Essay: Investment Banking

Do you want to make money out of money? If yes, then the solution is Investment bank. To be precise, Investment bank is nothing but a bank which matches the expectations of people having the capital with people who need the capital. 1

It is a financial intermediary that specializes primarily in selling securities and underwriting the issuance of new equity shares to raise capital funds. This is different from a commercial bank, which specializes in deposits and commercial loans. It assists individuals, corporations, and governments in raising financial capital by underwriting or acting as the client’s agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities and FICC services (fixed income instruments, currencies, and commodities). Unlike commercial banks and retail banks, investment banks do not take deposits.

When a company or other organization wants to raise funds, it frequently does so by issuing and selling new securities, such as stocks or bonds. An investment bank usually helps in this process by providing expertise and customers to buy the securities. A company does not need to use an investment bank, but it usually does, because it is less costly than trying to issue and sell securities directly to the public.

An investment bank is not a bank in the usual sense. It doesn’t offer bank accounts like savings or recurring ones, nor does it make loans. In simpler terms, it is a bank which helps businesses, governments, and agencies to get financing from investors. The same thing done by regular banks is by way of lending the deposited money of Accountholders. In other words, Investment banks act as a financial intermediary for businesses and other large organizations, connecting the need for money with the source of money. In fact, the term “investment bank” is something of a misnomer. In many cases, helping companies raise capital is just one part of a much bigger operation.

Concept of Investment Banking

The main concept behind which an Investment bank revolves is to match the gap between a need of capital and availability of capital along with again matching the gap between advice seekers(client) and Advice givers(the bank).By and large, Investment banks in India are itself an institution which generates funds either by drawing public funds via the capital market or by way of venture capital or private equity.

Role of an Investment bank

As an advisor

Raising capital

Raising capital is always an important function for any business and so deciding how to raise it becomes very crucial for any company. It is the Investment bank which provides the tailor made solution. At the macro level, investment bank performs the primary function of assisting the capital market in its function of capital intermediation, i.e., the movement of finance from the investors to issuers. The sale of stocks and bonds is one of the primary ways for a company to raise capital. But executing these transactions requires special expertise, from pricing financial instruments in a way that will maximize revenue to navigating regulatory requirements. That’s where an investment bank usually comes into the picture.

Taking into account the current investing climate, the bank will recommend the best way to raise funds. This could entail selling an ownership stake in the company through a stock offer or borrowing from the public through a bond issue. The investment bank also helps to determine the pricing of these instruments. In the case of a stock offering, its financial analysts will look at a variety of different factors – such as earnings potential and the strength of the management team – to estimate how much a share of the company is worth. If the client is offering bonds, the bank will look at prevailing interest rates for similarly rated businesses to figure out how much it will have to compensate borrowers. They also track the market to determine the time of public offering and to explore the best possible way of managing the public assets of businesses. Many a times such a role seems to overlap with that of a private brokerage house.

It is very hard to demarcate a line between the investment banking and other forms of banking in India as all the banks nowadays besides their normal functions also tend to play the role of Investment bank.

Over the decades, investment banks have proved their worth by fulfilling the needs of the finance community and thus have became one of the most vibrant and exciting segment of financial services. In essence, investment banks are a bridge between large enterprises and the investor. Their main roles are to advise businesses and governments on how to meet their financial challenges and to help them procure financing, whether it be from stock offerings, bond issues or derivative products.

Merger or acquisition

The major role played by investment banks is in the field of consultancy. Investment banks also offer advice in a merger or acquisition scenario. For example, if a business is looking to purchase a competitor, the bank can advise its management team on how much the company is worth and how to structure the deal in a way that’s favorable to the buyer.Their main task is to help in organising mergers, helping target companies to develop and implement defensive tactics, helping in valuing the target company, helping in financing mergers and investing in stock of firms which are likely to merge. These M& A services are a huge source of profit for these Investment bankers.

Underwriting stocks and bonds

If an entity decides to raise funds through an equity or debt offering, one or more investment banks will also underwrite the securities. This means the institution buys a certain number of shares – or bonds – at a predetermined price and re-sells them through an exchange.

Other activities

While advising companies and helping them raise money is an important part , most Investment banks perform a number of other functions as well. In fact, most major banks are highly diversified in terms of the services they offer. Some of their other income sources include:

Research – Larger investment banks have large teams that gather information about companies and offer recommendations on whether to buy or sell their stock. They may use these reports internally but can also generate revenue by selling them to hedge funds and mutual fund managers.

Trading and Sales – Most major firms have a trading department that can execute stock and bond transactions on behalf of their clients.

