1. Securities Firms and Investment Banks
Lecture 2
Securities Firms and Investment Banks

2. broker-dealers assist in the trading of existing securities
Investment banks (IBs) help corporations and governments raise capital through debt and equity security issues in the primary market
underwriting is assisting in issuing new securities. This includes the origination, underwriting, and placement of securities in money and capital markets for corporate or government issuers.
IBs also advise on mergers and acquisitions (M&As) and corporate restructuring.
Securities firms assist in the trading of securities in secondary markets
broker-dealers assist in the trading of existing securities 2

4. Equity capital in the industry in 2012 was $223 billion
The size of the industry is usually measured by the equity capital of firms rather than total asset size
Equity capital in the industry in 2012 was $223 billion
The number of firms in the industry changed due to economies of scale and scope, losses with the economy, scandals at some firms, and regulations that allowed both inter- and intra-industry mergers
5,248 firms in 1980
9,515 firms in 1987
5,063 firms in 2010
As with commercial banks, consolidation has largely occurred through mergers and acquisitions. Some of the most recent consolidations include the acquisition of Bear Stearns by J. P. Morgan Chase, the bankruptcy of Lehman Brothers, and the acquisition of Merrill Lynch by Bank of America. the investment banking industry has seen the failure or acquisition of all but two of its largest firms (Goldman Sachs and Morgan Stanley) and these two firms converted to commercial bank holding companies in 2008.
Scale and scope economies provide pressure to get larger to improve profitability. Several mergers occurred due to scandals at firms and in the late 1980s regulators allowed more cross border mergers.
The industry underwent shakeouts in the 1970s after “May Day” and again after the 1987 crash 4

6. service corporate customers by underwriting security issues
Commercial bank holding companies (so called financial holding companies) that operate diversified national full-line firms
service both retail and wholesale customers by acting as broker-dealers
service corporate customers by underwriting security issues
National full-line firms (not bank holding companies) specializing in corporate finance
The second largest group of firms are full-service firms that specialize in corporate finance or primary market activity (i.e., focus less on secondary market activities)
Commercial bank examples include Bank of America and J.P. Morgan Chase. These firms’ income comes primarily from brokerage, lending, and underwriting and trading activities.
National full line firms specializing in corporate finance such as Goldman Sachs. Their income is primarily from underwriting, placement, mergers and acquisitions other consulting services and trading income. 6

7. Largest full-service investment banks
1 - Goldman Sachs.
2 - Morgan Stanley.
3 - JPMorgan Chase.
4 - Bank of America Merrill Lynch.
5 - Deutsche Bank.
6 (tie) - Citigroup.
6 (tie) - Credit Suisse.
8 - Barclays Capital.

8. Large investment banks Lazard Ltd Greenhill and Company
Have only limited branch networks concentrated in major cities and service primarily financial institution clients
Smaller specialized firms (Raymond James) such as:
regional investment bankers (sometimes labeled ‘boutiques’)
discount brokers
Internet brokers
venture capital firms
exchange floor specialists
dealers in off exchange trading
Large investment banks include Lazard Ltd and Greenhill and Company
regional investment bankers (D.A. Davidson, Raymond James), (sometimes labeled ‘boutiques’)
discount brokers (Schwab),
Internet brokers (E-Trade),
venture capital firms (New Enterprise) &
exchange floor specialists (LaBranche & Co.)
dealers in off exchange trading (Knight Capital Group) 8

9. Lines of Business Investment banking
first time debt and equity issues occur through initial public offerings (IPOs)
new issues from a firm whose debt or equity is already traded are called seasoned equity offerings (SEOs)
a private placement is a securities issue that is placed with one or a few large institutional investors
public offerings are offered to the public at large
IBs act only as an agent in best efforts underwriting
IBs act as principals in firm commitments 9

