INVESTMENT BANKING

INVESTMENT BANKING

INDEX

Sr. No Topic Page No.

1. Executive Summary 1

2. Introduction 2

3. Investment Banking and Merchant Banking

Distinguished

4

4. Evolution of American Investment Banks 6

5. European Investment Banks 10

6. Global Industry Structure 12

7. Business Portfolio of Investment Banks 13

8. The Indian Scenario 15

9. Characteristics and Structure of Indian Investment

Banking Industry

19

10. Service Portfolio of Indian Investment Banks 23

11. Interdependence between Different Verticals in

Investment Banking

29

12. Regulatory Framework for Investment Banking 31

13. Regulatory Framework for Merchant Banking 35

14. Anatomy of Some Leading Indian Investment Banks 38

15. Recent Trends in Investment Banking 51

16. The Conflict of Interest Issue 56

17. Conclusion 60

1

2

EXECUTIVE SUMMARY

1

Introduction

At a very macro level, ‘Investment Banking’ as the term suggests, is

concerned with the primary function of assisting the capital market in its

functions of capital intermediation, i.e. the movement of financial resources

from those who have them (the Investors), to those who need to make us of

them for generating GDP (the Issuers). As already discussed banking and

financial institutions on the one hand and the capital market on the other are

the two broad platforms of institutional intermediation for capital flows in

the economy. Therefore, it could be inferred that investment banks are those

institutions that are the counterparts of banks in the function of

intermediation in resource allocation. Nevertheless, it would be unfair to

conclude so, as that would confine investment banking to a very narrow

sphere of its activities in the modern world of high finance. Over the

decades, backed by evolution and also fuelled by recent technological

developments, investment banking has transformed repeatedly to suit the

needs of the finance community and thus become one of the most vibrant

and exciting segment of financial services. Investment bankers have always

enjoyed celebrity status, but at times they have paid the price for excessive

flamboyance as well.

To continue from the above, in the words of John F. Marshall and M.E.

Ellis, ‘investment banking is what investment banks do’. This definition can

be explained in the context of how investment banks have evolved in their

functionality and how history and regulatory intervention have shaped such

as evolution. Much of investment banking in its present form thus owes its

2

origin to the financial market in USA, due to which, American investment

banks have been leaders in the American and Euro markets as well.

Therefore, the term ‘investment banking’ can arguably be said to be of

American origin. Their counterparts in UK were termed as ‘merchant banks’

since they had confined themselves to capital market intermediation until the

US investment banks entered the UK and European markets and extended

the scope of such businesses.

3

Investment Banking and Merchant Banking Distinguished

At this stage, it would be relevant therefore, to draw a fine line of distinction

between the terms ‘Investment Banking’ and ‘Merchant Banking’ as both

these terms are extensively used in this project. ‘Merchant Banking’ as the

term suggests, is the function of intermediation in the capital market. It

consists of assisting issuers to raise capital by placement of securities issued

by them with investors. However, merchant banking is not merely about

marketing securities in an agency capacity. The Merchant Banker has an

onerous responsibility towards the investors who invest in such securities.

The regulatory authorities require the merchant banking firms to promote

quality issues, maintain integrity an ensure compliance with the law on own

account and on behalf of the issuers as well. Therefore, merchant banking is

a fee based service management of public offers; popularly know as ‘issue

management’ and for private placement of securities in the capital market. In

India, the Merchant Banker leading a public offer is also called as the ‘Lead

Manager’.

On the other hand, the term, ‘Investment Banking’ has a much wider

connotation and is gradually becoming more of an inclusive term to refer to

all types of capital market activity, both fund-based and non-fund based.

This development has been driven more by the way the American

investment banks have evolved over the past century. Given this situation,

investment banking encompasses not merely merchant banking but other

related capital market activities such as –stock trading, market making,

underwriting, broking and asset management as well. Besides the above,

4

investment banks also provide a host of specialized corporate advisory

services in the areas of project advisory, business and financial advisory and

mergers and acquisitions. The activity profile of investment banks is

discussed in more in detail later in this chapter.

5

Evolution of American Investment Banks

The earliest events that are relevant for this discussion can be traced to the

end of World War I, by which time, commercial banks in the USA were

already preparing for an economic recovery and consequently, to the

significant demand for corporate finance. It was expected that American

companies would shift their dependence from commercial banks to stock

and bond markets wherein funds were available at a lower cost and for

longer periods of time. In preparation for a boom in the capital markets in

the 1920s, commercial banks started to acquire stock broking businesses in a

bid to have their presence made in such markets. The first of such

acquisitions happened when the National City Bank of New York acquired

Halsey Stuart and Company in 1916. As in the past, in the entire 1920s,

investment banking meant underwriting and distribution of securities.

The stock and bond market boom in 1920s was as opportunity that banks

could not miss. But since they could not underwrite and sell securities

directly, they owned security affiliates through holding companies.

However, they were not maintained like water tight compartments. The

affiliates were sparsely capitalized as were financed by the parent banks for

their underwriting and other business obligations. While the boom lasted,

investment banking affiliates made huge profits as underwriting fees,

specially in the segment called ‘Yankee Bonds’ issued by overseas issuers in

US market. In the stock market, the banks mainly conducted broking

operations through their subsidiaries and lent margin money to customers.

But with the passage of the McFadden Act in 1927, bank subsidiaries began

6

underwriting stock issues as well. National City Bank, Chase Bank, Morgan

and Bank of America were the most aggressive banks present at that time.

The stock market got over-heated with investment banks borrowing money

from the parent bank in order to speculate in the bank’s stock, mostly for

short selling. Once the general public joined the frenzy, the price-earning

ratios reached absurd limits and the bubble eventually burst in October 1929

wiping out millions of dollars of bank depositors’ funds and bringing down

with it banks such as Bank of United States/

In order to restore confidence in the banking and financial system, several

legislation measure were proposed, which eventually led to the passing of

the Banking Act 1933 (popularly know as Glass-Steagall Act) that restricted

commercial banks from engaging in securities underwriting and taking

positions or acting as agents for others in securities transactions. These

activities were segregated as the exclusive domain of investment banks. On

the other hand, investment banks were barred from deposit taking and

corporate lending, which were considered the exclusive business of

commercial bank. The Act thus provided the water tight compartments that

were needed before. Since the passing of this Act, investment banking

became narrowly defined as the basket of financial services associated with

the floatation of corporate securities, i.e. the creation of primary market for

securities. It was also extended to mean at a secondary level, secondary

market making through securities dealing.

By 1935, investment banking became one of the most heavily regulated

industries in USA. The Securities Act, 1933 provided for the first time the

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preparation of offer documents and registration of new securities with the

federal government. The Securities Exchange Act, 1934 led to the

establishment of the Securities Exchange Commission. The Maloney Act of

1938 led to the formation of the NASDAQ, the Investment Company Act,

1940, which brought mutual funds within the regulatory ambit and the

Investment Advisers Act, 1940 which also regulated the business of

investment advisers and wealth managers.