Asset Management – The likes of J.P. Morgan and Goldman Sachs manage huge portfolios for pension funds, foundations and insurance companies through their asset management department. Their experts help select the right mix of stocks, debt instruments, real estate trusts and other investment vehicles to achieve their clients’ unique goals.

Wealth Management – Some of the same banks that perform investment banking functions also cater to everyday investors. Through a team of financial advisors, they help individuals and families save for retirement and other long-term needs.

Securitized Products – These days, companies often pool financial assets – from mortgages to credit card receivables – and sell them off to investors as a fixed-income products. An investment bank will recommend opportunities to “securitize” income streams, assemble the assets and market them to institutional investors.

How it works

Investment bank act as a
mediator between companies issuing securities and the buyer individuals or entities. In this respect, Investment banks operate along two main lines: a “buy” side and a “sell” side. “Buy” side operations include services such as securities trading and portfolio management. For eg. suppose an investor wants to purchase 100 shares of company XYZ. They can solicit the services of an investment bank, where a stock broker can place an order and deliver these shares.

“Sell” side activities include underwriting new lines of stock, marketing financial products, and publishing financial research. It involves trading securities for cash or for other securities. For example company XYZ plans to issue new shares of stock in an initial public offering (IPO) XYZ can solicit an Investment bank to underwrite the shares, market and sell them to their clients. This way, the investment bank raises the funds that company XYZ hopes to gain from the issue of the new shares.

Organizational structure

Front office

As far as revenue generation is concerned, it is the Front office of any Investment bank.This front office can be divided between two main areas if Investment banking which involves advising on mergers and acquisitions, as well as a wide array of fund raising strategies and markets which is divided into “sales and trading” (including “structuring”) and “research”.

Middle office

The middle office of the bank includes treasury management, internal controls and internal corporate strategy.

Corporate treasury is primarily responsible for an Investment bank’s funding, capital structure management and liquidity risk monitoring.

Internal control tracks and analyzes the capital flows of the firm, the finance division is the principal adviser to senior management on essential areas such as controlling the firm’s global risk exposure and the profitability and structure of the firm’s various businesses via dedicated trading desk product control teams.

Internal corporate strategy tackling firm management and profit strategy, unlike corporate strategy groups that advise clients, is non-revenue regenerating yet is having a key functional role within investment banks.

Back office

Although many Investment banks use to outsource it, but the back office remains a critical part of the bank involving data-checking trades to ensure their correctness and transacting the required transfers.

Technology

Every major Investment bank has considerable amounts of in-house software, created by the technology team, who are also responsible for technical support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading. Some trades are initiated by complex algorithms for hedging purposes.

Big foreign players in Indian Investment banking sector –

Many foreign investment banks are set up in India, so the banking sector in India becomes more competitive. Following are list of top investment banks in India.

-ABN-AMRO Bank

-Nomura

-The Bank of New York Mellon

-BNP Paribas Bank

-Citi Bank

-Deutsche Bank

-HSBC

-JPMorgan Chase Bank

-Goldman Sachs

-Morgan Stanley

-Barclays

List of Top Indian Investment Banks

-Bajaj Capital

-Avendus

-ICICI Securities Ltd

-Kotak Mahindra Capital Company

-SBI Capital Markets

-Yes Bank

Regulatory Framework for Investment Banking in India2

Investment Banking in India is regulating in its various facets under separate legislations or guidelines issued under statute. The Regulatory powers are also distributed between different regulators depending upon the constitution and status of Investment Bank. Pure investment banks which do not have presence in the lending or banking business are governed primarily by the capital market regulator (SEBI). However, Universal banks and NBFC investment banks are regulated primarily by the RBI in their core business of banking or lending and so far as the investment banking segment is concerned, they are also regulated by SEBI. An overview of the regulatory framework is furnished below:

-At the constitutional level, all invest banking companies incorporated under the Companies Act, 1956 are governed by the provisions of that Act.

-Investment Banks that are incorporated under a separate statute such as the SBI or IDBI are regulated by their respective statute. IDBI is in the process of being converted into a company under the Companies Act.

-Universal Banks that are regulated by the Reserve Bank of India under the RBI Act, 1934 and the Banking Regulation Act which put restrictions on the investment banking exposures to be taken by banks.

-Investment banking companies that are constituted as non-banking financial companies are regulated operationally by the RBI under sections 45H to 45QB of Reserve Bank of India Act, 1934. Under these sections RBI is empowered to issue directions in the areas of resources mobilization, accounts and administrative controls.

-Functionally, different aspects of investment banking are regulated under the Securities and Exchange Board of India Act, 1992 and guidelines and regulations issued there under.