12. Best Effort Versus Firm Commitment

13. An investment bank agrees to underwrite an issue of 20,000,000 shares of stock for Murray Construction Corp. on a firm commitment basis. The investment bank pays $15.50 per share to Murray Construction Corp. for the 20,000,000 shares of stock. It then sells those shares to the public for $16.35 per share.
How much money does Murray Construction Corp. receive? What is the profit to the investment bank?
If the investment bank can only sell the shares for 14.75, how much money does Murray Construction Corp. receive?
What is the profit to the investment bank?
If the investment bank sells the stock for $16.35 per share, Murray Construction Corp. receives $15.50 × 20,000,000 shares = $310,000,000. The profit to the investment bank is ($ $15.50) × 20,000,000 shares = $17,000,000. The stock price of Murray Construction Corp. is $16.35, since that is what the public agrees to pay. From the perspective of Murray Construction Corp., the $17,000,000 represents the commission that it must pay to issue the stock.

14. If the investment bank sells the stock for $14
If the investment bank sells the stock for $14.75 per share, Murray Construction Corp. still receives $15.50 × 20,000,000 shares = $310,000,000. The profit to the investment bank is ($ $15.50) × 20,000,000 shares = - $15,000,000. The stock price of Murray Construction Corp. is $14.75, since that is what the public agrees to pay. From the perspective of the investment bank, the - $15,000,000 represents a loss for the firm commitment it made to Murray Construction Corp. to issue the stock.
Suppose instead the investment bank agrees to underwrite these 20,000,000 shares on a best efforts basis. The investment bank is able to sell 18,400,000 shares for $15.50 per share, and it charges Murray Construction Corp. $0.375 per share sold.
How much money does Murray Construction Corp. receive?
What is the profit to the investment bank?
If the investment bank can only sell the shares for 14.75, how much money does Murray Construction Corp. receive?

15. If the investment bank sells the stock for $15
If the investment bank sells the stock for $15.50 per share, Murray Construction Corp. receives ($ $0.375) × 18,400,000 shares = $278,300,000, the investment bank's profit is $0.375 × 18,400,000 shares = $6,900,000, and the stock price is $15.50 per share, since that is what the public pays.
If the investment bank sells the stock for $14.75 per share, Murray Construction Corp. receives ($ $0.375) × 18,400,000 shares = $264,500,000, the investment bank's profit is still $0.375 × 18,400,000 shares = $6,900,000, and the stock price is $14.75 per share, since that is what the public pays.

16. Venture capital
(VC) is a professionally managed pool of money used to finance new (i.e., start-up) and often high-risk firms.
VC usually purchases an equity stake in the start-up
usually become active in management of the start-up
institutional venture capital firms find and fund the most promising new firms
venture capital limited partnerships
financial venture capital firms (subsidiaries of banks)
corporate venture capital firms (subsidiaries of nonfinancial ) 16

17. Types of VCs
 Institutional venture capital firms are business entities whose sole purpose is to find and fund the most promising new firms. 
The federal government, through the SBA, operates Small Business Investment Companies (SBICs). SBICs are privately organized venture capital firms licensed by the SBA that make equity investments (as well as loans) to entrepreneurs for start-up activities and expansions. As federally sponsored entities, SBICs have relied on their unique opportunity to obtain investment funds from the U.S. Treasury at very low rates relative to private-sector institutional venture capital firms. 
Angel venture capitalists (or angels) are wealthy individuals who make equity investments. Angel venture capitalists have invested much more in new and small firms than institutional venture capital firms.

18. Private equity investments
Private equity (PE) differs from VC in funds sources and in types of investments
PE firms raise funds by selling securities rather than commingling private funds
PE firms often acquire established existing firms (restructuring, selling parts …)rather than purchase start-ups
During and after the crisis however there have been fewer promising startups so VC firms have begun engaging in PE type investments. 18

19. Market making involves the creation of secondary markets for an issue of securities. In addition to being primary dealers in government securities and underwriters of corporate bonds and equities, investment banks make a secondary market in these instruments.
Agency transactions are two-way transactions on behalf of customers. Acting as a stockbroker or dealer for a fee or commission
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.
Goldman Sachs managed $43 trillion in derivatives securities in 2013 (about 18% of total held by FIs)
Derivatives are a major source of income for banks and why they don’t like the new restrictions in the Dodd-Frank bill. Losses from subprimes and derivatives were over $1 trillion in 2009 so these are risky. 19

