INTRODUCTION

At a very macro level, Investment Banking as term suggests, is concerned with

the primary function of assisting the capital market in its function of capital
intermediation, i.e., the movement of financial resources from those who have
them (the Investors), to those who need to make use of them for generating GDP
(the Issuers). Banking and financial institution on the one hand and the capital
market on the other are the two broad platforms of institutional that investment for
capital flows in economy. Therefore, it could be inferred that investment banks are
those institutions that are counterparts of banks in the capital markets in the
function of intermediation in the resource allocation. Nevertheless, it would be
unfair to conclude so, as that would confine investment banking to very narrow
sphere of its activities in the modern world of high finance. Over the decades,
backed by evolution and also fuelled by recent technologies developments, an
investment banking has transformed repeatedly to suit the needs of the finance
community and thus become one of the most vibrant and exciting segment of
financial services. Investment bankers have always enjoyed celebrity status, but
at times, they have paid the price for the price for excessive flamboyance as well.

To continue from the above words of John F. Marshall and M.E. Eills,
investment banking is what investment banks do. This definition can be
explained in the context of how investment banks have evolved in their
functionality and how history and regulatory intervention have shaped such an
evolution. Much of investment banking in its present form, thus owes its origins to
the financial markets in USA, due o which, American investment banks have
banks have been leaders in the American and Euro markets as well. Therefore,
the term investment banking can arguably be said to be of American origin.

Investment banks help companies and governments and their agencies to raise
money by issuing and selling securities in the primary market. They assist public
and private corporations in raising funds in the capital markets (both equity and
debt), as well as in providing strategic advisory services for mergers, acquisitions
and other types of financial transactions. Investment banks also act as
intermediaries in trading for clients. Investment banks differ from commercial
banks, which take deposits and make commercial and retail loans. In recent years
however, the lines between the two types of structures have blurred, especially as
commercial banks have offered more investment banking services.

Definition
An individual or institution, which acts as an underwriter or agent for corporations
and municipalities issuing securities. Most also maintain broker/dealer operations,
maintain markets for previously issued securities, and offer advisory services to
investors. Investment banks also have a large role in facilitating mergers and
acquisitions private equity placements and corporate restructuring. Unlike
traditional banks, investment banks do not accept deposits from and provide
loans to individuals.

History of Investment banking

Given its history, merchant banking is often thought of as a European, and
especially British, financial specialty, and British institutions continue to maintain a
major presence in this area. Since the 1800s and even earlier, however, U.S.
firms (such as J.P. Morgan) also have been active in merchant banking. However,
although both investment banks and commercial banks, as well as other types of
businesses, have been authorized to engage in private equity investment in the
United States, financial institutions have not been major providers of private
equity.
Until the 1950s, U.S. investors in private equity were primarily wealthy individuals
and families. In the 1960s and 1970s, corporations and financial institutions joined
them in this type of investment. (In the 1960s, commercial banks were the major
providers of one kind of private equity investing, venture-capital financing.)
Through the late 1970s, wealthy families, industrial corporations, and financial
institutions, for the most part investing directly in the issuing firms, constituted the
bulk of private equity investors.
In the late 1970s, changes in the Employee Retirement Income Security
AcTERISA) regulations, in tax laws, and in securities laws brought new investors
into private equity. In particular, the Department of Labor's revised interpretation
of the "prudent man rule" spurred pension fund investment in private equity
capital. Currently, the major investors in private equity in the United States are
pension funds, endowments and foundations, corporations, and wealthy
investors; financial institutions-both commercial banks and investment banks-

represent approximately 20 percent of total private equity capital, divided

approximately equally between the two.
The market also has grown dramatically in recent years, increasing from
approximately $4.7 billion in 1980 to its 1999 figure. Despite this tremendous
growth, the private equity market is extremely small compared with the public
equity market, which was approximately $17 trillion at year-end 1999
Evolution of investment banking in India
The origin of investment banking in India can be traced back to the late 19th
century when European merchant banks set up their agency house in the country
to assist in the setting up of new projects. In the early 20th century large business
houses followed suit by establishing managing agencies which acted as issue
house for securities, promoters for new projects and also provided finance to
green field ventures. But these entire roles were limited to small capital base.
In 1967, ANZ Grindlays bank set up separate Merchant banking division to handle
new capital issues. It was soon followed by Citibank, which started rendering
Merchant Banking services. The foreign banks monopolized merchant banking
services in the country. The banking commission, in its report in 1972, took note if
this with concern and recommended setting up of merchant banking institutions
by commercial banks and financial institutions. SBI ventured into this business by
starting a merchant business bureau in 1972. In 1973, ICICI

became the first financial institutions to offer merchant banking. JM finance was
set up in 1973. The growth of industry during that period was very slow. The
industry remained more or less stagnant in the eighties.
Some of tie ups player were

JM Finance- Morgan Stanley

DSP Financial consultants- Merill lynch

Kotak Mahindra- Goldman Sachs

SBI Capital Markets Lehman Brothers

The main activities and units

The primary function of an investment bank is buying and selling products both on
behalf of the bank's clients and also for the bank itself. Banks undertake risk
through proprietary trading, done by a special set of traders who do not interface
with clients and through Principal Risk, risk undertaken by a trader after he or she
buys or sells a product to a client and does not hedge his or her total exposure.
Banks seek to maximize profitability for a given amount of risk on their balance
sheet
An investment bank is split into the so-called Front Office, Middle Office and Back
Office. The individual activities are described below:
Front Office
Investment Banking is the traditional aspect of investment banks which
involves helping customers raise funds in the Capital Markets and advising on
mergers and acquisitions. Investment bankers prepare idea pitches that they
bring to meetings with their clients, with the expectation that their effort will be
rewarded with a mandate when the client is ready to undertake a
5

transaction. Once mandated, an investment bank is responsible for preparing all

materials necessary for the transaction as well as the execution of the deal, which
may involve subscribing investors to a security issuance, coordinating with
bidders, or negotiating with a merger target. Other terms for the Investment
Banking Division include Mergers & Acquisitions (M&A) and Corporate Finance
(often pronounced "corp. fin").
Investment management is the professional management of various
securities (shares, bonds etc) and other assets (e.g. real estate), to meet
specified investment goals for the benefit of the investors. Investors may be
institutions (insurance companies, pension funds, corporations etc.) or private
investors (both directly via investment contracts and more commonly via collective
investment schemes e.g. mutual funds) .
Financial Markets is split into four key divisions: Sales, Trading, Research
and Structuring.

Sales and Trading is often the most profitable area of an investment bank ,
responsible for the majority of revenue of most investment banks In the process
of market making, traders will buy and sell financial products with the goal of
making an incremental amount of money on each trade. Sales is the term for the
investment banks sales force, whose primary job is to call on institutional and
high-net-worth

investors to suggest trading ideas (on caveat emptor basis) and take orders.
Sales desks then communicate their clients' orders to the appropriate trading
desks, which can price and execute trades, or structure new products that fit a
specific need.

Research is the division which reviews companies and writes reports about their
prospects, often with "buy" or "sell" ratings. While the research division
6

generates no revenue, its resources are used to assist traders in trading, the
sales force in suggesting ideas to customers, and investment bankers by covering
their clients. In recent years the relationship between investment banking and
research has become highly regulated, reducing its importance to the investment
bank.

Structuring has been a relatively recent division as derivatives have come into
play, with highly technical and numerate employees working on creating complex
structured products which typically offer much greater margins and returns than
underlying cash securities.
Middle Office
Risk Management involves analyzing the market and credit risk that
traders are taking onto the balance sheet in conducting their daily trades, and
setting limits on the amount of capital that they are able to trade in order to
prevent 'bad' trades having a detrimental effect to a desk overall. Another key
Middle Office role is to ensure that the above mentioned economic risks are
captured accurately (as per agreement of commercial terms with the
counterparty) correctly (as per standardized booking models in the most
appropriate systems) and on time (typically within 30 minutes of trade execution).
In recent years the risk of errors has become known as "operational risk" and the
assurance Middle Offices provide now include measures to address this risk.
When this assurance is not in place, market and credit risk analysis can be
unreliable and open to deliberate manipulation.
Back Office
Operations involve data-checking trades that have been conducted,
ensuring that they are not erroneous, and transacting the required transfers.
7

While it provides the greatest job security of the divisions within an investment
bank, it is a critical part of the bank that involves managing the financial
information of the bank and ensures efficient capital markets through the financial
reporting function. The staff in these areas are often highly qualified and need to
understand in depth the deals and transactions that occur across all the divisions
of the bank.