After the passing of the Glass-Streagall Act of the 1930s, until the beginning

of the 21st century, investment banking had been through several phases of

transformation which had broken down the water tight compartments to a

great extent. Due to the 1973 Arab oil embargo, world economies were

under pressure and inflation and interest rate volatility became disturbing. It

was at this time that institutional investors madder their advent into

securities markets. It was also the time when the industrial and financial

service sectors were beginning to expand and globalize. Due to these

developments, investment banking and commercial banking once again

became constrained by the very legislation that was meant to clean up the

system in the 1930s. This led to several relaxations over the years such as

the Securities Acts Amendments, 1975 which had permitted commercial

banks to have subsidiaries (called section 20 subsidiaries) that were allowed

to underwrite and trade in securities. In 1990, J.P. Morgan was the first bank

to open a section 20 subsidiary. Since the Glass-Streagall Act did not apply

to foreign subsidiaries of US banks, they continued to underwrite in the

Eurobond market and by 1984, they had a 52% market share in that

business. But there was stiff competition from Japanese banks in this market

and by 1987, they underwrote only 25% of the Eurobond issuances.

8

During the economic growth and globalization of the 1980s, investment

banking expanded to several new areas and services which had included

currency trading, real estate, financial futures, bridge loans, mortgage-

backed securities and several others. But the stock market crash of 1987

once again brought the focus back to core areas of specialization. Similarly,

the ambitious expansion that took place on a global scale was also halted to

some extent. However due to technological advancements in the 1990s and

the availability of global access through the revolution in communication

technologies fuelled the global growth again. But this time though,

investment banking is no more restricted to underwriting new issuances and

security dealing. The shift is more towards providing expertise in new

products and risks. Apart from these activities, investment banking also

encompasses a considerable spectrum of advisory services in the areas of

corporate restructuring, mergers and acquisitions and LBOs, fund raising

and private equity. On the dealing and trading side, investment banks

participate in derivatives market, arbitrage and speculation. In the area of

structured finance, investment banks also provide financial engineering

through securitization deals and derivative instruments.

9

European Investment Banks

In continental Europe (excluding UK), the concept of a ‘Universal Bank’

had been the undercurrent since the late nineteenth century, when most of

these banks were set up. The term ‘universal banking’ meant the co-

existence of commercial banking (lending activity) along with investment

banking (investment and distribution activity). Their universality was in the

sense of harnessing the vast retail customer base that these banks enjoyed to

market security issuances by their investment banking arms. These issues

were mostly in the local markets designated in the local currencies. France’s

Banques d’affiars and Germany’s Universalbanken are good examples.

The United Kingdom, which is considered as Europe’s largest investment

banking market, had its own structure evolved from history. The oldest

merchant bank in London was Barings Brothers which had played a

prominent role in the nineteenth century. Securities distribution was the

function of stock brokers, secondary market trading was held by jobbers and

advisory services were provided by merchant bank. The term ‘merchant

bank’ was evolved so as to distinguish between commercial banks and those

that provided capital market advice. However, the breaking down of such

barriers in 1986 by allowing banks to own broking outfits led to a

consolidation and most of the broking firms got absorbed by larger and

diversified entities. Around the same time, the US too was witnessing the

disappearance of distinction between pure broking entities restricted to the

secondary markets and investment banking entities involved with the

primary markets. The US investment banks with their integrated global

business model entered UK and Europe and later into Japan. The

10

introduction of the Euro currency in 1999, helped the US invasion further by

neutralizing the local currency advantages enjoyed by European universal

banks. By 2001, the US bulge group garnered 29.7% of the investment

banking fee generated in Europe as compared to 16.3% by the European

universal banks.

Post-1986, the merchant banks and commercial banks in UK could not

match up to the US onslaught which ultimately led to the sale of SG

Warburg, the merchant bank to Swiss Bank Corporation (which was

acquired by UBS later) in 1995. In 1997, Natwest Bank and Barclays Bank

exited investment banking business. Morgan Grenfell, a merchant bank was

sold to Deutsche Bank in 1990. In this upheaval, niche players such as

Drexel Burnham and Barings Bank also collapsed with internal deficiencies.

This led to cross border M&A between European banks inter-se and their

American counterparts to create bigger investment banks. UBS Warburg

was born out of merger of UBS and Swiss Bank Corporation which had

earlier acquired SG Warburg. Deutsche Bank acquired Bankers Trust.

11

Global Industry Structure

The investment banking industry on a global scale is oligopolistic in nature

ranging from the global leaders (known as the ‘Global Bulge Group’) to

‘Pure’ investment banks and ‘Boutique’ investment banks. The bulge group

consisting of eight investment banks has a global presence and these firms

dominate the league tables in key business segments. The top ten global

firms in terms of their fee billing as in 2001 are listed in Table

Within the listing given in the table referred to above are the top ‘pure’

investment banks, i.e. which do not have commercial banking connections,

which are Merrill Lynch, Goldman Sachs and Morgan Stanley Dean Witter.

Listed therein are also the leading European Universal Banks that are called

so due to their role in both commercial and investment banking. The five

leading universal banks in the world and their important group affiliates are

given in Table

Therefore, the global investment banking industry ranges form the

acknowledged global leaders to a larger number of mid-sized competitors at

a national or regional level and the rear end is supported by boutique firms

or advisory and sectoral specialists.

12

Business Portfolio of Investment Banks

Globally, investment banks handle significant fund-based business of their

own in the capital market along with their non-fund service portfolio which

is offered to clients. However, these distinct segments are handled either on

the same balance sheet or through subsidiaries and affiliates depending upon

the regulatory requirements in the operating environment of each country.

All these activities are segmented across three broad platforms –equity

market activity, debt market activity and merger and acquisition (M&A)

activity. In addition, given the structure of the market, there is also a

segmentation based on whether a particular investment bank belongs to a

banking parent or is a stand-alone pure investment bank. Figure represents

the broad spectrum of global investment acitivity.

From this diagram, it may be appreciated that investment banking

encompasses a wide area of capital market based businesses and services

and has a significant financial exposure to the capital market. Though

investment banks also earn a significant component of their income from

non-fund based activity, it is their capacity to support clients with fund-

based services, which distinguishes them from pure merchant banks. In the

US capital market, investment banks underwrite issues or buy them outright

and sell them later to retail investors thereby taking upon themselves

significant financial exposure to client companies. Besides, being such large

financial power houses themselves, the global investment banks play a

major role as institutional investors in trading and having large holdings of

capital market securities. As dealers they take positions and make a market

for many securities both in equity and derivative segments. They hold large

13

inventories and therefore influence the direction of the market. Goldman

Sachs, Salomon Brothers, Merrill Lynch, Schroeders, Rothschild and other

significant Market Investors both on their own account and on behalf of the

billions dollars of funds under their management.

The global mergers and acquisitions business is very large and measures up

to trillions of dollars annually. Investment banks play a lead advisory role in

this booming segment of financial advisory business. Besides, they come in

as investors in management buy-outs and management buy-in transactions.

On other occasions, wherein investment banks manage private equity funds,

they also represent their investors in such buy-out deals.

In the case of universal banks such as the Citigroup or UBS Warburg, loan

products form a significant part of the debt market business portfolio. Pure

investment banks such as Goldman Sachs, Merrill Lynch and Morgan

Stanley Dean Witter do not have commercial banking in their portfolio and

therefore, do not offer loan products. Besides the larger firms, there are a

host of other domestic players present in each country and mid-sized

investment banks, which either specialize in local markets or in certain

product segments.

Some investment banks in the overseas markets also specialize in niche

segments such as –management of hedge funds, bullion trade, commodity

hedges, real estate and other exotic markets.

14

The Indian Scenario

Origin

In India, though the existence of this branch of financial services can be

traced to over three decades, investment banking was largely confined to

merchant banking services. The forerunners of merchant banking in India

were the foreign banks. Grindlays Bank (now merged with Standard

Chartered Bank in India) began merchant banking operations in 1967 with a

license obtained from the RBI followed by the Citibank in 1970. These two

banks were providing services for syndication of loans and raising of equity

apart from other advisory services.

