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THE BUSINESSOF INVESTMENT

BANKING


THE BUSINESSOF INVESTMENT

BANKINGA Comprehensive Overview

Third Edition

K. THOMAS LIAW

John Wiley & Sons, Inc.


This book is printed on acid-free paper. ∞©

Copyright © 2012 by Dr. K. Thomas Liaw. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Liaw, K. Thomas.The business of investment banking : a comprehensive overview / K. Thomas Liaw. – 3rd ed.

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ISBN 978-1-118-12763-6 (ebk)1. Investment banking. I. Title.HG4534.L528 2012332.66–dc22

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Contents

Chapter 1Introduction to Investment Banking: How the Financial Crisisand Reforms Changed the Industry 1

Chapter 2New Investment Banking Structure: Financial Holding Companies,Full-Service, and Boutique Investment Banks 9

Chapter 3The Structure of Investment Banks: Divisions and Services 21

Chapter 4Investment Banking Strategies: How They Compete and Profit 37

Chapter 5Employment Opportunities in Investment Banking 49

Chapter 6Venture Capital and Private Equity: Direct Investing in Companies 77

Chapter 7Mergers and Acquisitions 99

Chapter 8Equity Underwriting and IPOs 117

Chapter 9Debt Underwriting: Issuing Bonds 141

Chapter 10Asset Securitization: Turning Income Streams into NewInvestment Vehicles 173

Chapter 11Listing in New York, London, and Other Markets 195

v


vi Contents

Chapter 12Trading: Market Making, Arbitrage, and Brokering 213

Chapter 13Repurchase Agreements and Prime Brokerage 237

Chapter 14Derivatives and Financial Engineering: Foreign Exchange,Commodities, and Interest Rates 257

Chapter 15Investment Management for Pension Funds, Endowments,and Wealthy Families 279

Chapter 16Securities Regulation and Ethics: The Dodd-Frank Bill and OtherKey Laws 297

Chapter 17The BRICs: Investment Banking in Brazil, Russia, and India 323

Chapter 18The BRICs: Investment Banking in China 339

Chapter 19Investment Banking Trends and Challenges 359

Index 367

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CHAPTER 1

Introduction to InvestmentBanking: How the Financial

Crisis and Reforms Changedthe Industry

The investment banking market has ex-perienced dramatic changes since 2008. Three of the top five investment banksin the United States have disappeared, while Goldman Sachs and MorganStanley have converted to commercial banking charter. The bankruptcy ofLehman Brothers has also brought about unprecedented quantitative easing inmonetary policies in many countries. Recent financial regulation overhaul willhave significant impact on what investment banks do and how they operatethose activities. The Volcker rule will shake up trading desks. Investment bankssuch as Goldman Sachs, Morgan Stanley, JPMorgan, Deutsche Bank, and CreditSuisse have reshuffled proprietary trading. Therefore, the investment bankingmarket is very different today.

The New Investment BankingOne important lesson from the financial crisis is the need for more effectiveregulation. The recent financial reform legislation, most notably the Dodd-Frank bill, aims at setting standards for financial operations and preventinganother crisis. The reforms focus on several essential areas. The first is to end“too big to fail.” Taxpayers should not be protecting the shareholders andbondholders of even the most systemically important financial firms. Instead,these firms should be required to structure themselves so that they can berecapitalized without taxpayer money, and before local problems can spiral intoa systemic crisis. Second, financial firms are required to practice consistency.Regulators should require that all assets across financial institutions be similarly

1


2 The Business of Investment Banking

valued. Within each financial firm, there needs to be greater consistency andrigor in the way assets are valued and accounted for. Firms should no longer beallowed to move risk around to areas where it will be less rigorously monitoredor more generously valued. Third, the regulatory system has more dynamicregulation. Across the board, the regulatory system should be comprehensiveand strong enough to identify and constrain excesses in markets, before theycan threaten the broader economy.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) is a comprehensive regulatory overhaul. Certain portions of theAct were effective immediately; other portions follow an extended transitionperiod. Implementation of the Act will be accomplished through numerousrulemakings by multiple governmental agencies. The Act also mandates thepreparation of studies on a wide range of issues, which could lead to additionalregulatory changes.

In addition, legislative and regulatory initiatives continue outside the UnitedStates that will affect investment banking business. Basel III, the new global reg-ulation on bank capital adequacy and liquidity, introduces new capital, leverage,and liquidity standards. It is designed to improve the banking sector’s ability todeal with financial and economic stress. A provision of the Dodd-Frank Act(the Volcker rule) will over time prohibit investment banks from engaging inproprietary trading. The rule will also require banking entities to either restruc-ture or unwind certain relationships with hedge funds and private equity funds.The rule is expected to become effective in July 2012, and banking entities willthen have a two-year period to come into compliance with the Volcker rule.

