Institutions Ch 16 (Done)

Securities Firms and Investment Banks

Securities firms and investment banks

__________________________________ help net suppliers of funds (e.g., households) transfer funds to net users of funds (e.g., businesses) at a low cost and with a maximum degree of efficiency

Investment banking involves transactions such as the raising of debt and equity securities for corporations or governments

• Includes the origination, underwriting, and placement of securities in money and capital markets for corporate or government issuers, as well as corporate finance activities (e.g., advising on mergers and acquisitions (M&As) and the restructuring of existing corporations)

• Investment banks specialize in origination, underwriting, and distributing issues of new securities (commercial side of the business)

Investment banks

________________ specialize in origination, underwriting, and distributing issues of new securities (commercial side of the business)

Securities services involve assistance in the trading of securities in the secondary markets (brokerage services or market trading)

• Securities firms specialize in the purchase, sale, and brokerage of existing securities (retail side of the business)

Securities firms

_______________ specialize in the purchase, sale, and brokerage of existing securities (retail side of the business)

Size of the industry is usually measured by the equity capital of firms participating in the industry rather than by “asset size”

• Equity capital in the NYSE reporting broker-dealers amounted to $239 billion in 2021

Number of firms in the industry changed dramatically over time, with the major cause being regulatory changes (e.g., Financial Service Modernization Act of 1999)

• 5,248 firms in 1980

• 9,515 firms in 1987

• 5,052 firms in 2006

• 3,794 firms in 2021

Investment banking industry was irrevocably changed as a result of the financial crisis

• Five largest investment banks at the beginning of 2008 were all gone as investment banks by the end of the year

Firms in the industry can be divided along several dimensions:

• Largest firms are diversified financial service (or national full-service) investment banks that service both retail and corporate customers

  • Assist retail customers by acting as broker-dealers

  • Assist corporate customers by securities underwriting

National full-service firms fall into three subgroups:

1. Commercial banks (or financial services holding companies) are the largest of the full-service investment banks (e.g., JPMorgan) and have extensive domestic and international operations

2. National full-service firms specialize more in corporate finance or primary market activities and are highly active in trading securities, or secondary market activities (e.g., Goldman Sachs)

3. Large investment banks maintain more limited branch networks concentrated in major cities operating with predominantly institutional client bases (e.g., Greenhill & Co.)

Remainder of industry is comprised of firms that perform a mix of primary and secondary market services for a particular segment of the financial markets:

• Regional securities firms

  • E.g., Raymond James Financial

• Specialized discount brokers

  • E.g., Charles Schwab

• Specialized electronic trading securities firms

  • E.g., E*Trade

• Venture capital and private equity firms

• Other firms include research boutiques, companies with large clearing operations, and other firms that do not fit into one of the categories above

Investment banking refers to activities related to underwriting and distributing new issues of debt and equity securities

• New issues can be either first-time issues of a company’s debt or equity securities or the new issues of a firm whose debt or equity is already trading (i.e., seasoned issues)

Investment banking

___________________ refers to activities related to underwriting and distributing new issues of debt and equity securities

$11.47 trillion of debt and equity was underwritten globally in 2021

Securities underwriting can be undertaken through either public or private offerings

• Public offering represents the sale of a security to the public at large

  • Securities may be underwritten on a best efforts or a firm commitment basis

• In a private offering, an investment bank acts as a private placement agent for a fee, placing the securities with one or a few large institutional investors (e.g., life insurance companies)

Investment bank

___________________ may also participate as an underwriter in government, municipal, and mortgage-backed securities

Venture Capital

Difficulty for new and small firms in obtaining debt financing from CBs is that CBs are generally not willing to make loans to new companies with no assets or business history

Venture capital (VC) is a professionally managed pool of money used to finance new and often high-risk firms

• Generally provided to back an untried company and its managers in return for an equity investment in the firm

• VC firms are not generally passive investors; they provide valuable expertise to the firm’s managers and may help with recruiting

• Many different types of VC firms:

  • Institutional VC firms are business entities whose sole purpose is to find and fund the most promising new firms

    • Include limited partner VC firms, financial VC firms, and corporate VC firms

  • Angels are wealthy individuals who make equity investments 

Venture capital (VC)