It was in 1972, that the Banking Commission Report asserted the need for

merchant banking services in India by the public sector banks. Based on the

American experience which led to the passing of the Glass-Streagall Act, the

Commission recommended a separate structure for merchant banks so as to

distinct them from commercial banks and financial institutions. Merchant

banks were meant to manage investments and provide advisory services.

Following the above recommendations, the SBI set up its merchant banking

division in 1972. Other banks such as the –Bank of India, Central Bank of

India, Bank of Baroda, Syndicate Bank, Punjab National Bank, Canara Bank

also followed suit to set up their merchant banking outfits. ICICI was the

first financial institution to set up its merchant banking division in 1973. The

later entrants were IFCI and IDBI with the latter setting up its merchant

15

banking division in 1992. However, by the mid eighties and early nineties,

most of the merchant banking divisions of public sector banks were spun off

as separate subsidiaries. SBI set up SBI Capital Markets Ltd. in 1986. Other

such banks such as –Canara Bank, BOB, PNB, Indian Bank and ICICI

created separate merchant banking entities.

16

Growth

Merchant banking in India was given a shot in the arm with the advent of

SEBI in 1988 and the subsequent introduction of free pricing of primary

market equity issues in 1992. However, post 1992, the merchant banking

industry was largely driven by issue management activity which fluctuated

with the trends in the primary market. These have been phases of hectic

activity followed by a severe setback in business. SEBI started to regulate

the merchant banking activity in 1992 and a majority of the merchant

bankers who registered with SEBI were either in issue management or

associated activity such as underwriting or advisorship. SEBI had four

categories of merchant bankers with varying eligibility criteria based on

their networth. The highest number of registered merchant bankers with

SEBI was seen in the mid-nineties, but the numbers have dwindled since,

due to the inactivity in the primary market. The number of registered

merchant bankers with SEBI as at the end of March 2003 was 124, from a

peak of almost a thousand in the nineties. In the financial year 2002-03

itself, the number decreased by 21.

17

Constraints in Investment Banking

Due to the over dependence on issue management activity in the initial

years, most merchant banks perished in the primary market downturn that

followed later. In order to stabilize their businesses, several merchant banks

diversified to offer a broader spectrum of capital market services. However,

other than a few industry leaders, the other merchant banks have not been

able to transform themselves into full service investment banks. Going by

the service portfolio of the leading full service investment banks in India, it

may be said that the industry in India has seen more or less similar

development as its western counterparts, though the breadth available in the

overseas capital market is still not present in the Indian capital market.

Secondly, due to the lack of institutional financing in a big way to fund

capital market activity, it is only the bigger industry players who are in

investment banking. The third major deterrent has also been the lack of

depth in the secondary market, especially in the corporate debt segment.

18

Characteristics and Structure of Indian Investment Banking

Industry

Investment banking in India has evolved in its own characteristics structure

over the years both due to business realities and the regulatory regime.

On the regulatory front, the Indian regulatory regime does not allow all

investment banking functions to be performed under one entity for two

reasons–(a) to prevent excessive exposure to business risk under one entity

and (b) to prescribe and monitor capital adequacy and risk mitigation

mechanisms. Therefore bankruptcy remoteness is a key feature in structuring

the business lines of an investment bank so that the risks and rewards are

defined for the investors who provide resources to the investment banks. In

addition, the capital adequacy requirements and leveraging capability for

each business line have been prescribed differently under relevant provisions

of law. On the same analogy, commercial banks in India have to follow the

provisions of the Banking Regulation Act and the RBI regulations, which

prohibit them from exposing themselves to stock market investments and

lending against stocks beyond certain specified limits.

Therefore, Indian investment banks structure their business segments in

different corporate entities to be able to meet regulatory norms. For e.g. it is

desirable to have merchant banking is a separate company as it requires a

separate merchant banking license from the SEBI. Merchant bankers other

than banks and financial institutions are also prohibited from undertaking

any other business other than that in the securities market. However, since

19

banks are subject to the Banking Regulation Act, they cannot perform

investment banking to a large extent on the same balance sheet. Asset

management business in the form of a mutual fund requires a three-tier

structure under the SEBI regulations. Equity research should be independent

of the merchant banking business so as to avoid the kind of conflict of

interest as faced by American investment banks. Stock broking has to be

separated into a different company as it requires a stock exchange

membership apart from SEBI registration. A complete overview of the

regulatory framework for investment banking is furnished later.

Investment banking in India has also been influenced by business realities to

a large extent. The financial services industry in India till the early 1980s

was driven largely by debt services in the form of term financing from

financial institutions and working capital financing by commercial banks

and non-banking financial companies (NBFCs). Capital market services

were mostly restricted to stock broking activity which was driven by a non-

corporate unorganized body industry. Merchant banking and asset

management services came up in a big way only with the opening up of the

capital markets in the early nineties. Due to the primary market boom during

that period, many financial business houses such as financial institutions,

banks and NBFCs entered the merchant banking, underwriting and advisory

business. While most institutions and commercial banks floated merchant

banking divisions and subsidiaries, NBFCs combined their existing business

with that of merchant banking.

Over the subsequent years, two developments have taken place. Firstly, with

the downturn in the capital markets, the merchant banking industry has seen

20

a tremendous shake out and only about a 10% of them remain in serious

business as pointed out earlier. The other development is that due to the

gradual regulatory developments in the capital markets, investment banking

activities have come under regulations which require separate registration,

licensing and capital controls.

Due to the above reasons, the Indian investment banking industry has a

heterogeneous structure. The bigger investment banks have several group

entities in which the core and non-core business segments are distributed.

Others have either one or more entities depending upon the activity profile.

The heterogeneous and fragmented structure is evident even if Indian

investment banks are classified on the basis of their activity profile. Some of

them such as –SBI, IDBI, ICICI, IL & FS, Kotak Mahindra, Citibank and

others offer almost the entire gamut of investment banking services

permitted in India. Among these, the long term financial institutions are

gradually transforming themselves into full service commercial banks

(called ‘universal banking’ in the Indian context). They also have full

service investment banking under their fold. Other entities such as NBFCs or

subsidiaries of public sector banks mainly offer merchant banking and other

capital market services. There are also several others who are providing only

corporate advisory services but prefer to hold merchant banking or

underwriting registrations.

Presently, there are no global Indian investment banks although there is a

bulge bracket of investment banks in India that have some overseas presence

to serve Indian issuers and their investors. At the middle level are several

21

niche players including the merchant banking subsidiaries of some public

sector banks. Some of these subsidiaries have been either shut down or sold

off in the wake of two securities scam seen in 1993 and in 2000. However,

certain banks such as Canara Bank and Punjab National Bank have had

successful merchant banking activities. Among the middle level players are

also merchant banks structured as non-banking financial services companies

such as Rabo India Finance Ltd, Alpic Finance etc. There are also in the

middle level, some pure advisory firms such as –Lazard Capital, Ernst &

Young, KPMG, Price Waterhouse Coopers etc. At the lower end are several

niche players and boutique firms, which focus on one or more segments of

the investment banking spectrum.

