INTRODUCTION TO INVESTMENT BANKING

An investment bank is a specialized organization that takes in your money and after analyzing the possible risks and economic conditions gives you advice to convert it into more money. Investment Banks profit from companies and governments by raising money through issuing and selling securities in the capital markets (both equity and bond), as well as providing advice on transactions such as mergers and acquisitions. Investment banking is the term used to describe the business of raising capital for companies and advising them on financing and merger alternatives. Capital essentially means money. Companies need cash in order to grow and expand their businesses. Investment banks sell securities (debt and equity) to investors in order to raise this cash. These securities can come in the form of stocks, bonds, or loans. Once issued, these securities trade in the global financial markets, or depending on the size and nature of the investment bank, in the financial market of the country it is operating in. When we talk about Investment Banks, in the global arena these are huge entities worth billions of dollars. A number of firms have remained pure investment banks (Goldman Sachs, Morgan Stanley), while others have commercial banking arms (JPMorgan, Citigroup, Bank of America). The current market leaders in Asia include Goldman Sachs, Citi Markets & Banking, UBS, Morgan Stanley, Deutsche Bank, Credit Suisse and JPMorgan. Most global investment banks such as Goldman Sachs, Morgan Stanley, UBS, JPMorgan, Credit Suisse and Citi all have presence in most Asian countries. Most global banks such as Societe Generale, Banque Nationale de Paris (BNP), HSBC and Standard Chartered Bank have some presence in Asia with most of their investment in Singapore or Hong Kong to cover the Southeast Asia region and sometime including India. It is interesting to point out that none of these banks have their operations in Pakistan. The countries mentioned above are mostly those who have a sound financial (money and capital) market, or are emerging as promising new economies with a lot of potential in them. Pakistan is missing from this list. We link this with our topic, i.e. the scope of investment banking in Pakistan, and shall see why there is the absence of global investment banks as well as the prevailing state of the local investment banks operating in the country.

DIFFERENCE BETWEEN A COMMERCIAL BANK AND AN INVESTMENT BANK

A commercial bank is in business to do two main things: hold deposits and make loans. The commercial bank creates money by lending out deposits to individuals seeking a loan for some designated purpose. People borrow to buy a house, finance a car, or finance an addition to their homes. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks range in size from the local dry cleaner to the multinational conglomerate such as General Electric, Sony, and Samsung. The commercial bank also keeps deposits on hand for individuals wishing to use the money to make payments (like a checking account). The commercial bank makes profit by lending out to individuals and other entities and collecting payments from these borrowers for principal and interest. An investment bank operates quite differently from a commercial bank. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, from a market-making perspective, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. An investment bank also provides advisory services (for mergers and acquisitions), which does not require it to deal in the securities of the underlying companies. It is important to note however that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it can raise funds via a loan from a commercial bank or it may also ask an investment bank to sell equity or debt (stocks or bonds) on its behalf in the public markets. Because commercial banks already have funds available from their depositors and an investment bank typically does not, an investment bank must spend considerable time finding investors in order to obtain capital for its client.

BASIC FUNCTIONS
 Strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.  Trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) was referred to as the "sell side".  Pension funds, mutual funds, hedge funds, and the investing public who consumed the products and services of the sell-side in order to maximize their return on investment constitute the "buy side". Many firms have buy and sell side components.

The BUY Side and the SELL Side

The traditional investment banking world is considered the sell-side of the securities industry. Investment banks create stocks and bonds, and sell these securities to investors. Sell is the key word, as they continually sell their firms capabilities to generate corporate finance business, and salespeople sell securities to generate commission revenue. The buyers are individual investors and institutional investors and organizations. The universe of institutional investors is appropriately called the buy-side of the securities industry and includes asset managers, pension funds, insurance firms, and hedge funds. Growth in the institutional investor universe during the past ten years has been largely fueled by the growth in the hedge fund universe, representing over a trillion dollars of assets under management. As hedge funds seek to place capital to work in more sophisticated ways, the markets have evolved, with investment banks now offering more complex financial products than ever.

MAIN AREAS OF OPRERATIONS FOR INVESMENT BANKS

1) Corporate finance Considered the bread and butter of a traditional investment bank, corporate finance generally performs two different functions: 1) Mergers and acquisitions advisory and 2) Underwriting. y On the mergers and acquisitions (M&A) advising side of corporate finance, bankers assist in negotiating and structuring mergers between companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price, structure the deal, and generally ensure a smooth transaction. The underwriting function within corporate finance involves the process of raising capital for a company. In the investment banking world, capital can be raised by selling equity (stocks) or debt (bonds or loans) to investors. Underwriting is unique, in that it involves the investment bank assuming a large amount of risk. This means that the investment bank assumes the risk of the transaction not selling in the market.

