Securities Firms and Investment Banks
Overview of Securities Firms and Investment Banks
Instructor: An Qin
Course: FINC 337-101: Banking, Money, and Capital Markets
Term: Fall 2025
Services Offered by Securities Firms versus Investment Banks
Securities firms and investment banks facilitate the transfer of funds between net suppliers (e.g., households) and net users of funds (e.g., businesses) efficiently and at low cost.
Investment Banking:
Involves transactions including the raising of debt and equity securities for corporations or governments.
Activities include:
Origination: Process of creating new securities.
Underwriting: Underwriting securities involves verifying and evaluating securities for sale.
Placement: Distributing securities in the money and capital markets.
Corporate finance activities include advising on mergers and acquisitions (M&As) and restructuring of corporations.
Investment banks focus on the commercial side of business through origination, underwriting, and distribution of new securities.
Securities Services:
Involve assistance in trading securities in the secondary markets (brokerage services or market trading).
Securities firms specialize in the purchase, sale, and brokerage of existing securities, representing the retail side of the business.
Total Value of U.S. Mergers and Acquisitions Managed by Investment Banks (1990-2019)
A graph indicates the increasing trend of mergers and acquisitions over two decades, with values reaching significant figures annually, peaking near $2 trillion in certain years.
Size, Structure, and Composition of the Industry
Industry size is usually assessed by the equity capital of firms rather than asset size.
Equity Capital in the Industry (2018):
Total: $263.2 billion.
Number of Firms Over Time:
1980: 5,248 firms
1987: 9,515 firms
2006: 5,052 firms
2018: 3,788 firms
The investment banking industry was profoundly affected by the financial crisis of 2008, with all five largest investment banks vanishing as independent firms by the end of that year.
Subgroups of Industry Firms
Categories of Firms:
National Full-Service Investment Banks:
Largest firms with diversified financial services that serve both retail and corporate customers.
Operate as broker-dealers for retail clients and underwrite securities for corporate clients.
Specialized Sectors:
Commercial Banks / Financial Services Holding Companies:
Examples include JPMorgan. They have a wide array of operations domestically and internationally.
National Full-Service Firms:
Focus on corporate finance and primary market activities, actively engage in trading (e.g., Goldman Sachs).
Large Investment Banks:
Limit branch networks, primarily serve institutional clients (e.g., Greenhill & Co).
The rest of the industry comprises firms that offer both primary and secondary market services targeting specific market segments, including regional securities firms (e.g., Raymond James Financial), discount brokers (e.g., Charles Schwab), electronic trading firms (e.g., E*Trade), and venture capital/private equity firms.
Investment Banking
Definition: Investment banking involves underwriting and distributing new issues of debt and equity securities, including both first-time issues and seasoned issues.
In 2019, global underwriting reached $10.86 trillion.
Securities underwriting can occur through:
Public Offerings: Sale of securities to the general public.
Can be offered on a basis of best efforts or firm commitment.
Private Offerings: Investment banks act as placement agents, placing securities with a few large institutional investors for a fee.
Investment banks also underwrite government, municipal, and mortgage-backed securities.
Venture Capital
Challenges for New Firms:
Difficulty in obtaining debt financing from commercial banks (CBs) due to lack of assets and business history.
Venture Capital (VC):
Professionally managed money used to finance high-risk, often startup firms.
VC firms back companies with potential for returns in exchange for equity, actively engaging in management and recruiting.
Types of VC Firms:
Institutional VC Firms: Entities funding promising new businesses, including limited partner and corporate VC firms.
Angels: Wealthy individuals making equity investments.
Venture Capital vs. Private Equity
Differences:
VC focuses more on startup concerns while PE involves companies already established in the market.
VC teams often comprise scientific and business professionals targeting emerging technologies for investments.
Post-financial crisis, distinctions between VC and PE have blurred due to scarcity of new ventures.
Market Making
Definition: Market making creates a secondary market in an asset through securities firms or investment banks, involving two types of transactions:
Agency Transactions: Two-way transactions conducted on behalf of customers.
Principal Transactions: Market makers profit from price movements, taking both long and short positions.
Designated Market Makers (DMMs): Provide liquidity in securities by assuming risk and showing quotes in the exchange limit order book, contributing approximately 17% of liquidity volume in NYSE-listed securities in 2019.
Trading Activities
Relation to Market Making: Traders actively manage positions in assets.
Types of Trading Activities:
Position Trading: Large block purchases expecting favorable price moves.
Pure Arbitrage: Buying in one market and selling immediately in another at a higher price.
Risk Arbitrage: Buying securities before expected information releases (e.g., mergers).
Program Trading: Simultaneous trading of at least 15 stocks valued over $1 million via computer programs.
Stock Brokerage: Acting on behalf of customers to trade securities.
