Chapter Sixteen

Securities Firms
and Investment
Banks
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Securities Firms and Investment
Banks (IBs)
 Investment
Investment banks
banks (IBs)
(IBs) help
help corporations
corporations and
and
governments
governments raise
raise capital
capital through
through debt
debt and
and equity
equity
security
security issues
issues in
in the
the primary
primary market
market
 underwriting
underwritingisisassisting
assistingin
inthe
theissue
issueof
ofnew
newsecurities
securities
 IBs
IBsalso
alsoadvise
adviseononmergers
mergersandandacquisitions
acquisitions(M&As)
(M&As)andand
corporate
corporaterestructuring
restructuring
 Securities
Securities firms
firms assist
assist in
in the
the trading
trading of
of securities
securities
in
in secondary
secondary markets
markets
 broker-dealers
broker-dealersassist
assistin
inthe
thetrading
tradingof
ofexisting
existingsecurities
securities

16-2
Securities Firms and Investment
Banks (IBs)

 The
Thesize
sizeof
ofthe
theindustry
industryisisusually
usuallymeasured
measuredby
bythe
theequity
equity
capital
capitalof
offirms
firmsrather
ratherthan
thantotal
totalasset
assetsize
size
 Equity
Equitycapital
capitalininthe
theindustry
industryinin2010
2010was
was$214.5
$214.5billion
billion
 The
Thenumber
numberof offirms
firmsin inthe
theindustry
industrychanged
changeddueduetoto
economies
economiesof ofscale
scaleand andscope,
scope,losses
losseswith
withthe
theeconomy,
economy,
scandals
scandalsatatsome
somefirms,
firms,and
andregulations
regulationsthat
thatallowed
allowedboth
both
inter-
inter-and
andintra-industry
intra-industrymergers
mergers
 5,248
5,248firms
firmsinin1980
1980
 9,515
9,515firms
firmsinin1987
1987
 5,063
5,063firms
firmsinin2010
2010
 As
Aswith
withcommercial
commercialbanks,
banks,consolidation
consolidationhas
haslargely
largely
occurred
occurredthrough
throughmergers
mergersand
andacquisitions
acquisitions

16-3
Securities Firms and Investment
Banks (IBs)
 Commercial
Commercialbank bankholding
holdingcompanies
companiesthatthatoperate
operate
diversified
diversifiednational
nationalfull-line
full-linefirms
firms
 service both retail and wholesale customers by acting as
service both retail and wholesale customers by acting as
broker-dealers
broker-dealers
 service corporate customers by underwriting security
service corporate customers by underwriting security
issues
issues
 National
Nationalfull-line
full-linefirms
firmsspecializing
specializingin
incorporate
corporatefinance
finance
 The second largest group of firms are full-service firms
The second largest group of firms are full-service firms
that
thatspecialize
specializein incorporate
corporatefinance
financeor
orprimary
primarymarket
market
activity
activity(i.e.,
(i.e.,focus
focusless
lessononsecondary
secondarymarket
marketactivities)
activities)

16-4
Securities Firms and Investment
Banks (IBs)
 Large
Largeinvestment
investmentbanks
banks
 Have
Haveonly
onlylimited
limitedbranch
branchnetworks
networksconcentrated
concentratedininmajor
majorcities
cities
and
andservice
serviceprimarily
primarilyfinancial
financialinstitution
institutionclients
clients
 Smaller
Smallerspecialized
specializedfirms
firmssuch
suchas:
as:
 regional
regionalinvestment
investmentbankers
bankers (sometimes
(sometimeslabeled
labeled‘boutiques’)
‘boutiques’)
 discount
discountbrokers
brokers
 Internet
Internetbrokers
brokers
 venture
venturecapital
capitalfirms
firms
 exchange
exchangefloor
floorspecialists
specialists
 dealers
dealersininoff
offexchange
exchangetrading
trading

16-5
Lines of Business

 Investment
Investment banking
banking
 first
firsttime
timedebt
debtand
andequity
equityissues
issuesoccur
occurthrough
through initial
initial
public
publicofferings
offerings(IPOs)
(IPOs)
 new
newissues
issuesfrom
fromaafirm
firmwhose
whosedebtdebtor
orequity
equityisisalready
already
traded
tradedare arecalled
calledseasoned
seasonedequityequityofferings
offerings(SEOs)
(SEOs)
 aaprivate
privateplacement
placementisisaasecurities
securitiesissue
issuethat
thatisisplaced
placed
with
withoneoneororaafew
fewlarge
largeinstitutional
institutionalinvestors
investors
 public
publicofferings
offeringsare
areoffered
offeredtotothe
thepublic
publicatatlarge
large
 IBs
IBsact
actonly
onlyasasan
anagent
agentin inbest
bestefforts
effortsunderwriting
underwriting
 IBs
IBsact
actasasprincipals
principalsin infirm
firmcommitments
commitments