Services Provided by an Investment Bank

Investment Bankers work with the different product groups
within the broader Investment Bank to service our clients
needs
Transaction

Product Group

Equity

Equity Capital
Markets (ECM)

Debt - Bonds

Debt Capital
Markets (DCM)
Investment Bankers

Debt - Loans

Corporate Bankers

M&A, Restructuring,
Divestiture

M&A Group

Client

Scope of investment Banking The Investment banker plays a vital role in

channel zing the financial surplus of the society into productive investment
avenues. The merchant banker has fiduciary role in relation to the investor.
Some of the major functions performed by investment banker are as follows

.1. Management of debt and equity offering This is the traditional bread and
butter operations for most of the investment banker in India. The role of the
investment banker is dynamic and it has to be nimble footed to capitalize on
available opportunities. It has to assist its clients in raising fund from the market.
It may also be required to counsel them on various issues that affect their
finances.
The main area of its role includes:

Instrument Designing

Pricing the issue

Registration of the offer document

Underwriting the support

Marketing the issue

Allotment and refund

Listing on stock exchange

Listing on stock exchange

2. Placement and distribution The distribution network of Investment banker

can be classified as institutional and retail. The network of institutional investors
consist of Mutual Funds, FIIs, bank, domestic and multinational financial
institutions, PE, pension funds, etc. the size of this network represent the
wholesale reach of the Investment banker. The basic requirement to create and
service the institutional segment is the existence of good in-house research
facilities. The investment proposal should be accompanied by high quality
research

reports

of

the

Investment

banker

to

justify

the

investment

recommendation. The retail distribution reach depends upon the networking with
the investors. Many Investment banks have associate firms which are brokers on
the stock exchange. These brokers appoint sub-brokers at various locations to
service both the primary market and secondary market needs of the local
investors. Thus a large base of captive investors is created and maintained.

The distribution network can be used to distribute various financial products like:
Equity

retail and institutional investors

Debt Instruments

retail and institutional investors

Mutual Fund products :

retail investors

Fixed deposits

retail investors

Insurance products

retail investors

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3. Corporate advisory Services - investment bankers offers customized

solutions to the financial problem of their clients. One of the key areas for
advisory role is financial structuring. The process includes determining the
appropriate level of gearing and advising the company whether to leverage, deleverage or maintain its current debt-equity levels. The asset turnover ratios may
be analyzed to study whether the company is over trading or under trading. The
companys working capital practices are studied and alternative working capital
policies are suggested. The investment banker may also explore the possibility of
refinancing high cost funds with alternative cheaper funds. They play advisory
role in securitization of receivables. They also help their cash rich clients in
deployment of their short-term surpluses.
4. Project Advisory - investment bankers are associated with their clients from
the early stage of their project. They assist the companies in conceptualizing the
project idea when it is at nebulous stage. Once the project is conceptualized,
they carry out the initial feasibility studied to examine its viability. Investment
bankers provide inputs to their clients in preparation of the detailed project report.
They also offer project appraisal services to clients.
4. Loan syndication - investment bankers arrange to tie up loans for their
clients. The first step involves analyzing the clients cash flow pattern so that
terms of borrowing can be defined to suit the cash flow requirements. The
important loan parameters include amount, currency, tenure, drawdown,
moratorium and the amortization. The investment bankers then prepare the
detailed loan memorandum. The loan memorandum is then circulated to various
banks and financial institutions and they are invited to participate in the
syndicate.

11

The banks indicate the amount of exposure of service they are willing to take and
the interest rates thereon. The terms are further negotiated and fine- tuned to the
satisfaction of both parties. The final allocation is done to the various members of
the syndicate. The investment banker also helps the clients in loan
documentation

procedures.

5. Research Services - Nearly all banks have a staff of research analysts who
study economic trends and news, individual company stocks, and industry
developments to provide proprietary investment advice to institutional clients and
in-house groups, such as the sales and trading divisions. Until recently, the
research division has also played an important role in the underwriting process,
both in wooing the client with its knowledge of the clients industry and in
providing a link to the institutions that own the clients stock once its publicly
traded. Indeed, in many cases, research analysts compensation was tied to
investment banking revenues. However, in recent times banks have faced public
and regulatory outcries over conflicts of interest inherent in having bankers and
researchers work hand in hand.
6. Venture capital - Venture capital is risks money, which is used in risky
enterprises either as equity or debt capital. It may be in new sunshine industries
or older risk enterprises. The funds, which finance such risky, are called venture
capital funds. Venture capital is a post-war phenomenon in the business world,
mainly developed as a sideline activity of the rich in USA. To connote the risk &
adventure & some element of investment, the generic name of venture capital
was coined. In the late 1960s a new breed of professional investors called
venture capitalists emerged whose specialty was to combine risk capital with
entrepreneurial management & to use advance technology to launch new
products and companies in the markets place. Undoubtedly, it was venture

12

capitalists astute ability to assess and manage enormous risks & export from
them tremendous returns that changed the face of America.
In India, as the majority of the above institutions are in the public sector, only
the government or public financial institutions can provide the funds for venture
capital. Venture capital is a post-war phenomenon in the business world, mainly
developed as a sideline activity of the rich in USA. To connote the risk &
adventure & some element of investment, the generic name of venture capital
was coined. In the late 1960s a new breed of professional investors called
venture capitalists emerged whose specialty was to combine risk capital with
entrepreneurial management & to use advance technology to launch new
products and companies in the markets place. Undoubtedly, it was venture
capitalists astute ability to assess and manage enormous risks & export from
them tremendous returns that changed the face of America.

Venture Projects
Proposals come to the venture capitalists in the form of business plans. He
appraises the same, giving due regard to the credentials of the founders, the
nature of the product or services to be developed, the market to be saved & the
financing required. If satisfied, he will invest his own money in the equity shares
of the new company, known as the assisted company. In addition to money,
managerial & marketing assistance may also be provided that is, the venture
capitalist not only provides funds but also on line operational advice.

Indian Position in venture capital

In India, most project financing schemes require at least 25 per cent of
the project cost to be contributed by the promoters, while the latter can raise
barely 5-10 percent. For long, there were a few agencies such as IFCIs

13

subsidiary company, Risks Capital And Technology Foundation of India, which

provides finance to bridge the shortfall in the promoter contribution, but they
could fulfill the requirements of a great many budding entrepreneurs. As results
of promoters not being able to bring in those vital initial inputs of money, many of
their good projects were hanging fire. Venture capital could remedy this situation
as well.
A beginning was made in this direction by the setting up of venture capital
divisions under the aegis of ICICI, IDBI & IFCI. Encouraged by the response to
technology financing, ICICI floated a separate company ---Technology
Development and Information Company of India (TDICI) includes, apart from
venture capital financing, technology, consultancy as well as entrepreneur escort
services such as marketing, business management, vendor development etc.
The successful operation of this fund will hopefully spark off some interest from
the private sector, which will then consider entering this line of activity. Ultimately,
it is only when venture capital financing becomes more broad-based and
widespread that it will truly taking root in economy. In tune with its tradition of
pioneering new ideas, ICICI deviated from the beaten path to usher in an unusual
type of financial support. Addition to equity participation (up to maximum of 49
percent) undertaken by typical venture capital companies, TDICI offer the
conditional loans. The entrepreneur neither pays interest on it nor does he have
to repay the principal amount. If the venture capital succeeds, TDICI recoups its
investment in the form of royalty on sales which ranges between two and eight
percent. On the other hand, if the venture fails to take off even after five years
TDICI will consider writing off the loan.