-Investment Banks that are set up in India with foreign direct investment either as joint ventures with Indian partners or as fully owned subsidiaries of the foreign entities are governed in respect of the foreign investment by the Foreign Exchange Management Act, 1999 and the Foreign Exchange Management (Transfer or issue of Security by a person Resident outside India) Regulations, 2000 issued there under as amended from time to time through circulars issued by the RBI.

-Apart from the above specific regulations relating to investment banking, investment banks are also governed by other laws applicable to all other businesses such as – tax law, contract law, property law, local state laws, arbitration law and the other general laws that are applicable in India.

Project Finance3

Project Finance is an age old form of financing high-risk, development-oriented projects and is one of the key focus areas in today’s world because of continuous growth and expansion of the industries at a rapid rate.

It is the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. In other words, it can also be said as a loan structure that relies primarily on the project’s cash flow for repayment, with the project’s assets, rights, and interests held as secondary security or collateral. Project finance is especially attractive to the private sector because they can fund major projects off balance sheet. They are most ordinarily non-recourse loans, which are fortified by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part braced by financial modeling.

Methods of Project Financing

The various sources of finance can be broadly divided into two categories, viz. equity capital and debt capital (borrowed
capital),namely the Share capital ,Term loan, Debenture capital, Commercial banks and Bills discounting. The combination of equity and debt
should be judiciously chosen, and it varies according to the nature of the project.

Some other financing are Seed Capital which is an assistance given by way of long term interest free loan. It is provided to small as well as medium scale units promoted by eligible entrepreneurs.Along with this subsidies are also important source of finance, drawn-out by the Central as well as State Government.

Stages in Project Financing

Pre- finance stage

a)Project identification- A Project or Projects selected should be integrated with the Strategic Plan of the Organisation. The project plan should match the goals of the organization. It should be realistic to be implemented.

b) Identifying risk and minimizing- “The right project at the right time at the right place and at the right price”.There should be adequate amount of resources available for the project to be implemented.

c) Technical and Financial feasibility

An organization before starting any new project or expanding an existing one must look into analyzing each and every factor which is essential for the project to be feasible. It must be financially as well as technically feasible.

Financing stage

At financing stage, it includes arrangement of equity/debt/loan; negotiation and syndication of the same ; documentation and checking all the rules and regulations or polices relating to the starting of the project and payment.

Post Financing

Post financing includes monitoring and review of project from time to time ;Project closure which is ending of the project and Repayment and monitoring whereby the amount taken in the form of loan, equity and debt must be repaid back and proper monitoring and control of the project must be carried.

Framework and Guidelines

The borrower may have to get certain statutory and non – statutory clearances essential for the projects like techno economic clearance, pollution, environment and forest clearance, company registrations, financing and land availability/ concessions etc.

The promoter while making the application to the financial institutions records the copies of documents most vital of which are: i) copy of letter of allotment of plot/ sale deed in good turn of the borrower of the plot. ii) Detailed plan of project approved by the local body. iii) Partnership deeds/ articles of association in case of a company.

Venture Capital4

It is a type of capital more in news because of a sudden boom of startups. It is money provided by investors to startup firms and small businesses with perceived long-term growth potential. Venture capital has became very important source of funding for startups because of their non access to capital markets. It is a very high risk capital for the investor, but at the same time has the potential for above-average returns.

Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. One more reason to raise this form of capital is limited operating history of companies which cannot raise funds by issuing debt. Although it is a good source of funds for new beginners but then it allows Venture capitalists to have a say in company decisions, along with their equity share.

It is money that is provided to seed early-stage, emerging growth companies. Venture capital funds invest in companies in exchange for equity in the companies they invest in, which usually have a novel technology or business model in high technology industries, such as biotechnology and IT. The typical venture capital investment occurs after a seed funding round as the first round of institutional capital to fund growth in the interest of generating a return through an eventual exit event, such as an IPO or trade sale of the company.

To obtain venture capital is substantially different from raising debt or a loan. Lenders have a legal right to interest on a loan and repayment of the capital irrespective of the success or failure of a business. Venture capital is invested in exchange for an equity stake in the business. The return of the venture capitalist as a shareholder depends on the growth and profitability of the business. This return is generally earned when the venture capitalist “exits” by selling its shareholdings when the business is sold to another owner.

Since there are no public exchanges listing their securities, private companies meet venture capital firms and other private equity investors in several ways, including warm referrals from the investors’ trusted sources and other business contacts; investor conferences and symposia; and summits where companies pitch directly to investor groups in face-to-face meetings, including a variant known as “Speed Venturing”, which is akin to speed-dating for capital, where the investor decides within 10 minutes whether he wants a follow-up meeting. In addition, some new private online networks are emerging to provide additional opportunities for meeting investors.

