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definition - Investment_banking

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Investment banking

                   

An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities.

Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass–Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G8 countries, have historically not maintained such a separation.

There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) is the "sell side", while dealing with pension funds, mutual funds, hedge funds, and the investing public (who consume the products and services of the sell-side in order to maximize their return on investment) constitutes the "buy side". Many firms have buy and sell side components.

An investment bank can also be split into private and public functions with a Chinese wall which separates the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas such as stock analysis deal with public information.

An advisor who provides investment banking services in the United States must be a licensed broker-dealer and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulation.[1]

Contents

  Organizational structure

Investment banking is split into front office, middle office, and back office activities. While large service investment banks offer all lines of business, both sell side and buy side, smaller sell side investment firms such as boutique investment banks and small broker-dealers focus on investment banking and sales/trading/research, respectively.

Investment banks offer services to both corporations issuing securities and investors buying securities. For corporations, investment bankers offer information on when and how to place their securities on the open market, an activity very important to an investment bank's reputation. Therefore, investment bankers play a very important role in issuing new security offerings.

  Core investment banking activities

  Front office

  Investment banking

Corporate finance is the traditional aspect of investment banks which also involves helping customers raise funds in capital markets and giving advice on mergers and acquisitions (M&A). This may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Another term for the investment banking division is corporate finance, and its advisory group is often termed mergers and acquisitions. A pitch book of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry, such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance, public finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt and generally work and collaborate with industry groups on the more intricate and specialized needs of a client.

  Sales and trading

On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products. In market making, traders will buy and sell financial products with the goal of making money on each trade. Sales is the term for the investment bank's sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on a 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. Structuring has been a relatively recent activity 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. In 2010, investment banks came under pressure as a result of selling complex derivatives contracts to local municipalities in Europe and the US.[2] Strategists advise external as well as internal clients on the strategies that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place companies and industries in a quantitative framework with full consideration of the macroeconomic scene. This strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products. Banks also undertake risk through proprietary trading, performed by a special set of traders who do not interface with clients and through "principal risk"—risk undertaken by a trader after he buys or sells a product to a client and does not hedge his total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and trading has created jobs for physics, mathematics and engineering Ph.D.s who act as quantitative analysts.

  Equity research

The research division reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While the research division may or may not generate revenue (based on policies at different banks), its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. Research also serves outside clients with investment advice (such as institutional investors and high net worth individuals) in the hopes that these clients will execute suggested trade ideas through the sales and trading division of the bank, and thereby generate revenue for the firm. There is a potential conflict of interest between the investment bank and its analysis, in that published analysis can affect the bank's profits. Hence in recent years the relationship between investment banking and research has become highly regulated, requiring a Chinese wall between public and private functions.

  Middle office

This area of the bank includes risk management, treasury management, internal controls, and corporate strategy.

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 on a desk overall. Another key Middle Office role is to ensure that the 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 includes 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.

Additionally, corporate treasury is responsible for an investment bank's funding, capital structure management, and liquidity risk monitoring.

Financial control tracks and analyzes the capital flows of the firm, the Finance division is the principal adviser to senior management on essential areas such as controlling the firm's global risk exposure and the profitability and structure of the firm's various businesses via dedicated trading desk product control teams. In the United States and United Kingdom, a Financial Controller is a senior position, often reporting to the Chief Financial Officer.

Corporate strategy, along with risk, treasury, and controllers, also often falls under the finance division.

  Back office

  Operations

This involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. Many banks have outsourced operations. It is, however, a critical part of the bank. Due to increased competition in finance related careers, college degrees are now mandatory at most Tier 1 investment banks.[citation needed] A finance degree has proved significant in understanding the depth of the deals and transactions that occur across all the divisions of the bank.

  Technology

Every major investment bank has considerable amounts of in-house software, created by the technology team, who are also responsible for technical support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading. Some trades are initiated by complex algorithms for hedging purposes.

Firms are responsible for compliance with government regulations and internal regulations.

  Other businesses

  • Global transaction banking is the division which provides cash management, custody services, lending, and securities brokerage services to institutions. Prime brokerage with hedge funds has been an especially profitable business, as well as risky, as seen in the "run on the bank" with Bear Stearns in 2008.
  • Merchant banking can be called "very personal banking"; merchant banks offer capital in exchange for share ownership rather than loans, and offer advice on management and strategy. Merchant banking is also a name used to describe the private equity side of a firm.[3] Current examples include Defoe Fournier & Cie. and JPMorgan's One Equity Partners and the original J.P. Morgan & Co. Rothschilds, Barings, Warburgs and Morgans were all merchant banks. (Originally, "merchant bank" was the British English term for an investment bank.)