16-6
Lines of Business

 Venture
Venture capital
capital (VC)
(VC) isis aa professionally
professionally managed
managed
pool
pool of
of money
money used
used to to finance
finance new
new (i.e.,
(i.e., start-up)
start-up)
and
and often
often high-risk
high-risk firms
firms
 VC
VCusually
usuallypurchases
purchasesan anequity
equitystake
stakeininthe
thestart-up
start-up
 usually
usuallybecome
becomeactive
activein
inmanagement
managementof ofthe
thestart-up
start-up
 institutional
institutionalventure
venturecapital
capitalfirms
firmsfind
findand
andfund
fundthe
themost
most
promising
promisingnewnewfirms
firms
 venture capital limited partnerships
venture capital limited partnerships
 financial venture capital firms
financial venture capital firms
 corporate venture capital firms
corporate venture capital firms

16-7
Lines of Business

 Private
Private equity
equity investments
investments
 Private
Privateequity
equity(PE)
(PE)differs
differsfrom
fromVC
VCin
infunds
fundssources
sourcesand
andin
in
types
typesof
ofinvestments
investments
 PE firms raise funds by selling securities rather
PE firms raise funds by selling securities rather
than
than commingling
commingling private
private funds
funds
 PE firms often acquire established existing firms
PE firms often acquire established existing firms
rather
rather than
than purchase
purchase start-ups
start-ups

16-8
Lines of Business

 Market
Market making
making involves
involves the
the creation
creation of
of secondary
secondary
markets
markets for
for an
an issue
issue of
of securities
securities
 agency
agencytransactions
transactionsare
aretwo-way
two-waytransactions
transactionsononbehalf
behalf
of
ofcustomers
customers
 with
withprincipal
principaltransactions
transactionsmarket
marketmakers
makersseek
seektotoprofit
profit
for
fortheir
theirown
ownaccounts
accounts
 Investment
Investmentbanks
banksmanaged
managed$88
$88trillion
trillionin
inderivatives
derivatives
securities
securitiesinin2010
2010

16-9
Lines of Business

 Trading
Trading involves
involves taking
taking an
an active
active net
net position
position in
in an
an
asset
asset
 Position
Positiontrading
tradinginvolves
involvesrelatively
relativelylong-term
long-termpositions
positionsinin
assets
assets
 Pure
Purearbitrage
arbitrageinvolves
involvesattempts
attemptstotoprofit
profitfrom
fromprice
price
discrepancies
discrepancies
 Risk
Riskarbitrage
arbitrageinvolves
involvesattempts
attemptstotoprofit
profitbybyforecasting
forecasting
information
informationreleases
releases
 Program
Programtrading
tradingisisthe
thesimultaneous
simultaneousbuying
buyingand andselling
sellingof
of
at
atleast
least15
15different
differentstocks
stocksvalued
valuedatat$1
$1million
millionorormore
more

16-10
Lines of Business

 Trading
Trading (continued)
(continued)
 Stock
Stockbrokerage
brokerageinvolves
involvestrading
tradingon
onbehalf
behalfof
ofcustomers
customers
 Electronic
Electronicbrokerage
brokerageoffers
offerscustomers
customersdirect
directaccess,
access,via
via
the
theinternet,
internet,to
tothe
thetrading
tradingfloor
floor

16-11
Lines of Business

 Investing
Investing involves
involves managing
managing pools
pools of
of assets
assets such
such
as
as closed-
closed- and
and open-end
open-end mutual
mutual funds
funds
 as
asagents
agents
 as
asprincipals
principals
 Cash
Cash management
management involves
involves deposit-like
deposit-like accounts
accounts
such
such asas money
money market
market mutual
mutual funds
funds (MMMFs)
(MMMFs) that
that
offer
offer check
check writing
writing privileges
privileges

16-12
Lines of Business

 Merger
Merger and
and acquisition
acquisition (M&A)
(M&A) assistance
assistance
M&A activity by year
US Global
2008 $924 billion $2.85 trillion
2009 713 1.70
2010* 452 1.28
* First nine months