Difficulties in India
Fundamentally, there are no private pools of the capital of finance risk ventures
in India. The financial institutions perforce occupy a dominant position in the
14

provision of long-term capital to Indian industry. They and the State development
agencies do provide limited amount of equity finance to assist the development
of new business but there is no private, professionally managed investment
capital sources. There are no private sector insurance companies or the pension
funds gathering regular premium income and virtually no private banks willing to
devote a small portion of their resources to the venture capital niche. It is unlikely
that such enterprises will be created in the foreseeable future to mobilize private
saving for investments. As an answer the situation, mutual funds and investment
trusts are permitted to set up and to commit the part of their resources to the
venture capital area. As a part of the broader equity investment fund, given
suitable standards of the valuation for unquoted investments, it should be
possible for the fund managers to commit the portion of there portfolios to
venture capital situations. The participation of the private sector in venture capital
funding, as it has come to be defined in the narrow Indian context, is not possible
in isolation from the opportunity to develop a broadly spread investment
business.
Tax Treatment for venture capital
The tax treatment of the venture capital funds in India is ungenerous and falls
well short of what is required. Whereas the Mutual Funds established by the
government controlled financial institutions and nationalized commercial bank
suffer no tax on either income or capital gains, a venture capital fund would

suffer at 20 per cent on dividend income and a similar rate on long-term capital
gains. Given an adequate investment spread and tax incentives, mutual funds
step into the early stage financing arena, professionally assess and the monitor
investments assist the launch of new medium size businesses. SBI Mutual Fund
is really undertaking investment work with its brought deals. The creation of

15

more funds to participate in this area of the market is now clearly seen. Early
stage financings could then be syndicated between number of professionally
managed funds and sound, competitive situation between them might also be
created.
The Government has since 1995-96 been treating the venture funds like
Mutual funds for tax benefits and brought them under Regulation of SEBI. The
SEBI has set out the guidelines for their registration and control by itself a code
of conduct for them to operate as in the case of capital market mutual funds and
for their investment and operations on the fund. In the Central Budget for 200001 the income of the Venture Capital Fund is taxed at the rate of 20%, although
the dividends declared in the hands of the investors are tax-free.

8. Initial Public Offerings: - Initial Public Offerings (IPO) is the first time a
company sells its stock to the public. Sometimes IPOs are associated with huge
first-day gains; other times, when the market is cold, they flop. It's often difficult
for an individual investor to realize the huge gains, since in most cases only
institutional investors have access to the stock at the offering price. By the time
the general public can trade the stock, most of its first-day gains have already
been made. However, a savvy and informed investor should still watch the IPO
market,

because

this

Reasons for an IPO: -

is

the

first

opportunity

to

buy

these

stocks.

When a privately held corporation needs to raise

additional capital, it can either take on debt or sell partial ownership. If the
corporation chooses to sell ownership to the public, it engages in an IPO.
Corporations choose to "go public" instead of issuing debt securities for several
reasons. The most common reason is that capital raised through an IPO does
not have to be repaid, whereas debt securities such as bonds must be repaid

16

with interest. Despite this apparent benefit, there are also many drawbacks to an
IPO. A large drawback to going public is that the current owners of the privately
held corporation lose a part of their ownership. Corporations weigh the costs and
benefits of an IPO carefully before performing an IPO.

Going Public
If a corporation decides that it is going to perform an IPO, it will first
hire an investment bank to facilitate the sale of its shares to the public. This
process is commonly called "underwriting"; the bank's role as the underwriter
varies according to the method of underwriting agreed upon, but its primary
function remains the same.
In accordance with the SEBI act, the corporation will file a registration statement
with the Securities Exchange Board of India (SEBI).The registration statement
must fully disclose all material information to the SEBI including a description of
the corporation, detailed financial statements, biographical information on
insiders, and the number of shares owned by each insider. After filing, the
corporation must wait for the SEBI to investigate the registration statement and
approve of the full disclosure.

During this period while the SEBI investigates the corporation's filings, the
underwriter will try to increase demand for the corporation's stock. Many
investment banks will print "tombstone" advertisements that offer "bare-bones"
information to prospective investors. The underwriter will also issue a preliminary
prospectus, or "red herring", to potential investors. These red herrings include
much of the information contained in the registration statement, but are
incomplete and subject to change. An official summary of the corporation, or
prospectus, must be issued either before or along with the actual stock offering.
After the SEBI approves of the corporation's full disclosure, the corporation and
17

the underwriter decide on the price and date of the IPO; the IPO is then
conducted on the determined date. IPOs are sometimes postponed or even
withdrawn in poor market conditions.
Performance
The aftermarket performance of an IPO is how the stock price behaves after the
day of its offering on the secondary market (such as the BSE or the NSE).
Investors can use this information to judge the likelihood that an IPO in a specific
industry or from a specific lead underwriter will perform well in the days (or
months) following its offering. The first-day gains of some IPOs have made
investors all too aware of the money to be had in IPO investing. Unfortunately, for
the small individual investor, realizing those much-publicized gains is nearly
impossible. The crux of the problem is that individual investors are just too small
to get in on the IPO market before the jump. Those large first-day returns are
made over the offering price of the stock, at which only large, institutional
investors can buy in. The system is one of reciprocal back scratching, in which
the underwriters offer the shares first to the clients who have brought them the
most business recently. By the time the average investor gets his hands on a hot
IPO, it's on the secondary market, and the stock's price has already shot up.

Appointment

of

Investment

Bankers

and

Other

Intermediaries

The company first selects the Investment Banker(S) for handling the issue.
The investment banker should have a valid SEBI registration to be eligible for
appointment.
The criteria normally used in selection of Investment Bankers are:
i. Past track record in successfully handling similar issues

18

ii.

Distribution network with institutional and individual investors

iii.

General reputation in the market

iv.

Trained manpower and skills for instrument designing and pricing

v.

Good rapport with other market intermediaries

vi.

Value added services like providing bridge loans against public issue
proceeds

Issue in any of the capacities

An investment banker can be associated with the issue in any of the following
capacities:
Lead Manager to the issue
Co Manager to the issue
Underwriter to the issue
Advisor/Consultant to the issue

SEBI has set certain limits on the maximum no of intermediaries associated with
the issue
Size of the issue

No of lead managers

Less than Rs 50cr

Rs 50cr to Rs 100cr

Rs 100cr to Rs 200cr

Rs 200cr to Rs 400cr

Above Rs 400cr

5 or more as agreed by the board

The no of co managers cannot exceed no of lead managers appointed for that

issue.
There can be only one advisor or consultant to the issue. There is no limit on the
no of underwriters to the issue. An associate company of the issuer company
cannot be appointed either as lead manager or Co manager to the issue. However
19

they can be appointed as Underwriter or Advisor/Consultant to the issue. The lead

investment banker enters into a MOU with the issuer company. The no of co
managers cannot exceed no of lead managers appointed for that issue. There is
no limit on the no of underwriters to the issue. An associate company of the issuer
company cannot be appointed either as lead manager or Co manager to the issue.
However they can be appointed as Underwriter or Advisor/Consultant to the issue.
The lead investment banker enters into a MOU with the issuer company. MOU
specifies the mutual rights, obligations and liabilities relating to the issue. The lead
investment banker has to ensure that copy of MOU is submitted to the board along
with the draft offer document. In case of more than one lead manager is appointed,
all lead managers have a meeting and the entire issue related work is distributed
among them. This agreement is called as Inter-se Allocation of Responsibilities.
Once the lead manager(s) is/are appointed, the other intermediaries are appointed
in consultation with them. The selection of the intermediary is based on their past

records, ranking, previous relationship with the issuer company, fees charged etc
The other intermediaries appointed are:
a.

Registrar to the issue

b.

Bankers to the issue

c.
d.

