Introduction to Investment Banking

We've decided the best way to start this course is by providing you with some historical background about the investment banking industry. History doesn't play a critical role in many modern businesses. This is not the case in the world of investment banking. History, name, tradition, and reputation are some of the most valuable assets these companies have. An investment bank that's been established 200 years ago has the connections, partnerships, and know-how allowing it to attract top-tier clients and investors. Therefore, it is imperative we understand how these organizations operated in the first place and how their businesses evolved throughout the distance of time. The main drivers of change we will have to examine are government regulations and market dynamics. The aim of this section is to enable you to see the full picture. Before studying the services offered by investment banks, we will learn what led to the conception of these services. In addition, these are some of the most popular topics at investment banking interviews. Recruiters and industry practitioners will likely test your knowledge to determine whether you have a genuine interest to work in their industry. In the next lesson, we will go back in time and learn who started offering investment banking services and why their role was so important for the growth of the U.S. economy in the 19th century. Here's an important piece of proof that history and tradition play a big role in the world of investment banking. The list you see here shows the names of the largest investment banks in the world. Barclays Capital, J.P. Morgan, Citigroup, Credit Suisse, Goldman Sachs, Deutsche Bank, Merrill Lynch, and Morgan Stanley. The youngest of these banks is 80 years old, but their average age is significantly higher, 172 years. Here's our first challenge for you. We've seen that some of the players in the world of investment banking started operating centuries ago. Please try to find out the oldest bank in the world and when it was founded. Investment banking emerged in America in the 19th century, when the American economy was growing so fast that commercial banks could not serve the expansion of railroads, mining companies, and the heavy industry. The main activity of investment banks is now known as security underwriting. They bought financial securities, like bonds and stocks, from an issuer and resold these securities to a group of investors. We can say that investment banks served as a bridge between demand and offer, between people who had capital and wanted to invest it and people who needed financing for one of their projects. The main clients that investment banks had in these early days were government entities. When these governments required financing, they needed to issue bonds and sell them to investors. To do that, they used the services of middlemen, or investment bankers as we would call them today. The governments didn't have the expertise to sell bonds on their own, they didn't know how to price them, they weren't unbiased in the negotiation of proper terms, and individual investors didn't think their interest would be protected without having a significant bargaining power. This is how prominent middlemen came on the stage. Their role was to negotiate great terms with the government, buy a fraction of the bonds that the government wants to offer, and sell the bonds to final investors. There is one important detail we shouldn't forget though. Before agreeing to distribute the government's bonds, the middlemen contacted potential investors and created a list with the ones who were ready to purchase the bonds. They had to be certain that they could resell all bonds issued and wouldn't be stuck with any of these. As you can imagine, when an investor buys government debt, they can have two types of problems. The government can default and stop repaying its debt, or it could try to renegotiate it. That's why most investors felt more comfortable when they had an established middleman on their side. In 1842, eight American states defaulted because their economies relied heavily on the production of cotton, and the price in that year was too low. These states could not repay their loans and refused to do it, which put at risk the capital of the investors who bought these securities. The middlemen who arranged this sale reacted in a decisive manner. All the attempts of these states to raise new capital were unsuccessful. James Rothschild was quoted as saying to the representatives of the federal government, you may tell your government that you have seen the man who is at the head of the financiers of and that he has told you that they cannot borrow a dollar, not a dollar. The result of these actions was that the defaulted states agreed to a restructuring plan, which satisfied the investors and repaid them their capital. This episode proves how important investment bankers were in the 19th century. Such episodes increased their reputation, which allowed them to work with top-tier investors. All issuers of debt and equity wanted to work with middlemen who could contact top-tier investors. We can conclude that investment banking services were born because they were needed by both investors and financiers. These so-called middlemen brought to the table something very important, their reputation. The quality of a security was associated with the name of the investment banker who sold it to the market. This aligned the goals of investment bankers and investors. Investors wanted to maximize their returns, while investment bankers needed to keep their investors happy and keep their business in the years to come. In this lesson, we mentioned the Rothschild family and one of its members. Prominent middlemen like Rothschild paved the way for the investment banking industry and epitomized the first investment bankers, people with huge influence and a loyal client base. The Rothschild family is one of the historical powerhouses in investment banking. Let's learn a few interesting facts about them. The Rothschilds knew about Napoleon's defeat at Waterloo before the government. They had a very efficient network of couriers, which allowed them to learn about Napoleon's defeat a day before the government did. Nathan Rothschild kept the secret to himself and immediately started buying British government debt. And given that Napoleon was defeated, the prices of British government bonds soared the very next day. Nathan Rothschild could sell the bonds two years later at a profit of 40%. German Emperor William was fascinated by their castle in France and said that kings couldn't afford this, it could only belong to a Rothschild. Lord Walter Rothschild was a passionate zoologist and an immensely rich person. He is famous