FINC write-up

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Securities Firms and Investment Banks

Securities Firms and Investment Banks (IBs)

Investment banks (IBs) help corporations and governments raise capital through debt and equity security issues in the primary market

Underwriting is assisting in issuing new securities

IBs also advise on mergers and acquisitions (M&As) and corporate restructuring

Securities firms assist in the trading of securities in secondary markets

Broker-dealers assist in the trading of existing securities

Investment bankers assist borrowers in raising capital in debt and equity markets and provide advice about mergers and acquisitions, corporate restructuring and general assistance in finance. Bankers also provide many creative over the counter derivative products. Securities firms provide brokerage and market making services. The investment banking and securities industries are complementary and many firms provide a broad range of services. Some specialized entities with advantages in certain market niches remain less diversified. The industry underwent tremendous consolidation in the last decade due to increasing scale and scope economies and the need for greater capital. The face of the industry was changed forever during the financial crisis of 2007-2008 with forced buyouts of Merrill-Lynch and Bear-Stearns, failure of Lehman Brothers and Goldman-Sachs and Morgan Stanley becoming commercial banks. Nevertheless, working for many of these firms is often considered the penultimate finance career, with prestige and remuneration to match. With industry profits down, firms on the Street are having a difficult time maintaining their large salaries and bonuses. A very significant portion of profits are paid out in the form of remuneration to executives. The chapter presents an overview of the size of the industry and the general strategies of the participants, major activities, primary assets and liabilities on the balance sheet, recent in the news events concerning breaches of ethics and the trend toward globalization.

Size, Structure and Composition of Industry

The size of the industry is usually measured by the equity capital of firms rather than total asset size

Equity capital in the industry in 2015 was $235 billion

The number of firms in the industry changed due to economies of scale and scope, losses with the economy, scandals at some firms, and regulations that allowed both inter- and intra-industry mergers

5,248 firms in 1980

9,515 firms in 1987

6,016 firms in 2006

4,115 firms in 2016

As with commercial banks, consolidation has largely occurred through mergers and acquisitions

Total assets in 2016 comprised $4.32 trillion. Equity capital, the more traditional measure for this industry, was $235 billion. The industry underwent shakeouts in the 1970s after “May Day” and again after the 1987 crash. The number of firms fell from 9,515 in 1987 to 5,063 in 2010 and to 4,115 in 2016. Ever larger firms have also been created via intra and inter-industry mergers. The amount of capital firms employ has also grown dramatically and probably now represents a valid entry barrier.

The industry can be broken down into three major subdivisions and a group of smaller specialized firms:

Commercial bank holding companies that operate diversified national full line firms that serve both retail and corporate customers such as Bank of America and J.P. Morgan Chase. These firms’ income comes primarily from brokerage, lending, and underwriting and trading activities.

National full line firms specializing in corporate finance such as Goldman Sachs. Their income is primarily from underwriting, placement, mergers and acquisitions other consulting services and trading income.

Large investment banks such as Lazard Ltd and Greenhill and Company

Specialized firms such as

regional investment bankers (D.A. Davidson, Raymond James), (sometimes labeled ‘boutiques’)

discount brokers (Schwab),

Internet brokers (E-Trade),

venture capital firms (New Enterprise) &

exchange floor specialists (LaBranche & Co.)

dealers in off exchange trading (KCG or Knight Capital Group)

The size of investment banking and securities trading is not properly measured by industry assets because, unlike bank or insurance financing, investment bankers and securities firms need not permanently hold all of their securities. Their purpose is to turn them over quickly. Equity capital measures a firm’s ability to turnover large issues since firms will only risk limited amounts of their capital at one time. Underwriting volume is also used to measure activity.

In May of 1975 brokerage commission rates were deregulated leading to reduced commission revenue. Lower commission revenue translated into lower profitability and caused a major industry shakeout of less competitive firms.

Investment Banking

Investment banking

First time debt and equity issues occur through initial public offerings (IPOs)

New issues from a firm whose debt or equity is already traded are called seasoned security offerings

A private placement is a securities issue that is placed with one or a few large institutional investors

Public offerings are offered to the public at large

IBs act only as an agent in best efforts underwriting

IBs act as principals in firm commitments

Investment banking is underwriting and distributing new issues of debt and equity. The top 5 underwriters are listed in Text Table 16-3. The top firms represented about 26.7% of the total underwriting volume. A key factor of success in the investment banking industry is reputation and bankers guard their firm’s name jealously.

