Investment Banking

1. Investment Banking Fall 2012 Global Development Institute Okyu Kwon

2. Contents I. Raised Issues -Financial Alchemist vs. Culprit of the Financial Crisis? II. Trends of Global IB III. Domestic IB - Current Status & Problems IV. Suggestion for Development of Domestic IB - Three Success Factors: Brand / Manpower / Money - Direction of Development

3. I. Raised Issues (Why Still Investment Banks Matter?) • 1823 Byron: described Rothschild and Barings as the true rulers of Europe. • 1907 JPMorgan: took the lender of last resort role in the financial crisis arising from the trust company’s expansion without restriction. →FRB created in 1913 after recognizing the risk that financial stability depends on an individual company like Morgan. • Investment banks expanded rapidly since the 1980s due to the fastest growing in direct financing. → Financial innovation through the development of new products goes beyond just meeting the existing demands to creating new demands. → There appears a trend that big financial institutions involves more in investment banking as investment banks lead financial industry. • In this process, it causes spread of risk due to excessive borrowing, underestimation of risks in securitization, profit supremacy in prioritizing organizations’ and their own interest, and blind faith in credit ratings, etc. → brought in the subprime crisis by causing a credit bubble.

4. I. Raised Issues (Why Still Investment Banks Matter?) • This is the result of investment bank's moral hazard, turning of commercial bank for investment banking, and failure of the regulatory authorities’ adequate supervision. • Although regulations on the ‘liberty‘ which is the biggest advantage with investment banks are being strengthened, the functions of investment banks in the capital market are still important. → IB will seek new developmental directions under the new regulatory framework for investment banks to prevent credit bubbles.(IB’s profit in 2010 already surpassed pre-crisis levels.) • In Korea’s case, investment banking still remains at an early stage. However, conditions for the development of investment banking have got ready. They are accumulation of capital, advanced workforce and institutional framework. We need to actively pursue development of investment banking.

5. The launch of major investment banks(Rothschild, Barings, Morgan) • Rothschild : -an international financial group established in Frankfurt in 1764 by Mayer with his five sons, a Jewish money changer and a court trader of William Ⅸ, the Lord of Hessen; co-leader with Barings in British financial markets in the 19th century. -His five sons became: (1)finance minister of Prussia, (2)financier of Austrian Premier Metternich, (3)a merchant banker in the UK, (4)financier in Italy, (5)financier in France. They formed a global network in that world. -Victory in the Battle of Waterloo by General Wellington actually depended deeply on Rothschild’s network to provide war fund under the sea blockade by Napoleon. -William IX: the first capitalistic Lord- raising capital through sending his people to war place as mercenary. -Mayer, a Jewish migrant, lived in ghetto; The name Rot Shield means that at the middle age when people lived without any name, he put a red shield on the outside of his house; Tat’s why he was called Rot Shield, which became his name later; At that time, interests were regarded as sin in Christian world, but a Jewish like Mayer was free from such a Christian ethic; -It flourished for 250 years in Europe involved in funding in the Battle of Waterloo, construction of the Suez Canal, the US’ purchase of Louisiana from France, laying European railways, and African business of the UK. -It’s influence began decreasing because of shrinking of London as a hub of international finance, nationalization of commercial banks in France, Hitler's press on Jewish in Germany, and delayed entry into the Wall Street. -But still, the 2011 league ranking of Rothschild in global financial market is at the 29th. Now, Rothschild family left financial business and turned into top class wine producer.

6. The launch of major investment banks(Rothschild, Barings, Morgan) • Barings : • Originally a wool company run by Barings family; London branch office began providing credit to merchants who wanted to by wool products from Barings Company. • It had grown through industrial revolution period as wool business flourished. Later, it became major financial partner of major governments in Europe and the new world. *War between England and Netherlands: Netherlands won three times; monopoly in international trade divided between the England’s East Indian Company and the Netherland’s East Indian Company; the latter was given exclusive right in spice trade while the former wool trade. • It’s status as a global financial leader had declined after receiving bailout money due the Argentine’s default crisis in 1890. • Nick Leeson, director of Singapore branch, caused on the total loss of $ 1.3 billion due to derivatives speculation transaction from 1992 to 1995, and as a result, the company went bankrupt in 1995. *This is a typical case of operational risk of financial institutions. • ING of the Netherlands acquired all subsidiaries of Barings by ￡1 + debt, became ING Barings. → After the 2008 global financial crisis, ING Barings dropped the name Barings, and returned to ING.