20. Trading involves taking an active net position in an asset
Position trading involves purchases of large blocks of securities on the expectation of a favorable price move. Position traders maintain long or short positions for intervals of up to several weeks or even months. 
Pure arbitrage entails buying an asset in one market at one price and selling it immediately in another market at a higher price. Pure arbitrageurs often attempt to profit from price discrepancies that may exist between the spot, or cash, price of a security and its corresponding futures price.
Risk arbitrage involves buying securities in anticipation of some information release—such as a merger or takeover announcement or a Federal Reserve interest rate announcement.  20

21. Program trading is defined by the NYSE as 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 the trading of securities on behalf of individuals who want to transact in the money or capital markets. To conduct such transactions, individuals contact their broker (such as Merrill Lynch), who then sends the orders to its representative at the exchange to conduct the trades.
 Electronic brokerage involves direct access, via the Internet, to the trading floor, therefore bypassing traditional brokers. Many securities firms and investment banks offer online trading services to their customers as well as direct access to a client representative  21

22. Investing involves managing pools of assets such as closed- and open-end mutual funds (in competition with commercial banks, life insurance companies, and pension funds). Securities firms can manage such funds either as agents for other investors or as principals for themselves and their stockholders
Cash management involves deposit-like accounts such as money market mutual funds (MMMFs) that offer check writing privileges
Currently money market investments have a fixed $1 net asset value (NAV). As part of increased oversight from the Dodd-Frank bill these accounts will soon be forced to trade at varying NAV so that investors can understand the risks they face in these investments. It remains to be seen whether investors will no longer consider these accounts as close substitutes for bank deposits. 22

23. Merger and acquisition (M&A) assistance
For example, they 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, and even assist target firms in preventing a merger (for example, writing restrictive provisions into a potential target firm's securities contracts). 
M&A activity brings large fees to bankers
M&A business remains very cyclical and depends on the economy 23

25. custody and escrow services, clearance and settlement services, and
Other Service Functions include
custody and escrow services,
clearance and settlement services,
and
research and advisory services—for example, giving advice on divestitures, spin-offs, and asset sales.
Investment banks are making increasing inroads into traditional bank service areas such as small-business lending and the trading of loans
Fees for these services are often bundled together and allocated for different activities 25

26. Industry Performance
Industry trends depend heavily on the state of the stock market and the economy
Commission income fell after the 1987 stock market crash and the stock market decline
Improvements in the U.S. economy in the mid-2000s led to increases in commission income, but income fell with the stock market in because of rising oil prices and the subprime mortgage collapse
In 2008 the industry reported net losses of $34.1 billion as revenues fell 38.7%. Expenses fell as well particularly because with the lower interest rates, interest expense declined. Trading and investment account losses for the industry were $65 billion. As a result employment in the industry fell from 869,000 to 840,800. Employment kept falling to 779,800 in September Profits rebounded sharply in 2009 reaching a record $61.4 billion. Commissions, fee income and trading profits all rebounded and interest expense remained very low as the Fed kept interest rates down. High profits helped in rebuilding capital and efforts to raise external equity. 26

27. Industry employment fell sharply
Revenues and profits fell record amounts in 2008, but rebounded sharply in 2009
Industry employment fell sharply
Low interest rates and strong stock market helped fuel profit recovery
Profits began to recover in 2010 but the ‘fiscal cliff’ problems and Euro area problems hurt profits in 2011 and 2012, but profits improved in 2013
In 2008 the industry reported net losses of $34.1 billion as revenues fell 38.7%. Expenses fell as well particularly because with the lower interest rates, interest expense declined. Trading and investment account losses for the industry were $65 billion. As a result employment in the industry fell from 869,000 to 840,800. Employment kept falling to 779,800 in September Profits rebounded sharply in 2009 reaching a record $61.4 billion. Commissions, fee income and trading profits all rebounded and interest expense remained very low as the Fed kept interest rates down. High profits helped in rebuilding capital and efforts to raise external equity.
 The years 2010 through 2012 brought many new challenges. The threat of a ‘fiscal cliff’ as U.S. government debt levels grew rapidly while Congress could not decide whether to increase the debt ceilings, the problems in the Euro area, increasing regulations and generally weak U.S. economic growth limited profitability for many firms. In May 2010 the ‘flash crash’ brought more scrutiny to trading activities as did the collapse in October 2011 of MF Global along with the trading glitch at Knight Capital in August Pretax profits fell from 2010 levels of $34.8 billion to $10.6 billion in 2011 and $12.4 billion in The fiscal cliff problem was resolved in January 2013 and after the European Central Bank pumped about $1 trillion into euro area banks the euro crisis subsided. In 2013, trading activity, and municipal bond and equity underwriting began to grow once more and profitability improved. 27

