1.What is Investment Banking?

Invetsment banking is a highly specialised segment of finance industry. Its basic function is to
bring together, directly through the mechanism of financial markets, ultimate savers and
savings-collecting institutions with those wishing to raise additional funds for investment or
consumption. It also facilitates holders of accumulated wealth, held in the form of financial
instruments, to re-allocate their assets using financial markets in accordance with their
changing evaluation of the attraction of the combination of risk/reward/liquidity attributes of
individual financial assets, compared with each other and with real assets. In performing these
two basic functions those involved in the investment banking act as market intermediaries.
They must be distinguished from banks and other savings-collecting and savings-managing
institutions who gather and decide themselves on the allocation of savings and who act as
financial intermediaries. The use of financial markets is thus at the heart of investment
banking. Its development and evolution have been closely linked to the growth and expansion
of financial markets (and above all capital markets), the instruments they employ and the
mechanisms they use.
There is an important distinction between investment banking activity and the institutions that
perform it. Investment banking activity can be, and is also undertaken by, banks (who are
financial intermediaries), provided the respective regulatory framework allows it and an
individual bank’s (i.e. universal banks) wish to engage in it.

Investment Banks as Financial Intermediaries

Issuers of Investors of
Equity or Debt Capital

Investment
Banks
2.Categories of Investment Banking Firms
There are two general ways to categorize investment banking firms: (1) relative status, as
differentiated by size, expertise, and reputation, and (2) functions offered or emphasized.
The status of investment banking firms can be classified as follows:
• Bulge-bracket firms, the blue-chip houses that are set apart from all others by
reputation, size, market power, and client list

Top 10 firms:

Capital $bn Employees

Merrill Lynch 20,68 43800

Salomon Inc. 16,10 8600

Lehman Brothers 14,72 8512

Morgan Stanley 12,10 9600

Bear Stearns 5,80 7600

CS First Boston 5,56 6000

Goldman Sachs 4,80 8200

Paine Webber 4,13 14500

Smith Barney 2,30 28000

Donaldson,Lufkin&Jenrette 1,77 4600

 • Major bracket firms, the large national full-line firms that do not have the same
investment banking status as the bulge-bracket firms.
• Submajor bracket firms, the solid, partnership-owned, often New York based firms
that create a niche by serving special investor groups and smaller issuing companies.
• Regional firms, the securities firms that are important in geographic areas outside of
New York. The invetsment banking departments of regional firms are usually weaker
than their trading departments, which cater to local investors.
• Specialized firms, the boutique firms that are strong in only a few focused areas, such
as specialists in banking securities or technology offerings.
• Research firms, the boutique that make their reputation by the quality of securities
analysis (their investment banking function is an extension of their research
capabilities).
• Merchant banks, the boutique firms that specialize in mergers and acquisitions and
leveraged buyouts. Many of these highly visible firms have been founded by highly
visible bankers who left the bulge-bracket firms; these boutiques do not perform
underwritings but have raised large pools of capital for merchant banking and LBOs.

3.Scope of Investment Banking

It would be easy to compile a long list of the those of activities that contemporary investment
bankers do. Following are 12 categories of investment banking activities.

