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The Investment Banking Industry

1. Introduction: Financial Institutions


2. Introduction: Investment Banks
2.1 What are Investment Banks
2.2 Types of Investment Banks

3. Trends in Investment Banking


4. Measure of Performance
5. Sub-prime Impact on Investment Banks

DR. YEO Wee Yong for FIN4112H (Semester II 2014/2015)

Introduction

1. Introduction: Recap Financial Institutions


Financial assets
What are some of the roles of financial assets play?
Transfer funds from surplus spending units to deficit
spending units
Reallocation of scarce resources from nonproductive to productive use
Pooling of funds
Management of risk

Introduction

1. Introduction: Recap Financial Institutions


Financial assets
Types of financial assets
Debt
Equity
Derivatives: forwards, futures, options, swaps
Commodities
Securitized assets
Credit derivatives

Introduction

1. Introduction: Recap Financial Institutions


Financial markets
A structure where financial assets are exchanged or
traded
What are some of the roles of financial markets play?
Price discovery process
Determination of price or return of financial assets
Influence by many factors (eg. liquidity, risk,
information, transaction process)
Provision of liquidity
Provide a place of gathering of willing buyers and
sellers
Reduction of transaction costs
Reduce search time and cost
Reducing contracting cost and risk

Introduction

1. Introduction: Recap Financial Institutions


Financial markets
Types of financial markets
There are many ways to classify
Primary and secondary
Primary:
New Issues
IPO and SEO
Secondary:
Trading of issued assets
Debt, equity, or derivatives

Introduction

1. Introduction: Recap Financial Institutions


Financial markets
Types of financial markets
There are many ways to classify
Money and capital
Money: Short-term: 1 year or less
Federal funds and discount windows
T-bills
Short-term municipal securities
Certificates of deposits (negotiable and
nonnegotiable)
Repurchase agreement
Commercial papers

Introduction

1. Introduction: Recap Financial Institutions


Financial markets
Types of financial markets
There are many ways to classify
Money and capital
Capital: More than 1 year
Stocks and bonds
Exchange or OTC
Spot or forward, future

Introduction

2. Introduction: Investment Banks


What are investment banks?
Investment banks are financial institutions that engage
in public and private market transactions for
corporations, governments, and investors
Examples of market transactions:
Fund sourcing: Issuance of equity and debt
securities
Mergers and Acquisition or M & A
Divestitures

Introduction

2. Introduction: Investment Banks


What are investment banks?
Other activities:
Proprietary trading: trades on its own capital
Securitization: pooling and repackaging of financial
assets into securities: Pros and Cons?
Financial engineering: using mathematical and
numerical methods and simulations to create
financial products, or to make trading, hedging and
investment decisions

Introduction

2. Introduction: Investment Banks


What are investment banks?
Other activities:
Investment management: helping individual and
institutions to invest
Prime brokerage
The offering of tools and services to clients to
support their operations in trading and portfolio
management
Example of services offered: lending of securities
and funds, to hedge funds and other professional
investors to support their investment strategies

Introduction

2. Introduction: Investment Banks


Types of investment banks
Financial holding companies
Large financial companies, under universal banking,
have always existed in places other than the US
Gramm-Leach-Bliley Act 1999 created large financial
holding companies in the US
Examples: HSBC, Deutsche Bank, UBS, Citigroup,
JPMorgan Chase, BOA

Introduction

2. Introduction: Investment Banks


Types of investment banks
Financial holding companies
Businesses includes:
Retail (or consumer) banking
Corporate banking
Investment banking
Asset management
Wealth (private) management
Credit cards

Introduction

2. Introduction: Investment Banks


Types of investment banks
Full service (bulge bracket) investment banks: Used to
be
Bear Stearns
Lehman Brothers
Merrill Lynch
Goldman Sachs
Morgan Stanley

Then, there were none!