31. Balance Sheets of Securities Firms and Investment Banks (IBs)

32. Receivables represent trading activity
Note that large amounts of receivables represents trading activity
Receivables represent trading activity
What are securities purchased under agreements to resell? 32

33. Securities purchased under agreements to resell (i. e
Securities purchased under agreements to resell (i.e., the broker gives a short-term loan to the repurchase agreement seller) accounted for percent of assets.
 Securities sold under repurchase agreement amounted to percent of total liabilities and equity.
Equity capital amounted to only 4.68 percent of total assets, while total capital (equity capital plus subordinated liabilities) accounted for 7.13 percent of total assets.
These levels are generally below the levels held by commercial banks (11.3 percent in 2013). Firms in this industry are required by the SEC to maintain a minimum net worth (capital) to assets ratio of 2 percent. 

34. One reason for their lower equity capital levels is that securities firm and investment bank balance sheets contain tradable securities compared to the relatively illiquid loans that represent a significant portion of banks' asset portfolios.
However, this low level of capital can leave stand-alone investment banks vulnerable to runs.
For example, in the summer of 2007, two Bear Stearns hedge funds suffered heavy losses on investments in the subprime mortgage market. The two funds filed for bankruptcy in the fall of Bear Stearns's market value was hurt badly from these losses. Because Bear Stearns operated with low levels of capital, the losses became so great that by March 2008 Bear Stearns was struggling to finance its day-to-day operations.

35. Shadow Bank 1 Shadow Bank 2 Interest Rate Risk Reverse Repo
Securities sold under
repurchase agreement
Long-term positions in
securities and commodities
(long-term)
Securities sold under
repurchase agreement
(short-term)
Interest Rate Risk

36. What are the major sources of financing?
Note that large amounts of receivables represents trading activity
What are the major sources of financing?
Is there a sufficient level of equity capital? 36

37. Question
What the trend in profitability in the securities industry has been over the last 20 years?
What the major assets held by broker-dealers are?
Why broker-dealers tend to hold less equity capital than commercial banks and thrifts?

38. Regulation of Securities Firms and Investment Banks (IBs)

39. The Securities and Exchange Commission (SEC)
The primary regulator of the securities industry has been the Securities and Exchange Commission (SEC), 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 United States.
The primary role of the SEC includes
administration of securities laws,
review and evaluation of registrations of new securities offerings (ensuring that all relevant information is revealed to potential investors),
review and evaluation of annual (10-K) and quarterly reports (10-Q) summarizing the financial status of all publicly held corporations, and
the prohibition of any form of security market manipulation.  39

40. The National Securities Markets Improvement Act (NSMIA) of reaffirmed the significance of the SEC as the primary regulator of securities firms.
According to the NSMIA, states are not allowed to require federally registered securities firms to be registered in a state as well.
States are also prohibited from requiring registrations of securities firms' transactions and from imposing substantive requirements on private placements.
Prior to NSMIA, most securities firms were subject to regulation from both the SEC and the state in which they operated. NSMIA provides that states may still require securities firms to pay fees and file documents submitted to the SEC, but most of the regulatory burden imposed by states has been removed. Thus, NSMIA effectively gives the SEC primary regulatory jurisdiction over securities firms. 

