Investment Banking

I

Introduction

Investment Banking, branch of finance concerned with the underwriting, distribution, and maintenance of markets in securities issued by business firms and public agencies. Investment bankers are primarily merchants of securities; they perform three basic economic functions: (1) provide capital for corporations and local governments by underwriting and distributing new issues of securities; (2) maintain markets in securities by trading and executing orders in secondary market transactions; and (3) provide advice on the issuance, purchase, and sale of securities, and on other financial matters. In contrast to commercial banks, whose chief functions are to accept deposits and grant short-term loans to businesses and consumers, investment bankers engage primarily in long-term financing.

II

Underwriting

When a corporation needs to obtain funds by issuing stock or bonds, an investment banker may buy the entire issue and resell the securities in smaller amounts to investors, a procedure known as underwriting. Investors include individuals, insurance companies, pension funds, trust companies, investment companies, and other institutions. Sometimes a corporate issuer sells an entire issue of securities directly to one or more institutional buyers, such as insurance companies, without registering the issue for public sale. These sales are known as private placements.

New public issues take two forms. The first time a corporation makes stock available for public sale, an investment banker puts together an initial public offering (IPO). Public companies in need of an infusion of capital may work with investment bankers to issue additional stock in a subsequent, or follow-on, offering.

The buying of a new issue may be handled by a single investment house, but large issues often are underwritten by syndicates or groups of firms. The risk sharing thus provided has become increasingly appealing in recent decades. The originating firm conducts a thorough investigation of the issuing corporation, analyzing financial, marketing, and production matters involved in the proposed transaction. It then enlists the participation of other firms in a syndicate; each syndicate member agrees to take a specified part of the issue.

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The typical underwriting transaction involves a commitment by an investment house to buy a whole issue. In some cases the firm acts only as an agent and attempts to sell the securities on a commission basis. In most cases, however, the investment house or syndicate guarantees the sale of an entire issue by buying the whole issue at a set price and assuming the risk of being able to sell the securities at a higher price.

The terms of most industrial issues are negotiated between the investment banking firm and the corporation issuing the securities. Public utility and railroad issues and state and municipal bonds, however, are usually sold through competitive bids. An important feature of the distribution of securities in recent years has been the increasing use of the direct sale of bonds by the issuing corporations to institutional investors rather than to investment houses. Institutional investors include pension funds and mutual funds.

III

Other Services

In addition to departments handling the purchase and resale of new issues, an investment-banking house typically has a trading department, a brokerage department, and a research or statistical department. The trading department buys and sells securities when profitable opportunities arise. Sometimes it may have to buy back securities it is marketing in order to prevent a decline in their market price. The brokerage department buys and sells securities, at a commission, for the accounts of other investors. The research department supplies the firm and its customers with information about securities.

An important segment of investment-banking operations is carried on by government-bond dealers. A few dozen large investment houses and commercial banks, most of them headquartered in New York City, handle the bulk of trading in U.S. government securities.

IV

History of Investment Banking

A

European Banking

Evidence indicates that ancient civilizations such as Greece and Rome engaged in investment-banking operations with practices such as extending long-term credits to governments and to certain industries. During the Middle Ages investment banking was concerned largely with financing governments. In the 1100s and 1200s, for example, the Lombard banks in Italy combined trading operations with long-term loans made to various rulers.

In Great Britain the earliest investment institutions of any importance were the acceptance houses, or merchant banks. As far back as the 1600s, these concerns financed foreign trade. Later the acceptance houses also floated foreign issues in London and accumulated funds for long-term investment abroad.

Also important in the evolution of investment banking were private banks, many of which were family enterprises, and finance companies. One of the former, the House of Rothschild, attained a dominant position in the financial centers of Europe during the 1800s and was still influential in the 1900s.

Currently, in Britain, channeling of capital into domestic industry is done mainly through specialized finance or investment companies. In many European countries, however, it is customary for the same institution to carry on both commercial and investment banking. In Germany, in particular, large banks play a leading role in financing industrial development. Investment banks also play a global role. Companies and governments frequently finance their needs in the market in which they can get the very best price and terms—whether that market is in the United States, Europe, or Japan.