MN50412 Investment Banking

General information Lecturer: Dr Bruno Deschamps Office: Wessex House 9.21 Email: bd207@bath.ac.uk Class time: Wednesday 3.15-5pm Office hours: Monday 11am-1pm

What is investment banking?

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

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)

Proprietary trading: Trading with the bank own money 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

Equity underwriting Asset management - Determine the offering price - 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 investors

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

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.

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

Banks that combine commercial and investment banking 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 banking Example: UBS, Citibank, Bank of America 11

Content of the course

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

Debt underwriting Derivatives products Pricing of bonds Yield curve Corporate vs. government bonds Callable bonds, convertible bonds Derivatives products Futures Options SWAPS, CDO, CDS

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

Contribution of financial services to the UK economy 16

Sectors' share in UK GDP 17

Financial services jobs in central London City of London Canary Wharf City-type UK Fin. servs Total 2000 158 330 11 46 325 1069 2001 134 309 24 62 312 1089 2002 143 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 1029 18

UK sector trade balances 19

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 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 --- 27.1 20

International financial markets in the UK 21

IB revenues 22

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 23

Sovereign wealth funds under management (global) 24

Global private equity 25

UK market shares % share UK US Japan France Germany Cross-border bank lending (Mar 2008) 20 9 7 11 Foreign exchange turnover (Apr 2007) 34 17 6 3 Exchange-traded derivatives turnover 40 2 1 13 Over-the-counter derivatives turnover 43 24 4 International bonds - secondary market 70 ... Fund management (as a source of funds, end-2007) 48 Hedge funds assets (end-2007) 66 - Private equity - investment value (2007) 71 IPOs (Jan-Sep 2008)5 Securitisation - issuance (2007) 76 26

Turnover of London based derivatives exchanges ICE Futures Europe Liffe LME EDX Total 1997 14.7 209.3 57.4 4.4 285.8 1998 19.4 149.8 53.1 7.3 229.6 1999 23.0 117.8 61.5 10.4 212.7 2000 25.5 131.1 66.4 11.6 234.6 2001 26.4 619.1 59.4 15.9 720.8 2002 30.4 697 58.6 14.1 800.1 2003 33.3 695.1 72.3 14.8 815.5 2004 35.5 787.8 71.9 21.5 916.7 2005 42.1 759.3 78.6 20.3 900.3 2006 92.7 730.3 86.9 28.8 938.8 2007 138.5 949 92.9 43.1 1,223.50 27

UK vs. US (1929-2007) 28

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). 29

Investment banking in the UK In the past, separation between: 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. Jobbers: Market makers that could trade only with the brokers, not with the general public. Merchant banks: Commercial banks that offer corporate finance services (M&A advisory, underwriting etc.). Did not own the brokers. In 1986: Big bang: Abolition of fixed commission to increase competition 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 31

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 32