7. The launch of major investment banks(Rothschild, Barings, Morgan) • Morgan : -started from a merchant bank established in London by Peabody, an American person. After his retirement, his partner Spencer Morgan took over the company and laid foundation in the Franco-Prussian War by supporting France’s Napoleon III. *As a latecomer, Morgan decided to support France which global banks would not do that. Morgan underwrote France’s sovereign bonds. As France lost the war, that bonds went default, and investors asked the underwriter to take over the bonds at almost default price. As the managing underwriter, Morgan took over them. Few years later, France’s republican government decided to repay their bonds, and price of the bonds skyrocketed. *Similar cases are found in the US local states’ bond issues. Morgan took the role as chief negotiator with European continent for the US local states’ debt rescheduling such as Pennsylvania and Maryland. Morgan was also a managing underwriter of many such bonds. Morgan repurchased those bonds, and as the local states resume interest payments, bond prices went skyrocketing. -Morgan became a leading investment bank representing the US in Piermont Morgan’s generation, who was Spencer’s son. *In the era when there was no central bank in the US, Morgan took an important part in taking over the US government bond to maintain gold standard, restructuring of the overinvested railway industry, and providing syndication loan to build industrial trusts such as the US Steel and The North Atlantic Marine, etc. Morgan had acted like a last resort lender in frequently arising financial panic situations including bailout measures for trust and brokers. *Such a role of Morgan led to the establishment of the Federal Reserve in 1913. After numerous bank failures in the Great Depression, Glass-Steagall Act was legislated to separate commercial banks from investment banking. Morgan was also divided into commercial bank JP Morgan and investment bank Morgan Stanley.

8. World Top 25 Financial Firms(2011, based on employment, by Vault)-IB 16, commercial banks 5, European UB 4: IB continued a leap after the 2008 global financial crisis.- Deloitte, an accounting firm, ranked at the 33nd; From Asia-Pacific, Macquarie ranked at the 38th and Nomura at the 40th.

9. Type of investment banks • Stock company type IB - Stock company directly runs investment banking or indirectly runs with a subsidiary or a subsidiary of the holding company. *Goldman Sachs, Morgan Stanley: They got commercial bank lincense after the financial crisis in order to open the road to get support from the FRB, but never intended to involve in commercial banking. *Blackstone, Lazard • Holding company type IB - Commercial bank indirectly runs investment banking through a subsidiary of holding company. *Citigroup, JP Morgan Chase, HSBC • Universal banking type IB - Commercial and investment banking are combined in universal banking, which has developed from merchant banking history in Western Europe. *Deutsche Bank, Barclays, UBS, ING, BNP Pariba

10. The role of investment banks • Commercial bank is basically financial intermediary engaging in indirect financing byaccepting deposits and providing loans. They pursue a margin business, where profit is generated from interest difference between deposits and loans. • Investment Bank supports company’s direct financing by advising securities issues or M&As. Initially IB pursues a simple fee business like a stock company or a realtor. Later, it advanced to pursue a commission business by advising the whole financing process. Advise itself generates small profits, but in the follow-up financing process, other sources of income reach 5-8 times bigger compared to the advise fee. -These advises include advises on bond maturities, bond interest rates, stock price, etc. In terms of IPO, IB tries to give full advices mobilizing all of its professional knowledge. Comparison of investment and commercial banks Investment Bank Valuation Sale Issue of shares Underwriting Assessed at 100 million won 10,000 shares (par value 10,000 won) Take-over at 90 million won Corporate Stock market deposit loan Corporate / household Surplus fund Commercial Bank interest interest

11. The role of investment banks -When financing method is determined, IB provides guarantees on price and selects underwriters. Mostly IB itself becomes the underwriter independently or jointly. *IB directly contacts potential buyers such as commercial banks or insurance companies and sells those securities. IB often sells to general public through advertisement. -In case of M&A, IB intermediates M&A and provides funding such as LBO loan or covenant-lite loan. -Financial innovation has been IB’s core work: securitization of laden assets, development of various credit derivatives such as CDO, CDS, etc. -IB invests with its own money as principal investor(PI), borrows money utilizing high leverage, or organizes a PEF. → In short, core concept of IB business is the risk warehouse function to make profit in the process of acquiring and managing risks.

