investment banking ii fall 2012 global development institute okyu kwon

Investment Banking II

Fall 2012

Global Development InstituteOkyu Kwon

Main Culprit of the Financial Crisis? End of Investment Banking?

-Main culprits of the financial crisis are as follows; (i) significant risk of high leverage and PI (ii) failures in derivatives risk management (iii)moral hazard in relation to own interests first attitude. *As many IBs were transformed into financial holding companies, they can be backed by FRB, but regulation

on them was inevitably strengthened. *Now questions arise: Does IB model come to an end? Is American capitalism declining?

-But the IB businesses model such as underwriting, M&A advisory, PI, and securitization, will not disappear, since it is required by the economy.

*IB has significant assets which are significantly different from those of CB.*Michael Milken’s junk bond case tells us that though he was jailed, junk bond market revived and was

developed further.*Efficient financial transactions that IB is pursuing will not disappear. -However, IB’s new position will be established in the direction that global capital market is moving. The new

direction would be;(i)From US dollar polarized system to multi-polarized currency system; (ii)From American neo-liberalism to much strengthened financial regulatory framework;(iii)From financial market led by IB to more balanced growth under stabilized financial market.*This implies that IB will continuously advance under the new regulatory framework given by G20’s

prescriptions.

Financial crisis in 2008- Macroeconomic policy caused asset market bubbles

Inflows of large capital into developed markets

`Global imbalance

Maintaining low interest rates

Increased preference for high yielding assets

Causing asset market bubbles

U.S. current account deficit & Changes in capital flows

Benchmark interest rates (1979-2008)

Direct factor of the financial crisis- Moral hazard and ineffective regulation

Compensation system

encouraged risk

Increase in risk appetite

Neglect risk management

Financial Pro-

cyclicality

Regulatory blind spots(Financial

innovation)

Opacity(Market &

goods)

Subprime Mortgage Crisis occurred

Increased counterparty risk

Sudden liquidity contrac-tion

Ineffective regulation

Financial Crisis-Summary

00.1 02.1 04.1 06.1 08.10

1

2

3

4

5

6

7

0.25

1.5000

0.10

미국 EU 한국일본

(%)

Major countries benchmark interest rates Changes in the subprime mortgage lending

U.S. household and financial sector debt trends CDS size trends02 03 04 05 06.1~9 월

0

5

10

15

20

25

0

1000

2000

3000

4000

5000

6000

7000금액

비중

80 년 00 년 07 년0%

20%40%60%80%

100%120%140%

가계금융

(Of GDP)

01 02 03 04 05 06 07 08.6 말0

10

20

30

40

50

60

70 (trillion, $)

HouseholdFinancial

EUJapan

U.S.Ko-rea

Amount of moneyProportion

(Unit: USD billion)USKo-rea

Japan

Framework to respond to financial crisis-Discussion of the G20

Financial Pro-cyclicality

Aspects caused

financial crisis

Aspects to cope with the

crisis

Opacity of financial markets & products

Reward system that promote risk

Strengthen transparency (accounting system, disclo-

sure)

Improving reward system

Mitigating Financial Procyclicality(Market assessment, allowance for doubtful

accounts and buffer capital. etc)

WG 1

WG 2

WG 3,4

Regulatory blind spots(Financial innovation)

Magnification of regulation scope

(Hedge funds, credit rating agencies, etc)

Neglect risk management

Improve risk management(Internal control, structure of governance,

etc)

Lack of interna-tional cooperation

Strengthening international cooperation(international supervision on

financial institutions, FSF membership enlargement)Lack of capacity of

international financial institutions

Reform ofIMF, WB, etc.

Strengthening health of financial

institutions

Regulation capital improvement(The concept of capital and minimum capital requirement adjustment, etc.)

Outlook for investment banking modelafter overcoming the global financial crisis

-National protection, government-led

-Highlighted financial sector’s support function for real sector

?

-Based on Washington Consensus -Financial liberalization and regulatory reform -Financial sector leads real sector, growing

as an independent industry

Before the financial crisis in 1997 After the financial crisis in 1997

Japanese Model Anglo-Saxon Financial Model

After Subprime Crisis

Through the process of

emphasizing the role of

financial sector for

economic recovery

Leading role of financial sector will be re-emerged as high value-added industry

* G20, reform of international financial institutions, etc.

G20's new financial regulation(1)(1) OTC derivatives regulation-Causes of the global financial crisis amplified by;(i)opacity of the market increased due to expanded OTC derivatives

transaction(ii)lack of systematic response to counterparty risk(iii)lack of appropriate regulatory framework and supervision. → Actions undertaken;(i)establishment of the central counterparty clearing house(CCP)(ii)arrangement of effective supervision on CCP(iii)promotion of standardized credit derivative products(iv)standardized OTC derivatives to be cleared through the CCP by 2012.-Dodd-Frank Financial Reform Act(US, July 2010);(i)Standardized OTC derivatives should be cleared by the CCP(ii)Non standardized products are required to meet a higher capital

requirements(iii)Total transaction balances and amounts are to be disclosed(iv)commercial bank’s derivatives trading is to be restricted(v)Volker’s rule is modified(vi)Governance structure of CCP(vii)Speculative position is restricted for trading of 28 commodities-EU, Korea

(2) Hedge fund regulation-IOSCO finalized hedge funds regulation in June 2009 including the six

principles for hedge fund oversight, and regulations on short selling.