Through the Dodd-Frank Act, investment banks face a comprehensive reg-ulatory regime in over-the-counter derivatives. The regulation of swaps andsecurity-based swaps in the United States will be effected and implementedthrough the CFTC, SEC, and other agency regulations. The Act requires cen-tral clearing of certain types of swaps and also mandates that trading of suchswaps be done on regulated exchanges or execution facilities. As a result, invest-ment banks will have to centrally clear and trade on an exchange or executionfacility certain swap transactions that are uncleared and executed bilaterally.The Act further requires registration of swap dealers and major swap partici-pants with the CFTC and security-based swap dealers and major security-basedswap participants with the SEC.

Investment Banking Business

Investment banks engage in public and private market transactions for cor-porations, governments, and investors. These transactions include mergers,


Introduction to Investment Banking 3

acquisitions, divestitures, and the issuance of equity or debt securities, or a com-bination of both. Investment bankers advise and assist clients with specializedindustry expertise. The industry or sector grouping often includes industrial,consumer, health care, financial institutions, real estate, technology, media andtelecommunications, and others. As noted throughout the book, investmentbanks today go far beyond investment banking to also include other securi-ties businesses such as trading, securitization, financial engineering, merchantbanking, investment management, and securities services. For those activities,investment banks earn fees, commissions, and gains from principal transactions.

Investment banking includes capital raising and merger and acquisition(M&A) advisory services. Investment banks help clients raise capital throughunderwriting in which investment banks purchase the whole block of newsecurities from the issuer and distribute them to institutional and individualinvestors. For the service, investment bankers earn an underwriting spread, thedifference between the price they receive from investors and the amount theypay to the issuing firm. The underwriting spread has been in the range of 6to 7 percent of the total proceeds raised for equity offerings. The competitivepressure has forced bankers to charge less, especially for a large deal in which thespread could go much lower. In debt offerings, the spread is much lower, oftenless than 100 basis points. Several chapters in this book describe the relevantregulatory issues and the processes investment banks and issuers go through tooffer the new securities.

Another major line in investment banking is strategic advising on mergers andacquisitions. Services offered include structuring and executing domestic andinternational transactions in acquisitions, divestitures, mergers, joint ventures,corporate restructurings, and defenses against unsolicited takeover attempts.Fees are usually negotiable. As the size of transactions gets larger and larger, theM&A advisory fees are generally less than 100 basis points and often much lower.M&A bankers still take in large sums of money, as the value of transactions growslarger. This line of business is attractive, because, win, lose, or draw, bankersearn fee income.

Other Securities Businesses

Full-service investment banks offer a service menu that goes beyond just in-vestment banking. Principal transactions have accounted for a very significantportion of total net revenues at many Wall Street houses. These transactionsinclude proprietary trading and merchant banking. In proprietary trading, theinvestment bank trades on its own capital. Under the Dodd-Frank ReformAct, investment banks are permitted to operate proprietary trading only on a



restricted and limited basis. Merchant banking invests the firm’s own capital aswell as funds raised from outside corporate and real estate investors.

Investment management is an integral part of investment banks. Major housessuch as Morgan Stanley, Goldman Sachs, and JPMorgan each manage hundredsof billions of dollars for their clients. This is an attractive segment of the financialservices industry. The income stream is less volatile than trading or underwritingand, hence, contributes to the stability of earnings.

Another line of business is securities services that include prime brokerage,securities lending, and financing. Prime brokerage offers tools and servicesdesired by clients looking to support their operations in trading and portfoliomanagement. In security lending services, investment banks find securities forclients to make good delivery so as to cover their short positions. Alternatively,financing services provide funds to finance clients’ purchases of securities.

Causes of the Financial CrisisDuring the recent global financial crisis, the world stock markets declined, largefinancial institutions collapsed or were bought out, and governments in even thewealthiest nations had to come up with rescue packages to bail out their financialsystems. In its reports, the Financial Crisis Inquiry Commission concludedthat factors contributing to the financial crisis included widespread failures infinancial regulation, dramatic breakdowns in corporate governance, excessiveborrowing and risk-taking by households and Wall Street, the poor preparationof policy makers for the crisis, and systemic breaches in accountability and ethicsat all levels. The following lists the commission’s principal findings.

1. This financial crisis was avoidable. The crisis was the result of humanaction and inaction. The captains of finance and the public stewards ofour financial system ignored warnings and failed to question, understand,and manage evolving risks within a system essential to the well-being ofthe American public.

2. There were widespread failures in financial regulation and supervision thatproved devastating to the stability of the nation’s financial markets.

3. Dramatic failures of corporate governance and risk management at manysystemically important financial institutions were a key cause of this crisis.There was a view that instincts for self-preservation inside major financialfirms would shield them from fatal risk-taking without the need for asteady regulatory hand, which, the firms argued, would stifle innovation.Too many of these institutions acted recklessly, taking on too much risk,



with too little capital, and with too much dependence on short-termfunding.