This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements, which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn, this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.

Role of Venture capitalists

As a Venture capitalists ,they are very selective about their investment.The basic factors to decide an investment are innovative technology, potential for rapid growth, a well-developed business model, and an impressive management team. Of these qualities, funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing financial returns and a successful exit within the required time frame (typically 3–7 years) that venture capitalists expect.

These investments are illiquid by nature and require the extended time frame to harvest, and so a Venture capitalist should carry out detailed due diligence prior to investment. He is also expected to nurture the companies in which they invest, in order to increase the likelihood of reaching an IPO stage when valuations are favorable. Any beginner company has got four stages for development ie. Idea generation; Start-up; Ramp up and Exit and as a Venture capitalist, he has to assist at all the four stages in the company’s development.

Loan Syndication5

It is a process of involving several different lenders to provide various portions of a loan. Basically it is needed in situations where the project is unusually large or complex and the borrower requires a large sum of capital which cannot be provided by a single lender or it is outside the scope of a lender’s risk exposure levels. For example, the amount of the loan may be too large, the risks too high, the collateral may be in different locations, or the uses of capital may require special expertise to understand and manage it. In these cases, a financial institution may bring other lenders into the deal Thus under Loan syndication, multiple lenders work together to provide the borrower with the required capital , at an appropriate rate agreed upon by all the lenders.

Usually, the loan syndication limits the liability of each lender to its share of the loan interest. In t
his way, each lender limits its loan amount to a manageable size, and limits its ris
k exposure. Additionally, each lender may have a collateral interest in a unique or specialized asset from the borrower, such as a piece of equipment.

Loan syndications involve a large amount of coordination and negotiation. Typically, loan syndication involve a lead financial institution, or syndicate agent, which organizes and administers the transaction, including repayments, fees, reporting and compliance, and loan monitoring. Often, such transactions require the services of a specialist who syndicates the loan on behalf of the borrower; identifying lenders while negotiating terms and conditions, and even representing the borrower throughout disbursements. .

It can be a useful tool for banks to maintain a balanced portfolio of loan assets among a variety of industries. If one loan is too large, it may overweight the bank’s portfolio. Therefore, banks may pursue a syndication to accommodate a loan and keep its portfolio in balance. At the same time, loan syndications may incur a large expense to the borrower. While the syndication fee is usually financed, the burden of repaying the loan and syndication fee is shouldered ultimately by the borrower. Loan syndication is common in mergers, acquisitions and buyouts, where borrowers often need very large sums of capital to complete a transaction, often more than a single lender is able or willing to provide.

Leveraged Lease6

Leveraged Lease is a lease agreement that is partially financed by the lessor through a third-party financial institution. Under long-term lease , the lessor borrows most of the funds needed to acquire the asset financed from a third party, usually a bank or insurance company. The lessor makes an equity investment equal to, say, 20% of the equipment’s original cost, and borrows the remaining 80% by issuing nonrecourse notes to the lenders, and writes a noncancellable lease for the equipment. The lessor makes an assignment of the lease and lease rental payments to the lender, who is entitled to repossess the asset if the lessee happens to default. A leveraged lease is a true lease for tax purposes, because the lessor, as owner of the asset, is entitled to all of the tax benefits of ownership, including accelerated depreciation write-offs, deduction of interest payments on the bank loan, and the investment credit, if any, for purchase of the asset. Banks write leveraged leases for their own customers through the leasing subsidiary of a bank holding company.

The term may also refer to a lease agreement wherein the lessor, by borrowing funds from a lending institution, finances the purchase of the asset being leased.In a leveraged lease, the lending company holds the title to the leased asset, while the lessor creates the agreement with the lessee and collects the payment. The payments are then passed on to the lender. After the agreement, of a leveraged lease, if the lessee stops making payments to the lessor, then the lessor stops making payments to the financial institution (lender). This allows the lender to repossess the property. The lessor may also have the right to retain the property upon lessee default, as long as the lessor continues making payments to the lender.

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Islamic Banking

Islamic banking ,although a new term in India is not a new one globally. The first Islamic bank was founded in Egypt in 1963, and since then, the phenomenon has grown slowly but steadily.7Islamic banking refers to a system of banking based upon the principles of the Sharia (Islamic rulings) which prohibits the payment or acceptance of interest charges (riba) for the lending and accepting of money. Most of the principles of Islamic banking have got global acceptance and are not a completely new one. Islamic finance was practiced predominantly in the Muslim world throughout the Middle ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife’s trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions.