Introduction

2. Introduction: Investment Banks


Types of investment banks
Full service (bulge bracket) investment banks:
Bear Stearns (Gone)
Lehman Brothers (Gone)
Merrill Lynch (Gone)
Goldman Sachs (Converted to BHC)
Morgan Stanley (Converted to BHC)

Introduction

2. Introduction: Investment Banks


Types of investment banks
Full service (bulge bracket) investment banks:
Bear Stearns (Gone)
Lehman Brothers (Gone)
Merrill Lynch (Gone)
Goldman Sachs (Converted to FHC)
Morgan Stanley (Converted to FHC)

Introduction

2. Introduction: Investment Banks


Types of investment banks
Boutique houses
Sandler ONeill:
Specializes in financial institutions (provides
research, acts as market markers, trading)
Full service investment bank?
Greenhill:
Specializes in M&A and financial restructuring
Happy to be boutique
Lazard:
Specializes in M&A and asset management

Introduction

2. Introduction: Investment Banks


Investment banks in Singapore
Number of investment banks:
Local: 3 (under the 3 local banking holding groups)
Others: 41 (called merchant banks)
Activities:
Normal investment banking activities
Operate in Asian Dollar Market through their ACUs
DBU: No SGD deposits or borrowings from the
general public
Can accept SGD deposits or borrow from banks,
finance companies, shareholders, and companies
controlled by their shareholders

Introduction

3. Trends in investment banking


Deregulation
Regulation to deregulation to re-regulation to ..
The financial industry has always been oscillating
between regulation and deregulation. Why?
Regulation leads to orderly market practices but
hamper growth and competition
Deregulation on the other hand promotes growth
and competition but give room for abuse and misuse
and ultimately cause too much damage to the
market

Introduction

3. Trends in investment banking


Deregulation
Regulation to deregulation to re-regulation to ..
Striking a balance is the responsibility of regulators.
Two schools of thoughts:
A dynamic optimal balance exist and the
regulators are responsible to locate it and keep it
current
Only minimal regulation is necessary. The illusion
of the existence of an optimal system will only
delay the occurrence and increase the intensity of
crisis and hence do more harm than good.
Discussion: What do you think in the light of
the recent financial crises?

Introduction

3. Trends in investment banking


Deregulation
Regulation to deregulation to re-regulation to ..
There is no perfect system against the
innovativeness of the human mind
General long term trend is towards less regulation
as market matures

Introduction

3. Trends in investment banking


Deregulation
Deregulation: Most countries have over the years taken
significant steps to deregulation
UK: Big Bang
Margaret Thatcher government's reform program in
the 1980s to deregulate the financial market
London, once a global financial centre was losing
ground to New York
Problems: overregulation and the dominance of
elitist old boys' networks
Solution: free market doctrines of unfettered
competition and meritocracy
Results: London is still one of the most important
financial centre in the world

Introduction

3. Trends in investment banking


Deregulation
Deregulation: Most countries have over the years taken
significant steps to deregulation
Japan: Big Bang
Financial reforms in the late 1990s
In reaction to the deteriorating condition of the
economy and financial sector
To open up Japans banking, insurance, pension,
and stock exchange to global competition

Introduction

3. Trends in investment banking


Deregulation
Deregulation: Most countries have over the years taken
significant steps to deregulation
Japan Postal system reform
Up to 2007, Japan Post offers postal services,
banking services, and life insurance.
One third of all government employees worked for
the Post
Largest saving system: US$3.2tr
Privatize in 2007: Split into 4 units (Japan Post,
Network, Bank, and Insurance)

Introduction

3. Trends in investment banking


Deregulation
Deregulation: Most countries have over the years taken
significant steps to deregulation
Singapore: Can you name some?
Privatization of POSB
Opening competition for the banking sector
Relaxing control of S$

Introduction

3. Trends in investment banking


Deregulation of the investment banking sector
Gramm-Leach-Bliley Act vs Glass-Steagall Act
Glass-Steagall Act 1933: What and why?
In the light of the great depression
To curb conflict of interest
Commercial banking, investment banking, and
insurance activities cannot be under the same
roof
Lead to the break up of big banks. Example JP
Morgan and Morgan Stanley

Introduction

3. Trends in investment banking


Deregulation of the investment banking sector
Gramm-Leach-Bliley Act vs Glass-Steagall Act
Gramm-Leach-Bliley Act 1999: What and why?
Repeal of the Glass-Steagall Act occurred in
steps
1987: Fed allowed banks to underwrite and deal
in Tier 1 securities: commercial papers, munis,
MBS, etc
1988: Fed allowed banks to underwrite and deal
in Tier 2 securities: all types of debt and equity
instruments (Why not allow investment banks
to conduct commercial banking activities?)
1989: underwriting revenue cap raised from 5% to
10% of total revenue