Electronic Brokerage: Internet-based access to trading, bypassing traditional brokers.
Investing and Cash Management
Investing: Managing asset pools such as mutual funds, with the objective of surpassing performance benchmarks (e.g., S&P 500 Index).
Securities firms manage funds as agents or principals, with cash management accounts (CMAs) offering money market mutual funds with check-writing privileges, often insured by FDIC.
Mergers and Acquisitions
Investment banks provide advice on mergers and acquisitions through:
Assisting in identifying potential merger partners.
Underwriting new securities for merged firms.
Valuation of target firms.
Recommending terms of merger agreements.
Supporting target firms to prevent unwanted mergers.
M&A activity totaled $1.82 trillion in 2019.
Other Service Functions
Additional functions performed by investment banks include:
Custody and escrow services.
Clearance and settlement services.
Research and advisory services.
They typically operate as agents and charge fees based on service bundles, with a portion allocated to research costs termed 'soft dollars.'
Recent Trends
Industry trends correlate with stock market states and economic conditions.
Historical Insights:
Commission income experienced declines after the 1987 market crash but attained record trading volumes between 1992-2000.
Post-2000s, commission income fluctuated, correlated with economic recoveries and declines, and fell during the 2006-2008 financial crisis.
In the early to mid-2010s, commission income rebounded but began to decline once again by the late 2010s.
By mid-2010s, while the financial crisis effects subsided, increased regulations on risk-taking were evident:
Pretax profits for 2013, 2014, and 2015 were reported as $26.3 billion, $27.0 billion, and $23.8 billion, respectively.
Strategic initiatives were adopted to comply with new regulations, resulting in balance sheet reductions and adjusted focus towards client services over risky principal investments.
Balance Sheets: Assets and Liabilities
Asset Components:
Predominantly cash-like instruments (money market instruments).
Receivables from other broker-dealers (29.3% of total assets) and reverse repurchase agreements (29.1% of assets).
Long positions in securities and commodities make up 22.6% of assets.
Liabilities:
Securities firms operate with high financial leverage, employing predominantly short-term market-based funding.
Major funding sources include:
Repurchase agreements: 34.3%
Payables to customers: 21.5%
Payables to other broker-dealers: 11.9%
Short securities: 8.3%
Equity capital represented 6.1% of total assets, while total capital accounted for 9.1% of assets.
Regulation Overview
Securities and Exchange Commission (SEC): Primary regulator established in 1934 to oversee the securities market, ensure compliance, and maintain fair trading practices.
Key roles include:
Administering securities laws.
Reviewing registrations of new securities.
Evaluating financial reports of publicly held corporations.
Preventing security market manipulation.
National Securities Markets Improvement Act (NSMIA) of 1996: Reinforced SEC's regulatory authority, restricting states from imposing additional registration requirements on federally registered firms.
Financial Industry Regulatory Authority (FINRA):
A not-for-profit organization monitoring daily trading practices, enforcing rules, and supporting market transparency.
Conducts firm compliance examinations and performs market regulation under contract.
Congress Oversight and Specific Incidents
U.S. Congress has a monitoring role through subcommittees like the Senate Permanent Subcommittee on Investigations.
Investigated Goldman Sachs regarding its actions during the housing market crisis, which included evidence of internal knowledge about market manipulation that generated significant profits during market downturns.
Securities Investor Protection Corporation (SIPC)
The SIPC protects against securities firm failures, covering losses of up to $500,000.
Not a government agency; its role includes overseeing the liquidation of bankrupt broker-dealers and restoring customer assets.
Global Issues
Securities firms and investment banks are globally oriented financial institutions, competing heavily across borders.
Growth in foreign securities trading and underwriting occurred alongside domestic trading growth during the 1990s and 2000s.
Post-financial crisis, global investment banks faced increased scrutiny regarding capital, liquidity, and leverage, leading many firms to reassess their international strategies, including possible market withdrawal or strategic alliances.
Notable ethical concerns arose from LIBOR manipulation during the crisis.
Foreign Transactions in U.S. Securities Markets
Graph representation of billions traded in U.S. securities markets from foreign investments, with notable fluctuations across various years (2003-2018) for categories such as Treasuries, stocks, and corporate bonds.
U.S. Transactions in Foreign Securities Markets
Graph representation showing the annual values traded in foreign securities markets across multiple years (2003-2018) specifically highlighting stocks and bonds.
Value of International Security Offerings (1995-2018)
Annual data showcasing the aggregate value of international security offerings broken down into:
Total international offerings, straight debt, convertible debt, common equity, and preferred equity.
Conclusion
The notes conclude with an overview reflecting on the complexity and interconnected nature of securities firms and investment banks, as well as the evolving market and regulatory landscape affecting their operations.