Chapter Twelve Investment Banking, Insurance, and Other Sources of Fee Income

Key Topics 1. The Search for Fee Income and Types of Fee Income 2. Investment Banking History, Services and Major Activities A. IPO – Initial Public Offering B. LBO – Leveraged Buyout C. M & A – Mergers & Acqusition 3. Questions that can help Investment Bankers 4. Future Issues for Investment Banks

Key Topics 4. Mutual Funds & Other Investment Products 5. Trust Services & Types of Trusts 6. Insurance Products 7. Convergence and Product-Line Diversification 8. Economies of Scope and Scale 9. Information Flows & Customer Privacy

Introductionp Banks are always looking for funds to make loans and investments to grow their revenues When deposit growth slows, financial-service managers must find new sources of funds and new ways to generate revenue Important source of growth in future revenues – fee income

1. THE SEARCH FOR FEE INCOME P SOURCES OF FEE INCOME ▫ Revenues from charging customers for the services they use ▫ Monthly service charges on transaction accounts ▫ Commissions for providing insurance coverage for homes and businesses ▫ Membership fees for accepting and using a particular credit or debit card ▫ Fees for providing financial advice to individuals and corporations ▫ “Swipe fees” at the point of sale

1. THE SEARCH FOR FEE ICNOME (continued) Banks and financial firms need to get more fee income as an important revenue source to: ▫ Add to the main sources of funds (such as deposits) when these sources are not enough. ▫ An attempt to lower production costs by offering many services using the same facilities and resources (economies of scope)

1. THE SEARCH FOR FEE INCOME (continued) ▫ Banks want to reduce risk to the bank’s cash flow by finding new sources of revenue not from sales of traditional services ▫ A goal to promote cross-selling of traditional and new services in order to further grow revenue and net income

2. INVESTMENT BANKING – What is it and a brief History An investment bank is a financial intermediary or institution that helps companies raise funds. Investment banks are middlemen between companies that want to start or grow a business and the buying public. Investment banks are the financial intermediaries that these companies want to hire.

2. HISTORY of the Investment Banking Industry HISTORY OF THE INDUSTRY I. Two forces shaped investment banking A. Legislation – laws B. Economics II. Early History A. Investment activities led by private bankers like J.P. Morgan raising funds for governments (war) and railroad companies. B. Investment Banking was not regulated by the banks and with much speculation (risk) there were panics and runs on banks, resulting in the Great Depression C. Finally the Glass-Steagall Act 1933 separated investment banks from commercial banks. J.P Morgan in 1907

2. Investment Banking Services (cont) p Investment Banking Services The best-known and a profitable investment banking service is security underwriting ▫ The purchase for resale of new stocks, bonds, and other financial instruments in the money and capital markets for companies who need to raise new money

2. Investment Banking & Its Services p. 350 Many U.S. banks have acquired (buy) their own investment banking affiliates in order to serve corporations and governments around the world Leading investment banks in the world today: ▫ Citigroup ▫ Morgan Stanley ▫ Goldman Sachs ▫ Bank of America ▫ JP Morgan Chase ▫ Credit Suisse ▫ Deutsche Bank

2. Investment Banking and Its Major Activities p. 350 Investment banking is known for being too risky yet the services they provide help grow economies and help businesses grow. There are 3 major activities that Investment Bankers are involved in to help companies grow: A. INITIAL PUBLIC OFFERINGS (IPO) B. MERGERS & ACQUISITIONS (M & A) C. LEVERAGED BUYOUTS (LBO)

2. Investment Banking and Its Major Activities p. 350 A. What is an INITIAL PUBLIC OFFERING (IPO)? It is taking a private company and bringing it to the public where people can buy shares, invest in the company and become owners of a company. The company must be something the public is interested in, like technology companies. And it must be a company that is growing for investment bankers to have success.

WHO IS THIS? AND WHAT COMPANY?

2. Investment Banking and Its Major Activities p. 350 Alibaba's IPO now ranks as the world's biggest at $25 billion, giving underwriters of the sale more than $300 million.

2. Investment Banking and Its Major Activities p. 350 B. LEVERAGED BUYOUTS (LBOs) ▫ Involve the acquisition (buy) of a company, usually by a small group of investors, and typically are funded by large amounts of debt. To remake a firm, or im- prove the value.

2. Investment Banking and Its Major Activities p. 350 C. MERGERS & ACQUISITIONS (M & A) WHY DO YOU THINK COMPANIES MIGHT WANT TO GROW?

2. Investment Banking and Its Major Activities p. 350 C. MERGERS & ACQUISITIONS (M&A) WHY DO YOU THINK COMPANIES MIGHT WANT TO GROW? 1. They want to get big fast 2. They want to add other products or fill out a product line 3. They want to expand into other countries 4. To make them better and have more value

CONCEPT CHECK 1.Fee Income is important to Banks. What are some sources of fee Income? 2.What are some of the services and activities of Investment Banks? 3.What company was involved in the largest IPO in history?

3. Questions that can Help Investment Bankers p. 349 Examples of client questions that investment bankers can assist in answering. Clients are corporations, government, large companies, schools. 1. Should we attempt to raise new capital? If so, how much, where, and how do we go about this fund- raising task? 2.Should our company enter new market areas at home or abroad?

