THE NEW INVESTMENT BANKING
One important lesson from the financial crisis is the need for more effective regulation. The recent financial reform legislation, most notably the Dodd-Frank bill, aims at setting standards for financial operations and preventing another crisis. The reforms focus on several essential areas. The first is to end ``too big to fail.'' Taxpayers should not be protecting the shareholders and bondholders of even the most systemically important financial firms. Instead, these firms should be required to structure themselves so that they can be recapitalized without taxpayer money, and before local problems can spiral into a systemic crisis. Second, financial firms are required to practice consistency. Regulators should require that all assets across financial institutions be similarly valued. Within each financial firm, there needs to be greater consistency and rigor in the way assets are valued and accounted for. Firms should no longer be allowed to move risk around to areas where it will be less rigorously monitored or more generously valued. Third, the regulatory system has more dynamic regulation. Across the board, the regulatory system should be comprehensive and strong enough to identify and constrain excesses in markets, before they can threaten the broader economy.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) is a comprehensive regulatory overhaul. Certain portions of the Act were effective immediately; other portions follow an extended transition period. Implementation of the Act will be accomplished through numerous rulemakings by multiple governmental agencies. The Act also mandates the preparation of studies on a wide range of issues, which could lead to additional regulatory changes.
In addition, legislative and regulatory initiatives continue outside the United States that will affect investment banking business. Basel III, the new global regulation on bank capital adequacy and liquidity, introduces new capital, leverage, and liquidity standards. It is designed to improve the banking sector's ability to deal with financial and economic stress. A provision of the Dodd-Frank Act (the Volcker rule) will over time prohibit investment banks from engaging in proprietary trading. The rule will also require banking entities to either restructure or unwind certain relationships with hedge funds and private equity funds. The rule is expected to become effective in July 2012, and banking entities will then have a two-year period to come into compliance with the Volcker rule.
Through the Dodd-Frank Act, investment banks face a comprehensive regulatory regime in over-the-counter derivatives. The regulation of swaps and security-based swaps in the United States will be effected and implemented through the CFTC, SEC, and other agency regulations. The Act requires central clearing of certain types of swaps and also mandates that trading of such swaps be done on regulated exchanges or execution facilities. As a result, investment banks will have to centrally clear and trade on an exchange or execution facility certain swap transactions that are uncleared and executed bilaterally. The Act further requires registration of swap dealers and major swap participants with the CFTC and security-based swap dealers and major security-based swap participants with the SEC.
Investment Banking Business
Investment banks engage in public and private market transactions for corporations, governments, and investors. These transactions include mergers, acquisitions, divestitures, and the issuance of equity or debt securities, or a combination of both. Investment bankers advise and assist clients with specialized industry expertise. The industry or sector grouping often includes industrial, consumer, health care, financial institutions, real estate, technology, media and telecommunications, and others. As noted throughout the book, investment banks today go far beyond investment banking to also include other securities businesses such as trading, securitization, financial engineering, merchant banking, investment management, and securities services. For those activities, investment banks earn fees, commissions, and gains from principal transactions.
Investment banking includes capital raising and merger and acquisition (M&A) advisory services. Investment banks help clients raise capital through underwriting in which investment banks purchase the whole block of new securities from the issuer and distribute them to institutional and individual investors. For the service, investment bankers earn an underwriting spread, the difference between the price they receive from investors and the amount they pay to the issuing firm. The underwriting spread has been in the range of 6 to 7 percent of the total proceeds raised for equity offerings. The competitive pressure has forced bankers to charge less, especially for a large deal in which the spread could go much lower. In debt offerings, the spread is much lower, often less than 100 basis points. Several chapters in this book describe the relevant regulatory issues and the processes investment banks and issuers go through to offer the new securities.
Another major line in investment banking is strategic advising on mergers and acquisitions. Services offered include structuring and executing domestic and international transactions in acquisitions, divestitures, mergers, joint ventures, corporate restructurings, and defenses against unsolicited takeover attempts. Fees are usually negotiable. As the size of transactions gets larger and larger, the M&A advisory fees are generally less than 100 basis points and often much lower. M&A bankers still take in large sums of money, as the value of transactions grows larger. This line of business is attractive, because, win, lose, or draw, bankers earn fee income.
Other Securities Businesses
Full-service investment banks offer a service menu that goes beyond just investment banking. Principal transactions have accounted for a very significant portion of total net revenues at many Wall Street houses. These transactions include proprietary trading and merchant banking. In proprietary trading, the investment bank trades on its own capital. Under the Dodd-Frank Reform Act, investment banks are permitted to operate proprietary trading only on a restricted and limited basis. Merchant banking invests the firm's own capital as well as funds raised from outside corporate and real estate investors.
Investment management is an integral part of investment banks. Major houses such as Morgan Stanley, Goldman Sachs, and JPMorgan each manage hundreds of billions of dollars for their clients. This is an attractive segment of the financial services industry. The income stream is less volatile than trading or underwriting and, hence, contributes to the stability of earnings.
Another line of business is securities services that include prime brokerage, securities lending, and financing. Prime brokerage offers tools and services desired by clients looking to support their operations in trading and portfolio management. In security lending services, investment banks find securities for clients to make good delivery so as to cover their short positions. Alternatively, financing services provide funds to finance clients’ purchases of securities.
