Investment and Commercial Banking, Research Paper Example

Introduction

Investment banking takes on a different structure and set of activities than a traditional banking environment. The differences between investment banking and commercial banking are derived from the core functionality and purpose of their systems. The illumination of the differences also pushes the need for differing acts and laws for each set of banking system. There are other acts and regulations that dictate, control and monitor the activities of investment banks. The Glass-Steagall Act and the Gramm-Leach-Bliley Act are key examples of the need for greater structure and control in the banking system.

Investment Banking

Investment banking has the role of assisting individuals, corporations and event government entities in raising funds. They do this by underwriting the entity borrowing the funds. By underwriting the investment bank raises the capital from other investors on behalf of the corporation or individual requesting the funds which is done in exchange for a premium on that investment. The investment bank bears the risk of raising the capital in exchange for this premium but their roles in the financial markets are not centrally based in loans and returns. The investment bank also facilitates mergers and acquisitions and also provides services for money markets, derivative trading and securities. The main functions of investment banks have evolved over the years and are constantly adapting to ever changing demands from both customers and regulatory bodies.

There are three distinct areas of investment banking that differentiates and establishes itself as a financial tool and market that requires monitoring and controlling by outside entities to ensure financial stability and continued prosperity(Fleuriet88). The distinct functions and corollary aspects of investment banking to the growth and stability of the nation has been under scrutiny and watch ever since the depression of the late 1920s and 1930s. The first area includes the front office portion of investment banking. This area is readily noticed and is normally associated with the investment banking environment. The front office includes corporate finance and raising funds in the capital market as well as arranging mergers and acquisitions which ultimately lead to growth and opportunities for the companies utilizing the investment bank. The biggest change from the initial implementation of the investment banks includes the ever increasing role the investmentbank has in the overall investment strategies of individuals and corporations. The initial responsibility of the investment bank was to create a market for securities to be bought and sold while utilizing this market to increase the capital for business and individual growth. This transition from public offerings, brokerage activities, mergers and acquisitions to a full-service investment firm allowed greater flexibility and investment prowess to be utilized by investors. Some of the key areas that expanded the role of the investment banks included investment research and analysis, investment portfolio management and proprietary trading. There was a market for advisory services and the front office of the investment banks filled that need with their ability to understand and provide guidance in the market.

Financial planning or laying out a plan on how to execute, allocate, collect and generate capital for an organization starts out with the estimation on what will be required by the organization to achieve their goals and objectives. This is where the front office and the middle office start to overlap. The middle office is where more analysis and management of the financial markets take place. There is a process for achieving the financial objectives of a corporation or individual which include establishing financial goals, researching pertinent data, data analysis, planning, implementation and monitoring and controlling the plan. The investment banks ultimately wanted to take that core competency out of the hands of the individual and provide their expertise to guide the decisions. The goals of raising capital and making sure it does not lose value hinges upon the marketable security is to keep capital available but still return benefits for short term investments. (Emery, Finnerty and Stowe45).

This is where the risk management of the middle office takes place. Risk is the possibility of a deviation from the expected result. Many people that are monitoring, controlling, reviewing or evaluating risk associate risk as a potential loss or a type of undesirable outcome to an intended plan, project, process or system. The result of a risk can be associated to specific outcomes or costs associated with the risk (Ramos13). This is heavily dependent upon the variables of the risk such as probability or likelihood of occurrence, level of deviation from the intended plan and the breadth or impact of the risk (Cooper, Grey, Raymond and Walker 126). The importance of risk management becomes increasingly apparent during downturns in the economy. That is another key factor in the heavy regulation and involvement of outside entities to provide a level of structure and integrity to the overall investment banking system. While the middle office is integral in the risk management and control aspect of investment banking there is also a back office.

The back office includes the operations of the investment bank system. This includes all aspects that are required to keep the financial institution up and running while also ensuring data integrity, security and validity. Everything from transactions processing correctly to data validation and retention are covered in the back office activities. This includes information technology infrastructure, software, storage, access and security.

Investment banking is a representation of corporate finance including both products and industries. The main role of investment banks is to oversee and provide guidance on financing, mergers and acquisitions and guidance and transactions. The investment bank in essence is the intermediary between two or more parties performing a multitude of financial services including the underwriting, intermediary for securities, facilitator and broker. When the roles and responsibilities of the investment bank are boiled down to the least common denominator they encompass the facilitation of financial opportunity by shifting risk from one area to the other for financial gain. This strategic approach by an investment bank to facilitate financial growth transactions will ultimately benefit both the party utilizing the securities or other financial instrument to gain capital as well as those investing their funds.

