CHAPTER 19

1. CHAPTER 19 INVESTMENT BANKING

2. Investment Banking • Investment Banks (IB) are the most important participant in the direct financial markets • Assist firms and governments in selling new securities in the primary market. • Assist in making (dealer) or arranging the buying and selling (broker) in the secondary market.

3. Investment And Commercial Banks Differ • Commercial Banks (CB) accept deposits and make commercial loans as a financial intermediary. • CB traditionally could underwrite only low-risk securities of governments per the Glass-Steagall Act. • Many large firms now use the direct financial markets to finance rather than bank loans.

4. Glass-Steagall Act • The legislated separation of CB and IB in the United States is unique • The Glass-Steagall Act of 1933 (Banking Act) restricted the asset powers of commercial banks to low-risk underwriting areas. • In other countries, universal banks were able to combine commercial and investment banking functions. United States, IB, and CB had to compete with these firms.

5. The Glass-Steagall Act Effectively Separated CB from IB • CB could not underwrite (buy and resell) risky business securities. • CB were limited as to the risk assumed in their investment portfolio--no risky corporate securities. • IB firms were prohibited from engaging in CB activity. • Firms became either IB or CB.

6. The Objectives of the Glass-Steagall Act • Discourage speculation in financial markets. • Prevent conflict of interest and self-dealing. • Restore confidence in the safety and soundness of the CB system.

7. Repealing the Glass-Steagall Act • Relaxing the Glass-Steagall restrictions was one of the major financial issues of the last twenty years. • CB increasingly had sought to be allowed to engage in investment banking activities. • The Federal Reserve Board had increasingly allowed CBs to engage in some investment banking activities. • In the late 1990s, several commercial banks purchased investment banking firms.

8. Gramm-Leach-Bliley Act • Financial Services Modernization Act of 1999 • Permitted commercial banking, investment banking and insurance underwriting under a financial holding company • Citigroup

9. Bringing New Securities to Market • New issues are called primary issues, first issued in the primary market. • If the issue is the first sold to the public, it is called an unseasoned offering or an initial public offering (IPO). • If securities are already trading, the new issue of securities is called a seasoned offering.

10. Bringing New Securities to Market (continued) • Three steps of bringing a new security issue to market include: • Origination--design of a security contract that is acceptable to the market; • prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus, • obtain a rating on the issue, obtain bond counsel, a transfer agency and a trustee, and print the securities.

11. Bringing New Securities to Market (concluded) • Underwriting--the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them. • Syndicates are formed to reduce the inventory risk. • Market price declines cut the IB's margin. • Sales and distribution--selling quickly reduces inventory risk. Firm members of the syndicate and a wider selling group distribute the securities over a wide retail and institutional area.

12. Trading and Brokerage in the Secondary Market • The brokerage function is to bring a buyer and seller together. • Dealer function--buying (bid) and selling (ask) from an inventory of securities owned by the seller.

13. Trading and Brokerage in the Secondary Market (continued) • Full service brokerage firms offer a wide range of financial services provided by licensed stockbrokers or account executives for commissions. Services include: • Storage or safekeeping of securities. • Execution of trades. • Investment research and advice. • Cash management service.

14. Trading and Brokerage in the Secondary Market (concluded) • Discount (Internet) brokerage firms offer fewer non-fee services than full-services brokers, but charge lower commissions on security purchases and sales. • Banks may act as a broker on behalf of its customers under the Glass-Steagall Act. Banks moved into this area in the 1980s and 1990s usually as a discount broker.

15. Private Placements • The sale of securities directly to the ultimate investor and not through a public offering. • The underwriting function/cost is avoided. • A fee is earned for the origination/selling or uniting the supplier and user of funds. • A private placement may reduce the total flotation costs for a business or government. • The extremes of high credit quality firms and low or unknown credit quality firms use private placements.

16. Private Placement, cont. • Traditional two-year trading delay with private placement securities • SEC Rule 144A permits trading among institutional investors • Increased liquidity of investment; lower liquidity risk premium; lower financing cost for borrower.

17. Mergers and Acquisitions • Specialized IB departments provide the following services. • Arrange mergers which would produce economic synergy or increased total value after merger. • Assist firms which have had unwanted merger offers (hostile takeovers). • Help establish the value of target firms.