4. A combination of excessive borrowing, risky investments, and lack oftransparency put the financial system on a collision course with crisis.Clearly, this vulnerability was related to failures of corporate governanceand regulation, but it is significant enough by itself to warrant our attentionhere.

5. The government was ill prepared for the crisis, and its inconsistent responseadded to the uncertainty and panic in the financial markets. As part of ourcharge, it was appropriate to review government actions taken in responseto the developing crisis, not just those policies or actions that preceded it,to determine if any of those responses contributed to or exacerbated thecrisis.

6. There was a systemic breakdown in accountability and ethics. The in-tegrity of our financial markets and the public’s trust in those markets areessential to the economic well-being of our nation. The soundness and thesustained prosperity of the financial system and our economy rely on thenotions of fair dealing, responsibility, and transparency. In our economy,we expect businesses and individuals to pursue profits, at the same timethat they produce products and services of quality and conduct themselvesproperly.

7. Collapsing mortgage-lending standards and the mortgage securitizationpipeline lit and spread the flame of contagion and crisis. When hous-ing prices fell and mortgage borrowers defaulted, the lights began todim on Wall Street. This report catalogues the corrosion of mortgage-lending standards and the securitization pipeline that transported toxicmortgages from neighborhoods across America to investors aroundthe globe.

8. Over-the-counter derivatives contributed significantly to this crisis. Theenactment of legislation in 2000 to ban the regulation by both the federaland state governments of over-the-counter (OTC) derivatives was a keyturning point in the march toward the financial crisis.

9. The failures of credit rating agencies were essential cogs in the wheel offinancial destruction. The three credit rating agencies were key enablersof the financial meltdown. The mortgage-related securities at the heartof the crisis could not have been marketed and sold without their seals ofapproval. Investors relied on them, often blindly. In some cases, investorswere obligated to use them, or regulatory capital standards were hinged onthem. Their ratings helped the market soar and their downgrades through2007 and 2008 wreaked havoc across markets and firms.



The Dodd-Frank Act and theVolcker RuleThe purpose of the Dodd-Frank Wall Street Reform and Consumer ProtectionAct (Dodd-Frank Act) is to “. . . promote the financial stability of the UnitedStates by improving accountability and transparency in the financial system, toend “too big to fail,” to protect the American taxpayer by ending bailouts,to protect consumers from abusive financial services practices, and for otherpurposes.” In addition, the Volcker rule imposes restrictions on proprietarytrading for banks.

The Dodd-Frank Act

The Dodd-Frank Act significantly restructures the regulatory regimes underwhich investment banks operate. The implications of the Act on investmentbanks depend on the provisions of future rulemaking by the Board of Gover-nors of the Federal Reserve System, the SEC, the Commodity Futures TradingCommission (CFTC), and other agencies, as well as the development of mar-ket practices and structures under the regime by the legislation and the rulesadopted. However, the principal impacts on investment banks include:

1. The prohibition on proprietary trading and the limitation on the spon-sorship of, and investment in, hedge funds and private equity funds (theVolcker rule).

2. Increased regulation of and restrictions on over-the-counter derivativesmarkets and transactions.

The Dodd-Frank Act, enacted in July 2010, significantly alters the frame-work within which investment banks operate. Under the Act, the newly createdFinancial Stability Oversight Council (FSOC) oversees and coordinates the ef-forts of the primary U.S. financial regulatory agencies in establishing regulationsto address financial stability issues. The act directs the FSOC to make recom-mendations to the Federal Reserve Board as to supervisory requirements andprudential standards. Those include risk-based capital, leverage, liquidity, andrisk management. The Act mandates that those standards be more stringent forsystematically important financial institutions than for other financial compa-nies.

The Act contains “derivative pushout” provisions that prevent investmentbanks such as Goldman Sachs and Morgan Stanley from conducting swaps-related activities through their insured depository institution subsidiaries. There



are exceptions for certain interest rate and currency swaps and for hedging andrisk mitigation activities directly related to banking business.

The Act also calls for the imposition of expanded standards of care by marketparticipants in dealing with clients and customers. It provides the SEC withauthority to adopt rules establishing fiduciary duties for broker-dealers anddirects the SEC to examine and improve sales practices and disclosure by broker-dealers and investment advisors. The Act also contains provisions designedto increase transparency in over-the-counter derivatives markets by requiringregistration of all swap dealers, and the clearing and execution of swaps throughregulated facilities. Under the Act, federal banking agencies are required todevelop rules whereby anyone who organizes or initiates an asset-back securitytransaction must retain a portion, generally at least 5 percent, of the credit risk.