Introduction

3. Trends in investment banking


Deregulation of the investment banking sector
Gramm-Leach-Bliley Act vs Glass-Steagall Act
Gramm-Leach-Bliley Act 1999:
1997: underwriting revenue cap raised to 25%
1999: Total repeal of Glass-Steagall Act
In the light of the financial crisis, what do you
think would happen if the Glass-Steagal Act
was not repealed?
Gramm-Leach-Bliley Act 1999 created large
financial holding companies in the US
These are big banks with underwriting arms
initially known as Section 20 subsidiaries

Introduction

3. Trends in investment banking


Deregulation of the investment banking sector
Gramm-Leach-Bliley Act vs Glass-Steagall Act
Gramm-Leach-Bliley Act 1999:
Deutsche Bank bought Morgan Grenfell
UBS bought Swiss Bank Corp and thus Dillon
Read and Warburg
Citigroup bought Travelers Group and thus SmithBarney
The repeal of the Glass-Steagall has been under
attack since the subprime crisis begin

Introduction

3. Trends in investment banking


New regulations in the investment banking sector
Sub-prime related
In the light of the recent failure of investment banks,
who should regulate investment banks?
The FED or SEC?

Introduction

3. Trends in investment banking


Other trends in the investment banking sector
Globalization
Tapping overseas market for growth
Emerging economies swell opportunities
First mover advantage
Challenges:
Political instability
Regulatory biases and prejudicial changes and
protectionism
SGX & ASX
LSE and TMX
Asean Trading Link?
Cultural differences

Introduction

3. Trends in investment banking


Other trends in the investment banking sector
Advance in technology
Information
Settlement system from
T+5 to T+3 to T+2(?) to T+1 (??)
Algorithmic trading
Internet trading
Dark pools
Crowd funding
Peer-to-peer lending

Introduction

3. Trends in investment banking


Other trends in the investment banking sector
Diversification
What is diversification?
Financial institutions, especially investment banks,
have become more diversified
Financial holding companies are diversified
behemoth (thanks to Gramm-Leach-Bliley)
Investment banking represent a smaller and smaller
portion of total income
Other income sources: trading, hedge funds,
securitization, asset and wealth management,
prime-brokerage, credit cards

Introduction

4. Measure of Performance
Risk and Returns: Returns
Income sources
Underwriting spread
M&A fee
Trading profits
Prime-brokerage (interest and fee)
Market making (spread)
Research

Introduction

4. Measure of Performance
Industry Size:

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size:

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: M&A

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: M&A

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: M&A

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: M&A

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Equity Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Equity Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Equity Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Equity Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Debt Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Debt Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Debt Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Debt Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Loans

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Loans

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Loans

Source: Financial Times

Introduction

4. Measure of Performance
Industry Size: Loans

Source: Financial Times

Introduction

4. Measure of Performance
Risk and Returns: Returns
League tables
Ranking of investment banks in terms of
underwriting, M&A, fee earned, etc
Investment banks treat this very seriously
Many have specialist teams devoted to supplying
data to the firms that compile the rankings, and to
challenging the positions of rivals
Blamed in part for the sub-prime crisis

Introduction

4. Measure of Performance
League Tables:

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: M&A

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: M&A

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: Equity Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: Equity Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: Debt Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: Debt Underwriting

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: Loans

Source: Financial Times

Introduction

4. Measure of Performance
League Tables: Loans

Source: Financial Times

Introduction

4. Measure of Performance
Risk and Returns: Risks
Market risk
Interest rate risk
Trading in fixed income securities
Price risk
Assets/securities price volatility
Forex risk
Forex exposure

Introduction

4. Measure of Performance
Risk and Returns: Risks
Credit risk
Counterparty default risk: swap, derivatives, credit
derivatives
Prime-brokerage: Hedge fund failures
Issuers default: MBS, bonds, commercial papers
In the light of the increasingly complicated securities,
who can really understand?