One can see the pecking order in the banking industry in a tombstone ad. The lead or managing underwriter(s)’ names will appear at the top of the list of bankers involved in the issue. Where the bankers’ name appears in this list is very important to the banker’s reputation.

U.S. corporate underwriting activity for debt issues is almost always many times larger than the volume of equity underwriting though equity deals usually dominate the headlines. Investment banking strategy elements can be discussed with the help of Text Table 16-3 which contains the top underwriters for different security types. For the period January to September 2016 Morgan Stanley was tops for IPOs and JPMorgan for equity, syndicated loans and global debt. After declining precipitously during the financial crisis, and peaking in 2015, $5,518 billion of debt and $420.9 billion in equity were underwritten in the first 9 months of 2016.

Placement methods:

Firm commitment: In a firm commitment the underwriter buys the issue from the issuer at a set price called the bid price and then attempts to sell the issue to the final buyers at a slightly higher amount called the offer price. The banker acts as a principle in this transaction and the banker bears the risk of a failed issue if it does not sell. The banker may not raise the offer price during the offer period once it is announced. In this sense the banker has a profit profile similar to a written put option with limited upside gains and unlimited downside loss potential. Bankers slightly underprice issues and charge fees to offset the risk of underwriting. A significant amount of pre-selling activity occurs (the so called “road show”) to limit the investment banker’s risk of selling the issue.

Best efforts: The investment banker agrees to market and distribute the issue and use their ‘best efforts’ to sell the issue to the public, but the banker does not buy the issue outright and is not at risk if buyers do not want the securities offered.

Private placements: Issues sold to a few large primarily institutional investors are termed private placements and are exempt from SEC registration requirements. Private placements can now be traded among institutional and high net worth investors.

https://www.reuters.com/article/us-hsbc-hldg-moves/hsbc-cuts-top-investment-bank-jobs-despite-wider-firing-freeze-idUSKBN22221F

Venture Capital

Venture capital (VC) is a professionally managed pool of money used to finance new (i.e., start-up) and often high-risk firms

VC usually purchases an equity stake in the start-up

VC firms are not generally passive investors, but instead provide valuable expertise to the firm’s managers

Institutional venture capital firms find and fund the most promising new firms

Venture capital limited partnerships

Financial venture capital firms

Corporate venture capital firms

It can be difficult for small firms to obtain sufficient capital to grow. Many banks are not willing to lend to small firms who do not have a sufficient record of profitability and may not have sufficient collateral. An alternative source of financing is through venture capital (VC) or angel investors. Venture capitalists are typically limited partnership organizations that specialize in financing and assisting in the management of small startup entities. VC investors purchase an equity stake in the enterprise and usually are actively involved in the business management of the firm in which they invest. The VC firm will have a well defined exit strategy and an exit timeline. The exit strategy is usually to take the firm public or to find a buyer for the firm, usually within 10 years. VC firms usually invest money in stages to limit their capital at risk. VC capital is not uniformly distributed among different industries. A VC investor is looking for the ‘next big idea’ and is often concentrated in whatever industry is ‘hot’ at the time, often in technology and bioengineering firms. The typical VC investor has traditionally been looking for a 20% to 30% annualized return on invested capital, although in recent years returns on the NVCA index have been less than returns on major stock indices.

Many small investors obtain funding from angel investors. Angel investors can range from wealthy individuals who are willing to put up capital without requiring such a high return on investment nor providing active management to professional investment firms that specialize in smaller deals than VC firms.

The federal government provides funding through the Small Business Administration (SBA) to assist in venture financing. The SBA licenses privately organized Small Business Investment Companies (SBICs) to help finance entrepreneurs. SBICs can obtain funds from the Treasury so they have a cost advantage over private VC firms.

Some banks operate VC firms (financial VCs) and some corporations such as Intel operate VC firms as well.

