Investment Banking

Introduction

Centuries have passed since ‘Investment Banking’ was first introduced to the world’s financial system. The fascination of making profit through newly created financial innovations, rather than basically depositing money in commercial banks in hope that the interest rate would not be reduced is truly a smokescreen. The first clear sign of another severe financial crisis since “The Great Depression” has been the instability of Bear Stearns: one of the five leading investment banks in the US followed by the collapse of Lehman Brothers which has led to the current global financial turmoil.

The question remains whether or not investment banks had accelerated the eruption of the crisis or were they contributed to the worsening of the crisis in any way? The dissertation will therefore examine specific issues of law which govern and regulate investment banks in the US and Thailand. The aim is to analyse points of law that have been overlooked and which have resulted in inadequate law enforcement over investment banks which have steered into the financial crisis as well as to discuss how financial regulators regulate financial institutions, particularly, investment banks.

Efforts to analyse the cause of the current global financial crisis have been well made and it is often said that the subprime or the lending which does not meet the standard of creditworthiness and often filled with high risk is the main factor that triggered the outbreak of the 2007 credit crunch. However, subprime lending is only an indication of the problem. The root of the problem is in fact related to securitisation. According to Prof. Graham Penn and Prof. Philip Rawlings, “Securitisation” is:

‘…a method of asset-backed financing whereby debt financing is raised against specific assets in a manner which seeks to insulate the investor in the debt securities from risks other than the risk of the assets financed not performing in the manner anticipated.’

With this, bad debts are bundled up together and are transformed to be derivatives, in other words, they are securitised. They then are sold to investors in the form of highly rated securities, particularly, Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs). These poisonous derivatives would not have been widespread without the help of investment banks that issues and trades a vast variety of securities, believing they could control the risk but in reality, they are the one who unbolted the most dangerous explosive.

As for the Asian financial crisis in 1997, the crisis started in Thailand with the collapse of Thai Baht and its effect was rapidly spread across Southeast Asia and East Asia. In any case, it seems clear that the crisis was a consequence of the mistake in policy made by Thai government and the Bank of Thailand. However, in this respect, it is important to note that apart from an attempt to rescue the Baht not to sink into the strong current, the government also had to bail out a large number of staggered financial institutions which was truly a futile help. The situation was worsening when internal financial misconducts committed by many firms including a famous investment bank were exposed, leading to questions on corporate governance and the ability to maintain market confidence.

Part I of this dissertation considers the definition of an investment bank, its structure and its activities.

Part II examines main points of laws and regulations in the US which regulate investment banks and other financial institutions in general. Suggestions will be presented where appropriate. Specific focus will be paid to the SEC (US Securities and Exchange Commission): a financial regulator in the US. The intervention of Fed (Board of Governors of the Federal Reserve System) will be referred to where related. Moreover, causes of the global financial crisis will be discussed along with implications the crisis renders to the current rules and regulations and how to improve them.

Part III addresses the implications of two financial crimes concerning embezzlement in Thailand and analyse how they were related to the Asian Financial Crisis. An issue concerning conflicts of interest and corporate governance will also be briefly addressed.

It could be tentatively assume that investment banks could greatly affect the market condition and the economy in general on account of their large assets which are connected to many financial sectors including common people who are indirectly being led to the financial cycle through their debts. Financial crises are not an unexpected result when greed is prioritized without prudent measures to cover the risk. From the lengthy analysis of this dissertation, it would be reasonable to conclude that investment banks were one of the main factors which stimulated the eruption of the financial crisis. However, it should also be emphasised that the actual underlying cause is the regulatory system and the lenient enforcement of rules and regulations performed by the regulator.

Investment Banking

A. Investment Banking: Definition and Background

An investment bank is a financial institution that raises capital, trades in securities and manages corporate mergers and acquisitions. According to Datamonitor, an investment bank ‘… helps companies and governments raise money by issuing and selling securities in the capital markets (both equity and debt), as well as providing advice on transactions such as merger and acquisitions.’

Historically, investment banking evolved gradually in the United States as a kind of financial services available in the early 1800s. With the outbreak of the Civil War in 1861, investment banking had made its presence as a significant financial activity and the growth of retail investment banking was accelerated by World War I as the US investment banks provided loans for all of the combatant nations. As a consequence, the US, for the first time, had become a creditor nation, made lucrative income from the war and acquired a leading role in international finance since then.

As for the European, investment banking bears directly on its evolution in the United States. Even though the United Kingdom is considered to be a prominent player in the financial market as London is the center of the European market, it will be seen at once that former long-established world leading investment banks were all based in the US, namely, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. They will be referred to in the next section.