12. Rapid development of investment banking • Thanks to financial innovation by investment bank just like an alchemist, width, depth, and richness of financial instruments have increased substantially. * IB develops and utilizes a variety of financial innovation such as swap, option, securitization, leverage loan, etc. - Financial assets in the world is expanding dramatically. Instead of the advantages of commercial banks, such as long-term loans and ongoing relationship with customers, and limitations, such as focusing on balance sheet business, IB expanded its business to off-balance sheet area and diversified risk management, and therefore, began to lead the market. - In investors’ perspective, the center of finance moved from deposit to investment. 19802005 • The global financial assets/ World GDP (%) 109 316 • Weight of savings in global financial assets (%) 42 27 • Total size of global financial assets in 2006: $146 trillion (U.S. GDP $12 trillion) - As Glass-Steagall Act was repealed in 1999, commercial banks and investment banks accelerated competition in the business boundary of the other sides. * UBS, CS, Deutsche Bank and many European banks entered the US investment banking market to avoid over-competition at home. PEF, hedge funds, and boutique investment banks also entered the US market. • Commercial bank-based Citi, JP Morgan, etc. also actively participate in the IB business utilizing their power base such as enormous funding capacity and assets size.

13. Factor of rapid development of investment banking(1) (1) The first financial innovation: swap and option - Swap allows evaluation of interest rates, etc. through calculation of future cash flows’ present value. * The first swap was brokered by Solomon Brothers between World Bank and IBM to exchange different currency debts. * During ’70s to early ’80s, floating rate bond market was expanded, which was transferrable, and therefore appealed to larger investors compared to syndication loans. Since cost of floating rate bond was cheaper than syndication loans, leading role in fixed income market turned over from loans to floating rate bond. But, still, commercial banks led the market. *Change occurred in ‘80s when swap market began developing. Thanks to swap arrangement, there appeared low cost fixed rate bond. In addition, as interest rate was declining due to inflation, investors preferred fixed-rate bonds. Now IB, which had extensive experiences in the bond market could prevail over commercial banks for the fist time. * In case of interest rate swap, two different customers are necessary. But it's not easy to find such customers and therefore, financial institutions usually saddled with inventory, which means commercial banks were advantageous with bigger asset size and higher credit rating. * In the US, since commercial bank and IB were separated, London branch of commercial banks entered into IB business by signing up swap transactions. That intensified competition, and the US commercial banks were astray with speculative behavior on off-balance sheet transactions. One result was the bankruptcy of Bankers Trust due to legal dispute with P&G on its sales of derivatives.

14. Factor of rapid development of investment banking(1) - Option allows to assess risks that can happen in the future. * Option transaction was kicked into high gear since Chicago Futures Exchange opened in 1973. On the basis of mathematical formula by Black-Scholes for pricing options, in the late ‘70s, stock option transaction was vitalized, and in the ‘80s, currency option and warrants trading were in boom. * Investment bank took advantage of options in stocks and foreign exchange trading. Commercial bank could make loans to institutional investors, outside of its conventional business based on balance sheet, which expedited commercial bank’s involvement in investment banking business.

15. Factor of rapid development of investment banking(2) (2) Financial Innovation: Securitization allowed locked(leaden) assets converted into liquid capital. - IB developed highly profitable businesses of credit derivatives trading such as CDS and CDO instead of dealing safe but low yield government bonds. Profits from credit derivatives trading came to occupy more than half of IB’s income. * Out of traditional stocks, bonds, foreign exchange, and commodities trading, IB expanded derivatives trading such as options, futures, and swaps. Now derivatives trading expanded to all aspects of life such as weather, risk of survival, exhaust gas emissions trading, even to disaster insurance. Sized of derivatives expanded from 3.5 trillion(1990) to 286 trillion dollars(2006), which was six times the size of global GDP at that time. * Asset managers pursued a high fee income by inventing the 130/30 funds, which mimicked hedge fund’s asset management, i.e. long/short strategy. - IB's assets on FICC(fixed income, currency, commodity) account surged by dealing with a variety of asset such as from subprime mortgage to yen currency, from copper futures to natural disaster insurance, from GE bonds to Zambia bonds. FICC revenues, half the size of stock trading, had doubled in 2006 compared to that in 2000. * Among them, the highest-growing area was ABS such as MBS based on commercial or residential real estate, which turned out to be a big failure in the case of subprime mortgages. High profitability from credit derivatives such as CDS and CDO, were also with high risks.