-Principles of hedge fund oversight ① Hedge funds and hedge fund operator should be registered. ② Organizational and operational standards, conflicts of interest,

disclosure, prudential regulatory requirements are required. ③ Prime brokers and banks related to hedge fund are under

mandatory registration and supervisory target. ④ Information related to systemic risk is to be provided to regulatory

authorities. ⑤ Regulatory authorities should promote industry's best practices

development, and its implementation and integration. ⑥ Regulatory authorities should cooperate each other and share

information based on IOSCO MMoU. *MMoU(Multilateral Memorandum of Understanding) was signed in

2002 to cooperate each other since the 9.11 terror.

G20's new financial regulation(2)

-Regulation on short selling ① Appropriate regulations should be enforced for short selling to

minimize potential risk that may undermine market’s fairness, efficiency and reliability.

② A reporting system should be equipped with for relevant information on short selling to be disclosed and reported to regulators in a timely manner.

③ Effective compliance and enforcement system should be equipped with for short selling transactions.

④ Exceptions should be recognized for regulation on a certain type of short selling when such a regulation can help enhance the effectiveness of the market.

-It is also advised to strengthen collateral management methods to enhance financial institutions’ counterparty risk management.


-Hedge fund size reached $2.8 trillion in 2012 exceeding pre-crisis level, but the number of funds remained below pre-crisis level.

-The core of the US Financial Reform Act taken into effect in July 2010 was SEC registration, provision of information, and restrictions on the banks’ investment.

* Mandatory registration at SEC is imposed on investment advisory firm which manage hedge funds or PEF of which asset size is more than $150 million.

* If the firm operates public offering part at the same time, the firm must register in case even though of which asset size is less than $150 million, public offering asset size is more than $100 million.

* Venture capital advisory firms will continue to be exempted from the obligation to register.

* Investment advisors are required to report to the SEC and retain documents for the fund and associated advisory information.

*To measure systemic crisis, if necessary, SEC can require provision of related information.

* Volker’s rule to ban banks’ investment in hedge funds was weakened and modified to limit investment up to 3% of the fund’s share, and also limit banks’ total investment up to 3% of its tier I capital.


(3) Regulation on compensation- Compensation system is short-term based as well as asymmetric

with only positive linkage and no negative linkage. → This attracts excessive risk which undermines stability of

financial system.- FSB's compensation principles are as follows; ① An effective governance structure is necessary for compensation

decision-making. ② Compensation should commensurate with risk taking. ③ Effective participation of shareholders and regulators should be built.

*France, Germany and the UK already introduced more robust and specific criteria for enforcement, such as delayed payments, restitution in case of loss (clawback), payment limit of guaranteed bonus, total compensation limit as a percentage of net profit, and sanctions on non-compliance.

* In case of UK, governance structure and disclosure system was already installed; Therefore, focusing on compensation limit structure, Financial Service Act of November 2011 authorized FSA to establish compensation rulemaking, to prohibit contract violating rules, and to restitute.


* Compensation provisions of the Compensation Committee of FSA stipulates that the compensation committee should construct a majority independent directors, and deferred bonus payments and restitution provisions are to apply, and in conjunction with the financial institution’s contribution to crisis burden-sharing, above £ 25,000 bonus are taxed by 50%.

*France and Germany also set up rules, focusing on compensation scheme and upper limit, such as deferred payment(deferral), restitution provision (clawback), and a limit of total bonus.

- In case if US, however, ineffective alternative was suggested, focusing on strengthening corporate governance and disclosure rather than the compensation structure.

* Passed in the House of Representatives in December 2009, Fair Compensation Act introduced very mild reform clauses such as Say on Pay System, and disclosure of top 5 executive’s compensation.

*Say on Pay is a system that for executive remuneration, shareholders can press the board of directors by non-binding votes.

* FRB’s Compensation Guideline, announced in October 2009, also mention that FRB will investigate compensation system by separating small and large financial institutions.


* Even though since subprime mortgage crisis, taxpayers' money equivalent to 12 % of US GDP was injected to bailout financial institutions, no one was indicted responsible for the crisis, special prosecutor was not appointed, and no company was accused for any securities fraud or accounting fraud.