Implementation of the Volcker Rule in July 2014 continues to lead to reduced investment in all forms of private equity by banks. Bank of America has eliminated its private equity fund and Goldman Sachs and Citigroup are reducing their investments. This may reduce the supply of funds available to VC and private equity, at least temporarily.

https://www.forbes.com/sites/suzytaherian/2020/04/26/what-is-the-future-of-venture-capital-post-crisis/#40e46e782981

Venture Capital vs. Private Equity

Private equity investments

Private equity (PE) differs from VC in funds sources and in types of investments

PE firms raise funds by selling securities rather than commingling private funds

PE firms often acquire established existing firms rather than purchase start-ups

Private equity (PE) differs from VC in funds sources and in types of investments. PE firms raise funds by selling securities rather than commingling private funds as many VC firms do. Second, PE firms often acquire established existing firms rather than purchase start ups. During and after the crisis however there have been fewer promising startups so VC firms have begun engaging in PE type investments.

https://nypost.com/2020/04/24/sba-bars-hedge-funds-private-equity-firms-from-ppp-small-business-loans/

Market Making

Market making involves the creation of secondary markets for an issue of securities

Agency transactions are two-way transactions made on behalf of customers

With principal transactions, market makers seek to profit for their own accounts

In 2016, J.P. Morgan Chase managed over $53 trillion in derivative securities (28% of all derivative securities held by FIs)

Market making is creating a secondary market for securities or contracts. These involve both agency (brokerage) and principle (dealer) functions. Brokerage is typically remunerated with commissions and dealers profit from the bid-ask spread. Dealers buy at the bid (low) and sell at the ask (high). Dealers incur the risk of price changes on the stock since they must maintain an inventory and bear inventory financing costs. On the NYSE, specialists are designated market makers that have an affirmative obligation to ensure ongoing market liquidity and price continuity. If the majority of investors wish to sell the stock, the specialist is charged with buying in order to provide market liquidity. In the event of a large market move the exchange’s circuit breakers may halt trading, relieving specialists of their obligation. In addition specialists may petition the exchange to halt trading in a given security.

The size of the spread is determined by the security’s volatility, inventory financing costs, the amount of trading and competition between non-colluding dealers and regulations. Decimalization reduced the minimum stock spread from about 6 cents (1/16) to 1 cent. To the extent that reduced spreads encourage more trading volume, specialists and other brokers could see an increase in commission revenue. Increased competition from ECNs and other markets have led to an erosion of specialist profits however.

JPMorgan managed $53 trillion in derivatives in 2016 (about 28% of the total held by FIs). Derivatives are a major source of income for banks, although they are risky. Losses from subprimes and derivatives were over $1 trillion as of 2009 so these are risky investments. Implementation of Dodd-Frank rules on OTC derivatives were phased in in 2013 and are now largely in place. The main changes are that OTC derivative positions such as swaps must be traded on an exchange and cleared through a clearing agency. This change will probably reduce profits per deal and may lead to increased capital commitments to meet margin requirements. However over the long run, one would expect a pickup in trading activity and perhaps volume which may create opportunities for banks to generate additional profits.

Trading

Trading involves taking an active net position in an underlying instrument or asset

Position trading involves relatively long-term views of market trends

Pure arbitrage involves attempts to profit from price discrepancies

Risk arbitrage involves attempts to profit by forecasting information releases

Program trading is the simultaneous buying and selling of at least 15 different stocks valued at $1 million or more

Stock brokerage involves trading on behalf of customers

Electronic brokerage offers customers direct access, via the internet, to the trading floor

Trading activities include:

Position trading: Holing a position for weeks or months

Pure arbitrage; arbitrage is taking advantage of a mispricing between two markets by simultaneously buying and selling the same commodity. Spot futures arbitrage is a common example.

Risk arbitrage; taking advantage of a real or perceived mispricing based on some information the trader possesses without perfectly covering or eliminating all the risk.

Program trading; defined as simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million in total using a computer program to initiate the trade. Some forms of program trading are either pure or risk arbitrage, such as stock index futures arbitrage trades. Portfolio insurance is another form of program trading.

Stock brokerage; processing buy and sell orders from the public. Many firms either buy or lease seats on the NYSE and/or are NASDAQ members.

