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Investment banks were created as separate entities after Banking Act of 1933 in USA. The great
depression in 1929 revealed the failure of commercial banks in their security operations. This led to
separation of commercial banking, investment banking and insurance companies into separate
entities.
Investment banks have a variety of opportunities in the form of venture capital financing, mergers
and acquisitions, underwriting of securities, asset securitization, investment management, private
placement, project finance and corporate advisory services.
Investment banks have become financial supermarkets providing one stop need for insurance,
securities and fund management services.
Investment banks are organized with divisions dealing with investment banking, sales and trading
and research. Their main functions include agency, market‐making, corporate advisory and
underwriting services.
Investment banks also arrange venture capital for new firms with little or no operating history. This
investment requires active personal involvement in the project. The investment becomes locked for
three to seven years. The project requires multiple rounds of financing.
Underwriting function assures client firms with adequate capital through public subscription when
they issue equity shares. An underwriter advices the client firms, shares the risk of issue, helps in the
distribution of securities and in the stabilization of market. The underwriter charges a commission
usually between 2.5% to 5% of the offer price.
Underwriting involves entering into an agreement with the client or manager of the issue, fixing
management fees, advising clients on the choices available, filing of registration statements with
Securities Board of India and distribution of preliminary prospectus. They decide on the offer price,
identify dealers for distribution, due diligence between underwriting and corporation and price
support after the issue.
Investment bankers organize road shows for the public issue they have undertaken. Where the issue
price determination involves risk the investment bankers undertake book building process wherein
they assess the market by inviting price quotations from investors and also their intention regarding
the quantity of shares they would like to invest. The final price is decided on the basis of these bids
before the issue of shares.
Sometimes price fixing may lead to agency problem as the investment banker may try to set a low
price for the issue to make the issue easy to sell and to avoid commitment in those shares.
Corporate Advisory Services
Investment bankers perform a variety of corporate advisory services such as mergers, acquisitions,
corporate restructuring, financial engineering, securitization and debt financing.
Corporate restructuring is a king of merger reversal and it may take different forms. These are
attempted with a view to meet increasing competition to align the interest of shareholders and
managers, to reverse conglomerate mergers and to make the firm attractive to investors.
The various types of corporate restructuring include spin‐offs wherein a company creates a
subsidiary retaining ownership of the subsidiary. Equity carve‐outs are another form of corporate
restructuring wherein the subsidiary is encouraged to go for public issue and the parent company
gains.
Split‐ups are another form of restructuring wherein a firm splits into two or more entities.
Divestitures involves sale of a segment of the company to a third party for cash or securities. The
purpose of divestitures is to dismantle conglomerates, changing strategies, discord unwanted
business, ward off takeovers and meeting government requirements.
LBOs (leveraged buy outs) are purchase of a company financed heavily with debt. Hostile mergers
involve taking over unwilling firms by unwanted bidders. Sometimes the target firm agrees to buy
back some shares from the bidder at a premium. In this buy back arrangement certain targeted
shareholders may be excluded.
Investment Management of Banks
Investment management is an important function carried out by banks to stabilize their income,
reduce credit risk exposure and to enhance liquidity. When deposits are low and loan demand is
high investments are used as collateral to borrow additional funds to meet increased loan demand.
When loan demand is weak; investments are used to increase the earning capacity of banks. Banks
usually invest their surplus funds in government bonds and other debt securities. This involves
analysis of interest rate and studying the behavior of yield curve.
Yield curve is a graphical statement of the relationship between bond yields and maturity. It is a
reliable indicator of economic activity and is used for forecasting interest rates, pricing bonds and
creating strategies Normally yield curve shows an upward movement indicating the expectation of
investors that the interest rates will increase in future.
There are three theories that explain the pattern of yield curve. The pure expectation theory holds
that the upward movement of yield curve reflects investors’ expectation for future short term
interest rates. Liquidity preference theory asserts that investors expect a premium for long term
commitments of funds in the market and hence long term rates will be higher than the short term
rates. The preferred habitat theory explains that investors have distinct investment horizons and
require a meaningful premium to invest in bonds with maturities higher than their preferred
maturity.
Riding the yield curve is a strategy where a bank holds its investments in bonds for a period of time
and sells them just before maturity to realize the gain. The investment strategies in debt securities
using maturity differentials are ladder or spaced maturity policy, front end load maturity policy, back
end load maturity policy, the Barbell investment portfolio strategy and the rate expectations
strategy. Sometimes a combination of these strategies will be used to enhance returns and reduce
risk.