for driving a carriage of six zebras to Buckingham Palace. Lord Walter wanted to prove that zebras could be tamed. Pretty cool, right? Here's our next challenge for you. So far, we've talked about the Rothschild family. Try to do some research and provide the names of three other families that formed investment banking dynasties and established some of the largest firms in the industry. Commercial vs. Investment Banks At this point, you might ask the following question. Hey, what about regular banks? The types of banks that provide mortgage loans and take deposits from regular customers? Aren't they the ones who should be dealing with investment banking operations? And it would be a fair question. The regular banks we see around us, providing loans to the population and collecting its savings, are called commercial banks. These are mainly involved with deposit-taking, credit-giving activities. These banks collect deposits from the population and then lend the money to borrowers. The difference between the interest they pay to depositors and the one they charge borrowers is called spread, and this represents their main source of revenue. I'm sure you'll agree this is very different than investment banking operations. The scale of these loans and the complexity of the operations are smaller. It is important that you understand the difference between investment banking and commercial banking lines of services. In our next lesson, we will learn about some banks that combined both types of services under the same roof. Goldman Sachs is, without a doubt, the number one bank on Wall Street. Its staff is the highest paid on average. In 2006, employees were paid an average of $622,000. This figure is significantly influenced by the enormous compensation of the CEO and other partners of the firm, but is still a stratospheric figure. Of course, things changed significantly after 2008, with the average salary going down to $399,506 per employee for 2012. In this lesson, we would like to challenge you to name and describe the two main differences between the business model of a commercial and an investment bank. As we anticipated in our previous lesson, we will talk about the combination of commercial and investment banking services, and why it creates anxiety among some regulators. First, let's start with a definition. Banks that perform commercial and investment banking services are called universal banks. There are several economic arguments why this combination makes sense. Many synergies exist between the two types of activities, the main advantage being that universal banks can sell more products to the same client. They can offer a one-stop-shop solution, where everything is provided under the same roof. Universal banks can be a client's trusted advisor in times of regular business and when the company must raise equity or debt. The advantage is that they will have a close relationship with the firm and will know its business inside out. At the same time, there are good reasons the marriage between investment banking and commercial banking activities can be dangerous. Given that universal banks have more information about their clients and that often their clients are also borrowers, universal banks may be tempted to sell to the market, through investment banking services, risky positions that are likely to cause losses. This will be a hit to their reputation but will prevent them from losing their own money. Due to these concerns, the Glass-Steagall Act was introduced in the US in 1933. It prohibited commercial banks' engagement in investment banking services. Commercial banks could not trade and distribute securities. Sixty-six years later, the Glass-Steagall Act was repealed, allowing banks to sell commercial and investment banking services under the same roof. This led to mergers and to the formation of global financing conglomerates, giants like HSBC, JPMorgan Chase, Bank of America and Deutsche Bank. Very few of the historically established names remained pure investment banks. Banks like Goldman Sachs, Morgan Stanley and Lazard chose not to enter the commercial banking market and continued to offer traditional investment banking services. Nowadays, investment banks offer a complex range of financial solutions. Their products encompass a wide range of areas, like underwriting of debt and equity, advisory on mergers and acquisitions, trading and asset management. It is understandable why underwriting and advisory are the two traditional activities that stand at the core of investment banking. This is, after all, how the business started in the first place and how investment bankers add the most value for their clients. This is how they build historical relationships that last decades and even centuries. Sounds very romantic, doesn't it? Trading and asset management are the two other areas where investment banks are very active. Historically, there has been a significant debate over the fact that some contain an intrinsic conflict of interest. For example, an investment bank may trade stocks on its own account or on behalf of its clients. If the market crashes, which are the securities that will be taken care of first, the ones of the clients or the ones of the bank? Another issue is that investment banks have research departments whose job is to examine stocks and provide recommendations. Banks provide underwriting services. It is highly possible that the opinion of a bank's researcher would be influenced by the bank underwriting the given company's securities. These situations represent a huge problem for the industry, and that's why the so-called Chinese walls have been created. The role of Chinese walls is to create a barrier between different divisions whose interaction could cause a conflict of interest. Client information is confidential and cannot be shared with people from the same firm who do not have an authorized access to it. We will look in-depth at these issues in the next section of the course, where we'll provide a detailed description of the four main areas of investment banking activity. See you there! Investment bankers' historical role was to be the trusted advisors of their clients. The epitome for that is Sidney Weinberg, Goldman Sachs' long-time leader. One of the most important relationships he had was with Henry Ford II. When Henry Ford II became president, Ford was the largest private corporation in the US, and it also had significant operational and financial difficulties. Weinberg was the trusted advisor that Henry needed. He helped him hire top-notch executives and turn around the company. As a reward, Ford chose Goldman to run its IPO in 1956. This was the largest IPO in the history of investment banking. The IPO cemented Goldman as one of the top firms on Wall Street.