Full service brokers offer research and advice about which stocks to buy, discount brokers process public orders for a reduced fee.

Electronic brokerage offers investors direct access to the trading floor, bypassing normal brokers and offering even lower fees than discount brokers. Examples include E-Trade and Ameritrade. Most large firms now offer clients a choice of full service brokerage or reduced cost electronic trading.

Investing and Cash Management

Investing involves managing pools of assets such as closed- and open-end mutual funds

As agents

As principals

Cash management involves offering deposit-like accounts, such as money market mutual funds (MMMFs), that offer check writing privileges

Securities firms have long offered accounts called Cash Management Accounts (CMAs) that were similar to bank checking accounts. Beginning in 1999 securities firms were allowed to offer federally insured deposits. These accounts have normally been checking accounts written on mutual fund investments. Many of these accounts now offer ATM and debit card services. CMAs make it easier and cheaper for brokers to process payments for security buy and sell orders. Note that since the FSMA securities firms can also offer loans, credit cards and other banking type services to customers and banks can offer traditional brokerage services. New rules that will soon be in place are likely to force these accounts to change. Currently money market investments have a fixed $1 net asset value (NAV). As part of increased oversight from the Dodd-Frank bill these accounts will soon be forced to trade at varying NAV so that investors can understand the risks they face in these investments. It remains to be seen whether investors will no longer consider these accounts as close substitutes for bank deposits.

Mergers and Acquisitions

Investment banks frequently provide advice on, and assistance in, mergers and acquisitions

Assist in finding merger partners

Underwrite any new securities to be issued by the merged firms

Assess the value of target firms

Recommend terms of the merger agreement

Assist target firms in preventing a merger

M&A activity

$1.15 trillion for the first nine months of 2016

Investment bankers help find merger partners, underwrite new securities to be issued as a result of a restructuring or acquisition, assess the value of a potential target, recommend takeover terms, or assist in fighting off a hostile takeover.

U.S. and global M&A activity boomed in the late 1990s and through 2000 topping out at $1.83 trillion in 2000, but activity declined substantially after that. In 2001 U.S. M&A activity totaled $819 billion, down 53% from the prior year, and declined again in 2002 to $458 billion. M&A activity picked up slightly in 2003 to $465 billion, but grew rapidly again in 2004 when the total value hit $748 billion, led by mergers of financial institutions. M&A activity in 2007 was $1.59 trillion before declining until 2011. M&A activity began to recover strongly in 2014 to $1.13 trillion and again in 2015 with M&As worth $1.50 trillion and continued strongly in the first nine months of 2016 at $1.15 trillion. Worldwide activity also increased over the same time period. While M&A activity brings large fees to bankers, this type of business remains very cyclical and it declined during the financial crisis, picking up in 2011.

According to a very interesting piece by Michael Jensen, “Agency Costs of Overvalued Equity,” M. Jensen, Spring 2005, Financial Management, pp, 5-19, many if not most of the large number of acquisitions in the late 1990s destroyed shareholder value. He argues that overpriced equity led to too low cost of capital and encouraged managers to engage in poor investments such as acquisitions in order to meet analysts’ earnings expectations. Given that a high P/E ratio predicts rapid earnings growth and/or low risk, too high a stock price then predicts an impossibly high growth rate (and/or an unrealistically low level of risk). The manager, expected to hit ever growing earnings targets, faces an impossible task, because with overvalued equity management cannot deliver the expected level of performance except by chance. Hence firms look for ways to keep the fiction of improving performance alive, even resorting to illegal accounting practices and poor acquisitions. This is a very interesting argument. It helps explain why there were extreme pressures on managers to produce short term performance. It is not that managers suddenly decided to ‘lie, cheat and steal.’ The pressure to perform has been very high, and brought about in part by too close a tie between Wall Street analysts and corporate executives, a conflict of interest. With overvalued equity, stock price signals are faulty and cannot be relied upon as indicators of long term value of the firm. Trying to do so when those signals are wrong must lead to suboptimal decisions for long term shareholder wealth. Several firms enlisted their professional consultants in accounting and finance to help them find ways to hit performance targets, which of course could not continue to occur without some form of ‘cheating’ such as accounting manipulations. This argument does not excuse managers. They should have known better. We have seen a major breakdown of corporate governance at the board level. Too many managers had ethical failures even though they were highly paid to act in shareholders interests.