____________________ is a professionally managed pool of money used to finance new and often high-risk firms

Institutional VC firms

____________________ are business entities whose sole purpose is to find and fund the most promising new firms

• Include limited partner VC firms, financial VC firms, and corporate VC firms

Angels

________ are wealthy individuals who make equity investments

VC and private equity (PE) are often used interchangeably, but there are distinct differences in the two types of investments:

• VC firms concern themselves more with startup business concerns

• VC firms tend to utilize teams of either scientific or business professionals to help identify new and emerging technologies in which to place their money

• PE firms deal more with existing companies that have already proven themselves in the business field

As a result of the financial crisis, the differences between VC and PE firms have become less distinct

• Fewer new ventures being brought forth means greater competition between VC and PE firms

Market making

____________________ involves the creation of a secondary market in an asset by a securities firm or investment bank

Market making can involve either agency or principal transactions:

• Agency transactions are two-way transactions made on behalf of customers

• In principal transactions, the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its own account

Agency transactions

_______________ are two-way transactions made on behalf of customers

principal transactions

In _____________________ , the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its own account

Designated market makers (DMMs)

_____________________________ provide liquidity in a given NYSE security by assuming risk and displaying quotes in the exchange limit order book

• Accounted for about 17% of liquidity adding volume in NYSE-listed securities in 2019

Trading

_______ is closely related to market-making; a trader takes an active net position in an underlying instrument or asset

There are at least six types of trading activities:

1. Position trading involves purchases of large blocks of securities on the expectation of a favorable price move

2. Pure arbitrage involves buying an asset in one market at one price and selling it immediately in another market at a higher price

3. Risk arbitrage involves buying securities in anticipation of some information release (e.g., merger or takeover announcement)

4. Program trading is the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million, using computer programs to initiate such trades

5. Stock brokerage involves trading securities on behalf of customers

6. Electronic brokerage involves direct assess, via the Internet, to the trading floor, therefore bypassing traditional brokers

Position trading

_______________ involves purchases of large blocks of securities on the expectation of a favorable price move

Pure arbitrage

_____________ involves buying an asset in one market at one price and selling it immediately in another market at a higher price

Risk arbitrage

___________ involves buying securities in anticipation of some information release (e.g., merger or takeover announcement)

Program trading

________________ is the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million, using computer programs to initiate such trades

Stock brokerage

______________ involves trading securities on behalf of customers

Electronic brokerage

___________________ involves direct assess, via the Internet, to the trading floor, therefore bypassing traditional brokers

Investing involves managing pools of assets such as closed- and open-end mutual funds

• Securities firms can manage such funds either as agents for other investors or as principals for themselves and their stockholders

• Objective in funds management is to select asset portfolios to beat some return-risk performance benchmark, such as the S&P 500 Index

Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs), money market mutual funds that offer checkwriting privileges

• Can be covered directly or indirectly by federal deposit insurance from the FDIC

Investment banks frequently provide advice on, and assistance in, mergers and acquisitions

• Assist in finding merger partners

• Underwrite any new securities to be issued by the merged firms

• Assess the value of target firms

• Recommend terms of the merger agreement

• Assist target firms in preventing a merger

Other service functions include the following:

• Custody and escrow services

• Clearance and settlement services

• Research and advisory services

In performing these functions, investment banks normally act as agents for a fee

• Fees charged are often based on the total bundle of services performed for the client by the firm

• Portion of the fee or commission allocated to research and advisory services is called soft dollars

IBs

______ are making increasing inroads into traditional bank service areas, such as small-business lending and the trading of loans

Industry trends depend heavily on the state of the stock market and the economy

• Commission income fell after the 1987 stock market crash 

• Record stock market trading volumes between 1992 through 2000 resulted in a recovery in commission income

• Improvements in the U.S. economy in the mid-2000s led to even greater increases in commission income, but income fell with the stock market in 2006-2008, due to rising oil prices and the subprime mortgage collapse

• Commission income again rose in the early and mid-2010s, as the economy and the stock market recovered, but it started declining again in late 2010s

By the mid-2010s, while the industry had put most problems from the financial crisis behind it, the industry was affected by post-crisis consequences, with increased regulation on risk taking and capital requirements

• Result of new regulations is that profitability is down: pretax profits in 2013, 2014, and 2015 fell to $26.3b, $27.0b, and $23.8b, respectively. In 2016 through 2021, the pretax profits rose because revenues grew faster than expenses.