22

Service Portfolio of Indian Investment Banks

Core Services

Merchant Banking, Underwriting and Book Running

The primary market which was quite small in India, was revitalized with the

abolition of the Capital Issues (Control) Act 1947 and the passing of the

Securities and Exchange Board of India Act, 1992. The SEBI functions as

the regulator for the capital markets similar to its counterpart, the SEC in

USA. SEBI vide its guidelines dated June 11, 1992 introduced free pricing

of securities in public offers for the first time in India. Over the last ten

years, there have been two distinct phases of primary market boom –the first

between 1992-1996 and the second between 1998-2001. The third wave of

primary market issues could shape up in the near future. This market is very

closely regulated by SEBI. In the days when the public offers market is very

vibrant, this area of service forms the main activity for most Indian

investment banks. In the past few years, though public offers have been very

few, the private placement market especially in the debt segment has been

very active and has served as an important source of funds for prime-rated

corporates. Notable among such offerings are related privately placed

debentures issued by public sector corporations and leading private

companies. Financial institutions have been raising funds via the public

offers and hand holding them in the private placements as well. Once the

private placement markets also come under regulatory stipulations,

investment banks would have a wider role to play in such issuances.

23

Mergers and Acquisitions Advisory

The mergers and acquisitions industry was pretty nascent in India prior to

1994 and continues to be tiny compared to the global scale of such

transactions. However, two main features that have given a big push to this

industry are:

The forces of liberation and globalization that have forced the Indian

industry to consolidate.

The institutionalization of corporate acquisitions by SEBI through its

guidelines, popularly known as the Takeover Code.

One of the cream activities of investment banks has always been M&A

advisory. The larger investment banks specialize in M&A as a core activity.

While some of them provide pure advisory services in relation to M&A,

others holding valid merchant banking licenses from SEBI also manage the

open offers arising out of such corporate events.

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Corporate Advisory

Investment banks in India also have a large practice in corporate advisory

services relating to project financing, corporate restructuring, capital

restructuring through equity repurchases (including management of buyback

offers under section 77A of the Companies Act, 1956), raising private

equity, structuring joint-ventures and strategic partnerships and other such

value added specialized areas.

25

Support services and Businesses

Secondary Market Activities

Most of the universal banks such as ICICI, IDBI and Kotak Mahindra have

their broking and distribution firms in both the equity and debt segments of

the secondary market. In addition several other investment banks such as the

IL & FS and pure investment banks such as DSP Merrill Lynch and JM

Morgan Stanley have a strong presence in this area of activity. In the past

few years, the derivatives segment has been introduced in Indian capital

market and this provides an additional avenue of specialization for

investment banks. Derivatives trading, risk management and structured

products offerings are the new segments that are fast becoming the areas of

future potential for Indian investment banks. The securities business also

provides extensive research offerings and guidance to investors. The

secondary market services cater to both the institutional and non-

institutional investors.

Asset Management Services

Most of the top financial groups in India which have investment banking

businesses such as the –ICICI, the IDBI, Kotak Mahindra, DSP Merrill

Lynch, JM Morgan Stanley, SBI and IL & FS also have their presence in the

asset management business through separate entities. As per the three layer

structure propounded by SEBI, the parent organization acts as the sponsor of

the fund and the fund itself is constituted as a trust. The trust is managed by

26

an asset management company and a separate trustee company which

oversees the interests of the unit holders in the Mutual Fund. The whole

structure has as arm’s length distance from the sponsor’s other businesses

and entities.

Wealth Management Services (Private Banking)

Many reputed investment banks nurture a separate service segment to

manage the portfolio of high networth individuals, households, trusts and

other types of non-institutional investors. This can be structured either as a

pure advisory service wherein the investment manager does not have any

access to the funds or as a fund management service wherein the investment

manager is given charge of the funds. In the former case, it becomes a non-

discretionary portfolio and in the latter case, it becomes a discretionary

portfolio. Such activity is regulated under the SEBI guidelines as already

discussed. In other cases, wealth management may be restricted to a research

based activity wherein the investor is provided good investment

recommendations from time to time.

Institutional Banking

Institutional investors have been a recent phenomenon in the Indian capital

market, which till then had the presence of a handful of public financial

institutions such as the UTI and the insurance companies. The term lending

institutions such as the IDBI and IFCI did not participate in secondary

market dealing as a matter of policy. With the advent of liberalization, there

27

are presently a large number of domestic institutional investors in the

secondary market apart from approved foreign institutional investors. In

addition, institutional investments have risen significantly in the primary

markets through venture capital and private equity investments by investors

in both the domestic and non-domestic categories. Several of the leading

investment banks either have dedicated venture funds or private equity funds

that invest in primary market. In addition they make proprietary investments

in the secondary market through their dealing and market activities. The

business portfolio of Indian Investment Banks has been briefly discussed in

Fig.

28

Interdependence between Different Verticals in Investment

Banking

As is evident from Figure , there are different verticals in investment

banking and they do enjoy synergies with one another. While some of the

service or business segments form the core of investment banking, others

provide invaluable support. This inter-dependence and complementary

existence has been explained below.

While merchant banking largely relates to management of public floatations

of securities or reverse floatations such as buy backs and open offers,

underwriting is an inherent part of merchant banking for public issues.

Similarly, bought out deals and market making are a part of the process of

floating issues on the OTC Exchange of India. The concept of market

making has now been introduced for listing of certain scrips in the main

stock exchanges as well. Advisory and transaction service have a close

linkage with merchant banking as more often than not, such services

culminate in a merchant banking assignment for a public issue or a reverse

floatation. Such services also help in maintaining an enduring relationship

with clients during those times when merchant banking is not a hot activity

due to depressed market conditions. The other segment of primary market

activity, i.e. venture capital and private equity has equal synergies with

merchant banking. Being in venture capital business which enables

identification of potential IPO candidates quite early, which helps not only

in generating good fee income from merchant banking services, but also

good in capital gains for the venture capital invested at earlier rounds of

29

financing in such companies. Similarly, being in private equity business

helps in harnessing the potential offered by later stage and listed companies,

which may approach an investment bank primarily for merchant banking

services.

The support business vertical in the secondary market operations also have

synergies with those in the primary equity and debt market segment as far as

investment banking is concerned. Stock broking and primary dealership in

debt markets nurture institutional, corporate and retail clients who can be

tapped effectively for asset management, portfolio management, and private

equity business. In addition, presence in the equity derivative and foreign

exchange derivatives segments can help in offering solutions in treasury

management to clients. In addition, the advisory and transaction services

vertical can draw expertise from such segments in providing structured

financing solutions to its clients. All these verticals are driven by support

services such as sales and distribution and also equity research and analysis.

Lastly but more importantly, the capability in sales and distribution also

determines the success of the merchant banking vertical.

Thus, it may be seen that the growth and success of an investment bank

depends on its strengths in each vertical and how well it combines them for

synergies. To sum up, investment banking is a business that is very sensitive

to the economic and capital market scenario and therefore, the broader the

platform of its operations, the more is likelihood of an investment bank

surviving business cycles and sudden shocks from the market.

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Regulatory Framework for Investment Banking

As discussed above, investment banking in India is regulated 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 the 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 also 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:

1. At the constitutional level, all investment banking companies

incorporated under the Companies Act, 1956 are governed by the

provisions of that Act.

2. Investment banks that are incorporated under a separate statute such

as the SBI or the IDBI are regulated by their respective statute. IDBI

is in the process of being converted into a company under the

Companies Act.

