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Unit 1 - Investment Banking Paradigm: Concepts And Definitions, Evolution Of American Investment Banks, Evolution Of Indian Investment Banking,

Conflict Of Interest In Investment Banking, Regulatory Framework For Investment Banking An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment banker may not accept deposits or make commercial loans. Investment bankers are the people who do the grunt work for IPOs and bond issues. Its a specific division of banking related to the creation of capital for other companies. Investment banks underwrite new debt and equity securities for all types of corporations. Investment banks also provide guidance to issuers regarding the issue and placement of stock. They may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities. At a very macro level, Investment Banking as the term suggests, is concerned with the primary function of assisting the securities market in its function of capital intermediation, i.e. the movement of financial resources from those who have them (the investors), to those who need to make use of them for generating GDP (the Issuers). Banking & financial institutions and securities markets are the two broad platforms of institutional intermediation for capital flows in the economy. Investment banks are the counterparts of banks in financial markets in the function of intermediation in resource allocation. The term investment banking is of American origin. Their counterparts in UK were termed as merchant banks and they had confined themselves to security market intermediation whereas American investment banks undertook both fund-based and advisory roles. American investment banks entered the UK and European markets and extended the scope of merchant banking to investment banking.

Responsibility of Merchant Banker: Merchant banking is not merely about marketing of securities in an agency capability. The regulatory authorities require the merchant banking firms to promote quality issues, maintain integrity and ensure compliance with the law on own account and on behalf of the issuers as well. Heart of investment banking consists of advising corporations on how best to configure their balance sheets with the aim of maximizing shareholder value and executing the transactions that flow from that advice. The title investment banker is usually reserved for those individuals within an investment banking firm who are responsible for the firms relationship with the issuer, as opposed to the investor clients, i.e., with clients who engage investment banks to issue new securities, restructuring existing liabilities; either increasing or decreasing leverage, moving from public to private ownership. Business Portfolio of Investment Banks Globally, investment banks handle significant fund-based business of their own in the capital market along with their non-fund service portfolio which is offered to clients. However, various services or segments of services are handled either on the same balance sheet or through subsidiaries and affiliates depending upon the regulatory requirements in the operating environments of each country. All these activities are segmented across three broad platforms-equity market activity, debt market activity, and mergers and acquisitions (M&A) activity.

Investment banking Core business portfolio Fund based Equity: Underwriting, market making Debt: Underwriting, market making M & A: Investing in Private Equity, Leveraged Buyout (LBO) and Management Buyout (MBO) Non-fund based Equity: Merchant banking (Public issue management), Private placement Debt: Public issue management, Private placement, Securitization for finance companies and banks M&A: M&A advisory, Corporate Advisory, Project Advisory Support business portfolio Fund based Equity: Proprietary trading and portfolio investing, private equity funds and asset management funds Debt: Proprietary trading and investing, asset management funds Derivatives: Proprietary trading, hedge fund investments Non-fund based Equity: Equity broking, distribution, asset management, custodial services, wealth management (private banking), research and analysis. Debt: Debt market broking, distribution, asset management, research Derivatives: Derivative broking, risk management services, custodial services

Evolution Of American Investment Banks In the mid-20th century, large investment banks were dominated by the dealmakers. Advising clients on mergers and acquisitions and public offerings was the main focus of major Wall Street partnerships. These bulge bracket firms included Goldman Sachs, Mo rgan Stanley, Lehman Brothers, First Boston and others. That trend began to change in the 1980s as a new focus on trading propelled firms such as Salomon Brothers, Merrill Lynch and Drexel Burnham Lambert into the limelight. Investment banks earned an increasing amount of their profits from proprietary trading. Advances in computing technology also enabled banks to use more sophisticated model driven software to execute trades and generate a profit on small changes in market conditions. In the 1980s, financier Michael Milken popularized the use of high yield debt (also known as junk bonds) in corporate finance and mergers and acquisitions. This fuelled a boom in leverage buyouts and hostile takeovers (see History of Private Equity). Filmmaker Oliver Stone immortalized the spirit of the times with his movie, Wall Street, in which Michael Douglas played the role of corporate raider Gordon Gekko and epitomized corporate greed. Investment banks profited handsomely during the boom years of the 1990s and into the tech boom and bubble. When the tech bubble burst, it precipitated a string of new legislation to prevent conflicts of interest within investment banks. Investment banking research analysts had been actively promoting stocks to investors while privately acknowledging they were not attractive investments. In other instances, analysts gave favourable stock ratings to corporate clients in the hopes of attracting them as investment banking clients and handling potentially lucrative initial public offerings. These scandals paled by comparison to the financial crisis that has enveloped the banking industry since 2007. The speculative bubble in housing prices along with an overreliance on sub-prime mortgage lending trigged a cascade of crises. Two major investment banks, Bear Stearns and Lehman Brothers, collapsed under the weight of