 M&A
M&Aactivity
activitybrings
bringslarge
largefees
feesto
tobankers
bankers
 M&A
M&Abusiness
businessremains
remainsvery
verycyclical
cyclicaland
anddepends
dependson
onthe
the
economy
economy

16-13
Lines of Business

 Other
Other Service
Service Functions
Functions
 Security
Securitycustodian
custodianservices
services
 Clearance
Clearanceandandsettlement
settlementservices
services
 Escrow
Escrowservices,
services,research
researchand
andadvice
adviceon
ondivestitures,
divestitures,and
and
asset
assetsales
sales

16-14
Industry Performance

 Industry
Industry trends
trends depend
depend heavily
heavily on
on the
the state
state of
of the
the
stock
stock market
market and
and the
the economy
economy
 Commission
Commissionincome
incomefell
fellafter
afterthe
the1987
1987stock
stockmarket
marketcrash
crash
and
andthe
the2001-2002
2001-2002stock
stockmarket
marketdecline
decline
 Improvements
Improvementsin inthe
theU.S.
U.S.economy
economyininthe
themid-2000s
mid-2000sledledto
to
increases
increasesin
incommission
commissionincome
incomebut
butincome
incomefell
fellwith
withthe
the
stock
stockmarket
marketin
in2006-2008
2006-2008because
becauseofofrising
risingoil
oilprices
pricesand
and
the
thesubprime
subprimemortgage
mortgagecollapse
collapse

16-15
Industry Performance

 Performance
Performance (continued)
(continued)
 Revenues
Revenuesand andprofits
profitsfell
fellrecord
recordamounts
amountsin
in2008,
2008,but
but
rebounded
reboundedsharply
sharplyin in2009
2009
 Industry
Industryemployment
employmentfell fellsharply
sharply
 Low
Lowinterest
interestrates
ratesand
andstrong
strongstock
stockmarket
markethelped
helpedfuel
fuel
profit
profitrecovery
recovery

16-16
Balance Sheets of Securities
Firms and Investment Banks (IBs)

Selected
Selected Major
Major Assets
Assets (2010)
(2010)
 Receivables
Receivablesfrom
fromother
otherbroker-dealers
broker-dealers 33.79%
33.79%
 Long
Longpositions
positionsininsecurities
securitiesand
andcommodities
commodities 26.54%
26.54%
 Reverse
Reverserepurchase
repurchaseagreements
agreements 26.40%
26.40%

16-17
Balance Sheets of Securities
Firms and Investment Banks (IBs)

Selected
Selected Major
Major Liabilities
Liabilities and
and Equity
Equity (2010)
(2010)
 Payables
Payablesto toother
otherbroker-dealers
broker-dealers 14.25%
14.25%
 Payables
Payablesto tocustomers
customers 13.35%
13.35%
 Short
Shortpositions
positionsin
insecurities
securitiesand
andcommodities
commodities 10.29%
10.29%
 Repurchase
Repurchaseagreements
agreements 40.82%
40.82%
 Other
Othernon-subordinated
non-subordinatedliabilities
liabilities 9.80%
9.80%
 Equity
Equity 4.94%
4.94%
(SEC
(SECrequires
requiresminimum
minimumnet networth
worthto
toassets
assetsof
of2%)
2%)

16-18
Regulation of Securities Firms
and Investment Banks (IBs)

 The
The Securities
Securities and and Exchange
Exchange Commission
Commission
(SEC)
(SEC) isis the
the primary
primary regulator
regulator of
of the
the securities
securities
industry
industry
 The National Securities Markets Improvement
The National Securities Markets Improvement
Act
Act (NSMIA)
(NSMIA) of of 1996
1996 reaffirmed
reaffirmed federal
federal (over
(over state)
state)
authority
authority
 Even
Evenso,
so,state
stateattorneys
attorneysgenerally
generallyintervene
intervenethrough
through
securities-related
securities-relatedinvestigations
investigationsthat
thathave
haveled
ledto
tomany
many
highly
highlypublicized
publicizedcriminal
criminalcases
cases

16-19
Regulation of Securities Firms
and Investment Banks (IBs)

 The Sarbanes-Oxley Act (SOX) of 2002

The Sarbanes-Oxley Act (SOX) of 2002
 created
created an
an independent
independent auditing
auditing oversight
oversight board
board
under
under the
the SEC
SEC
 increased penalties for corporate wrongdoers
increased penalties for corporate wrongdoers
 forced faster and more extensive financial
forced faster and more extensive financial
disclosure
disclosure
 created avenues of recourse for aggrieved
created avenues of recourse for aggrieved
shareholders
shareholders