16. Factor of rapid development of investment banking(3) Traditional balance sheet (3)The expansion of balance sheet business - IB expands investment with not only customer’s money, but also with its own capital(PI) on high leverage. * Traditionally, IB involved in fee business like real estate agents, brokering sales of financial assets. But now it carries out loans, development of structured products, direct investment as principal investor. Its activities turned from off-balance sheet business to balance sheet business. - IB takes advantage of leveraged loan as an important financing method for PEF. *Leveraged loan means bank loans that bank has the right to get first reimbursement when borrower's financial situation is worsened. *Covenant-lite loan is increasing as PEF, who is the borrower, strengthens control power. *Banks are requested to provide bridge loan, and even short-term equity participation(i.e. bridge equity). -IB’s so-called triple play, investment advisory, financing, and equity capital participation, provides greater profit potentials. Modern balance sheet

17. Factor of rapid development of investment banking(4) (4) Securing new markets and customers worldwide ① Earnings were deteriorated because of introduction of online trading system in developed countries, and brokerage fee cuts by mutual funds, the conventional biggest customers. *Fee cut was due to intensified competition with hedge funds and ETF. -But, IB acquired new customers such as private equity funds and hedge funds. *The number of hedge funds: 10,000, $1.6 trillion(2007) → 9,000, $2.8 trillion(2011) - These newly emerged customers frequently change their portfolios, and therefore, trading volume can be expanded. - IB can get higher fee income as a prime broker that carries out transactions and their settlement, securities lending, financing, and introduction of new investors for the launch of new funds. - IB can get even higher fee income to meet customer’s demand on new investment products. *For example, mutual funds market was divided into simple index-based products with low risk-low return, and very speculative high-risk, high-return products which stand comparison with hedge funds. IB invented a useful investment strategy such as 130/30 funds which is very similar to hedge fund’s long/short strategy. *130/30 fund maintains net position of 100 by purchasing 130 of which price rise is expected, and short sales of 30 of which price fall is expected. This strategy requires a highly selective ability, which makes it possible for IB to get higher fee income. - As a result, research work targeted for general investor has declined, and a new era comes to contend for victory by providing customized information for customers such as hedge funds.

18. Factor of rapid development of investment banking(4) ② Acquisition ofnew capital markets and customers abroad - IB business were expanded from the US to Europe and Asia. * Since 2006, outside of the U.S. market in terms of size surpassed the United States; The profit of IB from Europe and Asia also surpassed that from the US;European bond and stock issue surpassed the US; M&A amount outside the US also surpassed the US. -Market in Asia and Eastern Europe were also greatly expanded; *Among the Citi's global 1000 customers, developing countries took 40 in 1992, but in 2007, it increased to 170; *The world's major IPO occurred in developing countries such as IPO of Gazprom, Industrial and Commercial Bank (ICBC), etc.; *IB’s key sales targets are now BRICS. IB also pay attention to N11 countries and resources-rich Great Crescent Region; *Sovereign wealth funds, rich petro dollars, and large enterprises from developing countries such as CNOOC, Tata, Gazprom, etc., are joining overseas investment, as cheap cost of financing becomes available to them; these funds are targeting companies in advanced country and natural resources; *In case of Japan, financial market was relatively underdeveloped due to past wrong business practices, strict firewall between commercial banking and investment banking, not-transparent regulations, and lack of professional human resources in finance. However, positive views are increasing thanks to domestic and international M&A surge, etc.