failed mortgage-backed securities. In March, 2008, the Federal government began using a variety of taxpayer-funded bailout measures to prop up other firms. The Federal Reserve offered a $30 billion line of credit to J.P. Morgan Chase to that it could acquire Bear Sterns. Bank of America acquired Merrill Lynch. The last two bulge bracket investment banks, Goldman Sachs and Morgan Stanley, elected to convert to bank holding companies and be fully regulated by the Federal Reserve. Moving forward, the recent financial crisis has weakened both the reputation and the dominance of U.S. investment banking organizations throughout the world. The growth of foreign capital markets along with an increase in pools of sovereign capital is changing the landscape of the industry. The growing international flow of capital has also opened up opportunities for investment banking in new financial centres around the world, including those in developing countries such as India, China and the Middle East Evolution Of Indian Investment Banking The origin of investment banking in India can be traced back to the 19th century when European merchant banks set-up their agency houses in the country to assist in the setting of new projects. In the early 20th century, large business houses followed suit by establishing managing agencies which acted as issue house for securities, promoters for new projects and also provided finance to Greenfield ventures. The peculiar feature of these agencies was that their services were restricted only to the companies of the group to which they belonged. A few small brokers also started rendering Merchant banking services, but theirs was limited due to their small capital base. In 1967, ANZ Grindlays bank set - up a separate merchant banking division to handle new capital issues. It was soon followed by Citibank, which started rendering these services. The foreign banks monopolized merchant banking services in the country. The banking committee, in its report in 1972, took note of this with concern and

recommended setting up of merchant banking institutions by commercial banks and financial intuitions. State bank of India ventured into this business by starting a merchant banking bureau in 1972. In 1972, ICICI became the first financial institution to offer merchant banking services. JM finance was set-up by Mr. Nimesh Kampani as an exclusive merchant bank in 1973. The growth of the industry was very slow during this period. By 1980, the number of merchant banks rose to 33 and was set-up by commercial banks, financial institutions and private sector. The capital market witnessed some buoyancy in the late eighties. The advent of economic reforms in 1991 resulted in sudden spurt in both the primary and secondary market. Several new players entered into the field. The securities scam in may, 1992 was a major set back to the industry. Several leading merchant bankers, both in public and private sector were found to be involved in various irregularities. Some of the prominent public sector players involved in the scam were Can bank financial services, SBI capital markets, Andhra bank financial services, etc. leading private sector players involved in the scam included Fairgrowth financial services and Champaklal investments and finance (CIFCO). The market turned bullish again in the end of 1993 after the tainted shares problem was substantially resolved. There was a phenomenal surge of activity in the primary market. The registration norms with the SEBI were quite liberal. The low entry barriers coupled with lucrative opportunities lured many new entrants into this industry. Most of the new entrants were undercapitalized with little or no expertise in merchant banking. These players could hardly afford to be discerning and started offering their services to all and sundry clients. The market was soon flooded with poor quality paper issued by companies of dubious credentials. The huge losses suffered by investors in these securities resulted in total loss of confidence in the market. Most of the subsequent issues started failing and companies started deferring their plans to access primary markets. Lack of business resulted in a major shake out in the industry. Most of the small firms exited from the business. Many foreign investment banks started entering Indian markets. These firms had a huge capital base,

global distribution capacity and expertise. However, they were new to Indian markets and lacked local penetration. Many of the top rung Indian merchant banks, who had string domestic base, started entering into joint ventures with the foreign banks. This energy resulted in synergies as their individual strength complemented each other.

