Fleuriet - Investment Banking Explained

INVESTMENT BANKING
EXPLAINED

AN INSIDER'S GUIDE
TO THE INDUSTRY

MICHEL FLEURIET

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DOI: 10.1036/0071497331

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Investment banking is a complicated industry of traders, analysts, brokers, managers, hedgers, "quant jocks," retirement planners, and, yes, even bankers! This business is as creative as it is mechanical, as qualitative as it is quantitative; its clients range from middle-American mom-and-pops to international billionaires, from newly created firms to multinational giants. Investment banks also work for governments.

The business of an investment bank is to deliver a broad range of products and services to both issuing and investing clients. Its offerings go from strategic advice to the management of risk. In the last century, the main purpose of an investment bank was to raise capital and to advise on mergers and acquisitions. Investment-banking services were defined as either underwriting or financial advisory. We tend to use a broader definition today. This is how JPMorgan describes it: "In the simplest terms, investment banking helps companies decide on their marketplace strategy. Investment banking also provides access to public and private investment grade debt, high yield and bank markets for a wide range of high-profile clients from governments and Investment banks also trade for their own account, and many are involved in managing third-party assets.

The largest investment banks have been around for more than one hundred years, some of them even for two hundred years. However, their business has changed tremendously in the last ten years, as investment banks have innovated at a furious pace. This is probably why they still exist today, "for as all organic beings are striving, it may be said, to seize on each place in the economy of nature, if any one species does not become modified and improved in a corresponding degree with its competitors, it will soon be exterminated."

Forty years ago, if one could insure operational risks, investing on the stock market was rather like taking a bet. The stock market was the realm of speculators. In the 1960s, a new approach and new mathematical models, which could be run with recently invented computers, allowed financial service companies to develop revolutionary diversification techniques to manage the financial risks of investing. A good way for the investment banks to show their mettle in managing risks was to acquire asset managers.

Over the last decade, however, the approach to risk has changed. Investing in diversified assets is still a tenet of money management, but a new approach has transformed the financial markets. Instead of diversifying the risks among various assets, investment banks now slice them up and package them into bits that trade on markets. These bits, which we call swaps, derivatives, CDOs, and credit-default swaps, allow the transfer of risk from one party who cannot manage it to another party who wants it.

With this new approach to risk, investment banks have taken on more risk, and they have changed the mix of their business. They are now investing their own capital and trading more innovative products, and they have taken on more risk as they have moved away from the pure intermediary approach of their previous business model. This new way of doing business has, not surprisingly, created new kinds of conflicts of interest between the investment banks and their clients. In any of the big investment banks' 10-K filings with the Securities and Exchange Commission (SEC), there are tens of pages on pending legal claims from customers or regulators.

The late 1990s and early 2000s evoke many scandals in which investment banks were involvedthink of Enron, Global Crossing, and WorldCom (the telecommunications giant that filed for bankruptcy protection in 2002 with $30 billion in debt). Moreover, before that, there was the collapse of the two-hundred-year-old Barings Bank, one of the ancestors of today's modern investment banks, and the bankruptcy of Orange County.