Chapter 7. Investment Banks

Chapter 7. Investment Banks

Most people are familiar with the activities of commercial banks because of the role they play in every day life. Commercial banks take deposits in the form of certificates of deposits, passbook savings accounts, and money market accounts. They use this money to provide loans. You have your checking account at a commercial bank. These borrowing and lending activities are much different from the primary activities of investment banks.

The primary role of investment banks is to help companies raise capital by issuing securities. Company managers are experts in the business activities of their particular industry. They know how to build, market, sell, and service their products. These managers are not experts in obtaining the capital they may need to develop new products or expand operations. Should the company sell more stock or conduct a bond issue? What about more complex securities like preferred stock or convertible shares? Financial engineering over the past decade has created some very complicated securities. Should a firm sell the securities to public investors or to deep-pocket private investors like state pension funds? Indeed, even the process of registering new securities with the SEC is complicated. Investment banks specialize in steering firms through this maze of questions and helping them obtain the needed capital with the best security issue.

Both commercial and investment banks find capital for those who need it. Commercial banks are mostly compensated by the difference in interest rates that they receive from lending and paying depositors. Long after money initially changes hands, these banks continue to service both the depositors and lenders. Alternatively, investment banks are compensated by a fee that is charged to the company for selling the new securities. After the firm gets the capital and the investors get their security, the investment bank no longer is involved. That is, investment banks put together deals and then move on. They are an important and integral part of the corporate system.

Some Historical Perspective

Modern U.S. investment banks are descendents from the merchant bank. Merchant banks used their own capital to stake traders in their various risky endeavors. This was particularly the case for foreign trade in the 1600s and 1700s. In those days, conducting trade over long distances meant taking the risk of losing cargo to weather or piracy, and the normal risks of business, like competition and product substitutes. Merchant banks helped to fund the trade expeditions in exchange for a stake in the profits.

The merchant banks were especially active in the United States when it was still the American British Colonies. Trade ships brought natural resources from America to Europe and returned with goods supplied from all over the world. These voyages were funded through merchant banks. After the Revolutionary War, a fledgling United States found that it had an abundance of natural resources and capitalistic spirit, but very little capital. The merchant banks set up private banks in the United States to help businesses obtain capital. These banks had contacts in Europe, the source of most capital at that time. They became intermediaries between the sources of capital and the American businesses. [1] Junius Spencer Morgan founded one of the best-known firms, J.S. Morgan and Company. Junius, his son, and his grandson were particularly adept at funneling foreign capital to the United States. His son, John Pierpont Morgan, ran the activities in America and eventually named that operation J.P. Morgan. Today, the firm is called JPMorgan Chase & Co. Of course, many things have changed. Now, the United States is the greatest source of capital in the world. Foreign firms and even foreign countries issue securities in the United States to obtain capital.

In the early 1800s, most of the investment banking activities were in treasury , municipal, and railroad bonds . These early investment banks also helped to set up new markets in the United States. For example, Marcus Goldman established Goldman Sachs and Company in 1869 and created the U.S. commercial paper market. Commercial paper is a security similar to U.S. Treasury Bills except that financially strong companies issue them, not the government.

The differences between commercial-bank and investment-bank activities began to vanish in the mid-1920s. The go-go excesses of the 1920s were similar to those of the late 1990s. The economy was strong and the stock market continuously advanced. The government inadvertently contributed to the exuberance in 1927 by allowing commercial banks to participate in the stock issuance process. From 1926 to 1928, the number of new stock issues increased eight-fold. Many new companies were coming to market.

As described later in this chapter, there are different methods for a bank to help issue stock. One process is called underwriting. Underwriting involves the bank taking some risk. The bank guarantees that the company issuing the security will receive a specific amount of capital. If the stock doesn't sell well, the bank can lose money. This had a large impact on commercial banks in the stock market crash of 1929. They were stuck with stock they could not sell. The losses of the banks impacted the depositors. Indeed, worried people with bank deposits demanded their money back. The panicked rush to the banks forced them to close and caused runs on other banks. Soon, the whole banking system was in shambles. This contributed to the severity and duration of the Great Depression that followed.

After the stock market crash of 1929 and the following economic slowdown , the U.S. Congress held hearings and conducted investigations. Investors demanded reform. In the spring of 1933, a bill known as the Glass-Steagall Act of 1933 was introduced and passed relatively quickly. The law had two main components . The first part of the law was to create deposit insurance so that people would have confidence in the banking system and faith in the safety of commercial banks. The second part of the law was the separation of commercial banking and investment banking. Investment banks could not receive deposits from the public and commercial banks could not conduct underwriting activities.

History tends to repeat itself. By the early 1980s, the U.S. commercial banks were lobbying Congress to allow them into investment banking activities. The Federal Reserve Board finally allowed commercial banks to underwrite commercial paper, municipal bonds, and asset-backed securities (like mortgage- backed bonds). [2] This decision went to the U.S. Supreme Court in 1988, which let it stand. At the same time, investment banks were moving into areas of retail banking. For example, the money-market mutual fund plays a similar role as a bank deposit. Finally, much of the Glass-Steagall Act of 1933 was torn away in the Financial Services Modernization Act of 1999 (also known as the Gramm-Leach-Bliley Act). The passage of this act allowed investment banks and commercial banks to affiliate with each other under one holding company structure. Several banks quickly merged into this structure. For example, JPMorgan Chase & Co. is the financial holding company for two main banking entities, JPMorgan and Chase Manhattan Bank USA. JPMorgan is an investment bank while Chase Manhattan is a commercial bank.

It is hard not to notice that investment banking and commercial banking were allowed to merge in both 1927 and 1999. Both convergences occurred during the run-up of a stock market bubble and preceded a severe market decline.