In the United States, it is mandatory for an adviser to be registered as a licensed broker-dealer in order to be able to perform services in the area of investment banking under the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) regulations which will be discussed later in the related chapter.

Consider the following description discussed in the Government-Business Forum on Small Business Capital Formation in 2004:

‘… “finders” or “investment bankers” constitute a major problem in corporate finance transactions and in the area of mergers and acquisitions. The vast majority of these persons are unregistered broker-dealers under federal and state securities laws, and accordingly transactions in which they are involve jeopardize the issuer, its officers and directors, and other investors because of the use of the unregistered/non-exempt person …’

It would be reasonable to deduce that the main reason for imposing such rule (i.e. broker-dealer registration) is to protect investors and maintain market confidence as well as prevent fraudulent acts due to the fact that unregistered investment bankers may associate with those who have adverse regulatory histories. This may well ruin the legality of transactions in which they are involved.

It should also be emphasised that in the midst of the Great Depression, abuses related to securities activities of banks and their affiliates had been declared as the key provocations of the banking collapse. Therefore, the US congress attempted to restore public confidence by separating investment banking from commercial banking through section 21 of the Banking Act of 1933 (popularly known as the Glass-Steagall Act). The implicit reasoning behind this decision was the concern towards the danger of conflicts of interest between the promotional interests of investment banking and the obligations to render disinterested investment advice to customers which was a feature in commercial banking. On the other hand, in Europe and in England, the two activities can be operated in a single firm.

As a consequence of the global financial turmoil in 2008, the era of investment banking has come to an end as five world leading investment banks have no longer operated in investment banking. The details are as follows:

1. Bear Stearns has collapsed in March 2008. Its assets were acquired by JP Morgan Chase. It would be fair to assume that the collapse of Bear Stearns has initially triggered the global credit crisis which erupted in 2008.
2. Lehman Brother filed for bankruptcy protection under chapter 11 of the United States Bankruptcy Code.
3. Merrill Lynch was acquired by Bank of America.

4. 4. Morgan Stanley and Goldman Sachs have transformed themselves into traditional bank holding companies.

Despite the fact that the end of the Wall Street investment banks has shown that the business model of the investment banking no longer applicable and commercial banks have become a significant financial institution which is speculated to be an important drive towards a country’s economy, the fundamental business of an investment bank, e.g. dealing or trading in securities, offering financial advice, can continue to operate normally without the need to be the business under the name of investment bank.

B. Organisational Structure of an Investment Bank

Typically, an investment bank has three separate operational divisions which are the Front Office, Middle Office and Back Office.

Front Office

Main activities of the Front Office are as follows:

1. Provide advice for customers on matters related to raising funds in the capital markets and advise on mergers and acquisitions. These matters are mostly associated with the issuance of securities in order to meet specific investment goals.
2. Investment management: The professional management of securities for the benefit of customers which can be institutional investors, such as insurance companies, pension funds etc. or private investors which for the most part are high net-worth individuals.
3. Sale and trading: A process in which an investment bank attempts to trade securities at the most profitable price. This process involves a direct contact to institutional or high net-worth investors to propose the investment in customers’ securities.
4. Financial structuring via derivatives: This is a further step of ‘Sale and Trading’. As derivatives are particularly complex products of securities, they need expertise to analyse numerical prospects. Despite its complication, derivatives offer dramatically larger margins and returns than underlying cash securities which may be lower or higher rated.
5. Research: A division which does the research on the markets and writes reports about the economic circumstances, including the estimation about other factors that could affect the price of the customers’ securities. It would be fair to assume that the main purpose for doing such research is to help investors in deciding whether or not to trade in securities they are interested.
6. Provide advice about investment strategies. The advice will be in accordance with the investment policy of each investment bank.

Main Office

There is no need for this division to meet the customer and its main activities are as follows:

1. Risk management: The main purpose of the risk management is to prevent detrimental effects to the company and the market condition in general. The risk management can be done by analysing the market in conjunction with credit risks incurred.
2. Financial management: This sub-division is responsible for the capital management of an investment bank, including the duty to monitor potential credit risks. The aforesaid responsibilities are primarily necessary due to the need to maintain the investment bank’s satisfactory credit liquidity and to prevent unwanted problems related to liquidity and financial risks which could lead the company’s to financial difficulties. It should also be noted that this section also manages a firm’s capital to make profit.
3. Compliance: Apparently, this sub-division’s responsibility is to ensure that the company properly complies with rules and regulations being laid down by the authority.