2) Capital markets The role of capital markets is managing the interaction of the bankers in corporate finance with those in sales & trading (as well as research). Generally placed under the corporate finance umbrella, these jobs blend a bit of both corporate finance and sales & trading. Capital markets professionals are responsible for understanding recent transactions in the financial markets and using this information to structure new transactions. They serve as invaluable market advisors for their firms deals and many times are the leads in executing deals originated from other areas in corporate finance. Capital markets professionals are also usually grouped into either equity capital markets or debt capital markets.

3) Sales
Sales are another core component of any investment bank. Retail brokers develop relationships with individual investors and sell stocks and stock advice to the average Joe. Institutional salespeople develop business relationships with large institutional investors. Institutional investors are those who manage large groups of assets, for example pension funds, mutual funds, hedge funds, or large corporations. Salespeople make money through commissions on trades made through their firms or, increasingly, as a percentage of their clients assets with the firm. As investment bankers structure transactions requiring the issuance of new securities, salespeople are responsible for selling these securities to investors. Therefore, although a transaction might appear profitable on paper, it ultimately relies on those buying the securities and the investment banks relationships with those buyers. Furthermore, as those securities trade in the market, the salespeople are responsible for representing their clients and executing a purchase or sale on their behalf.

4) Trading
Traders provide a vital role for the investment bank. In general, traders facilitate the buying and selling of stocks, bonds, and other securities such as currencies, futures, and derivatives, either by carrying an inventory of securities for sale or by executing a given trade for a client. A trader plays two distinct roles for an investment bank: y Providing liquidity: Traders provide liquidity to the firms clients (that is, providing clients with the ability to buy or sell a security on demand). Traders do this by standing ready to buy the clients securities at any time (or sell securities to the client) if the client needs to place a trade quickly. This is also called making a market, or acting as a market maker. Traders performing this function make money for the firm by selling securities at a slightly higher price than they pay for them. This price differential is known as the bidask spread. (The bid price at any given time is the price at which an investor can sell a security to another, which is usually slightly lower than the ask price, which is the price at which investors can buy the same security from another investor.)

Proprietary trading: In addition to providing liquidity and executing traders for the firms customers, traders also may take their own trading positions on behalf of the firm, using the firms capital hoping to benefit from the rise or fall in the price of securities. This is called proprietary trading.

5) Research
Research analysts follow stocks and bonds and make recommendations to outside investors on whether to buy, sell, or hold those securities. They also forecast companies future earnings. Stock analysts (known as equity analysts) typically focus on one industry and will cover up to 20 companies stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as a particular industrys high yield bonds. Salespeople within the investment bank utilize research published by analysts to convince their clients to buy or sell securities through their firm. Corporate finance bankers rely on research analysts to be experts in the industry in which they are working. Reputable research analysts can generate substantial corporate finance business for their firm as well as substantial trading activity, and thus are an integral part of any investment bank.

6) Syndicate
The syndicate group provides a vital link between salespeople and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering. In a corporate deal, syndicate also determines the allocation of bonds and loans. This function often works very closely with the professionals in capital markets.

INVESMENT BANKING IN PAKISTAN

Before we list the factors affecting the scope of investment banking in Pakistan, it is vital to point out that in Pakistan there is a very small number of independent investment banks operating in the country. A few are also backed by large financial groups, such as IGI Financial Group, and others are merely departments within large commercial banks, such as RBS. Investments banks play a crucial role in the process of capital formation which is imperative for breaking the vicious circle of poverty we are faced with. A conventional investment bank mobilizes the savings and makes them available for investments in longer-term projects and provides a number of ancillary services which are equally instrumental in an economys capital formation process. These services, inter alia, include securities underwriting, stock and bond trading, facilitating mergers and acquisition, arranging and funding syndicated loans, arranging and managing public issues, and providing financial advice to businesses. The investment banking started to take roots in Pakistan in second half of 1980s when realizing the need for investment banking services the policy makers first time issued charter to investment banks. A broad range of business services were envisaged that included money and capital market activities, project financing, corporate financial services, and operations in call and money market. Since inception the sector showed strong performance and continued to flourish till the mid 1990s. While this growth was mainly backed by wide ranging financial liberalization measures and favorable economic conditions particularly the boom in the stock market, however, these institutions could not diversify their portfolio and thus failed to build in shock absorber to withstand the twists of changing economic and business environment. Resultantly, most of the investment banks started to face problems. This downturn also exposed the structural weaknesses that investment banks failed to redress during their growth phase. A few of these significant weaknesses are:        High fragmentation with only a couple of institutions dominating the market, Small capital bases with limited ability to absorb significant shocks, Failure to develop competencies for delivering non-fund based services, Lack of relevant expertise and acumen, Failure to develop stable source of long term funds, High cost of funds, Limited capacity to expand outreach.