3. Universal Banks 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. The RBI

has relaxed the exposure limits for merchant banking subsidiaries of

commercial banks. Till now, such companies were restricting their

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exposure to a single entity through the underwriting business and

other fund based commitments such as standby facilities etc to 25% of

their net owned funds (NOF). Therefore these companies are now on

par with other investment banks which can do so up to 20 times their

NOF.

4. Investment banking companies that are constituted as non-banking

financial companies are regulated operationally by the RBI under

Chapter IIIB (sections 45H to 45QB) of the Reserve Bank of India

Act, 1934. Under these sections RBI is empowered to issue directions

in the area of resource mobilization, accounts and administrative

controls. The following directions have been issued by the RBI so far:

Non-Banking Financial Companies Acceptance of Deposits

(Reserve Bank) Directions, 1998.

NBFCs Prudential Norms (Reserve Bank) Directions, 1998.

5. Functionally, different aspects of investment banking are regulated

under the Securities Exchange Board of India Act, 1992 and the

guidelines and regulations issued there under. These are listed below:

Merchant banking business consisting of management of public

offers is a licensed and regulated activity under the Securities

and Exchange Board of India (Merchant Bankers) Rules 1992

and Securities Exchange Board of India (Merchant Bankers)

Regulations 1992.

Underwriting business is regulated under the SEBI

(Underwriters) Rules 1993 and the SEBI (Underwriters)

Regulations 1993.

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The activity of the secondary market operations including stock

broking are regulated under the relevant by-laws of the stock

exchange and the SEBI (Stock Brokers and Sub Brokers) Rules

1992 and the (Stock Brokers and Sub Brokers) Regulations

1992. Besides, for curbing unethical trading practices, SEBI has

promulgated the SEBI (Prohibition of Insider Trading)

Regulations 1992 and the SEBI (Prohibition of Fraudulent and

Unfair Trade Practices Relating to Securities Markets)

Regulations 1995.

The business of asset management as mutual funds is regulated

under the SEBI (Mutual Funds) Regulations 1996.

The business of portfolio management is regulated under the

SEBI (Portfolio Managers) Rules, 1993 and the SEBI (Portfolio

Managers) Regulations, 1993.

The business of venture capital and private equity by such

funds that are incorporated in India is regulated by the SEBI

(Venture Capital Funds) Regulations, 1996 and by those that

are incorporated outside India is regulated under the SEBI

(Foreign Venture Capital Funds) Regulations 2000.

The business of institutional investing by foreign investment

banks and other investors in Indian secondary markets is

governed by the SEBI (Foreign Institutional Investors)

Regulations 1995.

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6. Investments 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.

7. 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 the –tax law, property law, state laws,

arbitration law and other general laws that are applicable in India.

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Regulatory Framework for Merchant Banking

Merchant Bankers are governed by the SEBI (Merchant Bankers) Rules

1992 and SEBI (Merchant Bankers) Regulations 1992. According to the

SEBI (Merchant Bankers) Rules 1992 a Merchant Banker means ‘a person

who is engaged in the business of issue management either by making

arrangements regarding selling, buying or subscribing to securities as

manager, consultant, advisor or rendering corporate advisory service in

relation to such issue management’.

Given the fact that Merchant Bankers are entrusted with the responsibility of

issue management by law, the regulatory framework is designed to ensure

that they sufficient competence and exercise diligence in their work such

that the issuers comply with all statutory requirements concerning the issue.

At the same time, the merchant banker shall have high levels of integrity so

that quality issues alone are brought to the primary market. Keeping these

objectives in mind and investor protection as the paramount objective, the

SEBI has laid emphasis on ensuring that merchant bankers fulfil the

eligibility criteria on an on-going basis and has therefore provided for

compulsory registration every three years. All Merchant Bankers need to

have a valid registration certificate under the said rules to perform the role of

Merchant Bankers to issues. In considering the application for registration,

SEBI shall pay regard to the professional qualification in finance, law or

business management, adequate office space, manpower, office equipment

and other infrastructure, at least two support staff members who have the

competence to be in the field of merchant banking business, existence of

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minimum stipulated capital and previous experience to investor grievance

redressal.

The activities that a Merchant Banker is authorized to do are issue

management and associated activities such as advising or providing

consultancy or marketing services for the issue, underwriting of issues and

portfolio management, though portfolio management alone requires

additional registration under the relevant regulations. Merchant Bankers are

precluded from carrying on any business or fund-based activity other than

that associated with the securities market. Merchant Bankers are also bound

by the Code of Conduct prescribed under the Regulations. In addition,

Merchant Bankers have to comply with general obligations and

responsibilities under the Regulations.

Presently there is only one category of Merchant Bankers prescribed by

SEBI (Category I) and the minimum stipulated networth for such Merchant

Bankers is Rs.five crore. Such Merchant Bankers holding valid certificates

of registration are alone qualified to manage public offers. SEBI levies a

one-time authorization fee, an annual fee and a renewal fee from each

Merchant Banker.

Under the regulations, Merchant Bankers have also to submit periodical

returns and any other additional information that SEBI might seek from time

to time. SEBI also has a right of inspection of the books of account, records

and documents of the merchant banker at any time if required. SEBI may

suo moto conduct an enquiry or launch an investigation into the working of

a Merchant Banker or on receipt of a complaint against such Merchant

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Banker. SEBI may even appoint an external auditor to inspect the books and

report to SEBI. Based on the findings, SEBI is empowered to take

appropriate action to award penalty points to the erring Merchant Banker

based on the degree of the default or contravention in accordance with the

SEBI (Procedure for Holding Enquiry by Enquiry Officer and Imposing

Penalty) Regulations 2002. The aggrieved Merchant Banker may prefer to

appeal the Central Government under the SEBI (Appeal to Central

Government) Rules 2003. It may also be mentioned here that a Merchant

Banker is deemed to be a connected person to the issuer under the SEBI

(Prohibition of Insider Trading) Regulations, 1992.

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Anatomy of Some Leading Indian Investment Banks.

ICICI Securities Ltd. (I-Sec).

I-Sec is a part of the ICICI group whose parent company is the ICICI Bankm

which till recently was a financial institution that converted itself into a

universal bank by it merger with its own commercial bank, the ICICI Bank

in 2003. I-Sec, which was initially a joint venture with J.P. Morgan of the

US, became fully owned by ICICI after J.P. Morgan exited from the

business.

I-Sec is a full service investment bank that provides services across all the

segments spanning –debt market, equity market, derivatives and corporate

advisory services. It has support services in research and broking. The

advisory business focuses on merger and acquisitions, cross border

acquisitions, equity and bidding for a number of reputed companies. The

equity business offers research, sales and execution services to institutional

investors in the secondary market and capital market related services such as

execution of public offerings, structuring and regulatory and legal

documentation services.

In order to assist/provide corporate clients and institutional investors with

investment banking services in the USA. I-Sec set up two US based

subsidiaries namely ICICI Securities Holding Inc and ICICI Securities Inc.

ICICI Securities Inc registered itself with the National Association of

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Security Dealers Inc as a broker-dealer, empowering it to engage in a variety

of securities transactions in the US market.

ICICI Brokerage Services Limited, a member of the National Stock

Exchange of India Limited, is the domestic broking subsidiary of I-Sec’s

distribution and secondary market services are handled by the broking

company.

DSP Merrill Lynch Ltd.