Underwriters to the issue

Debenture trustees (if applicable)

e.

Brokers to the issue

f.

Advertising agencies

g.
h.

Printers of issue stationery

Auditor

i. Legal advisor to the issue

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9. Working capital: - Working capital, also known as net working capital, is a

financial metric which represents operating liquidity available to a business. Along
with fixed assets such as plant and equipment, working capital is considered a part
of operating capital. Finance for working capital, particularly for new ventures,
often needs to be syndicated on behalf of the promoters, and merchant banks
assist in this as well. For existing companies, non/traditional sources such as
through the issue of debentures for this purpose, and others have been
successfully tapped by merchant bankers. This ensures that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing
short-term debt and upcoming operational expenses

10. Foreign currency finance: - Of late, India has become increasingly active in
the international money markets, and this trend is likely to continue. For import of
capital goods and services from overseas, the arrangement of various kinds of
export credits from different countries is also required.
In addition to this wide range of services, some of the larger banks are also
involved in areas such as the arrangement of lease finance, and assistance in
acquisitions and mergers etc.
11. Underwriting: - Underwriting refers to the process that a large financial
service provider (bank, insurer, investment house) uses to assess the eligibility of
a customer to receive their products (equity capital, insurance, mortgage or credit).
This is a way of placing a newly issued security, such as stocks or bonds, with
investors. A merchant banker underwrites the transaction, which means they have
taken on the risk of distributing the securities. Should they not be able to find
enough investors, they will have to hold some securities themselves. Underwriters
make their income from the price difference (the "underwriting spread") between

21

the price they pay the issuer and what they collect from investors or from brokerdealers who buy portions of the offering. When a dealer bank purchases Treasury
securities in a quarterly Treasury bond auction, it acts as underwriter and
distributor. Treasury securities purchased by a primary dealer are held in a dealer
bank's trading account assets portfolio, and they are often resold to other banks
and to private investors. The main work of merchant banks relates to underwriting
of new issues and rising of new capital for the corporate sector. Of the amount
underwritten, some part devolves on the underwriters, which varies depending on
the state of the capital market, and the intrinsic worth of the project. The SEBI has
made underwriting Compulsory for all issues offered to Public first but later it was
made optional. SEBI made it necessary for merchant bank to undertake or make
a firm commitment for 5% of issued amount to the public.
Structure of Securitization
Pooling and transfer
The originator initially owns the assets engaged in the deal. This is
typically a company looking to raise capital, restructure debt or otherwise adjust its
finances. Under traditional corporate finance concepts, such a company would
have three options to raise new capital: a loan, bond issue, or issuance of stock.
However, stock offerings dilute the ownership and control of the company, while
loan or bond financing is often prohibitively expensive due to the credit rating of
the company and the associated rise in interest rates.
A suitably large portfolio of assets is "pooled" and sold to a "special purpose
vehicle" or "SPV" (the issuer), a tax-exempt company or trust formed for the
specific purpose of funding the assets. Once the assets are transferred to the
issuer, there is normally no recourse to the originator. The issuer is "bankruptcy
remote," meaning that if the originator goes into bankruptcy, the assets of the

22

Issuer will not be distributed to the creditors of the originator. In order to achieve
this, the governing documents of the issuer restrict its activities to only those
necessary to complete the issuance of securities. Since the structural issues is
very complex, an investment bank facilitate (the arranger) the originator in setting
up the structure of the transaction.
Issuance
To be able to buy the assets from the originator, the issuer SPV issues tradable
securities to fund the purchase. Investors purchase the securities, either through a
private offering (targeting institutional investors) or on the open market. The
performance of the securities is then directly linked to the performance of the
assets. Credit rating agencies rate the securities which are issued in order to
provide an external perspective on the liabilities being created and help the
investor make a more informed decision.
In transactions with static assets, a depositor will assemble the underlying
collateral, help structure the securities and work with the financial markets in order
to sell the securities to investors. The depositor typically owns 100% of the
beneficial interest in the issuing entity and is usually the parent or a wholly owned
subsidiary of the parent which initiates the transaction. In transactions with
managed (traded) assets, asset managers assemble the underlying collateral, help
structure the securities and work with the financial markets in order to sell the
securities to investors. Some deals may include a third-party guarantor which
provides guarantees or partial guarantees for the assets, the principal and the
interest payments, for a fee.
The securities can be issued with either a fixed interest rate or a floating rate.
Fixed rate set the coupon (rate) at the time of issuance, in a fashion similar to
corporate bonds. Floating rate securities may be backed by both amortizing and

23

non amortizing assets. In contrast to fixed rate securities, the rates on floaters
will periodically adjust up or down according to a designated index such as a U.S.
Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The
floating rate usually reflects the movement in the index plus an additional fixed
margin to cover the added risk.
Credit enhancement and tranching
Unlike conventional corporate bonds which are unsecured, securities generated in
a securitization deal are "credit enhanced," meaning their credit quality is
increased above that of the originator's unsecured debt or underlying asset pool.
This increases the likelihood that the investors will receive cash flows to which
they are entitled, and thus causes the securities to have a higher credit rating than
the originator. Some securitizations use external credit enhancement provided by
third parties, such as surety bonds and parental guarantees (although this may
introduce a conflict of interest). Individual securities are often split into tranches, or
categorized into varying degrees of subordination. Each tranches has a different
level

of

credit

protection

or

risk

exposure

than

another: there is generally a senior (A) class of securities and one or more junior
subordinated (B, C, etc.) classes that function as protective layers for the A
class.

The

senior

classes

have first claim on the cash that the SPV receives, and the more junior classes
only start receiving repayment after the more senior classes have repaid. Because
of the cascading effect between classes, this arrangement is often referred to as a
cash flow waterfall. In the event that the underlying asset pool becomes insufficient
to make payments on the securities (e.g. when loans default within a portfolio of
loan claims), the loss is absorbed first by the subordinated tranches, and the
upper-level tranches remain unaffected until the losses exceed the entire amount
of the subordinated tranches. The senior securities are typically AAA rated,

24

signifying a lower risk, while the lower-credit quality subordinated classes receive a
lower credit rating, signifying a higher risk.
The most junior class (often called the equity class) is the most exposed to
payment risk. In some cases, this is a special type of instrument which is retained
by the originator as a potential profit flow. In some cases the equity class receives
no coupon (either fixed or floating), but only the residual cash flow (if any) after all
the other classes have been paid.
Credit enhancements affect credit risk by providing more or less protection to
promised cash flows for a security. Additional protection can help a security
achieve a higher rating, lower protection can help create new securities with
differently desired risks, and these differential protections can help place a security
on more attractive terms.
In addition to subordination, credit may be enhanced through
A reserve or spread account, in which funds remaining after expenses such
as principal and interest payments, charge-offs and other fees have been paid-off
are accumulated, and can be used when SPE expenses are greater than its
income.
Third-party insurance, or guarantees of principal and interest payments on
the securities.
Over-collateralization, usually by using finance income to pay off principal
on some securities before principal on the corresponding share of collateral is
collected.
Cash funding or a cash collateral account, generally consisting of shortterm, highly rated investments purchased either from the seller's own funds, or
from funds borrowed from third parties that can be used to make up shortfalls in
promised cash flows.

25

A third-party letter of credit or corporate guarantee.

A back-up servicer for the loans.
Discounted receivables for the pool.
Servicing
A servicer collects payments and monitors the assets that are the crux of the
structured financial deal. The servicer can often be the originator, because the
servicer needs very similar expertise to the originator and would want to ensure
that loan repayments are paid to the Special Purpose Vehicle. The servicer can
significantly affect the cash flows to the investors because it controls the collection
policy, which influences the proceeds collected, the charge-offs and the recoveries
on the loans. Any income remaining after payments and expenses is usually
accumulated to some extent in a reserve or spread account, and any further
excess is returned to the seller. Bond rating agencies publish ratings of assetbacked securities based on the performance of the collateral pool, the credit
enhancements

and

the

probability

of

default.