The recent rise of universal banking has further added to the woes of investment banks as the commercial banks are increasingly taking up the activities which were once considered to be the exclusive domain of the former. Presently the sector is undergoing a transformation process. Under the regulatory purview of the Securities and Exchange Commission of Pakistan (SECP), investment banks are classified as Non-Banking Financial Companies (NBFCs) and are regulated by the NBFC (Establishment and Regulation) Rules of 2003 which provide an enhanced framework of operations for investment banks and have considerably widened their scope of business. Accordingly, they have started to focus their attention on becoming multi-business entities instead of retaining their specialized business status so as to remain commercially viable. Over the last few years, the sector has also witnessed considerable consolidation; the number of banks came down to 9 from 16 in 2000. The total assets of these banks stood at Rs.32.7 billion in FY04 as compared to Rs.34.4 billion in FY03 and Rs.41.5 billion in FY2000. Similarly their total investments declined to Rs.16.4 billion in FY04 as compared to Rs.22.1 billion in preceding year. However, total investment in FY04 increased over its level in FY2000. Over the last couple of years the industry is shrinking and the current scenario reflecting a declining trend calls for concerted efforts by the regulators as well as industry itself to overcome the situation. Investment banks in Pakistan generally had limited success due to various reasons, primarily due to the weaknesses I have pointed out earlier. But they are not altogether devoid of opportunities. They are very much an integral component of our financial infrastructure. The corporate sector has perennial needs for services such as investment advisory, corporate restructuring, distressed assets acquisition and disposal, merger and acquisitions, equity and debt financing. With the maturing up of economy and financial markets the need for these services will further intensify thus holding good prospects for the investment banks proficient in these areas. Commercial banks will not be able to compete with them on those fronts as they lack specialized expertise in these areas. But the investment banks will have to refocus their current strategy of imitating commercial banks; they should focus on developing competitive advantages in specialized areas of corporate finance and advisory services. Once they have developed these competencies, they can leverage it by forming strategic alliances with commercial banks which lack these capabilities but have a competitive advantage in the form of wider outreach and ability to mobilize national savings with greater efficiency. This strategy not only promises lucrative growth to the investment banks but will also add much needed value to the society.

RESEARCH AT DIFFERENT INVESMENT BANKS :

In order get a greater understanding about the scope of investment banking in Pakistan, we researched a few financial institutions and investment banks to get insight on the opinions of the people working there. One of the major observations that we made was that sole Investment Banks themselves were very few in number throughout Pakistan. Most commercial banks had separate areas within the bank which dealt with investment banking. At Arif Habib Bank Ltd. Ms. Nazish Iftikhar, it was learned that the Wealth Management Operations of the bank had been shut down. There were multiple reasons given, amongst which the finger was pointed to the financial meltdown that was being faced by Pakistan for the past few months. The stock market crash in August 2008 had shattered investor s confidence due to erosion of billions of rupees in the market. Not only did it remove any investment coming in, IB s themselves faced huge losses since they raise capital and trade in securities. With an unstable stock market, the potential to invest more is very bleak. One interesting thing that Ms. Nazish pointed out was an example of country risk which deters investors or any major foreign Investment Bank from operating in Pakistan. She said that HSBC s launch in Karachi was supposed to be on the 27th of December, 2008. This being the day Ms. Benazir Bhutto was assassinated there was total chaos in the country. HSBC itself had to face a lot loss in terms of damaged branches. The picture portrayed to the foreign banking sector itself was a very damaging one, and when commercial banks themselves are wary before expanding into Pakistan, political uncertainty and an unstable environment deters large investment banks from venturing here also. Another interesting point was the fact that political instability and constant changes in the monetary policy or any policies made by the State Bank which directly affect the financial market makes the investment environment very unpredictable. Unless there is some consistency shown within our financial sector, no one would be willing to invest. As far as foreign investment banks are concerned, another reason why they do not venture into Pakistan is the fact that the global financial crisis has wiped out entire banks and financial institutions. They have been struggling to operate and minimize losses in their own country of operations, such as JP Morgan and Morgan Stanley, and they need to first stabilize their core business before venturing into a place like Pakistan.