Volcker Rule

The Volcker rule prohibits proprietary trading (other than certain risk mitigationactivities) and limits the sponsorship of, and investment in, hedge funds andprivate equity funds by banks. Proprietary trading, defined mainly as engagingin short-term trading, is subject to several exceptions that allow a banking entitysignificant leeway to engage in some short-term trading, including trading:

1. In U.S. government, state, and municipal obligations2. In connection with underwriting or activities related to market-making3. In connection with certain risk-mitigating hedging activities4. In any security or instrument on behalf of customers

The exception for regulation on hedge funds and private equity funds is forfunds that are organized or offered by the banking entity, subject to:

1. The banking entity owning no more than 3 percent of the fund2. An overall limit of 3 percent of the entity’s Tier 1 capital invested in private

funds

ConclusionsThis chapter reviewed the causes of the financial crisis and the subsequent regu-latory reforms afterward. The chapter also discussed the changing environmentunder the new regulatory regime, including capital requirements, leverage, pro-prietary trading, and hedge funds and private equity funds–related operations.


CHAPTER 2

New Investment BankingStructure: Financial HoldingCompanies, Full-Service, andBoutique Investment Banks

Full-service investment banks offer cli-ents a range of services including underwriting, merger and acquisition advice,trading, merchant banking, and prime brokerage. Goldman Sachs and MorganStanley are examples of such investment banks. Some of the large financial hold-ing companies such as Citigroup, HSBC, Credit Suisse, JPMorgan Chase, Bankof America, and Nomura operate full-service investment banking as well. Thesefinancial holding companies have a major advantage over other investment banksbecause they can offer clients large sums of credit. All these large, full-serviceinvestment banks are known as the Wall Street bulge bracket. The so-calledboutique investment banks specialize in particular segments of the market. Thischapter describes the lines of business offered by those institutions.

Types of Investment BanksThere are two basic types of investment bank: full-service and boutique. Full-service institutions engage in all kind of activities, including underwriting,trading, merger and acquisition (M&A), merchant banking, securities services,investment management, and research. In contrast, boutique houses focus onparticular segments. Some specialize in M&As, some in financial institutions,and some in Silicon Valley business.

Before the Gramm-Leach-Bliley Act of 1999 (GLB), there were large full-service investment banks and smaller boutiques that specialized in a particularsegment of the market. Section 20 of the Glass-Steagall Act of 1933 prohibitsthe affiliation of a member bank of the Federal Reserve System with a company

9



that is engaged principally in underwriting or dealing in securities. In 1987,the Federal Reserve Board of Governors interpreted that phrase to allow banksubsidiaries—so-called Section 20 subsidiaries or underwriting subsidiaries—tounderwrite and deal in securities. The Board approved applications by threebank holding companies to underwrite and deal in Tier 1 securities, suchas commercial paper, municipal revenue bonds, mortgage-backed securities,and securities related to consumer receivables. In 1988, the Board approvedapplications by five bank holding companies to underwrite and deal in Tier 2securities (all debt and equity securities).

Initially, a Section 20 subsidiary could not derive more than 5 percent ofits total revenue from activities involving bank-ineligible securities. The Boardincreased the limit to 10 percent of total revenue in 1989 and raised it to25 percent in 1997. Finally, with the passage of the GLB, the limit was ef-fectively eliminated. Under the Act, a bank holding company that elects tobecome a financial holding company may engage in securities underwriting,dealing, or market-making activities through its subsidiaries (called securitiessubsidiaries).

The GLB has enabled a financial services firm such as a commercial bank ora securities house to become a one-stop shop that can supply all its customers’financial needs. By allowing banks, insurance companies, and securities firmsto affiliate with each other, the Act has opened the way for financial servicessupermarkets that offer a vast array of products and services including savingsand checking accounts, credit cards, mortgages, stock and bond underwrit-ing, insurance (homeowners, auto, and life), mergers and acquisitions advice,commercial loans, derivative securities, and foreign exchange trading.

The GLB has not only opened up new opportunities for banks but has alsoprovided significant protection for investors and consumers while striving tocreate a level playing field for all financial services firms. It established a newsystem of functional regulation, whereby banking regulators oversee bankingactivities, state insurance regulators supervise insurance business, and securitiesregulators supervise securities activities. In this new regulatory environment,investment-banking houses are able to offer a full menu of financial servicesto meet client demand. At the same time, commercial banks can engage informerly forbidden activities such as stock underwriting and dealing. Citigroup,JPMorgan Chase, Bank of America, HSBC, Deutsche, UBS, and ICBC alloperate under this format.

The traditional full-service firms like Goldman Sachs and Morgan Stanleyoffer clients a full menu of investment banking services. Niche players are smallerin general, but are creative in specializing in a particular type of client or service.


New Investment Banking Structure 11

Sandler O’Neill works on the financial institutions segment. Lazard specializesin asset management and mergers and acquisitions.