When the issuer is structured as a trust, the trustee is a vital part of

the deal as the gate-keeper of the assets that are being held in the issuer. Even
though the trustee is part of the SPV, which is typically wholly owned by the
Originator, the trustee has a fiduciary duty to protect the assets and those who
own the assets, typically the investors.
Repayment structures
Unlike corporate bonds, most securitizations are amortized, meaning that the
principal amount borrowed is paid back gradually over the specified term of the
loan, rather than in one lump sum at the maturity of the loan. Fully amortizing
securitizations are generally collateralized by fully amortizing assets such as home
equity loans, auto loans, and student loans. Prepayment uncertainty is a important

26

concern with full amortization. The possible rate of prepayment varies widely with
the type of underlying asset pool; so many prepayment models have been
developed in an attempt to define common prepayment activity.
A controlled amortization structure is a method of providing investors with a more
predictable repayment schedule, even though the underlying assets may be nonamortizing. After a predetermined revolving period, during which only interest
payments are made, these securitizations attempt to return principal to investors in
a series of defined periodic payments, usually within a year. An early amortization
event is the risk of the debt being retired early.
On the other hand, bullet or slug structures return the principal to investors in a
single payment. The most common bullet structure is called the soft bullet,
meaning that the final bullet payment is not guaranteed on the expected maturity
date; however, the majority of these securitizations are paid on time. The second
type of bullet structure is the hard bullet, which guarantees that the principal will be
paid on the expected maturity date. Hard bullet structures are less common for
two reasons: investors are comfortable with soft bullet structures, and they are
reluctant to accept the lower yields of hard bullet securities in exchange for a
guarantee.
Securitizations are often structured as a sequential pay bond, paid off in a
sequential manner based on maturity. This means that the first tranche, which may
have a one-year average life, will receive all principal payments until it is retired;
then the second tranche begins to receive principal, and so forth. Pro rata bond
structures pay each tranche a proportionate share of principal throughout the life of
the security.

27

Structural Risks and Mis-incentive

Originators (e.g. of mortgages) have less incentive towards credit quality and
greater incentive towards loan volume since they do not bear the long-term risk of
the assets they have created and may simply profit by the fees associated with
origination and securitization.
14. Portfolio management services:- A list of all those services and facilities that
are provided by a portfolio manager to its clients, relating to the management and
administration of portfolio of securities or the funds of clients, is referred to as
portfolio management services. The term portfolio means the total holdings of
securities belonging to any person.
Portfolio Manager: - According to SEBI, Portfolio Manager means any person
who pursuant to contract or arrangements with a clients, advices or directs or
undertakes on behalf of the clients the management or administration of a portfolio
of securities or the funds of client, as the case may be
Discretionary Portfolio Manager:- According to SEBI, discretionary portfolio
manager means a portfolio manager who exercises or may, under a contract
relating to portfolio management, exercises any degree of discretion as to the
investments or management of the portfolio of securities or the funds of the clients,
as the case may be.
FUNCTIONS
The objective of portfolio management is to develop a portfolio that has maximum
return at whatever level of risk the investor deems appropriate.
Risk Diversification - An essential function of portfolio management is
spread risk akin to investment of assets. Diversification could take place

28

across different securities and across different industries. Diversification

achieved in different industries is an effective way of diversifying the risk
in an investment. Simple diversification reduces risk within categories of
stocks that all have the same quality rating. whereby portfolio risk are
sought to be reduced through combining assets, which are less than
perfectly positively correlated.
(B) Efficient Portfolio:-A portfolio manager aims at building dominant investment
called efficient portfolio. An efficient portfolio consists of combination of assets
that maximizes return and maximizes the risk level of expected return. The
objective of portfolio management is to analyze different individual assets and
delineate efficient portfolios. A group of portfolio of efficient portfolios is called
efficient set of portfolios. The efficient set of portfolio comprises efficient frontier.
(C) Asset allocation: - An important function of portfolio management is asset
allocation. It deals with attaining proportion of investments from categories.
Portfolio managers basically aim at stock-bond mix. For this purpose equally
weighted categories of assets are used.
(D) Beta Estimation: - Another important function of a portfolio manger is to make
an estimate of beta coefficient. It measures and ranks the systematic risk of
different assets. Beta coefficient is an index of the systematic risk. This is useful in
making ultimate selection of securities for investment by portfolio manager.
(E) Rebalancing Portfolios: - Rebalancing of portfolio involves the process of
periodically adjusting the portfolios to maintain the original conditions of portfolio.
The adjustments may be made either by way of constant proportion portfolio or by
way of constant beta portfolio. In constant proportion portfolio, adjustments are
made in such a way as to maintain the relative weighting in portfolio components

29

according to the change in prices. Under the constant beta portfolio, adjustments
are made to accommodate the values of component betas in the portfolio.
STRATEGIES
A Portfolio manager may adopt any of the following strategies as part of an
efficient management:
(A) Buy and Hold Strategy: - Under the buy and hold strategy, the portfolio
manager builds a portfolio of stock, which is not disturbed at all for a long period
of time. This practice is common in case of perpetual securities such as common
stock.
(B) Indexing: - Another strategy employed by portfolio managers is indexing.
Indexing involves an attempt to replicate the investment characteristics of a
popular measure of the bond market. Securities that are held in best-known bond
indexes

are

basically

high-grade

issues.

(C) Laddered Portfolio: - Under the laddered portfolio, bonds are selected in such
a way that their maturities are spread uniformly over a long period of time. This
way a portfolio manager aims at distributing the funds throughout the yield curve.
(D) Barbell Portfolio: - under this portfolio strategy, less investment of funds is
made in middle maturities.
15. Sales & Trading: - Make trades in securities for the primary and secondary
markets For currencies, stocks, bonds, derivatives, futures, commodities, assetbacked treasuries etc on Behalf of institutional clients (mutual and pension funds),
individual investors and for the Banks themselves. Sales are another core
component of any investment bank. Salespeople take the form of:

1) The classic retail broker

30

2) The institutional salesperson, or

3) The private client service representative.
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 or mutual funds. Private Client
Service (PCS) representatives lies somewhere between retail brokers and
institutional salespeople, providing brokerage and money management services
for extremely wealthy individuals. Salespeople make money through commissions
on trades made through their firms.
In trading traders also provide a vital role for the investment bank. Traders
facilitate the buying and selling of stock, bonds, or other securities such as
currencies, either by carrying an inventory of securities for sale or by executing a
given trade for a client. Traders deal with transactions large and small and provide
liquidity (the ability to buy and sell securities) for the market. (This is often called
making a market.) Traders make money by purchasing securities and selling them
at a slightly higher price. This price differential is called the "bid-ask spread.

SEBI

Guidelines
The Government has setup Securities Exchange Board of India

(SEBI) in April 1988. For more then three years, it had no statutory powers.
Its interim functions during the period were:
i. To collect information and advise the Government on matters relating to
Stock and Capital Markets.
ii. Licensing and regulatory and Merchant Banks, Mutual Fund, etc.
Iii To prepare the legal drafts for regulatory and developmental role of SEBI and
iv.To perform any other functions as may be entrusted to it by Government.

The need for setting up independent Government agency to regulate and develop
31

the Stock and Capital Market in India as in many developed countries was
recognized since the Seventh Five Year was launched (1985) when some major
industrial policy changes like opening up of the economy to out side the world and
greater role to the Private Sector were initiated. The rampant malpractices noticed
in the Stock and Capital Markets stood in the way of infusing confidence of
investors, which is necessary for mobilization of large quantity of funds from the
public, and help the growth of the industry. The malpractices were noticed in the
case of companies, Merchant Bankers and Brokers who are all operating in
Capital Markets. The security industry in India has to develop on the right lines for
which a competent Government agency as in UK (SIB) or in USA (SEC) is
needed.
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) MERCHANT
BANKING -ROLE & FUNCTIONS
(a) Authorization
Any person or body proposing to engage in the business of Merchant Banking
would need authorization by SEBI in the prescribed format. This will apply to
those presently engaged in the Merchant Banking activity, including as Manager,
Consultants or Advisers to issues.