https://www.forbes.com/sites/allbusiness/2020/04/17/impact-of-coronavirus-crisis-on-mergers-and-acquisitions/#65689deb200a

Other Service Functions

Custody and escrow services

Clearance and settlement services

Research and advisory services

IBs are making increasing inroads into traditional bank service areas, such as small-business lending and the trading of loans

In addition to the above functions, investment bankers and securities firms also provide security custodian services, clearance and settlement services, escrow services, research and advice on divestitures and asset sales. Fees for these services are often bundled together and allocated for different activities. Some of these ‘soft dollar’ allocations have come under scrutiny as alleged conflicts of interest have arisen between the underwriting and security selling functions of investment bankers

Industry Performance

Industry trends depend heavily on the state of the stock market and the economy

Commission income fell after the 1987 stock market crash

Improvements in the U.S. economy in the mid-2000s led to increases in commission income, but income fell with the stock market in 2006-2008 because of rising oil prices and the subprime mortgage collapse

Commission income again rose to between 15 and 20 percent of total revenues as the economy and the stock market recovered in the early- and mid-2010s

As goes the stock market, so goes securities firms’ profitability. Industry profits are strongly cyclical. Extended bull markets are good for profits, employment and growth; crashes and downturns hurt trading volume and hence commission income (a mainstay of revenue at most firms). Fewer firms seek to issue new equity during a bear market, and debt issuance drops off as coverage ratios decline so underwriting income is also cyclical. Both underwriting and brokerage income recovered dramatically in the 1990s after dropping off precipitously subsequent to the 1987 crash. Profitability remained strong with the bull market of the 1990s. Industry profits were at a record high $21 billion in 2000, but fell 50% in 2001. Reasons for the profit problems included the weak stock market, the September 11, 2001 attacks, the drop in M&A activity, and the loss of confidence by investors due to the many ethical violations by some corporations, bankers and auditors. Profitability remained poor in 2002 at $6.9 billion, but increased in 2003, hitting a record $22.5 billion and remained high at $19.5 billion in 2004 on large increases in underwriting activity and hefty cuts in interest and operating expenses. ROE for 2004 was 13.04%. Domestic underwriting activity was $3,358.3 billion in 2006. Profits would have been up in 2005 but interest expense on financing securities inventories increased as interest rates rose. Interest expense rose from $43 billion in 2003 to $136 billion in 2005 to almost $216 billion in 2006. Pre-tax profits fell to $17.6 billion in 2005 but recovered to $33.1 billion in 2006 due to additional revenue growth. The year 2007 was as bad a year for these firms as it was for most of the financial services industry due to the subprime crisis. UBS wrote down $10 billion of subprime related assets in 2007. Likewise, Morgan Stanley wrote down $9.4 billion, Merrill Lynch wrote down $5 billion. Two hedge funds of Bear Stearns collapsed and went bankrupt due to their subprime holdings as well. This was the setup to the Federal Reserve assisted bailout of Bear in March 2008 where J.P. Morgan Chase agreed to purchase Bear for $2 a share or $236 million. J.P. Morgan Chase also received guarantees on parts of Bear’s mortgage portfolio.

In 2008 the industry reported net losses of $34.1 billion as revenues fell 38.7%. Expenses fell as well particularly because with the lower interest rates, interest expense declined. Trading and investment account losses for the industry were $65 billion. As a result employment in the industry fell from 869,000 to 840,800. Employment kept falling to 779,800 in September 2009. Profits rebounded sharply in 2009 reaching a record $61.4 billion. Commissions, fee income and trading profits all rebounded and interest expense remained very low as the Fed kept interest rates down. High profits helped in rebuilding capital and efforts to raise external equity.