Back Office or operational section is responsible for checking data, documents, or evidences that are related to the operation of an investment bank in order to assure that the information is totally accurate. Other responsibilities are managing the firm’s accounts and IT (Information Technology).

Mention should also be made of the term “Chinese Wall” which McVea describes as

‘… the doctrine used to ensure that un-published price-sensitive information is not passed between certain departments within one corporate entity.’

As an investment bank is divided into three separate divisions, potential conflicts of interest may arise between those parts. As a consequence of implementing the Markets in Financial Instruments Directive (MiFID) which came into effect on 1 November 2007, the Financial Services Authority (FSA) in the United Kingdom sets out rules on conflicts of interests in SYSC 10 in the ‘High Level Standards’ section of the FSA Handbook which requires that a firm must take all reasonable steps to identify conflicts of interest between the firm itself and between clients (SYSC 10.1.3). Rules on ‘Chinese walls’ are also laid down under the same section at SYSC 10.2. This dissertation will not examine the doctrine in detail. However, a case study as well as general information will be discussed in the following section.

II. Regulatory System in Relation to the Financial Crisis in the United States, Investment Banks and Financial Regulators

A. A Brief Summary of Striking Matters during the Global Financial Turmoil

The global financial crisis which emerged in the mid-2007 would have accounted for what level of severity in the global economy and for how long is a matter that is difficult to speculate even in hindsight. However, it is clear that a crucial impact of the crisis renders it necessary to reform rules and regulations governing banking and financial services industries.

The situation is particularly severe in the United States as the crisis was initially begun in the US and its impacts had rapidly and globally spread. Primarily, there were problems concerning subprime lending in the US housing sector and many believed that these problems would be easily solved as players in this sector was not so large that it could affect the whole picture of the financial system and the economy in general. This could be the correct anticipation if the problem had not expanded from the housing sector to financial institutions sector via many sophisticated and complex forms of derivatives and the structured finance of securitisation which caused the collapse of Bear Stearns, one of the leading investment banks in the US, forcing the Federal Reserve (Fed) to immediately decrease the interest rate and fully increase liquidity to the financial institutions sector. As a reflection of Bear Stearns’ circumstance, US Treasury Secretary Henry Paulson proposed plans to increase Fed’s power to intervene with investment firms, particularly, investment banks’ activities which were considered to be risky and hazardous to the financial system in order to protect the stability of the financial system and markets. The plan would enable the Fed to make its uninvited entrance whenever it senses the possibility of systemic risk to prevent circumstances which could trigger another crisis. A potential downside of the aforesaid plan is that investment banks and hedge funds could be exposed to over-regulations and could be subject to rigid scrutiny which is totally not preferable for those firms. Nevertheless, the plan does not go smoothly as expected due to an objection by two economists, namely Allen Meltzer and John Taylor who claims that by making the Fed a “super-regulator” authorised to regulate and interfere with activities of large financial institutions which certainly includes investment banks as they are “too big too fail” could jeopardize Fed’s independence. Yet, there are limits to how far the concept of “super regulator” can be taken. The most striking point is the criticism that Fed had not done anything to prevent the current financial crisis and that if it was given more power, it would be more difficult for the Fed to focus on one task and work best at it. Should the Fed be given such power is still in question. Whether or not the Fed will be the one seriously regulated investment banks is not a crucial matter as long as investment banks are properly regulated.

It could be assumed that the global financial crisis is a direct consequence of recklessness. To be precise, lenient regulatory system encouraged banks to lend in a manner considered “moral hazard” as they knew the Fed would come to their rescue one way or another and insurance was also provided. Investment banks start doing businesses other than their typical activities in order to gain more profits. To achieve the goal faster, they need to be the player which means they have become an investor themselves. Investment banks organise various kinds of assets and securitised them. Rating agencies rate the assets based on information from many sources including investment banks. The question is – do rating agencies somehow associate with investment banks in rating assets higher than its true quality? If the answer is yes, then an issue of conflicts of interest will certainly arise. Generally, rating agencies should be an independent institution so that the rating will not distort the picture of assets and markets. If not, a severe problem could inevitably happen when those assets are found to be low in quality and that obligors of the underlying debts cannot pay back the money. A direct effect is the domino collapse of many financial institutions that we have witnessed and a profound crack in the financial and regulatory system.