(b) Authorized Activity

(i) Issue Management
(ii) Corporate Advisory services relating to the issue
(iii) Underwriting
(iv) Portfolio Management Services (PMS)
(v) Managers, Consultants or Advisers to the issue

(c) Authorization Criteria

32

All Merchant Bankers are expected to perform with high standards of integrity
and fairness in all their dealings. A code of conduct for the Merchant Bankers is
prescribed by SEBI which will take into account the following:
(i) Professional Competence
(ii)

Personnel,

their

adequacy

and

quality

and

other

infrastructure

(iii) Capital Adequacy

(iv) Past track record, experience, general reputation and fairness in all their
transactions.
(d) Terms of Authorization
(i) All Merchant bankers shall have a minimum net worth of Rs.5crore.
(ii) The Authorization will be for an initial period of 3 years.
(iii) All issues should be managed by at least one authorized to Merchant
banker functioning as the Lead Manager or sole Manager.
(iv) The Merchant Bankers shall exercise due diligences independently verifying
the contents of the prospectus. The Merchant Bankers of the issues shall certify to
this effect to SEBI.
(v)

In respect of issues managed by the Merchant Bankers, they would be

required to a minimum 5% underwriting obligation for issue subject to a ceiling of

Rs.25lakh.
(vi) The merchant bankers involvement will continue till the complete on of
essential to follow-up steps including listing of the shares and dispatch of
certificates.
(vii) The Merchant Banker shall make available to SEBI such information, returns
and reports as may be called for.
(viii) Merchant Bankers shall adhere to the code of conduct which shall prepared
by SEBI.

(ix)

Merchant Bankers to ensure that Publicity / Advertisement material

33

accompanying the application form to the issue meets the requirement of

GOI/SEBI.
(x) SEBI shall be informed well before the opening of the issue the Inter allocation
of activities/sub-activities, among lead managers to the issue.
(xi) Merchant Bankers performing or planning to perform portfolio management
services shall furnish the details in the prescribed format.
(f)

Grading of Prospectus
Grading of Prospectus will be done by SEBI using the following parameters:(i) Objective description of the project, its status and implementation.
(ii) Track record of the promoters and their competence.
(iii) Disclosure about Demand - Supply position, Market and Marketing
arrangements, Raw materials availability and infrastructural facility.
(iv) Objective assessment of Business prospects and profitability.

(g) Penalty Point System

SEBI has introduced penalty point system for Merchant Bankers who fail to
comply with the various provisions. The areas of non-compliance/defaults have
been categorized into following four categories. The activities are classified within
these four categories:

Commercial banking vs. investment banking

While regulation has changed the businesses in which commercial and investment
banks may now participate, the core aspects of these different businesses remain
intact. In other words, the difference between how a typical investment bank and a
typical commercial operate bank is simple. A commercial bank takes deposits for
checking and savings accounts from consumers while an investment bank does

34

not. We'll begin examining what this means by taking a look at what commercial
banks do.
Commercial banks

A commercial bank may legally take deposits for checking and savings accounts
from consumers. The federal government provides insurance guarantees on these
deposits through the Federal Deposit Insurance Corporation (the FDIC), on
amounts up to $100,000. To get FDIC guarantees, commercial banks must follow
a myriad of regulations. The typical commercial banking process is fairly
straightforward. You deposit money into your bank, and the bank loans that money
to consumers and companies in need of capital (cash). You borrow to buy a
house,
Finance a car, or finance an addition to your home. Companies borrow to finance
the growth of their company or meet immediate cash needs. Companies that
borrow from commercial banks can range in size from the dry cleaner on the
corner to a multinational conglomerate.

Investment banks

An investment bank operates differently. An investment bank does not have an

inventory of cash deposits to lend as a commercial bank does. In essence, an
investment bank acts as an intermediary, and matches sellers of stocks and bonds
with buyers of stocks and bonds.
Note, however, that companies use investment banks toward the same end as
they use commercial banks. If a company needs capital, it may get a loan from a
bank, or it may ask an investment bank to sell equity or debt (stocks or bonds).

35

Because commercial banks already have funds available from their depositors and
an investment bank does not, an I-bank must spend considerable time finding
investors in order to obtain capital for its client.

Risk involved in investment banking

In the course of their operations, investment banks are invariably faced with
different types of risks that may have a potentially negative effect on their
business. Risk management in investment bank operations includes risk
identification, measurement and assessment, and its objective is to minimize
negative effects risks can have on the financial result and capital of a bank.
Investment banks are therefore required to form a special organizational unit in
charge of risk management. Also, they are required to prescribe procedures for
risk identification, measurement and assessment, as well as procedures for risk
management.
The risks to which a investment bank is particularly exposed in its operations are:
liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk and
risk from change in market price of securities, financial derivatives and
commodities), exposure risks, investment risks, risks relating to the country of
origin of the entity to which a bank is exposed, operational risk, legal risk,
reputational risk and strategic risk.
Liquidity risk - is the risk of negative effects on the financial result and
capital of the bank caused by the banks inability to meet all its due obligations.
Credit risk - is the risk of negative effects on the financial result and capital
of the bank caused by borrowers default on its obligations to the bank.
Market risk - includes interest rate and foreign exchange risk.
1. Interest rate risk - is the risk of negative effects on the financial result and capita

36

of the bank caused by changes in interest rates.

Foreign exchange risk - is the risk of negative effects on the financial result
and capital of the bank caused by changes in exchange rates.
A special type of market risk is the risk of change in the market price of securities,
financial derivatives or commodities traded or tradable in the market.
Exposure risks - include risks of banks exposure to a single entity or a group
of related entities, and risks of banks exposure to a single entity related with the
bank.
Investment risks - include risks of banks investments in entities that are not
entities in the financial sector and in fixed assets.
Risks relating to the country of origin of the entity to which a bank is
exposed -(country risk) is the risk of negative effects on the financial result and
capital of the bank due to banks inability to collect claims from such entity for
reasons arising from political, economic or social conditions in such entitys
country of origin. Country risk includes political and economic risk, and transfer
risk.
Operational risk - is the risk of negative effects on the financial result and
capital of the bank caused by omissions in the work of employees, inadequate
internal procedures and processes, inadequate management of information and
other systems, and unforeseeable external events.
Legal risk it is the risk of loss caused by penalties or sanctions originating
from court disputes due to breach of contractual and legal obligations, and
penalties and sanctions pronounced by a regulatory body.
Reputational risk - is the risk of loss caused by a negative impact on the
market positioning of the bank.

37

Strategic risk - is the risk of loss caused by a lack of a long-term development

component in the banks managing team.
Need for risk management
The primary goal of risk management is to ensure that a financial institutions
trading, position taking, credit extension, and operational activities do not expose it
losses that could threaten the viability of the firm. As risk taking is an integral Part
of the investment banking business, it is not surprising that investment bank have
been risk management ever since they have been established. The only thing
which has change is the complexity.
It involves following steps
Identifying and assessing risks
Establishing policies, procedures, and risk limits
Monitoring and reporting compliance with reliance with these limits
Delineating capital allocation and portfolio management
Developing guidelines for new products and including new exposures
within the current frame work
Applying new measurements methods to the existing product
Risk management practices in front office
1.

Taping of telephone lines of traders and dealers to resolve of disputes at

a later date.
2.

Restriction on personal trading by the dealer.

3.

Restrictions on transaction at off market rates and documentation

procedures to justify any off-market transactions.

38

4. Restrictions on after-hours trading and off-premises trading and documentation

procedures to justify them when undertaken.
5. Adequate compensation policies should be formulated to protect dealers from
losses in case of disputed traders.
6. Revaluation of position may be conducted by traders to monitor positions by the
controllers to record periodic profit and loss, and by the risk mangers who seek to
estimate risk under various market conditions.
7. Traders should maintain professionalism, confidentiality and proper language in
telephone and electronic conversation.
8.Management should analyze the trading activity periodically.
Risk management in the back office
1.

