CHAPTER 4Financial Services: Securities Brokerage and Investment Banking

Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

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Overview

This chapter discusses securities brokerage firms and investment banks– Activities of securities firms and

investment banks– Size, structure, and composition– Balance sheets and recent trends– Regulation of securities firms and

investment banks– Global issues

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Securities Firms & Investment Banks

Nature of business– Underwrite securities– Market making– Advising (example: M&A, restructurings)

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Securities Firms & Investment Banks

Growth in domestic M&A:– Less than $200 billion in 1990– $1.83 trillion in 2000– In US: bottomed out at $458 billion in 2002

($1.2 trillion worldwide)– Topped $1.7 trillion 2007 ($4.5 trillion

worldwide)– Effects of financial crisis: fell to $808 billion in

2009 ($1.7 trillion worldwide)Worst financial crisis since 1930s, but M&A activity

still greater than early 2000s

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Mergers and Acquisitions, 1990-2009

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Structural Changes in Recent Years

Acquisition of Bear Stearns by J.P. Morgan Chase

Bankruptcy of Lehman Brothers Acquisition of Merrill Lynch by Bank of

America Only two remaining major firms:

– Goldman Sachs and Morgan StanleyConverted to commercial bank holding

companies in 2008

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Largest M&A Transactions

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Size, Structure & Composition

Dramatic increase in number of firms from 1980 to 1987; Decline of 37% following the 1987 crash, to year 2006

1987: Salomon Brothers held $3.21 billion in capital

2006: Merrill Lynch held capital of $35.5 billion

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Size, Structure & Composition

Many recent inter-industry mergers (i.e., insurance companies and investment banks)– Role of Financial Services Modernization Act,

1999

Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008

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Types & Relative Sizes of Firms

National full-line firms are largest– BOA (via acquisition of Merrill Lynch) Morgan

Stanley

National full-line firms specializing in corporate finance are second in size– Goldman Sachs, Salomon Brothers/Smith

Barney (Citigroup)

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Remainder of industry:– Large investment banks (Lazard Ltd. And

Greenhill & Co.)– Regional securities firms (subdivided into large,

medium and small)– Specialized discount brokers, electronic trading

firms, venture capital firms, and other firms

Types & Relative Sizes of Firms

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Top Bank Holding Companies 2009 (by brokerage fee income)

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Key Activities Investing Investment banking

– Activities related to underwriting and distributing new (IPOs) and secondary (seasoned) issues of debt and equityPublic offerings & private placements

Market making– Increasing importance of online trading

Technology risk

– Decimalization

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Activities (continued)

Trading– Position trading, pure arbitrage,

risk arbitrage, program trading

Cash management Assisting with M&A Back-office and service

functions

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Recent Trends Decline in trading volume and

brokerage commissions – Particularly since crash of 1987, although

some recovery since 1992; Record volumes 1995-2000

Declines in market values--and commission income 2001-2002

Resurgence in market values and commissions during mid-2000s

New lows in 2008

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Trends (continued) Pretax net income over $9 billion per

year 1996-2000 Pretax profits soared to $21.0 billion in

2000– Curtailed by economic slowdown and

September 11 attacks 2001 Worries over securities law violations

and investor confidence Financial crisis, 2008 Profits recovered, 2009

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Securities Industry Pretax Profits, 1990-2009

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Balance Sheet Key assets:

– Long positions in securities and commodities– Reverse repurchase agreements– Implications: Market, interest rate & F/X risks

Key liabilities:– Repurchase agreements major source of

funds– Securities and commodities sold short– Broker call loans from banks

Capital levels much lower than in banks

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Regulation

Primary regulator: SEC – Reiterated by National Securities Markets

Improvement Act (NSMIA) of 1996– Prior to NSMIA, regulated by SEC and

states

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Regulation

Early 2000s erosion of SEC dominance – Increased vigilance by State Attorneys

GeneralCriminal cases brought mainly by states against

securities law violators∙ New York State vs. Merrill Lynch

Spring 2003, $1.4 billion in penalties over investor abuses

New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest

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Regulation (continued)

Sarbanes-Oxley Act of 2002– Independent auditing oversight board

under SEC– Instigated by Enron, Global Crossings,

Tyco, WorldCom

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Regulation (continued)

SEC sets regulatory standards– Day-to-day regulation: Financial Industry

Regulatory Authority (FINRA)Example: Floor trader at Fleet specialist

fined $25,000 for mishandling customer orders (10,000 shares of GM sold from Fleet’s account on rumors of problems at GM)

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Extension of Oversight

Additional oversight from US Congress– Hearings focused on role of investment

banks in the financial crisisGoldman Sachs bundling of toxic assets

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Extension of Oversight

2010 Financial Services Regulatory Overhaul Bill – Financial Services Oversight Council– New authority for Federal Reserve to

oversee payment, clearing, and settlement systems

Executive compensation in the financial crisis culminated in “pay czar” (Feinberg)

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Investor Protection & Other Monitoring

Securities Investors Protection Corporation (SIPC)– Protection level of $500,000

October 2003 implementation of provisions of Patriot Act to combat money laundering– Scrutiny of individual identities and

affiliations with terrorists

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Web Resources

For details of regulation of securities firms and investment banks, visit:SEC www.sec.govNYSE www.nyse.comNASD www.nasd.comSIPC www.sipc.org

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Global Issues Global nature of securities firms

– Competition between US and European firms

– Foreign investors’ transactions in US securities and US investors’ transactions in foreign securities exchanges increased

– Global concern about capital, liquidity and leverage following the financial crisis Implications for global competitiveness

∙ Strategic alliances∙ Exits from foreign markets

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Pertinent Websites

Federal ReserveNASDNYSESECSecurities Industry

AssociationSIPC

www.federalreserve.govwww.nasd.comwww.nyse.comwww.sec.govwww.sia.com

www.sipc.org