  Size of industry

Global investment banking revenue increased for the fifth year running in 2007, to a record US$84.3 billion,[4] which was up 22% on the previous year and more than double the level in 2003. Subsequent to their exposure to United States sub-prime securities investments, many investment banks have experienced losses since this time.

The United States was the primary source of investment banking income in 2007, with 53% of the total, a proportion which has fallen somewhat during the past decade. Europe (with Middle East and Africa) generated 32% of the total, slightly up on its 30% share a decade ago.[citation needed] Asian countries generated the remaining 15%. Over the past decade, fee income from the US increased by 80%.[citation needed] This compares with a 217% increase in Europe and 250% increase in Asia during this period.[citation needed] The industry is heavily concentrated in a small number of major financial centers, including City of London, New York City, Hong Kong and Tokyo.

Investment banking is one of the most global industries and is hence continuously challenged to respond to new developments and innovation in the global financial markets. New products with higher margins are constantly invented and manufactured by bankers in the hope of winning over clients and developing trading know-how in new markets. However, since these can usually not be patented or copyrighted, they are very often copied quickly by competing banks, pushing down trading margins.

For example, trading bonds and equities for customers is now a commodity business,[citation needed] but structuring and trading derivatives retains higher margins in good times—and the risk of large losses in difficult market conditions, such as the credit crunch that began in 2007. Each over-the-counter contract has to be uniquely structured and could involve complex pay-off and risk profiles. Listed option contracts are traded through major exchanges, such as the CBOE, and are almost as commoditized as general equity securities.

In addition, while many products have been commoditized, an increasing amount of profit within investment banks has come from proprietary trading, where size creates a positive network benefit (since the more trades an investment bank does, the more it knows about the market flow, allowing it to theoretically make better trades and pass on better guidance to clients).

The fastest growing segment of the investment banking industry are private investments into public companies (PIPEs, otherwise known as Regulation D or Regulation S). Such transactions are privately negotiated between companies and accredited investors. These PIPE transactions are non-rule 144A transactions. Large bulge bracket brokerage firms and smaller boutique firms compete in this sector. Special purpose acquisition companies (SPACs) or blank check corporations have been created from this industry.[citation needed]

  Vertical integration

In the U.S., the Glass–Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities, and led to segregation of investment banks from commercial banks. Glass–Steagall was effectively repealed for many large financial institutions by the Gramm–Leach–Bliley Act in 1999.

Another development in recent years has been the vertical integration of debt securitization. Previously, investment banks had assisted lenders in raising more lending funds and having the ability to offer longer term fixed interest rates by converting lenders' outstanding loans into bonds. For example, a mortgage lender would make a house loan, and then use the investment bank to sell bonds to fund the debt, the money from the sale of the bonds can be used to make new loans, while the lender accepts loan payments and passes the payments on to the bondholders. This process is called securitization. However, lenders have begun to securitize loans themselves, especially in the areas of mortgage loans. Because of this, and because of the fear that this will continue, many investment banks have focused on becoming lenders themselves,[5] making loans with the goal of securitizing them. In fact, in the areas of commercial mortgages, many investment banks lend at loss leader interest rates[citation needed] in order to make money securitizing the loans, causing them to be a very popular financing option for commercial property investors and developers.[citation needed] Securitized house loans may have exacerbated the subprime mortgage crisis beginning in 2007, by making risky loans less apparent to investors.

  Financial crisis of 2007/2008

The 2007 financial crisis called into question the business model of the investment bank[6] without the regulation imposed on it by Glass-Steagall.[neutrality is disputed] Once Robert Rubin, a former co-chairman of Goldman Sachs, became part of the Clinton administration and deregulated banks, the previous conservatism of underwriting established companies and seeking long-term gains was replaced by lower standards and short-term profit.[7] Formerly, the guidelines said that in order to take a company public, it had to be in business for a minimum of five years and it had to show profitability for three consecutive years. After deregulation, those standards were gone, but small investors did not grasp the full impact of the change.[7]