Financial Holding CompaniesLarge financial holding companies now include investment banking in theirmenu of services. Under the universal banking scheme, large banks in Europeand Japan have operated in commercial banking and investment banking. Inthe United States, since the Gramm-Leach-Bliley Act of 1999 took effect, in-vestment banking has become an integral part of their businesses. Furthermore,these global financial holding companies all have operations in most financialcenters and are competing on nearly every continent of the world. The ad-vancement of technology has enabled these financial services giants to offer acomplete menu of services on a global basis. Table 2.1 provides a summary ofbusiness categories that form major financial holding companies.1

HSBC Holdings PLC

The HSBC Group provides personal banking, business and commercial bank-ing, global banking and markets, and private banking. It has operations inEurope, Asia-Pacific, the Americas, the Middle East, and Africa. The slogan ofits marketing campaign “The world’s local bank” emphasizes that it has localknowledge along with international experience and expertise.

Investment banking services provide tailored financial solutions to major gov-ernment, corporate, and institutional clients. They segregate clients by sector,and their service teams combine relationship managers and product specialiststo develop financial solutions to meet individual client needs. Services in-clude capital raising, corporate finance and advisory services, as well as projectand export finance. Capital raising includes debt and equity capital, structuredfinance, and syndicated finance. In corporate finance and advisory services,HSBC offers services in the fields of mergers and acquisitions, stock exchangelistings, privatizations, and capital restructurings. Project and export financeservices provide non-recourse finance to exporters, importers, and financialinstitutions.

1The following descriptions of business lines for financial holding companies are taken from their annualreports and materials published on their websites.

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Table 2.1Business Categories of Financial Holding Companies

Firms HSBC Deutsche Bank UBS Citigroup JPMorgan ChaseBank ofAmerica

BusinessGroupings

Personal BankingPrivate BankingBusiness and

CorporateGlobal Banking

and Markets

Corporate andInvestmentBanking

Private ClientsWealth

ManagementAsset

Management

WealthManagement

Asset ManagementInvestment BankingBanking in

Switzerland

Consumer GroupCorporate and

InvestmentBanking

InvestmentManagement

WealthManagement

Investment BankRetail Financial

ServicesCard ServicesCommercial

BankingTreasury and

SecuritiesAsset and Wealth

Management

PersonalSmall BusinessWealth

ManagementCorporate and

Institutional

12



Deutsche Bank

Deutsche Bank groups its products and services into Corporate and InvestmentBanking and Private Clients and Asset Management. Deutsche Bank’s invest-ment banking operates under the Corporate and Investment Banking division.Corporate and Investment Banking provides equities, fixed income, foreignexchange, commodities, corporate finance, asset finance and leasing, cash man-agement, trade finance, and trust and securities services. The Private Clientsand Asset Management comprises Deutsche Bank’s investment managementbusiness for both private and institutional clients, together with its traditionalbanking activities for private individuals and small and medium-sized busi-nesses. Asset Management comprises four businesses: the retail mutual fundsbusiness (DWS Investments), alternatives (RREEF Alternative Investments),institutional asset management (DB Advisors), and asset management for insur-ance companies (Deutsche Insurance Asset Management). Private Wealth Man-agement serves high net worth individuals and families worldwide. It providesthese clients with a fully integrated wealth management service, encompassingportfolio management, tax advisory, inheritance planning, and philanthropicadvisory services.

UBS AG

UBS is a global financial services firm serving a diverse client base that includesaffluent individuals, corporations, institutions, and governments. Its businesssegments include Wealth Management, Asset Management, Investment Bank,and Banking in Switzerland.

UBS Investment Bank provides securities products and research in equities,fixed income, rates, foreign exchange, and metals. It also provides advisoryservices as well as access to the world’s capital markets. UBS Investment Bankservices its clients’ needs through investment banking, equities, fixed income,interest rates, and currencies. The specific services provided to each targetclientele are:

� Corporations: Covers M&A, equity, and debt capital markets.� Institutions: Provides equities, fixed income, interest rate and foreign ex-

change, research, sales, trading, execution, and eCommerce services.� Hedge funds: Offers prime brokerage services of global clearing, custody,

financing, and full accounting support, as well as access to its foreign ex-change and fixed-income platforms. It provides settlement and clearing ofsecurities and cash balances for all transactions in more than 30 markets.



UBS’s integrated back office provides hedge funds access to a full rangeof operational and financing options through a single point of contact,allowing hedge funds to operate all over the world.

� Governments: Offers governments and central banks services in raisingcapital and privatization.

� Bankers, brokers, and advisors: Serves as “bank for banks.” It offers banks,brokers, and advisors its global infrastructure to enhance efficiency gainsand improve client service without the associated development costs.

