The Issuance of New Securities
Issuing and marketing new securities is a very complex proposition, and this is also a highly specialized business proposition. So rather than conduct these transactions themselves, institutions turn this over to investment banks to perform these duties for them.
Aside from the complexities involved in bringing these issues to the market, there is a lot of paperwork involved, things like writing prospectuses and filing the proper documents with regulatory agencies. Regulators understand this and require that these new issues be handled by accredited investment banks, so everyone is on board with this method of doing it and it is a necessity.
So there is a lot of research involved, and investment banks specialize in this sort of research, and one of the several other things they do is provide investment research, both for their own investment as well as for the benefit of mutual fund and hedge fund managers, which they sell the information to.
Aside from all the analysis and number crunching, and predictions that are involved in new stocks or bonds, investment banks also play the role of intermediary. Companies for instance don’t sell their stocks directly to investors, even large ones, they are in the business of something else, and the investment bank is in the business of distributing stocks and bonds so they are hired to serve that function.
In doing so, the bank will take on part or all of the risk involved, as this involves setting a target price and often purchasing the securities from the issuer for that price, to be sold on the market. It needs to be sold at a high enough price for the bank to show a profit, and depending on the demand for it, and how well they have done their homework, they may even have to sell it at a lower price than they paid for it.
In some cases, the issuer has to take on part of the risk themselves, but the banks do bear at least part of this themselves, and often will form a syndicate of investment banks with an issue, all bearing part of the risk and all distributing part of the stock or bond issue.
Banks don’t mind working together here because it does make the affair less risky for them and the risk with these transactions is pretty significant, especially when you’re talking about transactions in the billions of dollars.
It’s not just a matter of whether they have overpriced it, market risk also can play a big role, for instance a downturn in the market generally from the time they priced it to when it becomes sold to investors.
This is especially the case with stocks, but this can even affect bonds, which are less market sensitive than stocks due to lower volatility but still have this risk present. During down markets, there is less demand for the type of security in general, as evidenced by the very fact that a down market is present, and this means that the price obtained will often be lower than it otherwise would have been.
The potential for all risks needs to be factored into the equation though, and there are several types of risks with pricing investments, and this is a big reason why investment banks handle these transactions. It may seem like having syndicates handle these deals would restrict competition, but this is offset at least somewhat by having more interest in the deals from keeping the risks in line with the risk appetites of banks, and in practice, banks teaming up may even make the market for new issues more rather than less efficient, by having more rather than less competition for an issue then may be the case if banks had to bear the entire burden themselves.
Other Functions of Investment Banks
Investment banks also trade their own capital, called proprietary trading. In order to prevent a conflict of interest between a bank’s own interest with their funds and the interests of those whose funds they are managed, regulations serve to separate these functions in something known as the “Chinese Wall.” In other words, there is a firewall between a bank’s own trading interests and those of their clients, to an acceptable degree anyway.
Regulators have had a preference for separating investment banks and retail banks, and for instance legislation in the U.S. prohibited a bank from serving both markets, although this has been eased. Investment banks now provide wealth management services to individuals as well as institutions, and some retail banks in the U.S. now offer investment banking as well, as has been customary for a long time in several other countries.
Institutions still comprise the bulk of an investment bank’s business, and they manage some huge portfolios for them, dealing with hedge funds, mutual fund companies, foundations, government agencies, pension funds, and other big volume players in the investment world.
Investment funds also will package derivatives, particularly those that deal with the repackaging of debt. This does serve to add liquidity to these debt products, which include things like mortgages, loans, credit card debt, interest rate swaps, and other financial securities that involve debt instruments.
The idea here is to take these income streams, from debt as well as from things like real estate, and spread the risk through the combining of this debt, so that a certain percentage of defaults for instance won’t impact one’s holdings like if you held the entire debt. They are still subject to considerable market risk though, like a downturn in the housing market or a recession, but provided that the risks are transparent, this should not be an issue.
However, with the mortgage backed securities problem that we recently saw during the so called great recession of late, many investors had the perception that these securities were considerably less risky then they were, and only learned of their true risk when the bottom fell out. Many investment banks underestimated this risk as well, and this caused the death Lehman Brothers, and almost took down Bear Stearns, both among the largest investment banks in the world.
Investment banks also provide liquidity to trading by serving as market makers. Banks buy securities to be sold later, often very soon afterward, and this serves to make it easier to buy and sell the securities. The need for this goes back to floor trading, where an intermediary was necessary to ever do a trade, as individual investors did not have the means to interact with one another, and that’s what the exchange floor and exchange traders were for.
A lot of securities are still traded on exchange floors though, and even with electronic trading, banks will still play a role, and banks will actually pursue every opportunity here, and even engage in computerized trading that may only hold stocks for as little as fractions of a second to get a little edge on trades.
So investments do far more than just underwrite new securities, although that’s still a large part of their business and revenue. We’ve moved more and more away from this in the last while though and investment banks are well diversified and are well leveraged to use their investment expertise to assist in many processes and transactions that form the investment experience.