Originally incorporated as DSP Financial Consultants Ltd, its name was

changed to DSP Merrill Lynch (DSP-ML) in 1996 following its conversion

into a joint venture with Merrill Lynch of USA, a leading international

capital raising financial management and advisory company. Merrill Lynch

has a 40% equity stake in DSP-ML. DSP-ML is a part of the DSP group

which has been in the securities and brokerage business for 130 years in the

Indian market, thus pre-dating even the Bombay Stock Exchange.

DSP-ML is a leading full service Investment Bank that provides services

across debt market, equity market and corporate advisory segments. It also

provides services to private customers on equity and debt products and

wealth management. It has a full fledged research team serving the needs of

both its institutional and retail clients. The company is among the major

players on proprietary account in the debt and equity markets and is also a

registered primary dealer in government securities.

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The functional divisions at DSP-ML consist of the –Investment Banking

Group, the Equity Sales Group, the Equity Trading and Dealing Group, Debt

Sales Group, the Mergers and Acquisitions Group, the Research Group and

the Private Client Group. The investment banking group generates equity

and debt products emerging from IPOs, secondary issues and debt market

issues as well as private placements. It is also a leading underwriter in both

equity and debt products. These products are distributed through the equity

sales group and the debt sales group. Both the marketing groups serve a

cross section of institutional clients, other non-institutional clients such as

trusts and investment companies, retail clients and overseas investors. The

sales groups also distribute apart from their own products, the products

emerging from other entities such as DSP Merrill Lynch Mutual Fund and

other mutual funds. The sales groups are supported by a national distribution

networking comprising of approximately 8000 sub-brokers and alliance

partners.

The trading and dealing groups support the broking activity in equities and

the primary dealership activities in the debt market. DSP-ML, is one of the

largest institutional broking firms in India. It is a founding member of The

Stock Exchange, Mumbai (BSE) and is an active member of the National

Stock Exchange (NSE) of India in both the equity segment and the

wholesale debt market segment. It is an accredited primary dealer with the

RBI and an active participant in the Government Securities/Treasury bill

markets. As a primary dealer, it makes a market for debt securities by

offering to buy and sell quotes. These quotes are also available on wire

services like Reuters, Crisil Market wire, Bloomberg and Dow Jones

Newswires.

40

The mergers and acquisitions advisory has been structured as a separate

specialist group that offers their clients financial advice and assistance in

restructuring, divestures, acquisitions, de-mergers, spin-offs, joint ventures,

privatization and takeover defense mechanisms. The research group offers

products such as –sectoral reports, company reports and special theme

analyses, daily, weekly and monthly market views as well as specific policy

forecasts. The private client group offers depository, broking and investment

advisory services to high net worth individuals, professionals and promoters

of business groups, corporate executives, trusts and private companies.

In 1996, the DSP group floated a separate equity broking company called

DSP Securities Ltd. which is a member of the BSE.

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JM Morgan Stanley Pvt. Ltd.

JM Morgan Stanley (JMMS) is a joint venture between the JM Financial

Group and Morgan Stanley Dean Witter of the USA. In 1997, Morgan

Stanley which was established in New York in 1935, had acquired Dean

Witter, an investment bank founded in 1924 in San Francisco. JM Morgan

Stanley commenced operations in April 1999. However, the association of

the two partners is limited only to the investment banking area. Both of them

have separate asset management companies in India which run independent

of mutual fund businesses.

Unlike DSP-ML and I-Sec which have an integrated structure, the JM Group

has separate companies handling various components of the capital market

business. The core functions of investment banking are performed by

JMMS. This company focuses on capital raising, mergers and acquisitions,

private equity and advisory work for Indian corporations in both the

international and domestic capital markets. The function of distribution and

marketing securities is handled by two of its wholly owned subsidiaries –JM

Morgan Stanley Retail Services Pvt. Ltd. (JMRS) and JM Morgan Stanley

Fixed Income Securities Pvt. Ltd. (JMFI). JMRS provides equity distribution

services for primary market products, mutual funds, equity sales and

marketing support for the group broking activity and wealth management

and portfolio management services to high net worth individuals. JMFI

offers similar services in fixed income (debt) securities. A third company,

JM Morgan Stanley Securities Pvt. Ltd. handles all the broking operations

for the group and provides services to institutional clients and others. It also

provides research support for both FII and Indian institutional clients.

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SBI Capital Markets Ltd

Founded in 1986 as a hive-off of the SBI Merchant Banking division, SBI

Capital Markets Ltd. (SBI Caps) is amongst the oldest players in the Indian

capital market. It is a full service investment bank that provides investment,

advisory and financial services. In 2001, SBI Caps started its sales and

distribution activity along with equity and debt broking services.

SBI Caps provides services across the following spectrum:

Mergers and Acquisitions: This group provides advisory services

with regard to disinvestment of the government, valuations, mergers

and acquisitions in the corporate sector, financial and business

restructuring and other areas.

Project advisory and structure finance: It is arguably one of the

leading groups in the company that provides services such as

restructuring and privatization advisory for public utilities, policy

advisory to Central and State Governments, regulatory bodies and

government departments and organizations, project structuring and

advisory to the private sector and arranging finance for such projects.

SBI Caps has been a major player in governmental work and in the

infrastructure sector. The project advisory services consist of hand-

holding from the concept to commissioning stage involving project

structuring, contract structuring, financial modeling, preparation of

information memorandum, syndication of debt and equity and

assistance in documentation and financial closure. Other services

include appraisals for green-field and brown-field projects, techno-

economic appraisal from banks and financial institutions for

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establishing the viability of corporate restructuring plans, and vetting

of contracts, loan documents, project documentation etc.

Capital market: This group provides merchant banking services in

connection with public issues, rights issues and public offers for buy-

backs and open offers. It also advises clients on the private

placements, ADR and GDR issues and overseas bond issues by the

SBI.

Treasury and Investments: This group deals with the proprietary

investment of the company in the equity, debt and money markets.

Resource mobilization and management is also undertaken by this

group.

Broking of Equity and Debt: SBI Caps is a registered broker and a

member of the NSE in the equity and wholesale debt segments and is

also a member in the equity segment. The broking group caters to the

secondary market needs of financial institutions, FIIs, mutual funds,

banks, other corporates, high net worth individuals, non-resident

investors and retail investors. The company commenced wholesale

debt market broking in 2001. The company expects to have a strong

presence in institutional broking. The company plans to open a

derivative trading desk soon.

Sales and Distribution of equity and mutual fund products: SBI

Caps has been a leading mobilizer of funds both for public offers and

private placements.

Research: This group provides the research support for in-house

departments and for institutional clients. Besides regular updates on

companies and industries, the research group brings out India

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Strategy, Debt Market Review and Daily Debt Market review which

are circulated to SBI Caps investment banking and broking clients.

In its annual report for the year ending March 31, 2002, SBI Caps

reported that is has two business segments –(a) Fee based segment

providing merchant banking and advisory services like issue

management, underwriting, arranger, project advisory and structured

finance. (b) Fund based segment which undertakes deployment of funds

in leasing, hire purchase and securities dealing. However, as a result of

SEBI directives, fresh lending under leasing and hire-purchase was

stopped from 1st July 1998. For the period 2001-02, SBI Caps was ranked

first among issue managers by PRIME database.

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Kotak Mahindra Capital Company

Born in 1995 as part of a corporate re-organization as an unlimited

company. The Kotak Mahindra Capital Company (KMCC), is the

investment banking entity belonging to the Kotak Mahindra Group. It is a

strategic joint venture between Kotak Mahindra Bank Limited (KMBL)

and the Goldman Sachs Group LLP of USA. KMCC is a full service

investment bank whose core business centers on equity issuances and

fixed income securities, mergers and acquisitions and advisory services.