3.1.Public Offerings of Debt and Equity Securities

The public offering of that and equity securities is the foundation of investment banking.
Regarding an initial public offering, there are actually only two approaches that an investment
bank can take: firm commitment or best efforts.
• Firm commitment. A firm commitment means that the managing investment bank and
its syndicate will agree to buy the entire issue at a negotiated price. The underwriter
will than resell these shares to its clients, making as its profits the previously
negotiated spread, which is the difference between the gross proceeds paid by the
 public and the net proceeds given to the issuer. This means that the underwriters bear
the entire risk of per-share pricing and the amount of total proceeds to be raised.
• Best efforts. A best efforts relationship is where the investment bank uses its expertise
as structurer in designing the issue and as marketer in selling the issue. This means
that the underwriters bear no risk in the deal, leaving to the issuing company all the
uncertanity of per-share pricing and the amount of total proceeds to be raised.
Types of Public Offerings. 4 general types of public offerings that investment banks conduct:
1. Initial public offerings (IPOs) of securties issued by companies that have never before
issued any public securities (normally common stock is the first security to be issued
in an IPO).
2. Initial public offerings of new securities that companies that are already public have
not previously issued (e.g. a new class of convertible debt security issued by a public
company).
3. Further public offerings by issuing companies of securities that are already publicly
traded (e.g. the issuance of additional common stock when its price is sufficiently high
so that the cost of capital is sufficiently low).
4. Public offerings by company shareholders of securities that are already publicly traded
(e.g. when an original large shareholder, say a venture capital fund, once to cash out
its position).
The Underwriting Process. Underwriting is a formal process involving many simultaneous
functions, procedures, requirements, and activities. Following are some of the critical steps.
• Company expression of interest and underwriter selection.
• Preliminary analysis of issue structure and securities pricing.
• Due diligence reviews by underwriters and their counsels.
• Legal and accounting analysis and document preparation
• Preliminary compilation of the registration statement.
• Submission of registration statement to the Securities and Exchange
Commission/SEC
• Circulation of preliminary prospectus to prospective investors.
• Information meetings (“road shows” or “dog-and-pony shows”) in major cities
for describing the company and its securities.
• Reception and response to SEC comments.
• Final pricing negotiations and signing of the underwriting agreement.
• Final registration statement filed with the SEC.
 • SEC approval declaring the issue effective.
• Press releases and tombstone advertisement.
• Closing and settlement.

3.2.Public Trading of Debt and Equity Securities

Most large investment banks maintain strong trading capabilities, especially the bulge-bracket
firms. Trading is a significant though volatile profit center-profits are made both from
commissions generated by trading for clients and from capital appritiation generated by
trading from the firm’s own account.
Investment banks perform various levels of trading functions.
Brokers. Brokers are commissioned agent who represent either buyers or sellers and work
muchly same as real estate agents. Brokers communicate among aech other through actual or
electronic stock exchanges and arrange tarnsactions for their clients at prices set by those
clients. Stock brokers carry no securities in inventory and therefore assume no risk in price
variation or interest charge.
Dealers. Dealers set bid-and-ask prices for each security they offer for trade. When a bid
offered by a dealer is accepted (hit) by a seller (whether broker or institution), the dealer buys
a security and takes it into inventory.(By maintaining an inventory of securities, dealers
assume a price risk since the market may go up or down during the time they hold the
securities. They must also bear the cost of interest carried. Dealers can “lay off” or limit their
risk by taking counteracting hedging positions in derivative markets such as financial futures
and options. Risk can be reduced but at a cost.) Over-the-counter markets operate through the
dealer system.
Market Makers. Market makers establish (and support) the entire market for a security on
either buy or sell side of a transaction. Such market making is normally important following
its initial public offering before the becomes sufficiently broad, and it involves the entire
system of stock specialists, floor traders, and the like.
Risk Arbitrage. Risk arbitrage is the process of buying the securities of firms that have
announced mergers or acquisitions. Since the preclosing market price will almost always
reflect a lower price than that of the deal, savvy investors can generate a high rate of
annualized return-but they must beware the unexpected.
Logistics and Support. All trading functions are backed up by substantial logistical support
from a back office operation. Trading requires complex paper processing and record keeping
which are needed for the proper settlement of transactions, the recording and releasing of
price and volume data of traded securities, and the reconciliation of cash flows and stock
sertificate exchanges.
Trading Focus. The trading focus may differ from firm to firm depending on the specific
strategic niche.

3.3.Private Placements of Debt and Equity Securities

Private placement is the selling of corporate securities to investors without regulatory
requirements of public offerings. The regulations defining private placements are complex,
and the securities and investment vehicles offered are numerous. Corporations seeking to
replace their securities in the private markets engage investment banks to act as their agents
on a best effort basis. Privately placed securities carry a higher rate of return than similarly
structured securities that can trade in the public market. The loss of liquidity enhances risk
and therefore requires a proportionally higher return.

