Investment banking, and the industry's leading firms, have long been subject to much controversy. Characterised by flux and transformation, investment banking has experienced both periods of unprecedented expansion and abrupt collapse. Blamed by many as the principal culprits behind the Financial Crisis, they have since drawn much attention to their regulation or lack thereof and as a consequence, their role as financial intermediaries.
Investment bank's role as intermediaries encompasses a whole host of activities nearly all of which have seen criticism. Their intermediary services are employed by institutional investors, corporations, governments, quasi-governmental institutions (sovereign wealth funds and export credit agencies) and occasionally high net worth individuals (Bank of England Quarterly Bulletin, 2015).
The first service I will be discussing is their advisory work on mergers and acquisitions (M&A). Investments banks provide assistance to corporations undergoing mergers by appraising the value of the target company and representing both parties during the negotiations or bidding procedure. Their growing expertise in the sector has allowed them to over the past thirty years, develop an unparalleled degree of control over M&As.
Today, top-tier investment banks such as JPMorgan, Goldman Sachs and Bank of America Merrill Lynch, dominate the M&A scene (See table 1), and continue to prevail by upholding a reputation as specialists in the area (Kale J., Kini O. and Ryan H., 2003). Indeed, it is argued that the success of M&A deals relies heavily upon the hired investment bank's reputation (Allen et al, 2004; Kisgen D., Qian J. and Song W., 2009). This has been demonstrated in studies comparing the employment of first-tier and lower-tier investment banks in the returns earned by their clients (Bowers H. and Miller R., 1990; Hunter W. and Walker M., 1990; Michel A., Shaked I. and Lee Y., 1991; Bao J. and Edmans A., 2011) however others argue that investment banks aren't necessary in M&A transactions (Servaes H. and Zenner M., 1996; Rau P., 2000; Golubov A., Petmezas D. and Travlos N., 2012).
A recent example of a high profile merger, is Microsoft and LinkedIn's $26.2 billion deal. Microsoft drew on investment bank giant Morgan Stanley whereas LinkedIn used the boutique investment banks Allen & Co and Qatalyst Group (See table 2). As a result of the successful merger, share owners were entitled to approximately $196 per share, roughly a 47% premium over the immediately previous trading price of $133 (See table 3).
Table 2: M&A Global League Table, Bloomberg 2017
Table 3: Graph of LinkedIn's share price before and after its merger (on June 13th 2016) with Microsoft, Bloomberg 2017
However, this increasingly lucrative business together with its high proportion of failed new acquisitions (Koi-Akrofi G., 2016) continues to attract much scepticism (Hapeslagh P. and Jemison D., 1991). Indeed, as investment banks fees rose from approximately $3 billion to $21 billion per year, between 1994 and 2007 (Becher D. and Juergens J., 2009), motives began to be questioned.
One infamous example of investment bank malpractice was the 1988 lawsuit filed against Lazard Freres & Co and Dillon, Read & Co. RJR Nabisco's shareholders accused both investment firms of being accountable for instructing the company to accept a $24 billion takeover bid of Kohlberg, Kravis, Roberts & Co. They claimed that the advisors overvalued the bid by over $1 billion and refused a better proposal from a management-led group (Labaton S., 1988; Reuters, 1989). This led to the New York State Supreme Court 1990 ruling that granted shareholders, in the eventuality of negligent misrepresentation, the right to sue investment banks contracted by the company's board (Martin M., 1991).
Initial public offerings (IPOs) are another key activity investment banks are used to advise upon. Due to their expertise in marketing services to promote and stimulate investor interest, investment banks advice can often lead to an increase in the aftermarket stock price of the IPO (Dong M., Michel J. and Ari Pandes J., 2011). Indeed, by piquing investor interest, investment banks can strengthen the investor base of the IPO, leading to improved risk sharing and liquidity as well as a higher equilibrium market price after the offer (Merton R., 1987; Booth J. and Chua L., 1996; Zhang D., 2004, Cook D., Kieschnick R. and Van Ness R., 2006). See https://www.jstor.org/stable/pdf/41237902.pdf
However, with recurring issues of conflicts of interest, this sector has also been prone to criticism. After business columnist Joe Nocera obtained eToys.com's sealed IPO documents, it was found that Goldman Sachs, who led the offering, intentionally undervalued the stock. This artificially set, low price, allowed Goldman's institutional clients to profit from the first day run-up. In return, the elite investment bank asked for a portion of the profits to be kicked back to them (Nocera J., 2013). This strategy is known as “laddering” and is argued to have become a popular tactic amongst investment banks with some such as Morgan Stanley and Merrill Lynch having been caught engaging in it with some of their investment clients (Smith R., 2003; SEC Report 2006; Jennings M., 2006). As a consequence, to ensure the separation of their private and public functions and reduce insider information, they are required to have a “Chinese Wall”, regulating the passing of information between their advisory and market divisions (Gozzi R., 2003).
When it comes to their sales and trading arms, investment banks act as pure intermediaries by facilitating the access to finance through capital markets. They connect the providers and users of funds whilst reducing informational and transactional costs (French S. and Leyshon A., 2004; Fang L., 2005). Using a process called underwriting, investment banks are able to raise capital on behalf of their corporate or governmental clients (the users of funds) by selling securities to the buying public. Here, the buying public, primarily constituted of institutional investors such as mutual, hedge or pension funds as well as insurance companies and endowments, act as the providers of funds. Through determining the value and riskiness of the client's business, the investment banks are able to informatively price, underwrite and sell the securities in the primary market, through a best efforts offering. Alternatively, they can choose a firm commitment offering whereby they agree to purchase the entire issue, at a pre-determined price, to then resell in the secondary market. The difference between these two offerings is the amount of risk the investment bank bears.
Enlisting the help of investment banks to trade securities helps clients manage and reduce their risk. Furthermore, it supports the efficient functioning of financial markets whilst complying with end-investor wishes in the real-economy (Bank of England Quarterly Bulletin, 2015).
Historically having been discernibly separate from retail banks, the repeal of the Glass-Steagall Act in 1999 caused the lines between investment and retail banks to blur. With many investment firms such as Citigroup, Barclays and UBS operating in both markets and acquiring the title of “universal banks”, investment bank's role and influence in the financial markets grew (Cogan P., 2015). Indeed, due to the sheer scale and intricate nature of investment banks activities, they are able to easily generate and propagate risk throughout the global financial system. As a consequence, the recent Financial Crisis illustrated that despite any previous measures taken to monitor the industry, there still existed regulatory blind spots.
Considered to be part of the shadow banking system, investment banks were, prior to the crisis, able to escape the stringent regulation faced by traditional depository banks. This dearth of regulation allowed them to adopt greater market, liquidity and credit risks without holding the adequate capital provisions to support these, leading to over-leveraging (Ricks M., 2012). Therefore, in order to amend the fault lines that led to the crisis, there has since been an increased implementation of regulatory initiatives like the Dodd-Frank Act (2010) and Basel III, creating lasting effects within the investment banking industry and their role as financial intermediaries. Shying away from more traditional activities such as lending and trading, leading investment firms, Deutsche bank and Credit Suisse, have since shifted their focus to “capital light” activities such as M&As and capital raising for clients (Deutsche Bank Annual Report, 2015; Credit Suisse Strategy and Objectives, 2015).
In conclusion, when investment banks ethically perform their role as financial intermediaries, they contribute to an efficient and stable financial system. However, due to the vast amount of markets they operate in, when engaging in corrupt activities, they pose an immense threat not only to the clients they serve but also to the global financial markets.
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