As an investment bank, KMCC is registered with SEBI and is also

registered as a non-banking financial company with RBI. It is also an

active member of the association of Merchant Bankers of India (AMBI).

KMCC has two wholly owned subsidiaries –(a) Kotak Mahindra (UK)

Limited, which is registered with the Securities and Futures Association,

UK and regulated by the Financial Services Authority, UK and (b) Kotak

Mahindra Inc based in USA, which is registered with the Securities and

Exchange Commission, USA. KMCC is the first Indian investment bank

to have sought such regulations in USA and UK. A third company called

Kotak Mahindra (International) Limited., based in Mauritius provides

distribution and other client services to non-resident investors.

In KMCC, the Equity Capital Markets group focuses on structuring and

executing diverse equity financing transactions in the public and private

markets for corporates, banks, financial institutions and the Government.

Products include initial public offerings (IPOs), rights offerings,

convertible offerings, private placements and private equity for unlisted

and listed companies. In the advisory business, the Structured Finance

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(Project Finance & Advisory Business) Group provides expertise in

various vertical segments in the infrastructure sector including power, oil,

gas, ports, automobiles, steel & metals and hotels by offering structured

finance solutions to clients. The Fixed Income Securities Group at

KMCC advises PSUs, Government companies, financial institutions,

banks and corporates on raising capital by way of public or private

placement of debt. KMCC is credited with innovating on some bond

structures in the Indian market. The advisory group on mergers and

acquisitions provides complete solutions on strategy formulation

identification of targets or buyers, valuation, negotiations and bidding,

capital structuring, transaction structuring, assistance in legal

documentation and acquisition financing strategies and implementation.

KMCC is supported in its functions by Kotak Securities Ltd, a broking

firm incorporated in 1995 that is also a joint venture with Goldman Sachs

which handles all the broking, distribution and research business of the

group. Kotak Securities is a member of the debt segment of the NSE and

is also a member of the National Stock Exchange Members Association.

Kotak Securities offers services to investors, financial institutions, mutual

funds, religious and charitable trusts, insurance companies, etc. The

institutional business division has a comprehensive research cell with

sectoral analysts covering all the major areas of the Indian economy. In

the international arena, it provides brokerage services on the Indian

securities to institutional and other investors who are based outside India.

Due to its overseas presence, the company has marketing interests in

Indian GDR and ADR issues as well.

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The research products brought out by Kotak Securities include:

For the institutional clients, a product called AKSESS, which

primarily covers secondary market broking. It caters to the needs

of foreign and Indian institutional investors in Indian equities (both

local shares and GDRs).

The Daily Forex Monitor which tracks the Indian and international

foreign exchange markets and opines on currency strategies on a

daily basis.

The Weekly Money Market Update which gives the details of the

developments in markets and provides a short-term interest rate

view along with indicative pricing for Triple A credits.

The CURRENCY WATCH captures the monthly developments in

the Indian foreign exchange markets, analyses the key influencing

issues, assess future outlook and also recommends hedging

strategies.

Monthly FINSEC and FINSEC Focus.

Kotak Securities is also a registered primary dealer with the RBI in the

government securities market. As a primary dealer, the company acts as a

market maker and also provides two way quotes, acts as retailer and

marketing agent, provides underwriting support on government securities

issues and participates in auctions held by the RBI.

Besides, the above companies, the Kotak Group includes the Kotak

Mahindra Bank which was formerly a non-banking finance company that

has recently been converted into a bank, the Kotak Mahindra Mutual Fund

which is managed by the Kotak Mahindra Asset Management Co. Ltd and

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the OM Kotak Life Insurance, which is a joint venture with Old Mutual Plc

of UK and the Kotak Mahindra Venture Capital Co. which manages the

private equity fund of the group.

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Recent Trends in Investment Banking

One of the trends that has been developing in the past few years in the

global and Indian investment banking arena, is the strong emergence of

universal banks ahead of pure investment banks as market leaders. These

universal banks have the additional financial muscle of their banking

arms that add to their investment banking strengths. Pure investment

banks have found it unmanageable to maintain leadership positions due

to difficult market conditions and the economic downturn. The year 2002

has been dubbed as the watershed year in investment banking for over a

decade. Globally, universal banks such as the –Citigroup, JP Morgan

Chase and Deutsche Bank are emerging strongly against pure investment

banks such as Goldman Sachs and Morgan Stanley. This trend could

probably reappear in India as well with the emergence of SBI, ICICI,

IDBI and Kotak Mahindra Bank as strong universal banks. However, in

2002, pure investment banks such as JM Morgan Stanley and DSP

Merrill Lynch still occupied top positions in the investment banking

league tables.

Some recent developments in the investment banking industry as

reported in some financial dailies and other press clippings are listed

below:

International

The Wall Street IPO market has seen the fewest number of issues

since 1978 in the calendar year 2003, with just five in the first

quarter. These have mostly been from insurance and financial

services firms and four of them were IPOs.

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In 2002, there was a drop of 28% in global equity and equity

related issuances according to Thomson Financial. IPOs were the

main causality with a drop of 34% to $60.6 billion. European

market saw a drop of 53% drop in IPOs and 54% drop in

convertible bond issuances. In Europe, the market focus shifted

from fund raising through IPOs and public issues to more

restructuring deals. These are termed as ‘rescue finance’ deals such

as rights issue and fully convertible bond issues by troubled

companies. Ericsson, Sonera and Zurich Financial Services are

some companies that made rights issues in 2002. According to

Dealogic, the volume of rights issues in Europe rose from $20.7

billion to $21.5 billion in 2002. The most popular instrument in

USA and Europe has been the ‘mandatory convertible’ (fully

convertible) bond which is considered as a forward share sales

which is superior in nature to a rights issue.

The Citigroup was Wall Street’s top stock and bond underwriter in

2002. Citigroup affiliates Salomon Smith Barney arranged $414

billion of offerings with a 10.6% market share according to

Thomson Financial. Merrill Lynch and CSFB were ranked second

and third respectively. However, the total underwriting pie fell by

5% during the same year.

The top IPO investment bank in 2002 was Salomon Smith Barney

followed by Goldman Sachs. Goldman arranged the largest IPO of

2002, the $4.6 billion CIT Group Inc. (Tyco International Ltd)

unit.

The reported fee of American Investment banks fell by 21% in

2002 to $14.1 billion. Salomon took the highest fee of around $2

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billion followed by the other two with around $1.2 billion each.

Since April 2001, 78000 jobs were slashed in this industry in USA

accounting for about 10% of the total strength.

Global M&A market was also dull in 2002 witnessing a sharp fall

of 47% to stand at $996 billion from $1887 billion in the previous

year. The biggest deals in 2002 were HP-Compaq, Amgen-

Immunex Corp, AOL Time Warner-AOL Europe, Bayer-Aventis

Crop Science, Comcast Corp-AT&T Broadband, Philips

Petroleum-Conoco and Siemens Robert Bosch-Atccs

Mannesmann.

Some of the big universal banks such as JP Morgan Chase took

major hits in their private equity businesses due to the technology

meltdown. Incidentally, JP Morgan, which is one of Wall Street’s

largest private equity operators with a fund base of $28 billion,

generated $130 million in revenues in private equity in 2001

fuelled mainly by the IPO market boom in technology stocks. Due

to the meltdown, many investment banks have felt it necessary to

spin off their private equity operations into separate entities. BNP

Paribas, Deutsche Bank, HSBC and Zurich Financial Services are

some of these banks.