3. Questions that can Help Investment Bankers p Does our company need to acquire or merge with other firms? Which firms and how? And when is the best time to do so? 4. Should we sell our company to another firm? If so, what is our company worth? And how do we find the right buyer?

4. Future Issues for Investment Banks Recently investment banks & commercial banks have been under intense pressure to raise large amounts of new capital And what about being “Too big to fail?” Many people see more mergers ▫ Will future commercial bank - investment bank combinations turn out well ▫ One likely outcome is greater government regulation

Selling Investment Products to Consumers p. 354 In recent years many of the largest business and household depositors have moved money out of deposits at banks and into investment products ▫ Stocks, bonds, mutual funds, annuities, and similar financial instruments

Selling Investment Products to Consumers p. 354 MUTUAL FUNDS – WHAT ARE THEY? ▫ These are very popular. Share risk among different companies under one fund. ▫ Each share in a mutual fund has different stocks, bonds, or other securities, with each saver receiving a share of the earnings made by the pool of financial instruments.

Selling Investment Products to Consumers (continued)p ANNUITY INVESTMENT PRODUCTS Annuities are a product in which a customer invest savings with a contract that promises a stream of income in the future. This product provides a hedge (protection) against living too long and outlasting one’s savings. Fixed annuities promise a customer who contributes one large sum of savings a fixed rate of return over the life of the annuity contract

Selling Investment Products to Consumers (continued)p ANNUITY INVESTMENT PRODUCTS Variable annuities are also available, but there may be no promise of a guaranteed rate of return. The rate can change based on the market Great fee income for the bank

Selling Investment Products to Consumers (continued) Several problems and risks are associated with sales of investment products Current U.S. regulations require customers to sign a document about the investment products they buy. 1.Not insured by the Federal Deposit Insurance Corporation (FDIC) 2.Not guaranteed by the bank 3.Subject to investment risks, including possible loss of principal

5. Trust Services as a Source of Fee Income p. 358 Trust services is the management of property owned by customers, such as securities, land, buildings, and other assets Among the oldest non-deposit services that banks and some of their closest competitors offer parts of the financial firm

5. Trust Services as a Source of Fee Income p. 358 Trust departments often have large deposits because they manage property for their customers Deposits placed in a bank by a trust department must be fully secured

5. Trust Services as a Source of Fee Income p. 359 Popular kinds of trusts: Living trusts – act for a living customer to settle property when owner dies. Testamentary trusts – save on estate taxes and protect a customers property Irrevocable trusts – pass on a gift to a family member or friend and save on taxes Charitable trusts – giving to charity

6. Sales of Insurance-Related Products p Banks can use their branches to sell insurance Types of insurance products sold today: ▫ Life insurance policies – money paid to beneficiaries upon death of the owner of the policy ▫ Health insurance – medical coverage ▫ Property/casualty insurance policies Auto Insurance Insurance for jewelry and other valuable items

7. The Benefits of Financial-Services Diversification p. 362 When two or more different industry types merge with each other, this strategic move is called CONVERGENCE Banks benefit from the revenue from different product lines as they may move in different directions at different times. The result provides stability, cash flow and the risk of failure might also be reduced. This potential consequence of the convergence of two or more financial-service industries is called the product-line diversification effect

8. ECONOMIES OF SCALE AND SCOPE p Other benefits from offering multiple services include economies of scale and economies of scope ECONOMIES OF SCALE – cost savings due to size, more efficient in using resources to produce goods and services. A bank grows in size. The cost of production per unit goes down, lowering costs and creating more revenue. ECONOMIES OF SCOPE - cost of producing many services through separate firms is lowered. As a result, expanding the number of financial services offered may result in more intensive use of resources, reducing overall costs and widening a multiservice firm’s profit margin

9. Information Flows within the Financial Firm p Banks have become more and more like information gathering and information giving businesses The Gramm-Leach-Bliley Act of 1999 allowed financial-service companies to share customer information among their affiliated firms. This requires customers to say “yes” or “no” to having their personal information given to others Protecting customer privacy became increasingly more important

CHAPTER SUMMARY FEE INCOME – Essential source of revenue for bank INVESTMENT BANKS – Raising funds and growing businesses through activities like IPO’s, M & A and LBO’s INVESTMENTS – keys to increasing bank revenues. Stocks, bonds, derivatives PRODUCT LINE DIVERSIFICATION & CONVERGENCE – many different products

CHAPTER SUMMARY MUTUAL FUNDS – A way of minimizing risk by investing in a “pool” of different stocks with earnings coming from the different sources. ANNUITIES - ANNUITIES – Invest savings for a future flow of income to protect against living too long.\ TRUST SERVICES – Management of property for individuals and making sure that money is given to the people designated by the trust.

CHAPTER SUMMARY INSURANCE RELATED PRODUCTs – Health insurance for medical problems, life insurance to beneficiaries ECONOMIES OF SCALE – cost savings due to size, more efficient is using resources to produce goods and services ECONOMIES OF SCOPE – multiple services using the same location and resources