Citigroup

Citi is organized into two major segments: Citicorp and Citi Holdings. Citi-corp has two major divisions, including Regional Consumer Banking andInstitutional Clients Group. Citi Holdings is divided into Brokerage and AssetManagement and Local Consumer Lending.

The services offered by the four groups are:1. Regional Consumer Banking: Offers retail banking, local commercial

banking, and Citi personal wealth management. It provides services inCiti-branded cards and Latin America asset management as well.

2. Institutional Clients Group: In securities and banking areas, it offers ser-vices to clients in investment banking, debt and equity markets, lending,private equity, hedge funds, real estate, structured products, and equityand fixed income research. The transactions services division providesclients with cash management, trade services, custody and fund services,and clearing services.

3. Brokerage and Asset Management: Offers include investment in and asso-ciated earnings from Morgan Stanley Smith Barney joint venture as wellas retail alternative investments.

4. Local Consumer Lending: Provides banking services in consumer financelending, retail partner cards, and certain international consumer lending.

JPMorgan

JPMorgan offers products and services in asset management, commercial bank-ing, investment bank, private banking, securities services, and treasury services.The following is a brief description of lines of businesses operated by JPMorgan:

� Asset Management: Provides U.S., non-U.S., and global investment man-agement products ranging from traditional cash management, equity, fixedincome, and asset allocation to alternative asset classes such as private equity



and real estate. It also provides administrative, investment, and communi-cation services for corporate retirement plans.

� Commercial Banking: Provides banking services to corporate and individ-ual customers.

� Private Banking: Offers wealthy individuals and their families private bank-ing services including investing, wealth structuring, capital advisory, phi-lanthropy, and banking.

� Investment Banking: Provides advice on corporate strategy and structure,equity and debt capital raising, risk management, research, and market-making in cash securities and derivative instruments. It also operates pro-prietary investing and trading.

� Securities Services: Offers an integrated platform for the delivery offinancial services globally. Securities Services helps institutional investors,alternative asset managers, broker dealers, and equity issuers optimize ef-ficiency, mitigate risk, and enhance revenue. It also serves as a strategicadvisor to clients by way of delivering solutions tailored to meet clients’needs.

� Treasury Services: Treasury services provide treasury and cash management,trade finance, payment, and liquidity management services for multinationalcorporations, banks and non-bank financial institutions, and governments.The institutional trust services area provides services to debt and equityissuers, intermediaries, and investors in the global capital markets. Investorservices (custody and related services) are for mutual funds, investmentmanagers, pension funds, insurance companies, and banks.

Bank of America

Bank of America groups its services under the Personal, Small Business, WealthManagement, and Corporate and Institutional categories. The Corporate andInstitutional group is mainly serviced by Bank of America Merrill Lynch.

� Personal Banking: It covers online services, checking and savings, cards,investment management, specialized banking (such as military bank andstudent banking), and additional services.

� Small Business: Bank of America provides services in account access, check-ing and savings, loans and credit lines, leasing, cards, merchant services,payroll and tax, and investment and retirement. Additional services includetreasury management, insurance, wholesale mortgage lending, and tradeservices.

� Wealth Management: Offers services from investment, banking, and retire-ment products to college savings and estate-planning services.



Table 2.2Business Categories of Full-Service Investment Banks

Firms Goldman Sachs Morgan Stanley

BusinessCategories

Investment BankingInvesting and LendingInstitutional Client ServiceInvestment Management

Institutional SecuritiesInvestment ManagementGlobal Wealth Management

� Corporate and Institutional: Services to corporate and institutional clientsinclude capital markets, capital raising, and capital management. Capitalmarkets cover mortgage-backed securities, convertibles, emerging markets,energy derivatives, equities, equity derivatives, fixed income, foreign ex-change, interest-rate derivatives, and structured credit products. Capitalraising services raise capital for clients through debt issuance, equity is-suance, equity-linked products, leasing, mergers and acquisitions advisory,and private equity. Finally, capital management offers asset management,business capital, investment solutions, trade services, and treasury manage-ment services.

Full-Service Investment BanksThis section describes the businesses of Goldman Sachs and Morgan Stanley, thetwo U.S. independent full-service investment banks. These two firms convertedto commercial bank charter during the financial crisis after the bankruptcy ofLehman Brothers, but continue to operate as full-service providers and arenot part of a financial holding company. Table 2.2 summarizes the businesscategories offered by those two Wall Street houses.2

Goldman Sachs

Goldman Sachs is a global investment banking, securities, and investment man-agement firm, providing services to corporations, financial institutions, gov-ernments, and high-net-worth individuals. Its revenue-producing activities aredivided into four segments: Investment Banking, Institutional Client Services,Investing and Lending, and Investment Management.