American investors poured more money into debt mutual funds in

2002 accounting to $133 billion and there were few takers for

public issues of equity junk bonds and convertible bonds.

National

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During the year 2001, JM Morgan Stanley which acted as adviser to

M&A deals worth Rs.16022 crore was rated the top investment bank

in India. The other players in the big league were ABN-Amro

(Rs.10460 crore), DSP Merrill Lynch (Rs.7130 crore), Arthur

Andersen (now part of E&Y, Rs.3532 crore), Kotak Mahindra

(Rs.1719 crore), Rabo India Finance (Rs.833 crore) and Lazard

Capital (Rs.536 crore) –(as reported in the Economic Times 21st

November 2001).

In 2002, there was only one GDR/ADR issue as compared to 6 in

2001 and 9 in 2000. This was made by Mascon Global which raised

$10 million through issue of 2.5 million GDRs which are listed at

Luxembourg Stock Exchange. In this market, Citibank was the

leading depository banks according to Instanex Capital Consultants.

This was followed by Bank of New York, Deutsche Bank and JP

Morgan.

In the M&A market, the year 2002 saw an increase of around 5% in

the value of M&A deals in Inda. Among these, more than 50% were

cross-border deals according to a survey conducted by KPMG

Corporate Finance. The deals were mostly in the SME segment with

average size not exceeding $25 million. The banking, finance and

insurance sectors contributed almost one-third of the total volume.

Privatization deals also played a significant part.

DSP-ML de-listed from the stock exchange since its promoters,

Hemendra Kothari and Merrill Lynch together held more than 90% of

the shares. DSP was rated the ‘The Best Domestic Investment Bank’

in India for 2000 by Finance Asia. Euromoney voted it ‘Best

Domestic M&A House in India’ as well as ‘Best Domestic Equity

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House in India’ in 2000. This distinction has returned for three years

in a row with DSP-ML being named as the ‘Best Domestic Securities

House’ and ‘Best Domestic Investment Bank’ for 2002-2003 by

Asiamoney (May 2003 issue) and The Asset (January 2003 issue)

magazine respectively.

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The Conflict of Interest Issue

The most burning global issue in the investment banking industry is that of

conflict of interest between investment bankers and their research analysis

divisions. In the wake of the Enron, Worldcom and other corporate disasters,

the issue has gained some significance. The Securities and Exchange

Commission in the USA (SEC) have initiated investigations into instances of

investment banks issuing over-optimistic research and steering shares in hot

IPOs to important clients for vested interests. In such investigations some of

the banks have been imposed fines. Merrill Lynch paid up fines to the extent

of $100 million in regulatory proceedings in 2002 brought against its

misleading research reports. Citigroup’s Salomon Smith Barney is also in

the dock and may find itself paying the heaviest fines. CSFB also finds itself

in trouble with the regulators. Most of the other top investment banks such

as –Goldman Sachs, Lehman Brothers, Bear Sterns, Deutsche Bank, JP

Morgan Chase and others also found their names in the fines list in 2002.

CSFB was fined for misleading investors on offerings in technology shares.

JP Morgan on the other hand, has been under a cloud for its role in the

infamous off-balance sheet partnership it had crafted for Enron.

Besides, investment banks have also been the target of several lawsuits filed

by aggrieved investors. In late 2002, the French luxury goods leader LVMH

filed a 100 million euro lawsuit against Morgan Stanley alleging that its

research report on LVMH was biased because of the investment bank’s close

advisory relationship with LVMH’s arch rival Gucci Group NV. Morgan

Stanley was also the underwriter of Gucci’s IPO in 1995.

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Both the NYSE and NASDAQ came out with ‘research analysts’ conflict of

interest rules’ in May 2002 which was subsequently approved by SEC.

Market observers have felt that this is a good development from the point of

view of addressing conflict of interest, currently a burning issue in the

industry. While an investment bank may be advising a client on a buy out,

its private equity arm may be in the fray for its purchase. An example of this

was the sale of the power storage business of Invensys in 2001 wherein

Morgan Stanley was the advisor in the $505 million sale to EnerSys a

company owned by Morgan Stanley Capital Partners (Morgan Stanley’s

private equity firm).

So how does the conflict of interest really arise? Most investment banks

have in-house research divisions which act as a support function as

discussed earlier. The research divisions perform vital function of tracking

corporates and making recommendations to their clients in the secondary

market operations or to their own dealing rooms. They also issue reviews

and ratings to new issuances hitting the market. The conflict could arise if

the research analyst promotes a share, the public offering for which is being

handled by the merchant bank. Alternatively, it could also be that the analyst

is privy to insider information being provided by their merchant banking

division and there upon issue recommendations that could amount to

fraudulent deceit of investors or gains for select few. Over the years, the

ethical wall between merchant bankers and research analysts melted

especially in the heat of the IPO and the internet boom. The compensation

patterns of the investment bankers and research analyst were also getting

complementary to an extent thus undermining their independence.

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A study was conducted by the SEC in 2001on ‘full service investment

banks’ in Wall Street focusing on these conflicting relationships. The study

disclosed two main areas of conflict–(a) research recommendations tending

to become marketing tools for merchant banking assignments by the same

bank and analysts getting paid share of such investment banking gains, (b)

ownership of stocks by research analysts in the companies that they

recommend or research. The study disclosed that analysts leveraged their

position in pumping up recommendations in companies that they are

interested in when they went public.

In the revised dispensation, one of the main provisions is that analysts have

to disclose their interests in their recommendations. In addition, there is

sought to be a water tight compartment in the working of the merchant

banking departments and research divisions. The third area has been the

regulation of compensatory structures for research analysts based on the

profits of the merchant banking divisions. The developments in the USA

have also resulted in precautionary amendments to regulations made in India

by SEBI though such instances of conflict of interest have not surfaced so

far. SEBI has amended the regulations that have been in place for Merchant

Bankers, Underwriters and for the prohibition of insider trading. As a result,

analysts are barred from private trading in shares they analyze. There is still

room for more regulation in future in this area of importance for the survival

of the investment banking industry.

In conclusion, it can be said that the investment banking industry has been

through difficult times. On one hand, the economic slow down and the crash

of the markets that were propelled to dizzy heights by the new economy

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stocks have battered their bottom lines and led to a large scale cut back in

staff and operations. On the other hand, role of investment banks in

corporate scandals and their questionable business practices and ethics have

taken a toll on their reputation and image. A large scale cleaning up has to

take place in their methods of working and service offerings. Similarly, a

major resurrection of their confidence is required through resurgence of the

markets, whenever that happens. In the meantime, the industry has to live up

to the challenge through appropriate restructuring and consolidation.

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Conclusion

Given the scope for investment banking in India, the future looks bright for

the industry as a whole in India. Many more pure investment banks and

advisory firms could convert themselves into full service investment banks

that would broaden the market and make the service delivery much more

efficient. In addition, the technological and market developments shaping

the capital market as discussed would also provide an added impetus to

growth of investment banking. Better regulatory supervision and stricter

enforcement of the code of conduct of market intermediaries would ensure

that better quality issuers come to the market and existing issuers would

follow enhanced standards of corporate governance. In the long run, all these

developments would ensure fair return to investors, and bring back investor

support to the market. This would augur well for the capital market in

general and investment banking in particular.

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