19. Factor of rapid development of investment banking(4) - Investment philosophy of the IB such as Citi, Morgan Stanley, etc. were changed; They concentrate on countries with enormous domestic market like China and Russia; They adopted a strategy to invest and stay where business opportunities exist; For example, they established large subsidiaries in Dubai. *In case of Dubai, financial business is largely o.k., but other businesses are not. *Palm Ireland Project is basically a land developer’s project. - However, the difficulty of risk management still exists in developing country businesses; * Credit Suisse hit loss of $ 1.3 billion due to Russia’s bankruptcy in 1998; Before 2008 global financial crisis, many European banks from Sweden and Austria faces massive losses due to de facto default in Eastern European countries. *Croatian case: -Sovereign wealth funds: *size: 4.8 trillion dollar in 2012. *countries of origin: Norway, Singapore’s GIC, China’s CIC, Korea’s KIC, UAE, etc. *Santiago Principle: International Working Group on Sovereign Wealth Funds led by IMF drafted some sort of principle to be abided by theses funds: that includes 24 principles such as range of disclosure, governance structure, and risk management guideline, etc.

20. Decline and restructuring of investment bank Restructuring of the large U.S. financial institutions • Decline of investment bank is due to risk management failure on high-risk derivatives, excessive leverage, and moral hazard prioritizing interests of the company and traders ahead of investors. • Due to the global financial crisis, Goldman Sachs and Morgan Stanley, ranked at number 1 and 3 respectively, turned to financial holding company; Lehman Brothers, ranked at number 4, went bankruptcy; Merrill Lynch and Bear Stearns, ranked at number 6 and 13, merged to BOA and JP Morgan Chase respectively. z Licensed Commercial Banks Goldman Sachs Goldman Sachs Licensed Commercial Banks Investment Bank Group Morgan Stanley Morgan Stanley Merrill Lynch Merger Comprehensive Financial Group (commercial banks + investment banks) Bankrupt Lehman Brothers Bear Stearns Merger Citi group Citi group Commercial Bank Group BOA BOA J.P. Morgan Chase J.P. Morgan Chase Financial Crisis March 2009 April 2009

21. Factor of the difficulty of investment banking(1) (1) Liquidity problems of securitized products - Underlying present value of the securitized products were overvalued despite the bankruptcy probability. * Securitization was initially to take out laden assets such as loan, real estate, etc. from the balance sheet; Later, the securitization idea was developed to create products that appeal to investors. * The original idea of particle finance, which isolates credit risk available to sell, was created by Charles Sanford, the Bankers Trust chairman; But, litigation burden on derivatives sales to Proctor & Gamble made Bankers Trust bankrupt and merge to Deutsche Bank in 1999. • These products are from a box in which multiple assets are put in, so the total amount of risk does not change. Just like CDO, products from that box have different credit ratings, and therefore, available to sell to different investors who have different risk preference. * Michael Milken’s junk bond had the exactly same structure. • However, the probability of bankruptcy, representing the degree of credit risk, is a provability function depending on the odds to move up and down according to the business cycle; In addition, in case of uniformity of assets such as subprime mortgage, there is always the possibility of a sharp rise in bankruptcy probability; This is called fat-tail in probability distribution. Further, the degree of leverage involved is unclear. • In short, subprime mortgage, which was actually a low-value product, turned to high exchange value product through present value conversion. Technique itself had a significance, but brought about a big problem through two processes; i.e. product design and credit rating. Blind faith in credit rating agencies and over confidence and pride of IB were blamed to create all the problems. - In addition, even though laden assets were once liquidated, it was not continuously to be liquidated, and therefore, liquidity problems are still to be resolved. *Woori Bank’s subprime mortgage investment was troublesome since such an investment was not the thing a commercial bank should involve.

22. Factor of the difficulty of investment banking(2) (2) Failures in concentrated risk management - In the past, resell of risk was favorably taken into account since it divided the burden of risk. Thanks to that, even in case of bankruptcy of Enron and WorldCom, and degrading of credit rating of GM and Ford, market was not seriously disturbed. →However, in case of subprime mortgage, which was not concentrated on one company, but concentrated on the homogeneous product, bankruptcy risk has increased seriously. - In order to limit the expansion of derivative product’s risk, advanced management techniques such as VaR were introduced, but the calculated number from such a risk management technique can not reflect the risk factor that comes from attacks outside the market volatility risk, such as credit rating, liquidity, off-balance sheet risk, etc. * VaR is a business indicator to limit risk, which reflects fluctuation of the market in the past on the basis of the prior odds of loss. However, it overlooks possibility of big changes that belong to fat tail in probability distribution. * In addition, off-balance sheet transaction has increased substantially and it was not clear how much the counter party risks are carried.