Investment banks Bear Stearns (founded in 1923) and Lehman Brothers (over 100 years old) collapsed; Merrill Lynch was acquired by Bank of America, which remained in trouble, as did Goldman Sachs and Morgan Stanley. The ensuing financial crisis of 2008 saw Goldman Sachs and Morgan Stanley "abandon their status as investment banks" by converting themselves into "traditional bank holding companies", thereby making themselves eligible[6] to receive billions of dollars each in emergency taxpayer-funded assistance.[7] By making this change, referred to as a technicality, banks would be more tightly regulated.[6] Initially, banks received part of a $700 billion Troubled Asset Relief Program (TARP) intended to stabilize the economy and thaw the frozen credit markets.[8] Eventually, taxpayer assistance to banks reached nearly $13 trillion dollars, most without much scrutiny,[9] lending did not increase[10] and credit markets remained frozen.[11]

A number of former Goldman-Sachs top executives, such as Henry Paulson and Ed Liddy moved to high-level positions in government and oversaw the controversial taxpayer-funded bank bailout.[7] The TARP Oversight Report released by the Congressional Oversight Panel found, however, that the bailout tended to encourage risky behavior and "corrupt[ed] the fundamental tenets of a market economy".[12]

The TARP has all but created an expectation, if not an emerging sense of entitlement, that certain financial and non-financial institutions are simply “too-big-or-too-interconnected-to-fail” and that the government will promptly honor the implicit guarantee issued for the benefit of any such institution that suffers a reversal of fortune. This is the enduring legacy of the TARP. Unfortunately, by offering a strong safety net funded with unlimited taxpayer resources, the government has encouraged potential recipients of such largess to undertake inappropriately risky behavior secure in the conviction that all profits from their endeavors will inure to their benefit and that large losses will fall to the taxpayers. The placement of a government sanctioned thumb-on-the-scales corrupts the fundamental tenets of a market economy – the ability to prosper and the ability to fail.

—Congressional Oversight Panel, TARP Oversight Report

Under threat of a subpoena by Senator Chuck Grassley, Goldman Sachs revealed that through TARP bailout of AIG, Goldman received $12.9 billion in taxpayer aid (some through AIG), $4.3 billion of which was then paid out to 32 entities, including many overseas banks, hedge funds and pensions.[13] The same year it received $10 billion in aid from the government, it also paid out multi-million dollar bonuses to 603 employees and hundreds more received million-dollar bonuses. The total paid in bonuses was $4.82 billion.[14][15]

Morgan Stanley received $10 billion in TARP funds and paid out $4.475 billion in bonuses. Of those, 428 people received more than a million dollars and of those, 189 received more than $2 million.[16]

  Criticisms

The investment banking industry, and many individual investment banks, have come under criticism for a variety of reasons, including perceived conflicts of interest, overly large pay packages, cartel-like or oligopolic behavior, taking both sides in transactions, and more.[17]

  Conflicts of interest

Conflicts of interest may arise between different parts of a bank, creating the potential for market manipulation, according to critics. 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 to prevent communication between investment banking on one side and equity research and trading on the other. Critics say such a barrier does not always exist in practice, however.

Conflicts of interest often arise in relation to investment banks' equity research units, which have long been part of the industry. A common practice is for equity analysts to initiate coverage of 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 for investment banking business. Alternatively, companies may threaten to divert investment banking business to competitors unless their stock was rated favorably. Laws were passed to criminalize such acts, and 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 after the Dot Com Bubble.

Philip Augar, author of The Greed Merchants, said in an interview that: "You cannot simultaneously serve the interest of issuer clients and investing clients. And it’s not just underwriting and sales; investment banks run proprietary trading operations that are also making a profit out of these securities."[17]

Many investment banks also own retail brokerages. 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 for them to engage in some form of front running – the illegal practice whereby a broker executes orders for their own account before filling orders previously submitted by their customers, there benefiting from any changes in prices induced by those orders.