B. Causes of the 2008 Global Financial Crisis

According to Raghuram Govind Rajan, an American Economist, who was a former Chief Economist of the International Monetary Fund, suggested that the current financial crisis was composed of two main problems which were excessive credit facilities and excessive leverage which created a situation of severe illiquidity, the collapse of financial institutions, and financial markets fell into panicking conditions.

Excessive credit flowed into the US due to the fact that the financial market in the US is the most advanced market in respect of financial innovations which could render preferred high profits for foreign investors. So long as the housing sector in the US is still in a boom, the securitisation is still a risk that worth taking.

As for the excessive leverage, financial institutions were highly leveraged for the purpose of trading in derivatives. They were also leniently providing loans without performing appropriate investigation about the borrower’s creditworthiness which greatly affected derivatives that were issued on the grounds that the underlying debts would be perfectly performed. When the housing bubble exploded, the subprime borrowers defaulted, the value of derivatives were inevitably decreased, causing troubles for financial institutions in finding funds to pay back the leverage. Ultimately, banks stopped lending to one another causing “Credit Crunch” condition. It should be noted that large investment banks in the US (currently, five leading investment banks in the US were all transformed one way or another as previously mentioned in Part I) were highly leveraged while not being strictly regulated like other financial institutions. This may be one main reason behind the collapse of investment banks.

C. Who’s to Blame?

Consider the following descriptions from different sources:

1. In Joseph Stiglitz’s (the recipient of the 2001 Nobel Prize in Economics) article ‘The Fruit of Hypocrisy’, he asserts that there are flaws in many aspects of the US financial system, particularly; there were no reactions or attempts to manage risks or appropriately allocate capital. The initial point of the crisis as well as the collapse of Bear Stearns were attributed to financial innovations which are protected from being thoroughly regulated by those profited financial institutions in fear that regulations would suppress the growth of such innovations and banks and firms would gain less. Therefore, the crisis is ‘the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers.’ In brief, Stiglitz has concluded that weak and inefficient regulatory system itself and human greed are the roots of the crisis.
2. As reference to a Wall Street Journal article ‘Did Authorities Miss a Chance to Ease Crunch?’ and Gary Aguirre’s memorandum to the US Senate Committee on Banking, both reports probed into the US Securities and Exchange Commission’s (the SEC) inaction towards the investigation on Bear Stearns’ misevaluation of subprime debts which could have lead to a lawsuit against Bear Stearns and could have averted the subprime crisis. These two reports triggered the inspector general to conduct the investigation and find reasons why the case was suddenly dropped. It is said that the main reason was because there was an “ongoing personal relationship” between a senior SEC official and a Bear Stearns’ lawyer who was a former colleague at the SEC. Even though obvious evidences were not presented, the matter was still bothering on whether or not there was conflicts of interest. The general inspector also found that the SEC were aware of the possibility that Bear Stearns would collapse but due to the SEC deficiencies in enforcing firms to comply with voluntary accounting rules, the standard had not been met and a severe consequence ensued. Nevertheless, the SEC chairman critisised that in fact, the blame should be put on the regulatory system as it was more than apparent that the voluntary regulation did not effective. To conclude, this description shows that the SEC is clearly an inefficient regulator and is the main reason behind the collapse of Bear Stearns which triggered the crisis. Apparently, this is consistent with Stiglitz’s opinion in part of the incompetence of both the policymakers and the regulations.
3. Allan Meltzer claimed that there were no proper actions performed by the Federal Reserve (the Fed) to prevent the current financial turmoil. He also addressed that Fed’s actions had encouraged moral hazard of banks and firms and promoted incentives to take ventures. It could be deduced that as a reflection of the Fed’s previous actions which always supported financial institutions and came into rescue when they were in trouble, it would be fair to conclude that this is the root of the crisis. In fact, this opinion is back to the basic thought of reckless acts by financial institutions which caused troubles for every sector concerned.
4. Many investment banks have been critically affected by the financial turmoil, causing them to change their capacities into another form of financial institutions. This is undoubtedly a result of undue dependence on financial innovations without proper risk management. The fall in profit margins, higher capital needs due to recession surely and greatly affected businesses that are related much to capital markets, particularly investment banks. Furthermore, the turmoil also made it apparent that investment banks’ vulnerabilities were crucial. They depended much on the short-term repurchase market for secured funding, making investment banks susceptible to even the slightest changes in the markets. In addition, investment banks are big in activities and roles in the markets. Their collapse had an effect on the financial condition and market confidence as a whole. Therefore, it would be reasonable to assume that investment banks are definitely related to the crisis. They were at and behind the staring point of the crisis and the situation would not have been this severe if they were not involved in derivatives and securitisations.