The Investment Banking segment is organized along regional, product, andindustry groups. The main services are underwriting and financial advisory.Underwriting includes public offerings and private placements of equity and

2The following descriptions are from annual reports of those two investment banks.



debt securities. Financial advisory covers mergers and acquisitions, divestitures,corporate defense activities, restructuring, and spin-offs.

The Institutional Client Services segment facilitates trades on behalf of clientsand invests Goldman’s own capital using various debt and equity instruments.There are three subdivisions in the Trading and Principal Investments segment:

1. Fixed-income, Currency, and Commodities: Facilitates trades in fixed-income instruments, currencies, and commodities contracts. This groupseeks opportunities to profit from movements in interest rates and creditproducts.

2. Equities: Facilitates trades in equities. This segment is also involved inproprietary trading and derivatives.

3. Securities Services: Earns fees by providing financing, lending, as well asclearing and settlement of securities for clients.

Investing and Lending segments are generally long term investments and loansto large organizations. This portfolio consists of privately negotiated transactionssuch as acquisitions, equity and debt securities, buyouts, and investments inexternal funds.

The Investment Management division manages assets for large institutionalinvestors such as pension plans, endowments, and trusts. This includes providinga range of investment strategies and advice to these organizations.

Morgan Stanley

Morgan Stanley divides its services into Institutional Securities, Global WealthManagement, and Asset Management. Institutional Securities include invest-ment banking, equities, and fixed income. Investment banking covers securitiesunderwriting, institutional sales and trading in equity and debt securities, advi-sory services in M&As, corporate finance, and real estate.

The Investment Management line includes several important business areas.The traditional investments cover mutual funds, separately managed accounts,unit investment trusts, and variable annuities. Alternative investments offer pri-vate equity, hedge funds, fund of funds, managed futures, and real estate. Re-tirement services cover both defined contribution as well as defined benefit. Inaddition, this line provides advice in financial and estate planning, trust services,and securities transfer.

Global wealth management is one of the largest wealth management firmsglobally. Fees and commissions are the two large revenue sources for this division.



Table 2.3Specializations of Boutique Investment Banks

Firms Sandler O’Neill Greenhill Lazard

Specializations Financial Institutions andInsurance Companies

Advisory Services inM&As and FinancialRestructuring

Special CommitteeAdvisory

Advisory Services inM&As

Asset Management

Boutique Investment BanksBoutique investment banks do not offer a range of services and are not part of alarger financial institution that serves many competing interests. The followingprovides a brief description of several boutiques with different specializations,as summarized in Table 2.3.3

Sandler O’Neill

Sandler O’Neill specializes in the financial services sector. It is a partnership,and different by design. Since the firm’s founding in 1988, the firm’s partnershave aimed at providing financial services companies with an alternative tolarge Wall Street banking firms. The company raises capital, provides researchcoverage, acts as a market maker, advises on mergers and acquisitions, andtrades securities. Its services cover mutual-to-stock conversion (from a mutualownership structure to a public company), loan portfolio restructuring, strategicplanning, and balance-sheet interest rate risk management.

The investment banking team focuses on demutualization, M&A advice,fairness opinion, leveraged and management buyout, and strategic issues. Thecapital markets group specializes in convertible securities for financial institu-tions and in pooled trust preferred transactions for banks, thrifts, and insurancecompanies.4In balance sheet management, it offers clients techniques to en-hance earnings and manage interest rate risk, and it underwrites and trades alltypes of fixed-income securities. Its research covers financial services companies.In addition to covering large issuers, it is positioned to offer value to smallerissuers that are not widely followed by bulge bracket Wall Street houses. Fur-thermore, its mortgage finance group covers performing and non-performingloan portfolios. It engages in trading the whole loans as well. Finally, Sandler

3The descriptions are taken from their publications. Note that Sandler O’Neill is a private company.4A trust preferred security is a security with characteristics of both equity and debt. A company firstcreates a trust and issues debt to the new entity, then the trust issues the trust preferred securities.



O’Neill equity trading centers on financial institutions to enhance liquidity anddistribution.

Greenhill

Greenhill is a boutique house focused on mergers and acquisitions, financialrestructuring, and merchant banking. Its focus is on advisory work. It doesnot have research, trading, lending, or related activities. In contrast to manycompetitors, it is not part of a larger financial institution that serves manycompeting interests.

Greenhill’s M&A practice covers buy-side, sell-side, merger, special, andcross-border transactions. Sell-side advisory provides advice about the meritof the received bids to the target companies, special board committees, orselling shareholders. In buy-side advisory assignments, it advises principally onstock or asset purchases. Special committee advisory involves advising a SpecialCommittee of the Board of Directors that has been formed due to the conflictsin relation to a possible transaction. Often its role involves not only assistingwith a transaction process, but also delivering a fairness opinion.