Investment banking has also been criticised for its opacity.[18]

  Compensation

Investment banking is often criticized for the enormous pay packages awarded those who work in the industry. According to Bloomberg Wall Street's five biggest firms paid over $3 billion to their executives from 2003 to 2008, "while they presided over the packaging and sale of loans that helped bring down the investment-banking system." [19]

The highly generous pay packages include $172 million for Merril Lynch & Co. CEO Stanley O'Neal from 2003 to 2007, before it was bought by Bank of America in 2008, and $161 million for Bear Stearns Co.'s James Cayne before the bank collapsed and was sold to JPMorgan Chase & Co. in June of 2008. [19]

Such pay arrangements have attracted the ire of Democrats and Republicans in Congress, who demanded limits on executive pay in 2008 when the U.S. government was bailing out the industry with a $700 billion financial rescue package. [19]

Writing in the Global Association of Risk Professionals, Aaron Brown, a vice president at Morgan Stanley, says "By any standard of human fairness, of course, investment bankers make obscene amounts of money." [17]

  Top 10 banks

The ten largest global investment banks as of December 31, 2010, are as follows (by total fees):[20]

Rank Company Fees ($m)
1. J.P. Morgan $5,533.85
2. Bank of America Merrill Lynch $4,581.59
3. Goldman Sachs $4,386.52
4. Morgan Stanley $4,055.48
5. Credit Suisse $3,379.12
6. Deutsche Bank $3,286.80
7. Citi $3,238.67
8. Barclays Capital $2,864.44
9. UBS $2,614.44
10. BNP Paribas $1,433.89

World's biggest banks are ranked for M&A advisory, syndicated loans, equity capital markets and debt capital markets.

The Financial Times, The Wall Street Journal and Bloomberg often cover Mergers and Acquisitions and Capital Markets. League tables are also available:

  External links

  Further reading

  See also

  References

  1. ^ U.S. Securities and Exchange Commission
  2. ^ Rachel Sanderson (October 22, 2010). "UniCredit municipal deal nullified". The Financial Times. http://www.ft.com/cms/s/0/0fb16d54-de18-11df-88cc-00144feabdc0,dwp_uuid=eddfd4e0-4bc3-11da-997b-0000779e2340.html. Retrieved October 23, 2010. 
  3. ^ Merchant Banking: Past and Present
  4. ^ BANKING City Business Series
  5. ^ Morgan Stanley Real Estate Lending
  6. ^ a b c Jagger, Suzy (September 22, 2008). "End of the Wall Street investment bank". The Times (London). http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4800550.ece. Retrieved March 7, 2011. 
  7. ^ a b c d Matt Taibbi, "The Great American Bubble Machine" Rolling Stone magazine (April 5, 2010). Retrieved March 7, 2011
  8. ^ Erin Nothwehrm "Emergency Economic Stabilization Act of 2008" University of Iowa (December 2008). Retrieved June 1, 2012
  9. ^ "The true cost of the bank bailout" PBS/WNET "Need to Know" (September 3, 2010). Retrieved March 7, 2011
  10. ^ Samuel Sherraden, "Banks use TARP funds to boost lending – NOT!" The Washington Note (July 20, 2009). Retrieved March 7, 2011
  11. ^ "Fed May Keep Rates Low as Tight Credit Impedes Small Businesses" Bloomberg Businessweek (April 26, 2010). Retrieved March 7, 2011
  12. ^ Edward Niedermeyer, "TARP Oversight Report: Bailout Goals Conflict, Moral Hazard Alive And Well" (January 13, 2011). Retrieved March 7, 2011
  13. ^ Karen Mracek and Thomas Beaumont, "Goldman reveals where bailout cash went" Des Moines Register (July 26, 2010). Retrieved March 7, 2011
  14. ^ Stephen Grocer, "Wall Street Compensation–’No Clear Rhyme or Reason’" The Wall Street Journal Blogs (July 30, 2009). Retrieved March 7, 2011
  15. ^ "Goldman Sachs: The Cuomo Report’s Bonus Breakdown" The Wall Street Journal Blogs (July 30, 2009). Retrieved March 7, 2011
  16. ^ "Morgan Stanley: The Cuomo Report’s Bonus Breakdown" The Wall Street Journal Blogs (July 30, 2009). Retrieved March 7, 2011
  17. ^ a b c Aaron Brown, review of "The Greed Merchants: How Investment Banks Played the Free Market Game" by Philip Augar, Harper Collins, April 2005. Published in Global Association of Risk Professionals, March/April 05 Issue 23
  18. ^ William D. Cohan, author of House of Cards: How Wall St. Bankers Broke Capitalism, speaking on BBC Radio 5 Live, Up All Night, 13 April 2011
  19. ^ a b c Tom Randall and Jamie McGee, "Wall Street Executives Made $3 Billion Before Crisis (Update1)", Bloomberg, September 26, 2008
  20. ^ Investment Banking Review, Financial Times, December 31, 2010.
   
               

 

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