23. Factor of the difficulty of investment banking(2) - In this process, credit rating agencies and bond guarantee agencies like mono line are to be in part blamed for risk management failure, as well as supervisory authorities which neglected restrictions on off-balance sheet transactions. * Credit rating started from credit rating for the railroad companies in the 19th century. Their assessment on corporate itself and structured product is totally different things in the meaning that the latter assesses cash flow from the collateral the company holds, while the former assesses issuing company’s financial analysis. Therefore blind faith in credit rating (from the part of investors) and overuse of credit rating (from the part of investment bank) caused the problem. * Mono line was initially in charge of municipal bond guarantee, which later includes private bond. While multiple line handles all kinds of guarantees, mono line is dedicated to only bonds. * Fanny Mae and Fredie Mac were guarantee agencies, which were originally government sponsored enterprises(GSE) that went to privatization. They purchased housing-related loans from private financial institutions, and issued MBS based on those assets. They also provided guarantees for housing loans, which had the credit rebuilding effect since their guarantee had implicit government guarantee. Since subprime mortgage crisis, the US government injected public funds, and nationalized both of them, which now belong to Federal Housing Financial Services Agency since June 2010.

24. Factor of the difficulty of investment banking(3) (3) Excessive leverage and moral hazard problem from profitability first attitude -IB undertook balance sheet business like commercial banks. IB’s balance sheet was filled with excessive leverage items such as PI, PEF, and M&A using leverage loan, covenant-lite loan, etc. → IB rusted a sense of risk due to smooth business cycle and low ratio of default. And they purchased high-risk products with borrowed money in order to raise profitability. * By the end of 2007, asset/equity ratio of Merrill Lynch reached 27.8 times, GS 28.2 times, MS 32.8 times. - Since private equity funds and commercial banks, as well as hedge funds were all operating in high competition, product developers were requested to design their products with higher return. → Compensation of the individual as well as his section was directly connected to the profit they raise, so that such the profit first attitude brought about a moral hazard problem. - In fact, IB was the world's largest PEF, and at the same time advisor to that PEF, which caused various conflicts of interest problem. * Goldman Sachs was the advisor as well as the third largest investor to the PEF, next to Texas Pacific Group(TPG) and KKR, which took over the power company TXU of Texas amounted to $ 45 billion. It was not clear what was the role of GS. * In addition, IB’s services were provided for many customers at the same time, increasing the possibility of causing conflict of interest among customers.

25. Factor of the difficulty of investment banking(4) (4) Causing the credit bubble - After the collapse of the IT bubble, credit bubble was brought about by sustained low interest rate policy, but it was mistaken as effects of financial innovation. * Despite market signal that risk premium of junk bond has continuously decreased, since upturn of business cycle continued, the bubble was mistaken as a change in the structure of capital market. - With the proliferation of M&A bubble, market conceived that there was no company that can not be purchased. * KKR took over RJR Nabisco amounted to $25 billion with LBO method in 1987. In July 2006, KKR, Bain Capital, and Merrill Lynch acquired a chain of hospital HCA at $33 billion. In February 2007, Blackstone took over Equity Office Property, a REITS giant at $39 billion. Right after that, KKR, Texas Pacific Group, and GS purchased the power company TXU at $45 billion. * Covenant-lite agreements became popular, in which IB yielded agreement conditions since IB would get lion’s share of profit from the big M&A through arranging M&A and providing funding. - Since the subprime crisis, source of funding was dried up, which resulted in accumulation of NPL in the financial institutions saddling on LBO loans and junk bonds. * UBS's internal investigation report pointed out that the credit bubble failure was due to the rapid growth strategy for investment banking. It also mentioned that growth first principle and loose internal risk management system have been a hotbed for huge loss.