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The Rise of Investment Banking in the Last 3 Decades

The Rise of Investment Banking

Investment Banking has offered one of the best paid jobs and it’s questionable whether the Bankers did enough for the kind of money they got. Since the beginning of civilization, there have been borrowers and lenders going to intermediaries who operated as individuals, family business to bring together the borrowers and lenders. It used to be more local region-centric operation. Then Commercial Banks started as bigger organizations taking deposits and offering loans. Investment Banks came into existence in 18th / 19th century. The Investment Banking business grew with continuous financial innovation (notably derivatives and securitisation in the last 3-4 decades), geographical expansion and establishment of capital markets (stock markets for example). By some estimates, the Financial Services Industry had grown to account for almost 40% of American corporate profits in 2007. To put things in perspective, in the last decade, we can compare this $300,000 bankers’ average annual salary with US national average salary of around $35,000. Bankers tend to earn almost 9 times than that of an average employee in US, the most developed country, leading to a huge divide between rich and average household. And above all, do Bankers have a product; do they add enough into the economy, are they really worth what they get paid for? These questions will often be discussed and argued over. Another interesting thing is that even if stock markets (a good indicator of financial markets) go down, bankers still tend to make money. This is demonstrated in the graph below where theUSstock markets Index S&P500 returns have been depicted along with bankers’ average salary over the same period of time.

When S&P returns were negative in years 2001, 2002, 2008, bankers’ compensation fell slightly, but was still positive and way higher than the average national income. Another example proving the same as above is the Japanese market. Japanese growth has been very slow and even negative in the most of past 20 years or so, but nevertheless Investment Banks have been making sizeable revenues in Japanese market. Also, the other financial institutions pay hefty salaries to their employees. Hedge Funds are also known for compensating well their staff.

Rise of derivatives

Derivatives are financial instruments whose value changes in response to the changes in certain underlying variables. The main types of derivatives are futures, forwards, options, and swaps. Derivatives’ trading in different form has been happening for hundreds of years; betting is a good example. In finance, a futures contract is a standardized contract, traded on a futures exchange (or with another counterparty), to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security, or in a futures contract. In other words, the holder does not have to exercise this right, unlike a forward or future.

Since the discovery of Black Scholes Options pricing model (not going into details here) and improved risk management, derivatives usage has grown significantly in capital markets. After Futures and Options, the next derivative that became quite actively traded in the market was Interest Rate Swaps.

A swap is a contract between 2 entities in which one pays a fixed rate, and the other pays a variable rate. This helps counter the risk of uncertainty (for example for institutions who do not want to be exposed to Central Government’s variable interest rates). Financial innovation led swaps to an interesting and useful level (like Credit Default Swaps which were developed over the last decade or so). The one key problem with Swaps has been that its trading has grown to trillions of dollars, but it’s not transparent. It’s held between 2 counterparties and rest of the market and regulators in most cases are not necessarily aware of this.

Nevertheless, they have been vital in financial markets development. Derivatives have helped the Rise of Capital Markets, Investment Banking and operations of various Companies. They can be used as a great hedging tool by companies and institutions, as well as for betting to make profits by financial institutions. For example, an airline company might want to know how much it would pay for Oil price in few months time, Oil Futures help such a price discovery and help the airline company to fix the airfares which the customers can use to buy their tickets today, even up to several months later. Another example could be if a company operates ski resorts and relies on natural snowfall, it could lose out in its business in case of less or no snowfall. It can chose to hedge this risk, by entering into a weather derivative issued by most likely an Investment Bank in which the Bank would pay the ski resort a certain amount if there is low or no snowfall, and the company would pay the Bank a premium for issuing such a derivative. This is an extreme example in which the Derivatives have been used lately. Use of derivatives in the financial markets has grown significantly over the past few decades and has led to greater revenues for several financial firms.

Rise of Leverage

Leverage is an important concept in finance and is worth understanding. Leverage means borrowing to increase the return on investment. For leverage to be profitable, the cost of borrowing must be lower than the return expected from the investment. Taking a simple example, if an individual has $100 in cash and wants to buy a share that costs $100 and is expected to go up in value within a year to $110, the individual can buy 1 share and make $10 after a year. If on the other hand, the individual can borrow $1000 in cash and the cost for borrowing for a year is 5% i.e. after a year the individual will have to return $1050 ($1000 +5% of $1000). If the return on the share is the same as before, the individual can invest and buy 11 shares and make $110 (11*10). Hence net profit to the individual becomes $60 ($1110 – $1050) by the leverage of 10 times (borrowing $1000 against his own $100). It’s also worth understanding the increased risk in such leveraged transaction. If the stock price falls to around $90 in a year, then the individual will lose its original $100. If the stock falls more in value than $90, then the bank or institution who borrowed this money to the individual could lose part of its amount. Hedge Funds are good examples of such leverage investors, who borrow from Investment Banks to invest in the financial markets. This is an important risk factor that is analyzed carefully by Investment Banks acting as Prime Brokers for Hedge Funds. This is what makes Hedge Funds investments risky. Leverage within the financial system (within investment banks, hedge funds, etc.), as well as the economy (like leveraged companies, leveraged individuals with several loans and mortgages) has widely been attributed as an important reason behind the Credit Crisis. This leverage concept applies to Global economy and has grown significantly over the past few decades. Most Investment Banks by the end of 2007 were levered between 25 to 30 times of their own capital (In 2004, SEC in US removed rules that capped leverage at 15 for investment banks). Most Hedge Funds were leveraged between 3-10 times in the previous decade. Many corporations were also leveraged between 2-5 times. Higher leverage across the economy implies

  • More financing opportunities for Investment banks

  • More financial transactions, hence more Transaction fees for Investment banks

  • More inherent leverage within Investment Banks meant they could take more risks, and do more business; thereby making more revenues.

Rise of Securitisation

Securitization has been the one of the most important financial innovations that has helped reduce cost of financing several businesses, spread out the financial risks through intermediation and get investors better return for their investments. It significantly improved the functioning of global economy by allowing more individuals to receive mortgages, credit cards, study loans, etc. Securitization, simply put is the process of creation of financial securities. The Investment Banks are also called Securities houses because of this security creation process that they undertake. Creating Shares and Bonds as securities has existed for decades. But creating securities with cash-flows or mortgages or related and other assets as underlying was primarily started in early 1980s.

Securitization explained

Imagine that an Investment Bank could originate 3 loans for example as shown below, $100,000 each, and then issue 2 bonds worth $150,000 each. The monthly interest paid by A, B and C could be distributed to D and E. A, B and C would pay the interest on the mortgage that would be passed on to the D and E as the coupon payment on the bonds purchased by them.

The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply to be to “split it”. For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00% for example (with the remaining .50% going to the servicing company to send out the monthly bills and perform servicing work). This example depicted above is a simpler example explaining the securitisation process. In reality, this gets divided into several layers. Consider an example in which there are several banks or mortgage houses giving out loans and mortgages, they can pass on all these positions to an Investment Bank who will help securitize these loans by underwriting bonds and selling them to the investors as shown below.

Loans in reality are cash-flow products in which the loan interest acts as a cash flow to the bondholder. Securitization could be applied to individual loans, mortgages, credit card balances, any cash-flow related activities etc.

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