Chapter 5: Investment Bank Activities

Investment Bank Activities

• Accepting: agreeing to pay a specified amount on a bill of exchange at a future date
• Corporate Finance: handling new issues, rights issues, mergers, acquisitions, and research
• Securities Trading: buying and selling existing bonds and stocks in secondary markets
• Investment Management: managing bank funds or clients' funds, including high-net-worth individuals, corporations, and pensions
• Loan Arrangements: helping clients secure loans and find funding sources for international trade
• Foreign Exchange: trading currencies, with some banks becoming significant players in the market

Bank Regulation

• Historically, commercial and investment banks were separated, but have since integrated into universal banks
• Shadow Banking: non-bank institutions engaging in banking-like activities without being subject to banking regulations

Bank Bailouts

• Financial interventions by governments or central banks to rescue struggling banks
• Reasons for regulation:
  • Monopoly Power: preventing banks from distorting competition
  • Welfare Considerations: protecting people in cases of limited or costly information
  • Externalities: riskiness of individual banks affecting the entire economy
  • Moral Hazard: lenders can't tell if borrowers will take too many risks

Asymmetric Information and Solutions

• Asymmetric Information: when one party has more information than the other in a transaction
• Adverse Selection: lenders can't distinguish good from bad credit risks, discouraging transactions
• Solutions: government-required information disclosure, private collection of information, collateral, and requiring borrowers to invest substantial resources
• Moral Hazard: lenders can't tell if borrowers will take too many risks with borrowed funds
• Solutions: managers' reports to owners, managers investing substantial resources, and covenants that restrict borrowers' actions

Systemic Risk and Solvency

• Systemic Risk: risk of economic or financial market collapse affecting the entire market or economy
• Solvency: a bank's ability to meet its long-term financial obligations, determined by comparing assets to liabilities
• Funding Liquidity Risk: banks face challenges in borrowing money short-term due to changes in collateral requirements or market liquidity
• Market Liquidity Risk: banks struggle to sell assets at fair prices, leading to depressed values and difficulty in reducing balance sheet size

Systemically Important Financial Institutions (SIFIs)

• Large banks or financial entities whose failure could destabilize the entire financial system
• Characteristics: very big, international, and extremely complex, with many subsidiaries
• Concerns: central to finance and payments, pose systemic risks due to large size and interconnectedness

Regulation and Reform

• Dodd-Frank Act: a US law implemented in 2010 to increase financial regulation and prevent another financial crisis
• Objectives: establish a Financial Stability Oversight Council, deal with SIFIs, create a Consumer Financial Protection Bureau, and reform the Federal Reserve
• Volcker Rule: restricts banks from engaging in proprietary trading and limits investments in hedge funds and private equity
• UK Regulatory Response: Vickers Commission reforms to separate retail banking from investment banking, and EU regulatory response to establish a single supervisory mechanism

Interest Rates and Money Markets

• Interest Rate: the price of money, changing based on time and amount
• Factors affecting interest rates: risk, maturity, expectations, liquidity, supply and demand, and inflation
• Domestic Money Markets: short-term borrowing and lending within a country, regulated by the local central bank
• Includes: call money, interbank market, money market securities, treasury bills, and certificates of deposit

Bonds and Stock Markets

• Bonds: debt securities with fixed interest rates and maturity dates
• Types of bonds: government, local authority, mortgage, corporate, foreign, junk, and Islamic bonds
• Features of bonds: par value, rate of interest, maturity dates, and classification by remaining maturity
• Stock Markets: provide a platform for buying and selling shares of companies
• Indices: measures used to track the performance of a group of assets
• Listing process: companies go public to raise funds, establish a market value, and provide liquidity

Hedge Funds and Private Equity

• Hedge Funds: actively managed investment funds aiming for absolute returns, using complex strategies and leverage
• Private Equity: investing in early-stage companies and buying out public companies to improve and sell them later
• Mutual Funds: investment funds that pool money to buy a diversified portfolio of securities
• Hedge fund strategies: leverage, short selling, equity hedge, global asset management, relative value arbitrage, and event-driven investing