Another area of practice is advice on restructuring. It advises debtors, credi-tors, and prospective acquirers of companies that are faced with or going throughreorganization, recapitalizations, or out-of-court restructurings.

The merchant banking services are to identify private investment oppor-tunities and partner with strong management teams. During 2009, Greenhillannounced its separation from its historical merchant banking business in orderto focus entirely on the client advisory business. Specifically, it sold to seniormembers of the existing investment team the right to launch successor fundsto its three current merchant banking funds. The existing funds continue to bemanaged by the current investment team, through a new, independent entity,GCP Capital Partners (GCP).

Lazard

Lazard has two core businesses: One specializing in financial advisory and theother in asset management. Its mergers and acquisitions services include generalstrategic advice and transaction-specific advice in domestic and cross-borderM&As, divestitures, privatizations, takeover defenses, strategic partnerships, andjoint ventures. Lazard also receives special committee assignments. Lazard’s in-dustry focus includes consumer, financial institutions, healthcare and life science,industrial, power and energy, technology, media, and telecommunications. Bycontrast, the financial restructuring practice specializes in advising companies in



financial distress. The asset management business provides investment manage-ment and advisory services to institutions, financial intermediaries, and privateclients. Furthermore, Lazard operates two wholly owned subsidiaries: One is aprivate equity operation and the other is a bank in France.

ConclusionsThis chapter provided a brief description of bulge bracket houses and boutiqueinvestment banks. Some of the bulge bracket houses are part of larger financialholding companies. These large investment banks offer clients a full menu ofinvestment banking and securities services. In contrast, the so-called boutiquestend to specialize in the industry or the service.


CHAPTER 3

The Structure of InvestmentBanks: Divisions and Services

M ost people use the term investmentbanking to include underwriting and advisory services for mergers and acqui-sitions. Morgan Stanley described its investment banking in this way: “MorganStanley offers its investment banking clients, including corporations, govern-ments and other entities, underwriting and distribution services for debt andequity offerings in addition to financial advisory services regarding key strategicmatters, such as mergers and acquisitions, restructuring, real estate and projectfinance.” Today, investment banks are facing an intensely competitive environ-ment, fostered by regulatory changes, by globalization, and by technologicaladvances. As a result, most investment banks have expanded to comprise majorcapital market activities. In this chapter, we describe Morgan Stanley and Gold-man Sachs to review the typical organizational structure of an investment bank.

Morgan StanleyThe organizational structure at Morgan Stanley (MS) is divided into three broadareas: business units, company management, and operations and technology. Sixbusiness units provide institutions and individuals with a full spectrum of prod-ucts and services across the world’s major markets. Eleven management unitsprovide information and strategic analysis to the firm’s management commit-tee, help ensure efficient daily operations and long-term growth, and serve thewell-being of shareholders, employees, and clients. Operations and technologyprovide infrastructure and controls for the firm.

Business Units

There are six business units, including Morgan Stanley Smith Barney, Salesand Trading, Investment Banking, Global Capital Markets, Investment Man-agement, and Research.

21



Morgan Stanley Smith Barney provides a range of products and services toindividuals, businesses, and institutions, including brokerage and investmentadvisory services, financial and wealth planning, credit and lending, cash man-agement, annuities and insurance, and retirement and trust. In Sales and Trading,Morgan Stanley provides services in sales, trading, market making in most typesof financial instruments, including stocks, bonds, derivatives, foreign exchange,and commodities. It also provides analytics to clients as well. The InvestmentBanking group provides services in underwriting of equity and equity-relatedtransactions, high-yield debt financing, corporate debt issuance, and in mergersand acquisitions.

The Global Capital Markets group works with clients to arrange financ-ing and risk management solutions. This group provides guidance as to size,structure, timing, and marketing of transactions. The Investment Managementdivision offers individual and institutional clients a diverse array of equity, fixedincome, and alternative investments. In the Research division, equity analystsprovide research coverage for investment recommendations. Economists, strate-gists, and fixed-income analysts cover all major regions and other asset classesaround the world. Many investors, institutional and individual, consider suchrecommendations in their investment and trading decisions.

Company Management

There are 11 departments in Company Management, including legal and com-pliance, corporate services, finance, government relations, human resources,internal audit, corporate communications, community affairs, strategy and ex-ecution, firmwide marketing, and risk management. All those departmentstogether provide information and strategic thinking to the company’s manage-ment committee and help ensure long-term growth and efficient day-to-dayfunctioning of businesses.

Operations and Technology

Operations and Technology provide the global infrastructure and controls forthe firm. Technology provides quantitative trading systems, modeling and sim-ulation software, comprehensive risk and security systems, and infrastructuresupporting these systems and tools. Operations is the backbone for sales, trading,and other business activities. It ensures that the firm is aware of all operationalrisks, makes sure transactions are settled and recorded correctly, and supportsnew markets and products.

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