Investment bankers Investment bankers play an important role in the issue management process. Lead managers (category I merchant bankers) have to ensure correctness of the information furnished in the offer document. They have to ensure compliance with SEBI rules and regulations as also guidelines for disclosures and investor protection. To this effect, they are required to submit to SEBI a due diligence certificate conforming that the disclosures made in the draft prospectus or letter of offer are true, fair and adequate to enable the prospective investors to make a well informed investment decision. The role of merchant bankers in performing their due diligence functions has become even more important with the strengthening of the disclosure requirements and with the SEBI giving up the vetting up of prospectus. SEBIs various operational guidelines issued during the year to merchant bankers primarily addressed the need to enhance the standard of disclosures. It was felt that a further strengthening of the criteria for registration of merchant bankers was necessary, primarily through an increase in the net worth requirements, so that the capital would be commensurate with the level of activities undertaken by them. With this in view, the net worth requirement or category I merchant bankers was raised in 1995-96 to Rs.5 crore. In 1996-96, the SEBI (merchant bankers) regulations, 1992 were amended to require the payment of fees for each letter of offer or draft prospectus that is filed with SEBI.

Underwriters Underwriters are required to register with SEBI in terms of the EBI (Underwriters) Rules and Regulations, 1993. In addition to underwriters registered with SEBI in terms of these regulations, all registered merchant bankers in categories I, II and III and stock brokers and mutual funds registered with SEBI can function as underwriters. Conflict Of Interest In Investment Banking Conflicts of interest may arise between different parts of a bank, creating the potential for market manipulation. Authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall to prevent communication between investment banking on one side and equity research and trading on the other. Some of the conflicts of interest that can be found in investment banking are listed here:

Historically, equity research firms have been founded and owned by investment banks. One common practice is for equity analysts to initiate coverage of a company in order to develop relationships that lead to highly profitable investment banking business. In the 1990s, many equity researchers allegedly traded positive stock ratings for investment banking business. On the flip side of the coin: companies would threaten to divert investment banking business to competitors unless their stock was rated favorably. Laws were passed to criminalize such acts, and increased pressure from regulators and a series of lawsuits, settlements, and prosecutions curbed this business to a large extent following the 2001 stock market tumble. Many investment banks also own retail brokerages. Also during the 1990s, some retail brokerages sold consumers securities which did not meet their stated risk profile. This behavior may

have led to investment banking business or even sales of surplus shares during a public offering to keep public perception of the stock favourable.

Since investment banks engage heavily in trading for their own account, there is always the temptation for them to engage in some form of front running the illegal practice whereby a broker executes orders for their own account before filling orders previously submitted by their customers, there benefiting from any changes in prices induced by those orders.

Regulatory Framework For Investment Banking Investment Banking in India is regulating in its various facets under separate legislations or guidelines issued under statute. The Regulatory powers are also distributed between different regulators depending upon the constitution and status of Investment Bank. Pure investment banks which do not have presence in the lending or banking business are governed primarily by the capital market regulator (SEBI). However, Universal banks and NBFC investment banks are regulated primarily by the RBI in their core business of banking or lending and so far as the investment banking segment is concerned, they are also regulated by SEBI. An overview of the regulatory framework is furnished below: 1. At the constitutional level, all invest banking companies incorporated under the Companies Act, 1956 are governed by the provisions of that Act. 2. Investment Banks that are incorporated under a separate statute such as the SBI or IDBI are regulated by their respective statute. IDBI is in the process of being converted into a company under the Companies Act. 3. Universal Banks that are regulated by the Reserve Bank of India under the RBI Act, 1934 and the Banking Regulation Act which put restrictions on the investment banking exposures to be taken by banks.

4. Investment banking companies that are constituted as non-banking financial companies are regulated operationally by the RBI under sections 45H to 45QB of Reserve Bank of India Act, 1934. Under these sections RBI is empowered to issue directions in the areas of resources mobilization, accounts and administrative controls. 5. Functionally, different aspects of investment banking are regulated under the Securities and Exchange Board of India Act, 1992 and guidelines and regulations issued there under. 6. Investment Banks that are set up in India with foreign direct investment either as joint ventures with Indian partners or as fully owned subsidiaries of the foreign entities are governed in respect of the foreign investment by the Foreign Exchange Management Act, 1999 and the Foreign Exchange Management (Transfer or issue of Security by a person Resident outside India) Regulations, 2000 issued there under as amended from time to time through circulars issued by the RBI. 7. Apart from the above specific regulations relating to investment banking, investment banks are also governed by other laws applicable to all other businesses such as tax law, contract law, property law, local state laws, arbitration law and the other general laws that are applicable in India

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