3.4.Mergers and Acquisitions (M&A)

This is the high profit area of invetsment banking-the takeover battles, the hostile attacks, and
fierce defences- generating front-page news and massive fees. But M&A is not all war. The
vast majority of mergers and acquisitions are friendly and mutually desirable. M&A has
become a major part, in fact a central part of contemporary investment banking.
Valueofcomletedbids($trn)

$1.20

$1.00

$0.80
1st quarter
$0.60 2nd quarter
3rd quarter
$0.40
4th quarter
$0.20

$0.00
1997 1998 1999 2000 2001 2002

Graph 3.1 Global Mergers and Acquisitions

3.5.Merchant Banking
This is where investment banks commit and risk the firm’s own capital and seek very high
returns.Merchant banking is a hot new area of investment banking, energized by the excessive
returns (35-50%) that have been attained year after year. Committing and investment banks
own capital increases both ends of the risk/reward trade-off. Such commitment of capital is
made for two pruposes: (1)to facilitate a client transaction; or (2)to purchase an operating
company for the firm’s own account. It should be noted that bridge loans are highly
profitable, combining commitment fees, placement fees, high interest rates, and equity
incentivese.
3.6.Financial Consulting and Fairness Opinions
Financial consulting in itself is not a high-leverage investment banking activity. Rather, such
corporate finance consulting opens a door for marketing major investment banking services
such as M&A and underwriting.

3.7.Asset Monetarization and Securitization

Securitization is the process by which formerly illiquid assets, mostly small consumer
receivables of all kinds, can be liquefied into large, publicly tradable securities. Here is real
value added, a clear demonstration of innovative investment banking contribution to the
financial markets.

3.8.Risk Management
New methods of hedging positions in interest rates, foreign currency exchanges,and
commodity positions through swaps, options, and futures have permanently changed the
financial markets.
Swaps have emerged as a radical new mechanism for crafting optimum financial structure
positions with respect to interest and currency exchange rates and to the temporal matching of
assets and liabilities. Swaping instruments are the mechanisms by which two or more parties
exchange their debt obligations in order to control more precisely each party’s desired
risk/return profile. Swaps work because different corporations have different comparative
advantages when pricing different categories of debt in different financial markets.

3.9.Investment Research and Security Analysis

For many years, reserach capabilities of an investment bank’s security analysts were often the
firm’s most prestigious and most visible strength.
Research is still a foundational pillar of the industry, supporting both the securities trading
and investment banking operations.
It is important for large investment banks to field a top team of investment analyst stars. It
symbolizes the investment bank’s relative importance and comparative strength.

3.10.International Investment Banking

All the large investment banks have sought expansion into international finance with
significant representation in foreign markets. Several major American firms have made
enormous capital allocations and ongoing investments to establish major offices in London
and Tokyo.
Globalization is the new byword of investment banking. Financing has become a multimarket
search for the lowest cost of capital for issuers and a 24-hour-a-day quest for the highest
return for investors.

3.11.Money Management
With the enormous growth in pools of capital, money management has become a major
industry. Several investment banks have set up departments to handle the management of
these funds. Although they draw on their inherent strengths in understanding the capital
markets for purposes money management, firms must also be exquisitely sensitive to any real
or apparent conflicts of interest.

3.12.Venture Capital
Venture capital is a high risk-high return business of investing in young, fast-growing
companies. It is a volatile industry with sky-high crests and precipitious crashes.
Investment banks are involved at all levels of venture capital investments, from assembling
the capital for the funds to taking the portfolio companies public. Regarding management of
the funds, there are two approaches: First, an investment bank gets a commission for monies
raised and may have no further involvement. Alternatively, the investment bank can manage
the venture fund itself, setting up a separate subsidiary and management organization.