Industry Performance Continued

By the mid-2010s, while the industry had put most problems from the financial crisis behind it, the industry was affected by post-crisis consequences, with increased regulation on risk taking and capital requirements

This has led to balance sheet reductions, as well as downsizing or disposition of select businesses, trading products, and investments

Corporate strategies increasingly focus on client services and away from making large bets through principal investments

The years 2010 through 2012 brought many new challenges. The threat of a ‘fiscal cliff’ as U.S. government debt levels grew rapidly while Congress could not decide whether to increase the debt ceilings, the problems in the Euro area, increasing regulations and generally weak U.S. economic growth limited profitability for many firms. In May 2010 the ‘flash crash’ brought more scrutiny to trading activities as did the collapse in October 2011 of MF Global along with the trading glitch at Knight Capital in August 2012. Pretax profits fell from 2010 levels of $34.8 billion to $10.6 billion in 2011 and $12.4 billion in 2012. The fiscal cliff problem was resolved in January 2013 and after the European Central Bank pumped about $1 trillion into euro area banks the euro crisis subsided. In 2013, trading activity, and municipal bond and equity underwriting began to grow once more and profitability improved. Most of the problems of the financial crisis have been worked through now, but more restrictive regulations on derivatives, capital requirements, and in particular the Volcker Rule, have restricted profitability in 2013, 2014 and 2015. Pretax profits were $26.3 billion, $27.0 billion and $23.8 billion respectively over this time period. These are all lower than in 2012 even though the economy has strengthened substantially, security values are generally up and M&A activity has recovered.

Assets and Liabilities of Broker-Dealers as of 2015

Securities firms finance much of their securities inventory used in market making with repos. Notice the high levels of repurchase agreement liabilities (although these have dropped from 2013). This is one reason why the Fed reacted quickly to ensure liquidity to securities firms when the repo market briefly ceased functioning on collateral worries during the subprime crisis. These firms can hold lower capital than banks because they are subject to lower capital requirements and because their assets are more liquid than banks. Nevertheless, securities firms’ balance sheets are subject to high levels of both market and interest rate risk.

Non-commercial bank firms in this industry must maintain a minimum 2% capital ratio. This level is probably too low for the risks they take. Indeed Bear-Stearns probably failed because of its excessive leverage. During the crisis, these firms employed leverage ratios greater than 30 to 1. This means if the firm loses 3% of the value of their assets, they are bankrupt. Rumors of large losses at Bear in relation to their capital base led investors to stop lending and forced a liquidity crisis and a lack of confidence that led to the firm’s demise. J.P. Morgan Chase purchased the firm for $236 million even though Bear’s offices in New York were valued at over $2 billion.

Regulation

The Securities and Exchange Commission (SEC) is the primary regulator of the securities industry

The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed federal (over state) authority

Even so, state attorneys generally intervene through securities-related investigations that have led to many highly publicized criminal cases

The Securities Investor Protection Corporation (SIPC) insures losses of funds deposited with securities firms up to $500,000 per investor in the event of the failure of a securities firm. Losses to security values due to adverse market moves are not insured.

The daily activities of the securities industry are primarily regulated via the New York Stock Exchange and the Financial Industry Regulatory Authority (FINRA). Thus, to a large extent these firms are self-regulated according to rules promulgated by the SEC. The Federal Reserve regulates margin requirements on stocks and occasionally suggests rules changes involving securities trading and underwriting. Recently the Fed suggested shortening securities settlement from the current three days to one day because securities are often used as collateral for bank loans.

Since the passage of the National Securities Markets Improvement Act of 1996 removed state oversight of securities firms, the SEC has the primary jurisdiction over securities firms and sets standards for their activities. The SEC regulates underwriting and trading activities and promulgates a series of rules such as Rule 144A regulating private placements, Rule 415 allowing shelf registrations, etc. Under Rule 144A security issuers may avoid the registration process (and the considerable expense) if they are sold to a few qualified buyers. The buyers are typically institutional investors but certain high net worth individuals can qualify. These securities may now be re-traded among the qualified investors but may not be sold to the public.

Very few equities are privately issued; the private market is mostly for debt. Privately placed debt issues will have lower flotation costs but often carry higher interest rates.

