CHAPTER 19 INVESTMENT BANKING
Copyright© 2003 John Wiley and Sons, Inc. Investment Banking Investment Banks (IB) are the most important participant in the direct financial markets Assist firms and governments in selling new securities in the primary market. Assist in making (dealer) or arranging the buying and selling (broker) in the secondary market.
Copyright© 2003 John Wiley and Sons, Inc. Investment And Commercial Banks Differ Commercial Banks (CB) accept deposits and make commercial loans as a financial intermediary. CB traditionally could underwrite only low-risk securities of governments per the Glass- Steagall Act. Many large firms now use the direct financial markets to finance rather than bank loans.
Copyright© 2003 John Wiley and Sons, Inc. Glass-Steagall Act The legislated separation of CB and IB in the United States is unique The Glass-Steagall Act of 1933 (Banking Act) restricted the asset powers of commercial banks to low-risk underwriting areas. In other countries, universal banks were able to combine commercial and investment banking functions. United States, IB, and CB had to compete with these firms.
Copyright© 2003 John Wiley and Sons, Inc. The Glass-Steagall Act Effectively Separated CB from IB CB could not underwrite (buy and resell) risky business securities. CB were limited as to the risk assumed in their investment portfolio--no risky corporate securities. IB firms were prohibited from engaging in CB activity. Firms became either IB or CB.
Copyright© 2003 John Wiley and Sons, Inc. The Objectives of the Glass- Steagall Act Discourage speculation in financial markets. Prevent conflict of interest and self- dealing. Restore confidence in the safety and soundness of the CB system.
Copyright© 2003 John Wiley and Sons, Inc. Repealing the Glass-Steagall Act Relaxing the Glass-Steagall restrictions was one of the major financial issues of the last twenty years. CB increasingly had sought to be allowed to engage in investment banking activities. The Federal Reserve Board had increasingly allowed CBs to engage in some investment banking activities. In the late 1990s, several commercial banks purchased investment banking firms.
Copyright© 2003 John Wiley and Sons, Inc. Gramm-Leach-Bliley Act Financial Services Modernization Act of 1999 Permitted commercial banking, investment banking and insurance underwriting under a financial holding company Citigroup
Copyright© 2003 John Wiley and Sons, Inc. Bringing New Securities to Market New issues are called primary issues, first issued in the primary market. If the issue is the first sold to the public, it is called an unseasoned offering or an initial public offering (IPO). If securities are already trading, the new issue of securities is called a seasoned offering.
Copyright© 2003 John Wiley and Sons, Inc. Bringing New Securities to Market (continued) Three steps of bringing a new security issue to market include: Origination--design of a security contract that is acceptable to the market; prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus, obtain a rating on the issue, obtain bond counsel, a transfer agency and a trustee, and print the securities.
Copyright© 2003 John Wiley and Sons, Inc. Bringing New Securities to Market (concluded) Underwriting--the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them. Syndicates are formed to reduce the inventory risk. Market price declines cut the IB's margin. Sales and distribution--selling quickly reduces inventory risk. Firm members of the syndicate and a wider selling group distribute the securities over a wide retail and institutional area.
Copyright© 2003 John Wiley and Sons, Inc. Trading and Brokerage in the Secondary Market The brokerage function is to bring a buyer and seller together. Dealer function--buying (bid) and selling (ask) from an inventory of securities owned by the seller.
Copyright© 2003 John Wiley and Sons, Inc. Trading and Brokerage in the Secondary Market (continued) Full service brokerage firms offer a wide range of financial services provided by licensed stockbrokers or account executives for commissions. Services include: Storage or safekeeping of securities. Execution of trades. Investment research and advice. Cash management service.
Copyright© 2003 John Wiley and Sons, Inc. Trading and Brokerage in the Secondary Market (concluded) Discount (Internet) brokerage firms offer fewer non-fee services than full-services brokers, but charge lower commissions on security purchases and sales. Banks may act as a broker on behalf of its customers under the Glass-Steagall Act. Banks moved into this area in the 1980s and 1990s usually as a discount broker.
Copyright© 2003 John Wiley and Sons, Inc. Private Placements The sale of securities directly to the ultimate investor and not through a public offering. The underwriting function/cost is avoided. A fee is earned for the origination/selling or uniting the supplier and user of funds. A private placement may reduce the total flotation costs for a business or government. The extremes of high credit quality firms and low or unknown credit quality firms use private placements.
Copyright© 2003 John Wiley and Sons, Inc. Private Placement, cont. Traditional two-year trading delay with private placement securities SEC Rule 144A permits trading among institutional investors Increased liquidity of investment; lower liquidity risk premium; lower financing cost for borrower.
Copyright© 2003 John Wiley and Sons, Inc. Mergers and Acquisitions Specialized IB departments provide the following services. Arrange mergers which would produce economic synergy or increased total value after merger. Assist firms which have had unwanted merger offers (hostile takeovers). Help establish the value of target firms.