4.Investment Banking and the Financial System

In as much as investment banking enables the financial system to perform some of its basic
functions better and more efficiently, its evolution is one of the important factors propelling
the development of the financial system as a whole. The fundamental functions that the
financial system must perform are, first, to run and manage the payment clearence and
settlement system; second, to provide liquidity; third, to transfer savings from surplus units to
deficit units and allocate these according to respective risk/rewards/liquidity preferences;
fourth, to monitor and dicipline units using externally raised funds; and finally, to price,
transfer and trade risk.
Investment banking can be said to stimulate the pace of transformation of the system in that it
helps to move it from a bank-oriented system, where all five functions are performed by
commercial banks by way of bilateral agreements, to the market-oriented phase, where
markets play an increasing role in the performance of the last three functions and then to the
securitised phase where markets and investment banking dominate the financial system. This
path of progress is economically beneficial as it reduces the resources employed to perform
some of these basic functions; it improves quality in that it improves the risk evaluation risk-
sharing and risk-diversifying functions substituting joint market judgement based on jointly
shared information for bilateral judgement; and, finally by increasing the scope it enhances
the ability of an economy to carry more risk and to respond more rapidly to changes and to
take remedial action in relation to the performance of units using externally raised funds.

5.Strategies for Investment Banks

Volatility is the prime characteristic of the investment banking industry, and investment
bankers must never forget this ever-present uncertainity. Stock market fads and fluctuations
combine with personel emotion and mobility to generate an erratic and unpredictible
environment. Such unpredictable dynamism makes life uncomfortable for investment banking
executives but is fertile soil in which true strategic thinking and planning can flourish.
Following are some specific areas for strategic consideration that investment bankers should
consider when contemplating how best to plan their own futures. These are a few of the
fundamentals.

5.1.Strategic Constraints
There are four primary strategic constraints for investment banks:
A. Capital (e.g. amount, allocation, relationship to strategy, growth)
 B. Clients (e.g. sector, size, industry)
C. Services (e.g. underwriting, IPO, M&A, LBO, rate risk management, back-office
operations)
D. Personel (e.g. traders, bankers, rainmakers, innovators)
A firm must start its strategic planning process by assessing itself with respect to all four
constraints, and then it must postulate where it wants to be positioned at some future date.
Such an assessment must not be done in a vacuum. Investment banking is a highly
competitive industry, in addition to being exceptionally volatile. Comparative and competitive
analysis is essential at every stage of the process. Distinctive competencies and competitive
advantage-together with internal consistency-are the critical criteria for evaluating all strategic
alternatives.

5.2.Firm/Market Positioning
There are several ways to play the investment banking game. The key is to match the right
structure with the right strategy.
Firms must position themselves according to their assessment of the economic environment
and the coming competitive pressures. Medium size firms, for example, seem to be
particularly vulnerable to the dual crush of capital requirements and the back-office costs of
doing major-leauge business. On the other hand smaller firms that stake out strong positions
in circumscribed regions can do remarkably well by specializing in smaller local corporations
and regional individual investors. Intelligence and service are the keys to success for regional
investment banks.

5.3.Agent or Principal
Some investment banks are having difficulty deciding who they are-agents or principals. The
problem arises as a result of the enormous profits made through the ownership of companies,
primarily through leveraged buyouts.
Merchant banking involves risking the firm’s capital to make bridge loans for closing
acquisitions quickly (many acquisitions requiring bridge loans are made under competitive
pressures, and some are hostile). The bridge loan remains outstanding until the permanent
financing can be put into place. Merchant banking may also involve taking equity positions in
companies (often in partnership with clients).
5.4.Optimal Size
In some investment banks, the number of employees grew larger than the firm’s current
market position could support. The outcome, in some cases, was a balooning organization and
a bloated structure that eroded distincitve competencies and lost competitive advantage,
resulting in a fast fall into oblivion.
The most important factor in implementing a corporate strategy is designing the proper
organizational structure to support it. Size is perhaps the most critical criterion here: too
small, and you cannot provide the services that clients demand; too large,and you suffocate
the firm eith excessive costs and frustrate personnel with limited opportunity.
Capital efficiency is an important part of the optimal size analysis. Too much capital is always
better than too little, but just the right amount is better than buth. Investment banks should be
properly capitalized for accomplishing their specific business strategies and financial goals.

5.5.Competitive Advantage
Competitive advantage is the key reason any organization survives and successes. There must
be some reason why your firm exists, why employees should work there, why clients should
come there. What do you have that your competitors do not?
The most important thing to remember about competitive advantage is that it must constantly
be sought, because without advantage there is no advantage.

