FMI Lec16.2 Investment Banks

4 functions of Investment Banks

1. underwrite initial sale of stocks and bonds

2. deal maker in mergers and acquisitions

3. private broker/bank for the very wealthy

4. research by doing the above to provide forecasts

How do Investment Banks earn money

through fees, not interest spread

they do not perform asset transformation

Why are there no pure investment banks anymore?

Pure investment banks didnt survive 2008. Now IBs are arms of commercial banks

Glass steagall act

1933 Separation of commercial and investment banks

isolate risk

created the FDIC

Why use an IB to underwrite stocks and bonds?

1. Economies of scale

2. can advise on when, where and what price

3. know potential buyers

4. IBs signal high-quality valuation and are able to successfully sell due to reputation

traditional underwriting

IPOs

IB buys the full issue and then sells

firm is guaranteed a price

IB gains on the difference with price sold on secondary market

risky, so usually multiple IBs do together

Best-effort underwriting

SEOs

no price guarantee

IB makes a commission

less reputation at risk for IB than in traditional

Consequences of over and under subscribiption

If under-subscription, IBs must lower price and eat the loss

If over-subscription, IB loses reputation for pricing poorly for the firm

Are IPOs usually under or over priced

underpriced

Private placement

entire issuance is sold to a small group of large investors (FIs)

• no SEC registration = lower costs

• common for bonds, not equity

• reduced liquidity because not traded publicly

Conflict of Interest of Investment banks underwriting

Need to give objective analysis for good public reputation, but also need to win over firms as clients

IB wants to buy IPO low, but clients want high price

What is spinning?

IB allocates underpriced IPO shares to executives in exchange for promised business in the future.