At IGI Investment Bank Ltd., we met with Mr. Abdul Rauf, who is an Officer at Treasury Operations / Deposits. He had a more optimistic view about the scope of investment banking in Pakistan, and said that the current economic and financial environment was picking up the pieces and stabilizing over time, especially due to the IMF conditionalities which have kept a vigil eye on the policymakers to conform to their guidelines. He quoted the slashing of the inter bank rates as a positive step to encourage investment itself in the country, as well be beneficial to Investment Banks in terms of cutting its own costs while borrowing from other banks to raise funds. IGI Investment Bank Ltd. itself is a small entity. He said that Rs. 2 Billion might be a paltry amount for a commercial bank, but the size of investment banks in Pakistan was so small, that an amount this size is considered to be a considerable amount for the bank to invest. Mentioning the global financial crisis, he said that it has not affected the Pakistani financial market directly or had a big impact as it has in foreign countries. Rather, the financial meltdown in Pakistan itself had a dampening effect on the Investment Banks currently operating here. However, the domestic and capital markets freezing for long periods of time was unprecedented and made a predictable negative impact on business volumes. As of December 2008, IGI Investment Bank has become the largest investment bank in Pakistan in terms of its paid up capital. However, Mr. Abdul Rauf pointed out that the bank was surviving because its parent company, the IGI Group, has a large portfolio and is a strong financial group, and it helped inject funds into the bank to keep its operations current. Also, even though IGI Investment Bank made a loss of Rs. 297 million on December 21, 2008, it was due to the stock market alone, and they have since recovered. Speaking for other banks, he said that most of the investment banks operating in Pakistan were not sizable nor are any from foreign groups. Companies like JP Morgan see no scope in Pakistan due to the political environment, country risk, and an overall lack of demand in the country. There is a lack of awareness about Investment Banks prevailing all over Pakistan. With a weak demand, along with the other factors outlined earlier, it makes it discouraging for foreign companies to venture into the country.

At United Bank Limited, we spoke to Mr. Mirza Muhammad Ali, Assistant Manager Debt Capital Markets and Syndications, Investment Banking Groups. He said the problem with most investment banks was that they did not offer many derivatives (there were many products that companies are not willing to offer.) The main problem in his opinion was the fact that investment banks themselves were not so stable in the country. Most were merging with other banks, and banks which had separate investment banking divisions such as Allied Bank Ltd., had an overlap of services offered. Mr. Muhammad Ali believes that if Pakistan had not been hit by the liquidity crunch, then the prospects for investment banking would have been bright. The currently operating banks themselves are still struggling to handle the losses incurred, so it will take a considerable amount of time for them to At JS Investments we met with Mr. Syed Rehan Mobin, Treasurer. He quickly pointed out that JS Investment Bank had been wrapped up, but because he used to work there he was able to provide us with some valuable information. The liquidity crunch in the inter bank market has effected the balance sheets of investment banks by shrinking them to almost half their size, as they have cut down on their asset sides. Banks make money on their gearing ratio, so the shrinking of their asset side reduces the ability to generate greater spreads reduces. Also, investment banks have greater exposure to the stock market, and the recent fluctuations have caused impairments to the asset side and have thus caused significant damage to them. According to Mr. Mobin, investment banks can now have a positive outlook as the country is following the IMF conditionalities for their bailout plan and are restructuring the economy to make it stronger. The announced decreases in the KIBOR and expected drop in the inflation rate both will have positive effects for IBs. If interest rates are being chopped, then it bring more liquidity into the system thus providing a better environment for the banks to thrive on: it will help the M2 money aggregate go up, and the money will then trickle into investment banks, which will increase their capacity to increase their assets. He believed that the IMF conditionalities set a timetable for the Central Bank and is to put the financial market in order. Answering a question as to whether large foreign investment banks would consider starting operations in Pakistan, Mr. Mobin said that in Pakistan the role of investment banking has always been very small. It would not be very profitable for such firms to go through the costs and setup for a venture which is not suitable for the size of the firm itself. Also, since firms such as JP Morgan and Bank of America were struggling themselves, the last thing they would want to do is venture into Pakistan. Also, many large commercial banks have investment banking divisions with a large backing, so small investment banks find it difficult to compete with them. United Bank Limited s Investment Banking Division is one of the largest in Pakistan.