41. The early 2000s saw a reversal of this trend toward the dominance of the SEC with states—especially their attorneys general—increasingly intervening through securities-related investigations. Several highly publicized securities violations resulted in criminal cases brought against securities law violators by state prosecutors.
For example, the New York State attorney general forced Merrill Lynch to pay a $100 million penalty because of allegations that Merrill Lynch brokers gave investors overly optimistic reports about the stock of its investment banking clients.

42. Financial Industry Regulatory Authority (FINRA)
FINRA is not part of the government. It is an independent, not-for-profit organization authorized by Congress to protect America’s investors by making sure the securities industry operates fairly and honestly.
It does this by:
writing and enforcing rules governing the activities of more than 4,035 securities firms with approximately 638,020 brokers;
examining firms for compliance with those rules;
fostering market transparency; and
educating investors.

43. 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 monitors trading abuses (such as insider trading), trading rule violations, and securities firms' capital (solvency positions)—such as the 2 percent net worth to assets minimum capital ratio.
FINRA also performs market regulation under contract for the major U.S. stock exchanges. For example, in January 2013, FINRA announced that it is expanding its oversight of dark pool trading

44. The Sarbanes-Oxley Act (SOX) of 2002
Along with regulations instituted by the SEC, the U.S. Congress passed the SarbanesOxley Act, a corporate governance and accounting oversight bill, in July This bill
created an independent auditing oversight board under the SEC,
increased penalties for corporate wrongdoers,
forced faster and more extensive financial disclosure, and
created avenues of recourse for aggrieved shareholders. . 44

45. Sarbanes-Oxley Section 302

46. The goal of the legislation was to prevent deceptive accounting and management practices, which result when corporate governance in firms is weak, and bring stability to jittery stock markets battered in the summer of 2002 by the corporate governance scandals of Enron, Global Crossings, Tyco, WorldCom, and others.

47. The SEC sets rules governing underwriting and trading activity
SEC Rule 144A defines boundaries between public offerings and private placements.
Restricted securities are securities acquired in unregistered, private sales from the issuing company or from an affiliate of the issuer. Investors typically receive restricted securities through private placement offerings.
Rule 144A governs the sale of restricted securities.
Restrictive securities, have a certificate stamped with a "restrictive" legend. The legend indicates that the securities may not be resold in the marketplace unless they are registered with the SEC or are exempt from the registration requirements.
SEC Rule 415 allows shelf registration
allows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement summarizing the firm’s financing plans for the period 47

48. SEC Rule 415
allows shelf registration
allows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement summarizing the firm’s financing plans for the period

49. Other regulatory organizations oversee the day-to-day regulation of trading practices.
the New York Stock Exchange (NYSE)
The U.S.A. Patriot Act became effective in 2003
firms must verify identities of customers
firms must maintain records of identities of customers
firms must verify customers are not on suspected terrorist lists
The 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. In the spring of 2010, a subcommittee hearing focused on the contributing role of investment banks in the financial crisis. Investment banks such as Goldman Sachs bundled toxic mortgages into complex financial instruments, many of which were rated AAA by credit-rating agencies, and sold them to investors. 49

50. Investors in the industry are protected by the Securities Investor Protection Corporation (SIPC)
protects investors against losses of up to $500,000 due to securities firm failures (but not against poor investment decisions)
created following passage of the Securities Investor Protection Act in 1970 50

51. Under the Dodd-Frank Act, the Financial Services Oversight Council (FSOC) has oversight of systemic risk of the industry
More investment advisors will have to be registered with either the SEC or state advisors
Securitization markets should now have more oversight and originators will have to retain a greater interest in loans that will be resold
Greater transparency and regulation for OTC derivatives 51

52. Wall Street Reform and Consumer Protection Act
The government can also mandate higher capital requirements for larger and for interconnected firms
Conclusion: Government oversight of industry practices has increased as a result of the law
Wall Street Reform and Consumer Protection Act 52