16-20
Regulation of Securities Firms
and Investment Banks (IBs)

 The SEC sets rules governing underwriting

The SEC sets rules governing underwriting
and
and trading
trading activity
activity
 SEC
SEC Rule
Rule 144A
144A defines
defines boundaries
boundaries between
between
public
public offerings
offerings and
and private
private placements
placements

16-21
Regulation of Securities Firms
and Investment Banks (IBs)
 Two
Two self-regulatory
self-regulatory organizations
organizations oversee
oversee the
the
day-to-day
day-to-day regulation
regulation of
of trading
trading practices
practices
 the
theNew
NewYork
YorkStock
StockExchange
Exchange(NYSE)
(NYSE)
 the
theFinancial
FinancialIndustry
IndustryRegulatory
RegulatoryAuthority
Authority (FINRA)
(FINRA)
 The
The U.S.A.
U.S.A. Patriot
Patriot Act
Act became
became effective
effective in
in 2003
2003
 firms
firmsmust
mustverify
verifyidentities
identitiesof
ofcustomers
customers
 firms
firmsmust
mustmaintain
maintainrecords
recordsof ofidentities
identitiesof
ofcustomers
customers
 firms
firmsmust
mustverify
verifycustomers
customersare arenot
noton
onsuspected
suspectedterrorist
terrorist
lists
lists

16-22
Regulation of Securities Firms
and Investment Banks (IBs)

 Investors in the industry are protected by the

Investors in the industry are protected by the
Securities
Securities Investor
Investor Protection
Protection
Corporation
Corporation (SIPC)
(SIPC)
 protects
protectsinvestors
investorsagainst
againstlosses
lossesof ofup
upto
to$500,000
$500,000due
dueto
to
securities
securitiesfirm
firmfailures
failures(but
(butnot
notagainst
againstpoor
poorinvestment
investment
decisions)
decisions)
 created
createdfollowing
followingpassage
passageof ofthe
the Securities
SecuritiesInvestor
Investor
Protection
ProtectionAct Actin
in1970
1970

16-23
Regulation of Securities Firms
and Investment Banks (IBs)
 Under
Underthe theDodd-Frank
Dodd-FrankAct, Act,the
theFinancial
FinancialServices
ServicesOversight
Oversight
Council
Council(FSOC)
(FSOC)hashasoversight
oversightofofsystemic
systemicrisk
riskof
ofthe
theindustry
industry
 More
Moreinvestment
investmentadvisors
advisorswill
willhave
haveto tobe
beregistered
registeredwith
with
either
eitherthe
theSEC
SECor orstate
stateadvisors
advisors
 Securitization
Securitizationmarkets
marketsshould
shouldnownowhave
havemore
moreoversight
oversightand and
originators
originatorswill
willhave
haveto toretain
retainaagreater
greaterinterest
interestininloans
loansthat
that
will
willbe
beresold
resold
 More
Morederivatives
derivativesregulation
regulationisisexpected
expectedas aswell
well

16-24
Regulation of Securities Firms
and Investment Banks (IBs)
 The
Thegovernment
governmentcancanalso
alsomandate
mandatehigher
highercapital
capital
requirements
requirementsfor
forlarger
largerand
andfor
forinterconnected
interconnectedfirms
firms

 Conclusion:
Conclusion:Government
Governmentoversight
oversightof
ofindustry
industrypractices
practiceshas
has
increased
increasedas
asaaresult
resultof
ofthe
thebill
bill

16-25
Regulation of Securities Firms
and Investment Banks (IBs)
 Executive
Executivecompensation
compensationrestrictions
restrictionsimposed
imposedby
bythe
theObama
Obama
administration
administration
 Strengthen the independence of the compensation
Strengthen the independence of the compensation
committee
committeefrom
fromsenior
seniormanagement
management
 Shareholders now also have a non-binding vote on
Shareholders now also have a non-binding vote on
executive
executivecompensation
compensationpackages
packages
 Administration has a say on executive pay for firms that
Administration has a say on executive pay for firms that
accepted
acceptedbailout
bailoutmoney
money

16-26
Global Issues

 Securities
Securities firms
firms and
and investment
investment banks
banks are
are by
by far
far the
the
most
most global
global ofof any
any group
group ofof financial
financial institutions
institutions
 U.S. firms are increasingly looking to expand their
U.S. firms are increasingly looking to expand their
business
business abroad—particularly
abroad—particularly into into China
China andand India
India
 Increase in cross-border strategic alliances
Increase in cross-border strategic alliances

16-27