their market price. The brokerage department buys and sells securities, at a commission, for the accounts of other investors. The research department supplies the firm and its customers with information about securities. A significant sector of investment-banking operations is government bond dealing.

IV HISTORY OF INVESTMENT BANKING

Evidence indicates that ancient civilizations such as Greece and Rome engaged in investment-banking operations by extending long-term credits to governments and to certain industries. During the Middle Ages investment banking was concerned largely with financing governments. In the 12th and 13th centuries, for example, the Lombard banks in Italy combined trading operations with long-term loans made to various rulers.

In Britain, the earliest investment institutions of any importance were the acceptance houses or merchant banks. As far back as the 17th century, these concerns financed international trade. Later, the acceptance houses also floated foreign issues in London and accumulated funds for long-term investment abroad.

Also important in the evolution of investment banking were private banks, many of which were family enterprises, and finance companies. One of the former, the House of Rothschild, attained a dominant position in the financial centres of Europe during the 19th century and was still influential in the 20th century.

V 20TH-CENTURY INVESTMENT BANKING

In the United States during and following World War I, the investment-banking business expanded spectacularly. One aspect of this trend was the unprecedented increase in the number of individual security holders, resulting partly from the great prosperity of the 1920s. Many new and inexperienced firms entered the field. The ensuing wild competitive race for business ended during the Great Depression in a collapse of the security markets and the failure of many banking concerns. The abuses revealed during this period resulted in numerous federal reforms. Pressure for more effective legislation following the Wall Street Crash in 1929 led to the replacement of piecemeal state legislation by the Federal Securities Act of 1933. Its principal feature is “full disclosure”, the requirement that full and accurate information be made available regarding publicly offered securities through a registration statement filed with the Securities and Exchange Commission and through a prospectus (a condensed statement) given to prospective purchasers. Another reform instituted in 1933 was federal legislation compelling commercial banks to separate themselves from their securities affiliates, which had previously played a significant role in investment banking.

Currently, in Britain, channelling of capital into the domestic industry is done mainly through specialized finance or investment companies. In many European countries, however, it is customary for the same institution to carry on both commercial and investment banking. In Germany, in particular, large banks play a leading role in financing industrial development. Investment banks also play a global role. During the 1980s the Eurobond market grew tremendously. Companies and governments frequently finance their needs in the market—whether New York, Eurobond, or Tokyo—in which they can get the very best price and terms.

VI RECENT TRENDS

Investment banking has reached new high levels in many countries, despite the strong and increasing competition provided by direct borrowing by corporations from life-insurance companies and other institutional investors (including pension funds). The focus of legislation in recent years has been to increase investor protection and to increase competition in the provision of investment banking services. A leading example of the former are the insider trading laws enacted in many countries, which are designed to prevent those with privileged information from profiting from it. Examples of how competition has been fostered include the prohibition—in countries such as Britain and the United States—of fixed commissions on brokerage and underwriting arrangements.

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