5.6.Pricing Fees and Spreads

The pricing of fees and spreads is a critical strategic decision for investment banks.
How an invetsment bank prices its services goes a long way toward telling its story and
establishing its position. It can be tempting to cut prices in order to win business-after all,
bankers must be able to show their stuff. On the other hand, the battlefield must be picked
carefully. Shaving prices in the wrong underwriting can generate unexceptably large losses
and produce a poor industry image. Furthermore, by offering services for lower-than-normal
industry fees, a fee-cutting investment bank might inadvertently signal that its quality is lower
than that of its peers.
5.7.Personnel
The importance of personnel in investment banking is so great that it demands a separate
category and constant consideration. It is a truism that a firm’s primary assets ride down the
elevator every evening. Top personnel must be kept content or a bank cannot succeed.
Compensation and allocation bonuses are always knotty problems.

5.8.Internationalization
In the tightly wired world of international finance, the oppotunities are great but the risks may
be greater. It is frightfully complex to deal in foreign capital markets, not to mention
enormously expensive. A modern investment bank must determine its logical position in the
international firmament.

5.9.Strategic Alliances
One approach to several of the strategic issues discussed here is for an investment bank to
form a strategic alliance with another, complementary firm. The strategic alliance provides
international presence, visibility, an expertise with a much lower risk profile and cost
exposure.

6.Investment Banking in Major Countries

Among the major countries investment banking is in the most developed phase of its
development in the US and the UK and in a less developed phase in Germany and Japan. As
far as the reliance on external funds is concerned funds raised in the form of securities
represent a much higher proportion of credit funds for companies in the US and the UK
compared with Germany and Japan. For the latter two countries corporate debt in the form of
securities represent less than 10 % of credit as compared with 23% in the UK and over 50% in
the US -55%.
Another indicator of the relative importance of investment banking is the position of equity
markets (figure 6.1). In 1985 stock market capitalisation amounted to 48% of GNP in the US,
81% in the UK, but only 14% in Germany and 37% in Japan. By 1994 these differences must
have increased quite significantly if, as is likely, they moved in the same way as capitalisation
unadjusted for intercorporate shareholdings.

As a percentage of GNP
US UK Japan Germany

(1) (2) (1) (2) (1) (2) (1) (2)

1985 51 48 90 81 71 37 29 14

1994 91 na 111,9 na 71 na 25 na

Figure 6.1 Stock market capitalisation of domestic companies 1985-1994

1.Unadjusted for double counting of shares associated with intercorporate

shareholdings.
2.Adjusted for double counting of shares associated with intercorporate shareholding.
na means not available

Finally the relative importance of insurance and pension fund claims which are predominantly
held in the form of securities as compared with bilateral debt claims (mostly held in the form
of bank deposits) is significantly higher in the US and the UK compared with Germany and
Japan.
The differences in the present position of investment banking in major (and other) countries
can be attributed to the different impact and consequent interaction between economic,
regulatory and social factors responsible for the evolution of investment banking and the
financial system.

7.Prospect for the Future

Looking ahead both the economic and social-cum-institutional factors are likely to continue to
extend their influence in favor of expansion of investment banking, and changes in the
financial system regulatory framework will inevitably follow them. Globalisation of the world
economy can be expected to lead to a rise in the relative importance of investment banking on
the Anglo-Saxon model in other countries and to the convergence of the financial system and
regulatory approaches. The attention paid to and the need to contain systemic risk are likely to
accelerate this trend, palcing financial markets and investment banking even more firmly at
the center of finance and banking.

Bibliography

1.”Investment Banking -Theory & Practice” Second Edition

Edited by Prof. Edward Gardener & Dr. Philip Molynex
Published by Euromoney Books

2.”Investment Banking –The Art & Science of High Stakes Dealmaking”

Robert Lawrence Kuhn
Published by Harper & Row 1990

3.”Competition in the Investment Banking Industry”

Samuel H. Hayes , A. Michael Spence , David V. Marks
Cambridge MA:Harvard University Press 1983
4.” The Investment Banking Handbook”
Edited by J. Peter Williamson
New York : John Wiley & Sons 1988