Investment and Commercial Banking

Investment banks are entities that do just that. They invest or create the ability to invest. This is a different approach and technique to raise capital and conduct financial transactions. The investment bank does not take deposits while commercial banks base their ability to provide capital on the deposits they have and expect to have. Commercial banks manage accounts such as checking and savings. The commercial banks then make loans based on these accounts which are held as deposits. Investment banks raise capital through initial public offerings, facilitation of stock purchases and sells as well as other security exchanges. The difference on where the funds come from to raise capital is a very distinct and easy to recognize separation between commercial and investment banking but there are also other deviations between the two (Jackson3). The way each area is regulated is also vastly different. The commercial banking industry is heavily regulated by the Federal Deposit Insurance Corporation (FDIC) as well as the Federal Reserve. This is because the funds held by the commercial banks are insured by the government which protects the customer from losing their deposits. On the other hand, investment banks do not take deposits but only investments from their patrons. This means that the investment banking is inherently more risk tolerant than commercial banks. Investment banks are not federally insured and are generally loosely monitored and regulated by the Securities Exchange Commission (SEC)(Fleuriet 92). The investment banking risk model is skewed toward higher risks and ultimately higher return on investment. The commercial banking industry higher regulatory compliance effort restricts the ability to take on higher levels of risk.

The purpose of investment and commercial banking differ as well as how their funds are raised, monitored, controlled and risk mitigated but their core business function is to increase the return on investment by expanding the capability of the capital by allocating it to other growth opportunities. Prior to the late 1920s, both investment banking and commercial banking were housed and regulated under the same rules and regulations and the same banks took part in all financial activities. Mixing the investment and commercial banking activities led to disparate strategic goals and objectives as well as crossing many lines of segregation of duties on raising, dispersing and managing capital.

In the early 20^th century the great depression was thought to have been facilitated by the mix of commercial and investment banking activities and the ability to segregate and control the financial markets demanded something to be done on a grander scale. In 1933 the Glass-Steagall Act as part of the Banking Act of 1933, mandated a complete segregation of investment banking and commercial banking (Jackson 4). This allowed specific governance to be imposed upon the commercial banking industry without thwarting the ability to raise and issue capital in the investment banking environment.

The Glass- Steagall Act imparted total segregation between commercial and investment banking. This act laid out specific aspects of what entails an investment bank and what it could and could not become involved with regarding financial transactions and activities. They also outlined what a commercial bank could not become involved in. The provisions outlined in the act included sections that outlined that an institution that was a deposit institution could not take part in acting on behalf of customers with securities, investing in securities as themselves, underwriting securities, affiliate themselves with companies or institutions that take part in those activities or share employees with organizations that are involved in those activities (Carpenter, and Murphy 12). The purpose of this act was to separate the potential conflicts of interest in lending and investing credit, limit the enormity of power of the financial institution and shift risk and limit exposure to all markets when risk is generated by specific areas. These key areas were deemed potential causes or catalysts to the financial demise causing the financial market crash and the economic hardships felt during the 1920s and 1930s(Fleuriet 111). While this premise to limit conflicts of interests, regulate the inherent power of the financial markets and manage risk all are valid points and present critical pieces of the financial puzzle there are other voices to be heard regarding negation of the act and the ability for markets to act on their own. The Glass-Steagall Act focused primarily on those institutions that housed deposits. This mean that the regulations being developed were poised for those institutions and the investment firms would run their financial activities in a greatly less regulated environment. The power was initially limited because the financial institutions had to divide their business into separate and segregated entities. This led to investment banks combining resources and becoming more powerful than they were prior to the crisis in the 1930’s. The risk that is inherent in the nature of investing was shared with commercial and investment banks prior to the Glass-Steagall Act. The act took that risk away from the commercial side but it did not solve the problem. The risk was still evident and instead of isolating the risk it could have been mitigated through financial market diversification or other risk mitigation techniques.