53. Further Regulations
Executive compensation restrictions imposed by the Obama administration
Strengthen the independence of the compensation committee from senior management
Shareholders now also have a non-binding vote on executive compensation packages
Administration has a say on executive pay for firms that accepted bailout money
Ask students whether limits on executive pay are appropriate or not. What would be the pros and cons? The industry argues that they will be unable to attract top talent without large performance type bonuses. Executive pay would seem to be very high however and it is higher than is typical in much of the rest of the world. Many in the public would argue that executives in firms that took taxpayer dollars have no business receiving any performance bonuses. AIG executives received bonuses even as the firm was on the verge of bankruptcy. 53

54. Continuing Ethical Problems
Date
Firm/Principal
Activity
Settlement Payment
January 2011
Primary Global Research LLC, Bob Nguyen
Soliciting information for inside trading
June 2012
Barclays Bank
LIBOR manipulation
$450 million
July 2012
Peregrine Financial, Russell Wassendorf , Sr.
Misallocating and misreporting usage of $215 million in client funds
December 2012
Goldman Sachs trader Matthew Taylor
Concealed $8.3 billion futures position
$1.5 million
Morgan Stanley
Senior banker influenced analyst and share allocation of Facebook IPO
UBS
$1.5 billion
HSBC
Money laundering
$1.9 billion
February 2013
Royal Bank of Scotland
$610 million
October 2013
J. P. Morgan
Bad mortgage practices origination and sale
$13 billion
Trade error in London cost firm $6 billion
$920 million
Excessive credit card charges
$ 80 million
Manipulating energy markets
$410 million
December 2013
Deutsche Bank
Euribor manipulation
$981 million
February 2014
$1.25 billion
July 2014
Citigroup
$7.00 billion
This list is not complete. Charges of manipulating ISDAfix, a rate used for swaps, are also emerging, (the same banks involved in the LIBOR scandal). As of this writing, evidence is emerging of allegations that the Bank of England, the British central bank, knew of manipulations of currency rate quotes for as long as eight years without taking action. The currency markets involve over $5.3 trillion in daily trading volume. The SEC is investigating whether traders distorted prices for currency options and exchange traded funds. Reports are emerging that traders shared information about client orders in order to manipulate prices. As of June 2014 about 20 traders at the top three banks (Deutsche, Citi and Barclays) involved in currency trading had been fired.
See for instance: Carney Faces Grilling as Currency Scandal Snares BOE. Bloomberg, By Scott Hamilton and Suzi Ring Mar 10, :37 AM MT,
Interesting side note: As of January 1, 2013 Dutch bankers are required by law to swear an oath to act ethically, details can be found at:
Sources: Wall Street Journal & Bloomberg (various dates)
Sources: Text, Wall Street Journal and Bloomberg, various issues
Are bankers unethical?
Are regulations sufficient to limit ethical breaches? 54

55. Global Issues
More so than other sectors of the financial institutions industry, securities firms and investment banks operate globally.
Both U.S. and European investment banks compete for business worldwide.
Three of the top five underwriters of global debt and equity are U.S. investment banks (J. P. Morgan Chase, Citigroup, and Goldman Sachs) and the rest are European banks (Barclays Capital and Deutsche Bank).
Through September 2013, in M&A deals involving U.S. targets, 6 of the top 10 advisors were U.S. investment banks (including Goldman Sachs and J. P. Morgan Chase) and four were European banks (including Barclays Capital and Deutsche Bank).
Further, U.S. investment banks held 5 of the top 10 spots on M&A deals in Europe and held two of the top five spots on deals in Asia.
The financial crisis has increased the need for capital at banks. Many firms are now engaging in strategic alliances with foreign partners. For instance, Morgan Stanley sold a 21% stake of its firm to Mitsubishi UFJ in Citigroup took a different tact and sold some of its foreign businesses such as Nikko Asset Management and Nikko Citi Trust to increase capital. The industry continues to restructure as a result of the crisis. 55

56. The financial crisis has increased the need for capital at banks.
Many firms are now engaging in strategic alliances with foreign partners.
For instance, Morgan Stanley sold a 21% stake of its firm to Mitsubishi UFJ in 2008.
Citigroup took a different tact and sold some of its foreign businesses such as Nikko Asset Management and Nikko Citi Trust to increase capital.
The industry continues to restructure as a result of the crisis.

57. 57

58. 58