It should have written documentation indicating the range of permissible

products, trading authorities and permissible counterparties.

2.

It should have limits for each type of contract or risk type.

3.

The management should explicitly state the procedure for the written

authorization of the trades in excess of the laid down limits.

4.

Adequate procedure for promptly resolving the failure to receive or deliver

securities on the settlement dates must be established.

Other risk management practices
1.

As with traditional banki9ng transactions, an independent credit function

should conduct an internal credit review before engaging in transaction with the
prospective counterparties. Credit guidelines should ensure that the limits are
approved for only those counterparties that meet the appropriate credit criteria.

39

2. The credit risk management function should verify that the limits are approved
by the credit specialist.
3. The assessment of the counterparties based on simple balance sheet
measures the traditional assessment of the financial condition may be adequate
for many types of counterparties. The credit risk assessment policies should also
properly define the type of analysis to be conducted on the counterparties based
on the nature of their risk profile. In some instance stress testing may be needed
when counterpartys creditworthiness may be adversely affected by the shortterm fluctuations in the financial markets.
4. The top management has to identify those areas where the bank practices
may not comply with the stated policies. Necessary internal controls for ensuring
that the practices confirm with that stated policies should be put in place.

Possible conflicts of interest

It is crucial to note whether an investment bank has provided corporate finance
services to the company under coverage. Usually at the end of a research piece,
a footnote will indicate whether this is the case. If so, investors should be careful
to understand the inherent conflict of interest and bias that the research report
contains. Often covering a company's stock (and covering it with optimistic
ratings) will ensure corporate finance business, such as a manager role in equity
offerings, M&A advisory services, and so on. Potential conflicts of interest may
arise between different parts of a bank, creating the potential for financial
movements that could be market manipulation. Authorities that regulate
investment banking (the FSA in the United Kingdom and the SEC in the United
States) require that banks impose a Chinese wall which prohibits communication
between investment banking on one side and research and equities on the other.
40

Some of the conflicts of interest that can be found in investment banking

are listed here:
Historically, equity research firms were founded and owned by
investment banks. One common practice is for equity analysts to initiate
coverage on a company in order to develop relationships that lead to highly
profitable investment banking business. In the 1990s, many equity researchers
allegedly traded positive stock ratings directly for investment banking business.
On the flip side of the coin: companies would threaten to divert investment
banking business to competitors unless their stock was rated favorably.
Politicians acted to pass laws to criminalize such acts. Increased pressure from
regulators and a series of lawsuits, settlements, and prosecutions curbed this
business to a large extent following the 2001 stock market tumble
Many investment banks also own retail brokerages. Also during the
1990s, some retail brokerages sold consumers securities which did not meet
their stated risk profile. This behavior may have led to investment banking
business or even sales of surplus shares during a public offering to keep public
perception of the stock favorable.
Since investment banks engage heavily in trading for their own account,
there is always the temptation or possibility that they might engage in some form
of front running.

41

The Big Picture- Major Players in investment banking

Until the wave of consolidation and convergence that started in the 1990s in the
financial services industry, the playing field had changed very little and was easy
to understand. Commercial banks and investment banks each had their roles, as
defined by federal regulations, and seldom did the two meet. And within
investment banking, firms could be neatly categorized by their size, market focus,

or both. At the top was the bulge bracket, which consisted of the six largest firms:
Merrill Lynch, Goldman Sachs, Morgan Stanley, Salomon Smith Barney, First
Boston, and Lehman Brothers.

1. Bank of America Securities LLC -Bank of America Securities is the U.S.

investment banking arm of Bank of America, one of the biggest commercial banks
around. Together with Bank of Americas U.K. investment banking subsidiary,
Banc of America Securities Ltd., it offers a full range of investment banking and
brokerage services. The company was created in 1998, when its parent bank
acquired Montgomery Securities. Later, Bank of America was acquired by
NationsBank, and the combined entity took on the Bank of America name. Banc
of America Securities main offices are in San Francisco, New York, and
Charlotte. It employs people in areas including corporate and investment banking,
the global markets group (debt capital raising, sales, trading, and research),
portfolio management, e-commerce, global treasury services, and asset
management. Banc of America Securities offers full-time and summer associate
and analyst programs in the United States and in Europe.

2.

Credit Suisse first Boston LLC - Credit Suisse First Boston is the result

of the 1988 merger of the investment bank First Boston and Credit Suisse, a
European commercial bank. In 2000, the firm acquired Donaldson, Lufkin &
42

Jenrette, and a leading underwriter of high-yield bonds with a golden reputation

in research. A bulge-bracket bank, CSFB ranked fifth among all banks in 2003 in
terms

of

global

debt,

equity,

and

equity-related

issuance. CSFB has experienced trouble in recent years, with business

slackening in key areas (e.g., IPO underwriting) and regulatory trouble (the firm
paid a $200 million fine in 2002 for research improprieties and another $100
million in 2002 to settle charges that it received kickbacks in the form of higher
commissions from clients to whom it allocated hot IPO sharesand in the
process

rock-star

tech

banker

Frank

Quattrone

resigned

and

eventually was convicted of criminal charges). The firm has also been losing key
bankers in recent times; epitomizing this trend, the CEO of the investment bank,
John Mack, announced plans to leave the firm in the summer of 2004, reportedly
due to the fact that his desire to merge Credit Suisse with another firm was not in
line with the desires of the majority of the directors of Credit Suisse. After that
announcement, the firms head in China announced plans to leave the firm, and
as this guide goes to press the firm must surely be worried that an exodus of the
firms talent in Asia will ensue.

3.

Deutsche Banc Securities Inc. - Deutsche Banc Securities is the full-

service North American investment banking arm of German financial services

giant Deutsche Bank AG. It includes Deutsche Bank Alex. Brown, which provides
M&A, acquisition finance, and project finance advisory to clients in the healthcare, media, real estate, technology, and telecom sectors. The bank has been
undergoing some changes, with some key employees leaving the firm and the
addition of a number of senior-level hires. In March 2004, Deutsche announced it
was laying-off 50 employees in the equity group, including nine senior research
analysts, dropping coverage of 100 of the 731 companies it used to cover in the
process. Observers report that layoffs could continue as the bank cuts back on
43

research coverage, a common trend on the Street. Overall, though, Deutsche

Bank has been focused on building its presence in North America.
4.

J.P Morgan & Co. - This firm was formed by a mega-merger when

Chase Manhattan, one of the largest commercial banks around, paid $33 billion
to join with J.P. Morgan, one of the oldest and most prestigious commercial and
investment banks in the world. Subsidiaries include J.P. Morgan Fleming Asset
Management, which serves institutional investors; J.P. Morgan Partners, a
private-equity house; J.P. Morgan H&Q, an investment banking arm focused on
areas like tech and health care; and J.P. Morgan Private Bank, which serves
wealthy private clients. And now, with the 2004 acquisition of Bank One, its
getting even bigger. (However, the acquisition probably wont have a major effect
on the way things are done in the investment bank, J.P. Morgan.) J.P. Morgan is
a major player in terms of debt and equity issuance worldwide; in the first half of
2004, it was third in the league tables in global equity underwriting, in U.S. IPO
underwriting, and in overall debt underwriting. It is also a player in M&Afifth
best in the business, in terms of worldwide announced deals in the first half of
2004.

5.

