The Role of an Investment Bank
Staying apart to a large extent from the activities of a commercial or retail bank, an investment bank, as a financial institution assists individuals, corporations and governments in raising capital by underwriting or acting as the client’s agent in the issuance of securities. However extending its primary role of underwriting & distributing shares it plays some key roles in a market-based economy by bringing together entities in search of new capital and investors, providing ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities and equity securities.
An investment bank basically undertakes two lines of business; one as the insider which might be termed as the ‘sell side’ and the other as the outsider, sometimes coined as the ‘buy side’. Being in the sell side it trades securities either for cash or for other securities by facilitating transactions and making market. Underwriting and carrying research work for the promotion of securities are the other roles it performs as an insider. While in the buy- side it offers services to the investing public in order to maximize their return on investment by dealing with pension finds, mutual funds, and hedge funds etc. Lots of investment bankers are to be found to be working in both two lines. This is how an Investment bank offers services to both corporations & investors helping the earlier in issuing securities and the later in buying them but maintaining the Chinese wall to prevent information from crossing, that is blocking the classified information of a company to be disclosed in public and vice versa.
As far as the roles played by an investment bank are concerned, front office, & middle office have got their different shares with regards to the importance of the duties it performs.
Front Office Role:
In an investment bank the Industry coverage group focuses on a specific industry, such as healthcare, industrial, or technology, and maintain relationships with corporations within the industry and help them raise capital in several ways like Right Offerings, Public Offerings or Private Placements, among which a investing banker plays the most vital role in total IPO (initial public offering) process in the following ways:
By underwriting an investment bank bears the risk of adverse price fluctuations during the period in which a new issue of securities is being distributed. By Firm Commitment Underwriting Agreements it shoulders on the total risk involved in the issuance while by the Best Efforts Agreement it undertakes to help sell at least a minimum amount of the issue with any unsold amounts returned to the issuing firm. Providing that the investment banker fails to sell the minimum quantity agreed upon, the whole issue is cancelled and reissued as soon as the market gets ready to accommodate them.
As Weston and Copeland (1989), points out, investment banks play a very crucial role in reaching the interest of the issuing firm to a large number of investors which help the respective firm grow faster.
Advice & Counsel:
This involves the investment banker contributing to the decision making concerning the ways, means & time of entrance into the capital market with an IPO. Whether its inputs will turn valuable or not, largely depend on six key factors as identified by Ellis (1989). They are:
- Credibility earned over several years, with the senior management of the client company
- Understanding of need, financial goals & policies of the client company
- Ability to make useful recommendations to the company.
- Innovation of new financing techniques while improvising the older ones.
- Attaining specialization in a specific service.
- Advising on a specific transaction.
However, standing antagonistically against the reputation of the investment banks some bankers show a penchant for getting themselves involved in an unfair means of under-pricing of initial public offerings, as evidenced and clarified in the article entitled, ‘Investment Banking: Reputation and under-pricing of Initial Public Offering’ by Randolph Beatty and Jr. Ritter.
Financial Advice, Monitor & Research:
The Product coverage group of a Investment Bank involves itself into mergers and acquisitions, leveraged finance, project finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt .It works with the collaboration of Industry group on the more intricate and specialized needs of a client initializing its monitor & research wing. The key role of this department is to give financial advice especially on mergers & acquisitions determining the following factors:
- Increasing the range of products
- Increasing the business size in geographical context.
- complementing existing products
- protecting the position in the market
- raising profitability, and therefore the share price
- Ensuring a wider range of investors.
- shifting the business towards sectors more favorably viewed by the market
Research& monitor is the wing which operates research work & census over different companies and writes reports about their prospects, goals & attainments often focusing on their buy or sale rate. Its resources help the bank give suggestions & determine the way its client should approach.
Middle office roles:
Sales & Trading:
In broader sense 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. In this regard an investment banker’s primary role is to get to the investors to suggest trading ideas and take orders, ensuring them the maximum returns with the minimum risk.
For the benefit of its client an investment bank will professionally manage various securities like shares, bonds, etc. To meet specified investment goals. In this regard monitoring the market becomes very crucial in ensuring the possible gain from the fluctuations of the prices in the market.
Often termed as ‘very personal banking ‘, merchant banking is also a role played by an investment bank, offering capitals in exchange for share ownership. Defoe Fournier & Cie, JP Morgan’s One Equity Partners and the original J.P. Morgan & Co. are the current examples undertaking this role.
Management of the economic risks, credit risks, and operational risks; management of corporate treasury, tracking & analyzing the capital flows of the firm are the other roles that an investment banker Is supposed to deal with.
In discharging their duties & responsibilities the investment banks, though partake into a key role in economic mobilization, can not avoid conflicts over certain issues as:
a. Many investment banks, as they own retail brokerages, have the chance of selling consumer securities as some banks did during 1990s, going against their stated risk profile.
b. As investment banks engage themselves in trading for their own account they are likely to be tempted to benefit themselves by executing orders for their own account before filling orders previously submitted by their customers, providing that any changes in prices happen to take place induced by those orders.
Again without the regulation imposed on it by Glass-Steagall, the business model of the investment bank no longer works. The previous conservatism of underwriting established companies and seeking long-term gains was replaced by lower standards and short-term profit which resulted in to the credit crisis in 2007. According to the previous guide line a company had to be in business for a minimum of five years and it had to show profitability for three consecutive years before going public through IPO. After deregulation, those standards were gone paving way to some corrupt bankers as well as some companies a chance to make money risking the capital loss of the investors of low graded companies while ushering in their own down fall. For instance Investment banks Bear Stearn's, founded in 1923 and Lehman Brothers collapsed after 100 years of their operation. Another example is Merrill Lynch which had been in deep trouble and finally acquired by Bank of America, which remained in trouble, as did Goldman Sachs and Morgan Stanley.