Since 2013, many companies have taken strategic initiatives to respond to new regulations and de-risk their firms

• Led to balance sheet reductions, as well as downsizing or disposition of select businesses, trading products, and investments

• Corporate strategies increasingly focus on client services and away from making large bets through principal investments

Balance Sheets

Assets

• Many of the assets appearing on the balance sheet of securities firms are cash like money market instruments, not capital market positions

• Receivables from other broker-dealers and clearing organizations accounted for 30.7% of total assets

• Reverse repurchase agreements accounted for 28.7% of assets

• Long positions in securities accounted for 13.3% of assets

Balance Sheets

Liabilities

• Major similarity between securities firms and all other types of FIs is a high degree of financial leverage (i.e., all these firms hold high levels of debt)

• Difference in the funding is that securities firms tend to use liabilities that are extremely short-term and market-based

• Repurchase agreements were the major source of funds, amounting to 35.9% of total liabilities and equity

• Other major sources of funds were loans (27.0%), and payables owed to other broker-dealers and clearing organizations(15.0%), 

Balance Sheets

Equity

• Equity capital amounted to only 6.8% of total assets

Securities and Exchange Commission (SEC) is the primary regulator of the securities industry

• Established in 1934 largely in response to abuses by securities firms that many at the time felt were partly responsible for the economic problems in the U.S.

• Primary role of SEC includes administration of securities laws, review and evaluation of registrations of new securities offerings, review and evaluation of annual and semiannual reports summarizing the financial status of all publicly held corporations, and the prohibition of any form of security market manipulation

National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed significance of SEC as primary regulator; states are not allowed to

• Require federally registered securities firms to be registered in a state

• Require registrations of securities firms’ transactions or impose substantive requirements on private placements

While the SEC sets the overall regulatory standards for the industry, the Financial Industry Regulatory Authority (FINRA) is involved in the day-to-day regulation of trading practices

• FINRA is an independent, not-for-profit organization authorized by Congress

• FINRA writes and enforces rules governing the activities of securities firms, examines firms for compliance with those rules, works to foster market transparency, and supports investor education

• FINRA monitors trade abuses, trading rule violations, and securities firms’ capital (solvency positions)

• FINRA also performs market regulation under contract for the major U.S. stock exchanges

Wall Street Reform and Consumer Protection Act of 2010

Wall Street Reform and Consumer Protection Act of 2010

U.S. Congress also oversees the industry

• U.S. Senate Permanent Subcommittee on Investigations was created with the broad mandate to determine whether any changes are required in U.S. law to better protect the public

• Spring of 2010

  • Subcommittee hearing focused on the contributing role of investment banks (e.g., Goldman Sachs) in the financial crisis

  • Subcommittee brought up evidence and internal Goldman documents that showed Goldman knew the housing market was on the brink of collapse but continued to sell mortgage-backed securities to investors

  • Goldman allegedly bet against the securities it built and sold with the knowledge that the housing market’s collapse would bring the firm a sizable payday

Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 on securities firm failures

• Not an agency or establishment of the U.S. government, and has no authority to investigate or regulate its member broker-dealers

• Created under the Securities Investor Protection Act of 1970 as a non-profit membership corporation

• Oversees the liquidation of member broker-dealers that close when the broker-dealer is bankrupt or in financial trouble and customer assets are missing

• Focus is on restoring customer cash and securities left in the hands of bankrupt of otherwise financially troubled brokerage firms

Securities firms and investment banks are by far the most global of any group of financial institutions

• Both U.S. and European IBs compete for business worldwide

foreign securities trading and underwriting

As domestic securities trading and underwriting grew in the 1990s and 2000s, so did _____________________________________

Result of the financial crisis in the late 2000s was that large investment banks around the world became more concerned than ever with capital, liquidity, and leverage; however, they did not want to lose ground in the global competition for clients

• Global IBs looked for strategic alliances that would allow them to compete in foreign markets, or they exited those markets altogether

LIBOR

One of the more grievous actions by some global IBs during the financial crisis was the manipulation of the ________