Merill Lynch & Co., Inc. - Merrill was founded in 1914, when Charles

Merrill opened the first U.S. retail brokerage firm, winning his company the
nickname the firm that brought Wall Street to Main Street. He was joined a year
later by his friend Edmund Lynch. In recent years, the company has worked to
increase its presence in the global market place. The firms strength lays in its
vast retail brokerage network and large asset management business, as well as
its position near the top of the global underwriting and advisory league tables. All
has not been rosy for Merrill of late. Poor performance has forced the firm to drop
thousands of employees over the past several years. In 2002, the firm was
forced to pay $100 million to New York State after evidence supporting
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allegations of fraudulent stock recommendations by Merrill research analysts

came to light. Also in 2002, the firm was one of a number of major banks paying
between $80 million and $125 million as part of a $1.335 billion settlement with
regulators for research misdeeds. In 2003, the firm was charged by the SEC with
helping Enron fraudulently pump up its profits in 1999, and Merrill agreed to pay
$80 million to settle.

The Evolving industry structure

As the global economic climate cooled down following the economic and financial
meltdown, so did investment banking performance. Lower interest rates drive
business, such as mortgage-backed and municipal securities. At the same time,
the big banks found them selves tremendously overstaffed, having hired new
employees like gangbusters in the boom years of the 1990s. As a result,
investment banks have started laying-off.
Investment banking has witnessed a rash of cross-industry mergers and
acquisitions in recent times, largely due to the late-1999 repeal of the Depressionera Glass-Steagall Act. The repeal, which marked the deregulation of the financial
services industry, now allows commercial banks, investment banks, insurers, and
securities brokerages to offer one anothers services. As I-banks add retail
brokerage and lending to their offerings and commercial banks try to build up their
investment banking services, the industry is undergoing some serious global
consolidation, allowing clients to invest, save, and protect their money all under
one roof. These mergers have added a downward pressure on employment in the
industry, as merged institutions make an effort to reduce redundancy.
The Industry One of the biggest issues was the fact that banks overrated the
investment potential of client companies stocks intentionally, deceiving investors

45

in the pursuit of favorable relationshipsand ongoing banking revenue

opportunitieswith those companies. Firms also came under fire for the methods
by which they allocated stock offerings (specifically, for whether they charged
excessive commissions to clients who wanted to purchase hot offerings), as well
as for possible manipulation of accounting rules in the course of presenting
clients financial info to potential investors. By now, almost all of the important
investment banks have paid fines totaling in the billions of dollars to settle
allegations against them, and the scrutiny of regulators remains sharp. And banks
are paying millions to purchase independent research to provide to their
customers.

CASE STUDY ON INVESTMENT BANKING :

The article was cited by The Economist in October 2007 in a special report on
innovation, in which the magazine quoted Lyons highlighting the importance of
services innovation to fight commoditization. "Commoditization often occurs even
faster in services than in physical products because innovations are easier to
copy and there are fewer patent protections, lower front-end capital investments,
and shorter product cycles," Lyons, Chatman, and Joyce write in the article.

Behavior as Product
In their article an unusual collaboration between experts in finance and
organizational behavior the trio finds that innovation in services tends to be a
more gradual evolution rather than a disruptive revolution. The researchers also
argue that innovation in the services sector is more reliant on a culture that fosters
innovation than innovation in manufacturing organizations.

46

"In services industries, behavior is the product," Lyons says. Consequently, the
cultural and organizational foundations that guide behavior are essential for
competing on innovation effectively, Lyons, Chatman, and Joyce write.
"Services are all about the people," Chatman explains. "And if the people don't
have a mindset embedded with notions of innovation, then innovation is not going
to happen."

Innovation Ignored
Although services accounts for approximately 78% of US gross domestic product,
few researchers have examined innovation in the services industry, Lyons,
Chatman, and Joyce found.

The idea for their article originated with Lyons in the summer of 2006, when he
was spearheading the Haas School's Leading Through Innovation strategy as
executive associate dean. As he became more convinced of culture's powerful
role in fostering innovation, Lyons discussed the subject with Chatman, an expert
in organizational culture. They agreed to explore the topic further with Joyce, a
Ph.D. candidate in organizational behavior, in an article for the 50th anniversary
of California Management Review, which focused entirely on innovation.

After Lyons became chief learning officer at Goldman Sachs in November 2006,
the three researchers decided to include a mini-case study of investment banking
in the article.

Innovation in Investment Banking

From their case study, Lyons, Chatman, and Joyce identify four fundamental
enablers of innovation in the investment banking industry: client demand for
services that span boundaries; broad and deep client relationships; tight
47

integration between service design and execution; and the vision of innovation
articulated at the top. The authors suggest that those enablers likely apply to
other professional services industries such as consulting, law, and accounting.
BusinessWeek declared in 2006 that innovation in services is rare, but that's
not true in the context of investment banking," Lyons says. "If anyone in
investment banking fell asleep ten years ago and woke up today, they wouldn't
know how to do their job."
"Innovation in investment banking has been breathtaking not because of
radical innovation, but because of an accumulation of hundreds and even
thousands of small innovations," Lyons adds. "In services, innovation is a
marathon, not a sprint."

People, Not Products

That is true in part because services innovation is less tangible than product or
technical innovation. "Services innovation is not just a new product that you can
hold in your hand, but a new approach," Chatman explains.

Without a physical product line or technology, monitoring quality and consistency

is more difficult in a services firm, the authors note. Therefore, innovating in
service organizations requires that norms and values guide behavior to ensure
quality, consistency, and reliability.

Because people play such an important role in services innovation, innovation in

services is far more influenced by hiring and promotion decisions, leaders'
behavior, and formal firm-wide reward and incentive systems than innovation in
product or technology firms, Lyons, Chatman, and Joyce write.

48

Lyons, Chatman, and Joyce describe several pitfalls that can arise when services
companies apply innovation techniques used by firms with physical products. For
instance, technology companies often assign innovation to a particular unit, such
as research and development. But that approach in services misses the systemic
nature of innovation in services, which is much more distributed and thus affects
the behavior of a much wider range of employees, according to Lyons, Chatman,
and

Joyce.

"You need a culture of innovation at a services firm to foster innovation that

operates at the firm-wide level," Lyons says.

49

Conclusion
For the past couple of years the investment banking industry has been shrinking
and the current scenario calls for combined efforts by the regulators and the
industry itself to take measures for improving the situation. At present the industry
is going through changes. Many non banking finance companies are focusing on
becoming multi business entities so that they can remain commercially viable.
The corporate sector has perennial needs for services such as investment
advisory, corporate restructuring, distressed assets acquisition and equity and
debt financing. And as the economy improves the need for these services will
further intensify. This indicates good prospects for the investment banks proficient
in these areas of business. It is time for the investment banks to focus on
developing competitive advantages in the form of wider outreach and ability to
mobilize national savings with greater efficiency.

In this scenario, investment banks have had to increase their international

presence in order to retain existing clients and to generate new business. They
have been achieving these offices abroad as well as by acquiring or merging with
foreign investment banks. Similarly investment banks from other countries have
been strengthening their ties with American investment banks. The industry has
been witnessing consolidation across geographical functional-supermarket, where
all the financial need of all types of clients can be fulfilled. With the abolition of
glass-Steagell act, it is possible for bank to convert itself into a supermarket that
offers all types of financial services to issuers and investors, at both retail and
wholesale level. The range of services offered may cover underwriting services,
fund, management, insurance products, credit cards, loans, depository services.
Corporate advisory services, trust services etc.

50

The rapid technology changes have started affecting the industry. As various
commercial banking and investment banking activities have become digitalized,
the established players are facing challenge on pricing front from all small new
players. This is big forcing big banks to find means of turning the digitalization to
their advantage and reducing cost. Today they are focusing more on lower cost,
better quality services, innovative products and new service channel so that can
have deeper penetration in the market. During the downturn in the economy the
demand for the industries services declines equally fast. The earning in the
industry are extremely volatile as they depend upon extremely volatile factors like
interest rates, exchange rates., inflation etc. they need to stay big enough at all
times to be able to satisfy suddenly increasing demand, yet be flexible enough to
be able to downsize quickly in a declining market.

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Bibliography
Websites
1.
2.
3.
4.
5.

www.google.com
www.wikipedia.org
www.pfoo.com
www.financeconnectsingapore.com
www.management paradise.com
Books

1. Investment Banking (ICFAI)

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