Introduction

4. Measure of Performance
Risk and Returns: Risks
Operation risk
Settlement and clearing
Entry errors
Legal
Tons and tons of regulations - other than all the
different acts: Dodd-Frank, fair disclosure, money
laundering, funding of terrorists, etc
Liability law suits: eg Enron, WorldCom

Introduction

4. Measure of Performance
Risk and Returns: Risks
Funding risk
Borrowing: capital and money market
Credit crunch
Credit squeeze
Liquidity risk
What is liquidity risk?
The inability to liquidate immediately at fair value

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
HSBC
2007 Mar: write-off US$11bn sub-prime losses
2007 Sept: Close U.S. Subprime Mortgage Unit
2007 Nov: write-off another US$1bn losses
2008 Mar: annual reports - $17bn credit crisis loss
Total losses by 2010: US$76.0bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
UBS
2007 May: close its hedge fund arm, Dillon Read
Capital Management (DRCM)
2007 Oct: write-down of US$3.5bn losses
2007 Dec: write-down of US$10bn losses
2008 Jan: write-down of US$4bn losses
2008 Apr: write-down of US$19bn losses
2008 May: sell shares at 1/3 discount to raise fund

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
UBS
2008 July: possible write-down of a further $7.5bn of
losses
2008 July: CEO Peter Wuffli replaced by Marcel
Rohner
Selling major stakes (to Blackstone and Temasek)
and cut thousands of jobs
Possibility of chopping off of the investment banking
arm
Total losses by 2010: US$52.4bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
Citigroup
2007 Oct: write-down of US$5.9bn of losses
2007 Nov: chairman and CEO, Charles Prince resign
Sell stakes (to Abu Dhabi, Kuwait Investment Authority,
and GIC) and thousands of job loss
2008 Jan: write-down of US$18bn of losses
2008 Q4: $25 bn and $20 bn injection by government
2008 Dec: ratings cut to A2 by Moodys
Total losses by 2010: US$130.5bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
JPMorgan Chase
2008 Jan: write-down of US$1.3bn
2008 Mar: bought Bear Stearns
2008 Sept: bought WaMus assets
2009 Jan: profits drop 76%
Total losses by 2010: US$52.1bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
BOA
2007 Nov: write-off of US$5.3bn of losses
2008 Jan: buys Countrywide
2008 Sept: forced to buy Merrill Lynch
2009 Jan: cut 1,000 jobs from investment banking
unit
Total losses by 2010: US$87.6bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
Merrill Lynch
2007 Oct: $8.4 bn losses ($5.5 bn sub-prime)
2007 Dec: injection of $5 bn by Temasek and $1.2
bn by Davis Selected Advisors
2008 Jan: sold another $6.6 bn to foreign investors
2008 Apr: raise another $9.55 billion by debt and
preferred shares
2008 July: $5.7 bn writedown
2008 Sept: sold to BOA
Total losses by 2010: US$63.7bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
Lehman Brothers
2007 Aug: shut sub-prime lending units
2008 June: ratings cut to A by S&P
2008 June: $3bn losses
2008 June: $6bn block sales
2008 June: sell $130bn of assets
2008 Aug: secret talks of selling 50% stake
2008 Sept: failed
Total losses by 2008: US$26.5bn

Introduction

5. Sub-prime and the Credit Crunch


Impact on Investment Banks
Bear Stearns
2007 June: 2 hedge funds collapsed
2008 Mar: merge with JP Morgan Chase (with the
help of Fed) at US$2 per share
Total losses before acquired: US$3.2bn

Introduction

5. Sub-prime and the Credit Crunch


Total Losses for US and European Banks
BANK

2007

2008

2009

Citigroup

29.1

63.4

30.7

7.3

$130.50

Bank of America

12.1

29.2

35.5

10.8

$87.60

4.0

73.4

HSBC

19.3

30.3

Merrill Lynch

25.1

38.6

Wachovia

UBS

$77.40
26.4

50.6

1.8

4.5

10.2

29.5

Royal Bank Scotland

7.0

23.5

21.3

Washington Mutual

5.1

36.7

Barclays

7.0

16.5

12.7

Wells Fargo

3.5

8.7

18.2

12.5

14.0

Others

TOTAL

$76.00
$63.70

JPMorgan Chase

Lehman Brothers

2010 TOTALS

$52.40
7.9

$52.10
$51.80
$41.80
$36.20

5.3

$35.70
$26.50
$457.60

$1,189.30