The Gramm-Leach-Bliley Act

As part of the Financial Services Modernization Act of 1999, the Gramm-Leach-Bliley Act was enacted to repeal part of the Glass-Steagall Act of 1933 (Carpenter and Murphy 5). The main provision of this act was to remove the barriers between investment and commercial banks specifically in the areas of banking, securities and insurance. Previously one company could not act in any combination of those three. Now commercial banks, investment banks, insurance companies and securities firms could merge and consolidate their financial strategies and objectives. With the changing economic climate globally and the desire to manage financial transactions in one central location, there was a desire for the act to allow this financial conglomeration of activities under one central location. The ability to provide investment opportunities as well as savings or deposit accounts provided the financial institutions with greater flexibility and a more consistent stream of funding. The enactment of the Gramm-Leach-Bliley Act was eased into the center stage by the push of big financial institutions. Many companies such as Wells-Fargo, American Express and CitiBank pushed the envelope on what was allowed and what was in violation of the Glass-Steagall Act. In 1998, Citibank was given a forbearance on their activities based on the shear fact that Citibank was powerful enough to push an act through congress to remedy the guidelines established in 1933 (Carpenter and Murphy 5).This ended up being the case with the passage of the Gramm-Leach-Bliley Act. This afforded financial holding companies the ability to transact in ways that they were previously restricted from doing so.

As part of the changes in the financial environment, financial holding companies were created to transact in nonbanking activities. This included providing financial services such as investing in securities as well as insurance. These types of holding companies were allowed to affiliate themselves with securities firms and insurance companies who were previously forbidden. The creation and implementation of the financial holding companies also required specific handling and monitoring. The Federal Reserve Board was responsible for overseeing the financial holding companies that extended into the securities and insurance markets while also earning 85% of their gross incomes. The caveat to that is that while the company may become a financial holding company at this rate of investment and income, the company must diversify and divest itself from the nonfinancial business within ten years (Emery, Finnerty, and Stowe 18). With this act in place there was more flexibility in the financial market but there was also inherently more risk.

Developments

Investment banking encapsulates a range of activities and transactions including underwriting, selling and trading securities as well as financial advisory activities, mergers, acquisitions and managing assets for individuals, corporations and governments. This broad base of clients as well as the plethora of functions the investment bank can provide can be a daunting undertaking and requires a high level of expertise and management. The focus of maximizing client profitability, aligning the goals and objectives of the customer with the available opportunities, managing the fluctuating markets and maintaining adherence to regulatory guidelines place a burden on the financial companies. Recently the global economic outlook deteriorated based on the self-imposed volatility and unsustainability of the financial markets. The financial crisis ensued and new challenges were presented to the investment banking industry. The biggest development in the investment banking market is the force reduction in investment banking positions globally. Deep cuts to the workforce have removed many talented individuals from the investment banking career path and new talent is not pushing to accept the risk of a career in such an arduous and uncertain future. The financial crisis still has many markets reeling and is forcing the investment banking sector to take an internal view of it to understand how it can rebuild from the massive blow.

As the investment banking era was hit with the financial crisis it was all but ended when Morgan Stanley and Goldman Sachs registered with the Federal Reserve to become commercial holding banks as opposed to financial holding banks. This development shows the trend toward higher regulation, increased structure and a more risk adverse financial strategy by financial institutions. Survival through a tough crisis is the biggest recent development and the traditional investment banks are seeking shelter from the negative ramifications of the economic downturn.

Works Cited

Carpenter, D., and Murphy, M.Permissible securities activities of commercial banks under the glass–steagall act (GSA) and the gramm-leach-bliley act (GLBA).Congressional Research Service Report (R41181).(2010).Print.

Cooper, D. F., Grey, S., Raymond, G., & Walker, P. Project risk management guidelines, managing risk in large projects and complex procurements.John Wiley & Sons.(2005). Print.

Emery, D. R., Finnerty, J. D., & Stowe, J. D.Corporate financial management.Pearson College Division. (2007). Print.

Fleuriet, M. Investment banking explained, an insider’s guide to the industry. McGraw-Hill Professional. (2010). Print.

Jackson, W. Glass-Steagall Act: commercial vs. investment banking. Washington D.C., USA . (1987). Print.

Ramos, M. (2008). How to comply with sarbanes-oxley section 404: assessing the effectiveness of internal control. (3rd ed.). Hoboken, NJ: John Wiley & Sons, Inc. (2008). Print.