Principles of Islamic banking 8

Prohibition of Interest or Usury

Quran is the source for principles of Islamic finance and the followers of Islam believe them to be the exact words of God as revealed to the Prophet Mohammed. These Islamic principles of finance can be narrowed down to four individual concepts.

According to the first concept, both the charging and the receiving of interest are strictly forbidden. This is commonly known as Riba or Usury. Money, on its own, may not generate profits. When Riba infects an entire economy, it jeopardises the well-being of everyone living in that society. When investors are more concerned with rates of interest and guaranteed returns than they are with the uses to which money is put, the results can only be negative.

Ethical Standards

The second guiding principle for Islamic banking is based on ethical aspects. According to which Muslims have the religious duty to ensure the goodness and wholesomeness of their investment. This is the reason that Islamic investment always considers the kind of business for investing money, its policies, the products and services it provides, and the impact that these have on society and the environment.

Moral and Social Values

The third guiding principle reflects the moral and social values. The Quran has high thoughts for the poor and destitute and Islamic financial institutions are expected to provide special services to those in need. And so, it is not confined to mere charitable donations but also talks about profit-free loans or Al Quard Al Hasan for certain social projects, where an individual,if needs to go to hospital or wants to go to university, is given interest free loan, what is called Quard Al Hasan.

Liability and Business Risk

The final principle is based on the idea of both the parties sharing in the risk and profit of any endeavor. If an Investor wants a return, he must either accept business risk or provide some service such as supplying an asset. If not so, according to Sharia,it is sin on part of investor. The roots of this principle lies in a saying of the Prophet Mohammed that “Profit comes with liability” which simply means that one becomes entitled to profit only when one bears the liability, or risk of loss. By linking profit with the possibility of loss, Islamic law distinguishes lawful profit from all other forms of gain.

Islamic Banking in Kerala

Major issues and constraints in Islamic banking 9

In the straitjacket world of Indian banking, something as fascinating as Islamic Banking is a distant dream. The major issues and constraints involved in Islamic Banking are mentioned herein below:

Deposits with RBI

The conventional banks in India have to maintain deposit account with the RBI over which they get interest and they have to maintain Statutory liquidity ratio as well. Banks have to invest a fixed percent of demand and time liability in instruments for SLR. These instruments are unencumbered securities like government securities, bonds issued by NABARD,. IFCI, SIDBI, NHB, Government approved securities which are interes
t based. Since Islamic banks cannot observe conditions as mentioned above they cannot
be member of clearing system and cannot issue cheques and therefore they cannot be listed as scheduled bank.

Lender’s in last resort

A conventional bank after taking license by the RBI is a part of the monetary system and it helps deposit generation through acceptance of money. Since these assets in the form of deposits are interest based, Islamic bank cannot hold them. Besides, if Islamic banks have to accept deposits or borrow funds, they have to participate in interest based banking, which is again forbidden. The end result is that the RBI cannot act as the lender in last resort for them because such accommodation by RBI is also interest based.

Inability to maintain capital adequacy

Another constraint for Islamic banks in the conventional banking system is the inability to maintain capital adequacy .Since Islamic bank will have to maintain a fixed percentage of Capital Adequacy Ratio, they will have to raise through equity capital as well as through bonds for 2nd tier capital which goes partly against Shariah

Dealing with mega projects

Conventional banks because of their large scale of operation have the ability to deal with mega projects and are better equipped for long term lending and project appraisals.On other hand ,Islamic banking concentrates more on short-term and medium-term operations because of their structure. Most such banks are ill equipped to handle a big responsibility because of the smallness of their operations.

Priority sector finance

Priority sector finance on micro level cannot be extended to 200 Million borrowers based on Profit Sharing. But this is mandatory requirement and it is interest based.

Legal framework & Tax Procedures

India’s present laws obstruct the establishment of Islamic banking. Under section 5(b) of Banking Regulation Act 1949 it prohibits the operation of banks on a profit-loss basis. Section 8 forbids murabaha, or, the buying, selling, or barter of goods ,Section 9 impedes ijara, or, bars the holding of immovable property for a period greater than seven years and section 21 requires the payment of interest. Since conventional banking system is an interest based system having all the banking products based on interest mechanism, Islamic banking cannot be performed in India under the present legal framework because except current account, no other banking product in India can be modified to meet the conditions of Islamic Banking. Another important consideration is the taxation system. Although interest as well as profit are income, but the former is a passive income, while later is an earned income and there is different tax treatment for both of them. According to principles of Islamic Banking ,it is not possible to comply with the tax procedure.