NSMIA of 1996

The National Securities Markets Improvement Act (NSMIA) of 1996

Reaffirmed the significance of the SEC as the primary regulatory of securities firms

States are not allowed to require federally registered securities firms to be registered in a state as well

States are prohibited from requiring registrations of securities firms’ transactions and from imposing substantive requirements on private placements

Effectively gives the SEC primary regulatory jurisdiction over securities firms

In the early 2000s certain states began to take a much more active role in regulations of the markets. Former New York State General Attorney Spitzer led in this process. These prosecutions led to SEC rules changes to help ensure fewer conflicts of interests between analysts and investment bankers and better methods of allocating IPO shares.

Investment bankers paid large fines as a result. In particular, analysts have been barred from attending/participating in the ‘road shows’ and may not receive compensation based on the amount of underwriting business the firm generates. Within days of the settlement however, Bear Stearns allegedly violated the new rules. Morgan Stanley allegedly withheld emails pertinent to hundreds of arbitration cases, falsely claiming the email were lost in the September 11, 2001 terrorist attacks when they were not.

Regulation Continued

While the SEC sets the overall regulatory standards for the industry, the Financial Industry Regulatory Authority (FINRA) is involved in the day-to-day regulation of trading practices

FINRA is an independent, not-for-profit organization as opposed to the SEC, which is a government run regulator

FINRA writes and enforces rules governing the activities of securities firms, examines firms for compliance with those rules, works to foster market transparency, and supports investor education

Wall Street Reform and Consumer Protection Act of 2010

In July 2002, Congress passed the Sarbanes-Oxley Act seeking to improve corporate governance and accounting oversight. This bill created an independent auditing oversight board run by the SEC, increased penalties for corporate malfeasance, and gave disgruntled shareholders more options to pursue lawsuits. The law restricts accounting firms’ ability to provide non-audit services to audit clients and no longer allow the AICPA to set accounting and auditing standards. These will be set by the Public Company Accounting Oversight Board. The act requires that the CEO and CFO prepare and sign a statement certifying the reasonableness of the firm’s financial statements. The NYSE and the NASD have also changed their listing requirements with respect to corporate governance. Details may be obtained from their websites (see the list of websites at the end and in Chapter 8).

Anti-money laundering activities: The USA Patriot Act added three new requirements to securities firms as of October 2003. The new rules included:

Firms must verify the identity of any person seeking to open an account.

Firms must keep records of the information used to verify the client’s identity.

Firm must determine whether the client appears on any lists of known or suspected terrorists or terrorist organizations.

The industry is subject to Congressional oversight, but this usually takes the form of ex-post investigations after problems have emerged. For instance, Goldman Sachs (GS) was investigated by a congressional panel in 2010 concerning GS’ creation of mortgage backed CDOs which they had shorted to limit their risk. GS was accused of knowingly creating and selling risky mortgage investments after they knew they were likely to be riskier than the rating indicated and put themselves in a position to profit from a decline in the securities’ values. This is an obvious conflict of interest. Under the Dodd Frank Act, the Financial Services Oversight Council (FSOC) has oversight of systemic risk of the industry. More investment advisors will have to be registered with either the SEC or state advisors. Securitization markets should now have more oversight and originators will have to retain a greater interest in loans that will be resold. More derivatives regulation over time can be expected as well. FINRA is increasing oversight and reporting requirements for dark pools and for flash trading. As of this writing no formal limits have been proposed on these activities but they are suspected to increase volatility and of being used in market manipulation strategies.

The government can also mandate higher capital requirements for larger and for interconnected firms. Government oversight of industry practices has increased as a result of the bill. Executive compensation restrictions were also promulgated by the Obama administration which tried to strengthen the independence of the compensation committee from senior management. Shareholders now also have a non-binding vote on executive compensation packages.

Regulation Concluded

U.S. Congress also oversees the industry

U.S. Senate Permanent Subcommittee on Investigations was created with the broad mandate to determine whether any changes are required in U.S. law to better protect the public

Spring of 2010

Subcommittee hearing focused on the contributing role of investment banks in the financial crisis

Subcommittee brought up evidence and internal Goldman documents that showed Goldman knew the housing market was on the brink of collapse but continued to sell mortgage-backed securities to investors