In conclusion, it cannot be exactly concluded on who is the one to blame for the financial crisis as many of the aforesaid players were more or less contributed to the crisis. However, it is clear that weak regulatory system in regulating banks and firms including investment banks created moral hazard in operating businesses. Highly leveraged firms and inadequate capital reserve and assets made them susceptible to the change in markets’ condition and when the housing bubble reached its limit, derivatives which depended much on bad underlying debts became a problem for firms that heavily invested in them, of course, those firms includes investment banks which are the main investors who heavily damaged as well. Financial regulator, particularly, the SEC was badly criticised and was clearly the underlying reasons that contributed to the outbreak of the crisis as illustrated in the Bear Stearns’ case. Therefore, the regulatory system, banks and firms, particularly investment banks’ moral hazard, the SEC, the Fed, and financial innovations could be described altogether as the main factor that caused the crisis.

D. Implications of the Financial Crisis to Financial Regulations

The global financial crisis is a clear sign that financial regulations should be overhauled. The question is – what is the optimal solution for the current regulatory system?

Generally, the regulatory system should consist of rules and regulations that reflect the need of players in the financial markets without having to loosen the main policy of supervision. Rules and regulations should be easily and swiftly issued to serve the need of the financial markets in case there is a change in circumstances and those rules should be flexible enough to reduce the possibility of over-regulation.

Over-regulation is not preferable as it could create an opposite effect from what the authority or the regulator has expected. To be precise, financial institutions may find it uncomfortable from being strictly overseen. As a consequence, they will have incentives to avoid rules and regulations. Therefore, adjusting financial regulatory system to be more reasonable so that financial institution would have incentives to comply with the rules could be a productive solution.

As Raghuram Rajan has pointed out that occasionally financial crisis cannot be avoided and that it could affect large financial institutions which are “too big to fail”. The best solution is probably to concentrate on adjusting the financial structure to be more robust in order that the damage incurred as a consequence of the crisis could be alleviated by funds from the financial sector itself not from taxpayers’ money.

Moreover, collaborations between the authority in charge of the financial sector and the financial regulator are important. They should work together and share necessary information to each other in order to reach the optimal result in regulating as well as solving problems due to the financial crisis.

E. The Turner Review

The Turner Review (hereinafter, the Review) is a wide-ranging regulatory review in response to the global financial crisis. The aim is to identify underlying causes of the crisis and whether or not deficiencies in financial regulations contributed to the severity of the crisis. The significance of this review is that it is a comprehensive review that deeply analyses the origins of the global banking crisis and provides suggestions for reforming regulations within the UK and also at the international level.

This dissertation will not discuss the review in detail. Only striking points that are related to the topic of this dissertation will be presented and analysed.

The Review put emphasis on how securitised credit which is a type of financial innovation achieved the opposite effect despite the assumption that financial innovations are beneficial considered by definition. Rapid and massive growth in the use of securitised credit will not create satisfactory results for the banking system if capital requirements are inadequate compared to the size of activities performed by financial institutions. Therefore, it is suggested that if capital adequacy requirements are well practised, the risk of failing into the crisis stream will be alleviated. This is true in respect of banks and some types of financial firms in which the nature of their activities are subject to risks originated from the mismatch between their assets and liabilities and these matters will be particularly crucial at the time of the crisis. Good compliance with the capital adequacy requirements can help mitigate those risks and help prevent the fall of the banking system. Nonetheless, it is argued that the minimum capital requirements are of little significance in practice if the anti-avoidance provisions are not included. In other words, the anti-avoidance provisions will ensure that assets required to the specified minimum value are actually contributed. This can be considered in conjunction with a suggestion from the Review that the capital or assets contributed should be in high quality. However, it is doubtful whether the “high quality” assets are what type of assets and how or what criteria can be used to evaluate their value. This matter is open to a concern over possible mischievous collaborations to misevaluate the true value of those assets; nevertheless, appropriate regulations can help solve the problem.

The Review also addresses a concern about an issue of over-regulation. It is emphasized that if the regulation is over-tightened, there is a possibility that activities might move to non-regulated sectors e.g. hedge funds. Therefore, it is particularly important to regulate activities which have features like a typical bank’s activities but conducted by other financial institutions. This implies that it is necessary for the regulator or authorities to have the power to impose restrictions and lay down rules for a wider range of financial institutions to comply with on condition that those activities could threaten the stability of financial system and/or there is a potential that they will become systematically significant.