The inveestment strattegies may b be broadly classified into active and p
passive invesstment strateegies.
nvestment sttrategy may be speculative in nature and involve swap strate
Active in egy or yield ccurve
strategyy. Passive invvestment straategy focuse
es on duratioon and yield ccurve.
Mutual Fund
M ds
Banks esstablish sepaarate asset m
managementt companies to manage m mutual fund business. Mutual
funds arre investmen nt managemeent companiies. They poo ol their resou
urces of inveestors havingg a
common n financial go
oal through ssale of units under a scheeme. The funnd manager invests these
resourcees in securities and the in
ncome and ccapital appreeciation are sshared by unnit holders.
Interval scheme is a combination
n of open en
nded and clossed ended scchemes.
of investmen
Based on objective o nt, mutual fund schemes are many tyypes such as growth scheeme,
income scheme, balaanced schemme, tax savings scheme, m
money markket schemes, off shore funds,
index linked schemes, sector specific schemes, capital market linked schemes, fund of funds scheme
etc.
In India mutual funds are promoted by public sector banks, private sector banks and other corporate
entities.
Bancassurance
Liberalization of economic policies in India prompted banks to accept variety of functions to improve
their competitive strengths. Bancassurance is performing insurance business by banks. However,
banks are not permitted to combine banking and insurance business. They can promote separate
entities to run insurance business.
There are two types of risk viz., pure risk and financial risk. Pure risk focuses on probability of
occurrence of loss only whereas financial risk considers occurrence of both profit and loss. In
insurance business it is pure risk that the bank assumes to manage.
There are two types of insurance businesses, life insurance and general insurance. Under life
insurance banks may offer policies to cover the risk of loss of life, loss of income and loss of health
policies. Under general insurance property losses, accident compensation, credit risk and business
related risks are considered.
Banks need to be very careful in fixing the premium for the policies. The premium fixed should cover
the expected loss, its administrative expenses and profit. Estimating expected claim cost requires a
thorough study of population risk profile and reliable data bank. Risk classification of clients helps in
differentiating the premium charged.
Banks have a natural advantage in promoting insurance business since they have a wide network of
customers covering different geographical regions. There is a great potential for insurance business
in India as vast segments of society are not covered by insurance. It generates fee based income for
banks.
In 1999, the regulators of banking and insurance sectors from G‐10 countries produced a report
which focused on the capital adequacy for banking and insurance business. The report suggests
quantitative techniques to assess capital adequacy. The suggested approaches are building block
prudential approach risk based aggregation, total deduction and risk based deduction.
Division of Balance Sheet
Banking Insurance Securities Unregulated
(Parent) (60% ownership)
Full Consolidation
Banking Insurance Securities Unregulated Total
Capital required 42 12 20 12 86
Actual capital 50 15 25 10 100
Surplus
8 3 5 -2 14
(Deficiency)
Actual capital 50 15 15 10 90
Surplus
(Deficiency) 8 3 3 -2 12
Bank Capital
70
Bank capital 70
Deduction of capital investment in dependants
Insurance -15
Securities -12
Unregulated -5
Parent Bank
Down
streamed
Insurance Securities Unregulated capital
(60%
owned)
Capital
investment 15 12 5 32
Bank Capital
70
Full Consolidated
Down
streamed Group
Insurance Securities Unregulated Bank capital capital
Specific capital
required 15 15 14 32 76
Actual capital 18 20 10 70 -32 86
Surplus (Deficit) 3 5 -4 38 -32 10
Down
streamed Group
Insurance Securities Unregulated Bank capital capital
Specific capital
required 15 9 14 32 70
Actual capital 18 12 10 70 -32 78
Surplus (Deficit) 3 3 -4 38 -32 8
Questions
1. What is issue management?
2. What are the various services rendered by banks in issue management?
3. What is underwriting?
4. Explain the need for underwriting.
5. What are investment management functions of banks?
6. Explain the salient features of investment management in banks.
7. What is a yield curve?
8. How does yield curve analysis help in investment decisions?
9. What are the various strategies for investment in bonds?
10. What are corporate advisory services?
11. What is corporate restructuring?
12. What are the methods of corporate restructuring?
13. What are the objectives of mutual funds?
14. What are the various types of mutual fund schemes?
15. What is bancassurance?
16. What are the factors that led to acceptance of bancassurance in India?
17. Explain the special features of insurance business.
18. What are the factors to be considered while determining the premium for a policy?
19. What is capital adequacy for insurance business?
20. What are the norms suggested by the group of regulators from G‐10 countries for capital
adequacy of insurance business by banks?