He pointed out that InvestCap Investment Bank is coming up in a big way, and even though IGI Investment bank has faced nominal losses, it is still stable in terms of its operations. First Dawood Investment Bank is still recuperating from losses as it had a highly excessively leveraged Balance Sheet, with its gearing out of proportion. However, he related the bad experience of Orix Investment Bank. Orix had the misfortune of investing heavily in a Pakistani company, namely Callmate. Callmate was doing very well in the stock exchange, until it was discovered that there was a large scale scam going on, and the auditors had manipulated the numbers shown in the balance sheet. The company went bust, and at the time Orix held an astounding 20 million shares ranging from Rs. 35 to 40/share. Overnight all these shares became void, hitting Orix Investment Bank with huge losses. Indeed, the bank is in the process of wrapping up, and were unavailable for comment when contacted.

Conclusion: Scope of Investment Banking in Pakistan

Investment Banks are not very popular in the country. We see that there is a lack of understanding generally from the public, which also leads to a lack in overall demand. While the country has witnessed a boom of commercial banks, with large foreign banks expanding their operations into Pakistan, we cannot say the same for Investment Banks. Through our research and analysis, it can be safely said that there is a market for commercial banks, but it is not considered to be a viable business venture to open an investment bank in Pakistan.

The problem with the investment banks is that they've generally financed themselves for the good times, not the bad times. This means an excessive dependence on short-term funding and high leverage. This generated high ROEs in good times, supporting large payouts for employees and shareholders alike. But when times turned bad, compounded by poor risk management and bad investment decisions, such a capital structure has come back to haunt many a firm.

As outlined before, the major business of an investment bank is to raise capital for other firms. Elsewhere and in Pakistan, this is done mostly in the stock exchange. However, in Pakistan most large companies seem to skip the route of an investment bank and rather float their shares through brokerage firms and help from commercial banks.

The volatility of the stock exchange itself has wiped out many an investment bank s earnings, putting them in jeopardy most of the time. Also, investment banks underwrite the shares of many companies. As observed in the earlier example, one bad management decision in backing a firm which may default may lead to heavy losses. Local firms pose to be the riskiest for banks to invest. Unless a firm is well established and reputable, like Lucky Cement, the risk involved with other firms is too high for firms to jump into.

This leads us to the risk factor involved. In Pakistan, risk management is not carried out in an extensive manner, and very few firms have separate divisions in order to do so. When Orix Investment Bank invested so much in Callmate, they did not evaluate the entire risk they were getting involved in. Their risk appetite was overestimated: they bit off more than they could chew. This has discouraged many of the existing investment banks to be cautious in divulging further in investing in such companies.

Generally, Investment Banks thrive where there exists a strong market, as opposed to a weak one:

Strong Market

Weak Market

Higher Volumes of transactions Easier to raise capital

Lower Transaction Volume Capital is more difficult to raise

For foreign investment banks, there is a very negative perception about Pakistan s financial market as a whole. From being one of the emerging markets in the world to a very volatile and questionable one, investors seem unwilling to make the move of setting up an investment bank here. Especially due to recent events, such as the attack on the Sri Lankan cricketers, takeover of the Lahore Police Training Centre and other terrorist attacks, all have a big hand in dampening any hopes (whether foreign or our own) for recovery within the country. A country is not only viewed in terms of its financial markets, but also by the stability of its economy, country and political structure. When nearly all factors indicate negativity, the scope of investment banking seems to dampen with each attack this country faces.

Besides Pakistan s own financial market, there is the global financial crisis to take into consideration. Collapses of Lehman Brothers and Merill Lynch, and Bear Stearns who were the biggest players in the world have left questions to the survival of firms like JP Morgan and Goldman Sachs. These major firms first need to stabilize themselves, which will take a considerable amount of time, before they can even question about venturing into a country like Pakistan.

LETTER OF AUTHORIZATION

Dec.10th .09

To Whom It May Concern: Under the authorization of our lecturer Sarwat Ahson, for the course International Finance at the Institute of Business Management, we have been required to obtain all the possible information and material to prepare a detailed and accurate term report. This report is regarding the scope of investment banking in Pakistan, and has been submitted in the assigned due date.

Sincerely,

FAIZA BATLA

LETTER OF TRANSMITTAL

Dec.10th.09

Mrs. Sarwat Ahson Professor Institute of Business Management Korangi Creek Karachi 75100

Dear Mrs. Sarwat Ahson Here is the report about the Scope of Investment Banking in Pakistan. As you will see, we have published the assigned research in the report. We are confident that these results will help you recognize the reasons behind falling scope of investment banking in the country, as well as the multitude of factors which leads to it. We greatly appreciate being appointed on this term report, and on a topic which is challenging and very educational.

Sincerely,

FAIZA BATLA

Term Report

Date: April 6, 2009

Report Prepared For:

Mrs. Sarwat Ahson Instructor, International Finance Institute of Business Management (IoBM) Korangi Creek Karachi 75100

Prepared By:

FAIZA BATLA

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