In 2013 JPMorgan settled with the Department of Justice after agreeing to pay $13 billion on claims they sold investors bad mortgages ($9 billion in fines and $4 billion in remuneration to consumers). JPMorgan also paid $920 million to resolve the London Whale issue and $80 million in fines for charging credit card customers for unauthorized credit monitoring services (Morgan also returned $309 million in overbilled fees to customers). In 2012 Morgan Stanley paid $5 million to settle claims it attempted to impact research reports on Facebook before its IPO. In December 2014 more Wall Street banks were fined more than $43.5 million for offering overly optimistic stock research reports in order to gain the business for the Toy’s R Us IPO. In 2015 JPMorgan also admitted to improperly signing notifications of payment changes in bankruptcy courts without proper document review (the so called ‘robosigning’ issue) and agreed to pay $50 million to affected homeowners.

This list is not complete. Charges of the same banks as involved in LIBOR fixing of manipulating ISDAfix, a rate used for swaps, are also emerging as of July 2014. Also as of this writing, evidence is emerging of allegations that the Bank of England, the British central bank, knew of manipulations of currency rate quotes for as long as eight years without taking action. The currency markets involve over $5.3 trillion in daily trading volume. The SEC is investigating whether traders distorted prices for currency options and exchange traded funds. Reports are emerging that traders shared information about client orders in order to manipulate prices. As of June 2014 about 20 traders at the top three banks (Deutsche, Citi and Barclays) involved in currency trading had been fired.

SIPC

Securities Investor Protection Corporation (SIPC)

Not an agency or establishment of the U.S. government and has no authority to regulate its member broker-dealers

SIPC was created under the Securities Investor Protection Act of 1970 as a non-profit membership corporation

SIPC oversees the liquidation of member broker-dealers that close when the broker-dealer is bankrupt or in financial trouble and customer assets are missing

SIPC’s focus is on restoring customer cash and securities left in the hands of bankrupt of otherwise financially troubled brokerage firms

Global Issues

Securities firms and investment banks are by far the most global of any group of financial institutions

As a result of the financial crisis of the late 2000s, large investment banks around the world became concerned with capital, liquidity, and leverage, but did not want to lose ground in the global competition for clients

Result was that global investment banks looked for strategic alliances that would allow them to compete in foreign markets or they exited foreign markets altogether

Increase in cross-border strategic alliances

Investment banking activities are highly globalized. For instance, in 2012 Deutsche Bank was the number one underwriter of convertible debt and mortgage debt. Foreign transactions in U.S. stocks increased from $211.2 billion in 1991 to $12,037.9 billion in 2008. This represents a compound average annual growth rate of 26.85%. In 2016 this number was $11,064.1. U.S. transactions in foreign stocks increased from $152.6 billion in 1991 to $5,423 in 2008; an annual compound growth rate of over 23%. The financial crisis deterred the rate of growth. In 2013 foreign transactions in U.S. stocks were $7,571.68 billion and U.S. trading in foreign stocks was $3,969.5 billion. The similar numbers in 2016 are $11,064.1 billion and $5,193.7 respectively. International offerings have also grown rapidly, but recent scandals, the U.S. stock market weakness, disclosure requirements and the decline in the value of the dollar has probably deterred foreign investors and foreign issuers from participating in the U.S. markets. U.S. firms are seeking a greater presence in fast growing markets such as China and India.

The financial crisis increased the need for capital at banks and encouraged alliances and mergers at the time. For instance, Morgan Stanley sold a 21% stake of its firm to Mitsubishi UFJ in 2008. Citigroup took a different tact and sold some of its foreign businesses such as Nikko Asset Management and Nikko Citi Trust to increase capital. The industry continues to restructure as a result of the crisis.

Investment bankers can help U.S. institutions gain exposure to international markets. Banks have created structured derivative debt products that allow an institution to earn higher overseas interest rates while limiting exchange rate risk. Bankers can also sometime help improve the marketability of foreign bonds that are difficult to sell because they are denominated in a foreign currency. Many U.S. financial institutions are limited as to how much currency risk they can incur. Bankers have at times securitized these foreign currency denominated bonds by placing them in a trust and issuing dollar denominated claims to U.S. buyers. Hedge funds engage in risk arbitrage strategies on a global basis. The most famous of these (or infamous), Long Term Capital Management, engaged in risk arbitrage on an unprecedented global scale.