* On the other hand, the former management, who left the financial company that caused the problem, received tremendous amount of compensation; Stan O'Neal, former Chairman of Merrill Lynch, was allowed to resign, not dismissed, and therefore permitted to receive around $125 million; top five executives of Lehman Brothers received around $850 million during 7 years from 2000 to 2007; AIG was bailed out by receiving $130 billion from Treasury, but Joseph Cassano, the company’s financial product manager, received compensation of around $260 million; Goldman Sachs bought CDS from AIG, and for that, received around $55 billion from AIG, which turned government company due to public money injection. However, Treasury pressed AIG not to accuse Goldman Sachs which was responsible for selling subprime mortgage product identical to rubbish. It was a fraud because the seller knew that it was a rubbish, and all of the fact was exposed through Senate’s public hearings. (Charles Ferguson, Inside Job, 2011)


(4) Credit Rating Agency Regulation-One of the causes of the global financial crisis is inadequate risk

assessment of credit rating agencies and investors' overconfidence about credit ratings.

→ It is needed to enhance quality and transparency of credit ratings and to resolve conflicts of interests.

- The U.S. Dodd-Frank Act Signed taken into effect in July 2010 stipulates that:

①Credit rating agency oversight institution (OCR) is to be installed, that performs functions such as supervision and punishment, conducts investigation at least once a year conflicts of interest and internal control system, etc., and makes public important findings.

②Credit rating agency is to install internal control system to oversee the credit rating decision process; Credit rating agency is to disclose higher level of information to investors and general public; OCR is given authorities to cancel registration of credit rating agency in case inadequate credit ratings continue.


③Securities Act (Rule 436g) stipulates that credit rating given to bond is a simple opinion to ensure credit rating agencies mitigate legal liability that may occur due to the bond credit rating. Dodd-Frank Act maintains same clause for general case of bonds, but for ABS, the new law requires credit rating agency should have a legally responsible expert liability for their credit rating, and should issue consent for that.

* However, credit rating agencies refused credit rating as backlash against it, and ABS market temporally stopped. To resolve friction with the industry, SEC has allowed a six-month grace period in January 2011, and then made it permanent.

④If a private issuer is to disclose important information, it should do to all interested parties. (Regulation Fair Disclosure) However, this is exempted for credit rating agency, so that credit rating agencies can obtain important information.

-The new law deleted this article.


⑤Federal laws are to delete mandatory credit rating in order to reduce reliance on credit rating agencies and to replace it with various internal information. Progress is subject to report to the Congress.

⑥Criteria for filing lawsuit against credit rating agencies is to be eased to facilitate it.

→If it is proved that credit rating agency deliberately or carelessly did not deserve to do research, or it is proved that credit rating agency did not perform reasonable assurance on the information provided by a third party, filing a lawsuit is to be possible.

⑦ Code of conduct for credit rating agencies and their employees as an expert is to be established. When structured products are issued, the issuer is to be restricted to select credit rating agency by itself. Instead, SEC may establish an independent organization for structured products to get first credit rating by a credit rating agency selected by that independent organization.


-In September 2010, the European Parliament passed financial supervision reform bill.

①ESMA(European Securities Markets Authorities), to be established in 2011, is to oversee credit rating agencies.

→ The services of credit rating agencies do not apply only to a certain country so that ESMA directly supervises credit rating agencies.

②ESMA will have rights for information claim, investigation, on-site supervision, etc. Individual country's regulatory body will lose all the relevant authorities.

③Structured product issuers such as banks are to provide same information to other credit rating agencies so that they can also give a separate rating action.

④ The following items will be continuously under review; establishment of additional pan-European credit rating agency, sanctions on credit rating agency in case its incorrect evaluation brings in damage due to a sharp drop in credit rating, how to relieve excessive reliance on credit ratings, and conflict of interest arising from business model of credit rating agency.


Ⅰ. Raised Issues

Ⅱ. Trends of Global IB

Ⅲ. Domestic IB: - Current Status and Problems

Ⅳ. Suggestion for Development of Domestic IB

19

Con-tents

Trends of Global IB(1)-The US investment banks led the rapidly changing global financial landscape.(1) As bank failures were spread by the Great Depression, criticism of the bank's securities business has heightened. Glass-Steagall Act of 1933 separated banking and securities. In 1934, First Boston and Morgan Stanley separated its securities business.(2) Investors avoided long-term investment due to oil shock in the 1970s. As security companies invented MMF and banks invented CMA, boundary between them became blurring. As in securities market, expertise emerged as an important competitive factor, Goldman Sachs emerged. As securities underwriting market expanded in the 1980s, Merrill Lynch and Sarloman Brothers, strong in retail banking, emerged.

(3) The 1999 Gramm-Leach-Bliley Act allowed commercial banks owning investment banks. Commercial bank transformed to holding company, which incorporated investment bank as a subsidiary, while investment banks has strengthened further due to its expertise.

(4) As commercial banks and brokerages fiercely competed each other in investment banking business, boundaries of the business tend to be blurred further. Since global financial crisis, this trend is expected to continue as investment banks turned holding company.

Trends of Global Financial Banks(2)- In Europe, except UK, banks simultaneously operated commercial banking and investment banking business. Major banks became bigger banks through mergers and acquisitions like Deutsche Bank (Germany), BNP Paribas (France), and UBS (Switzerland). They have advantages to maximize synergies by sharing client company information, and mobilizing funds and marketing network. Disadvantage is that conflicts of interest may exist, and there is a risk that loss of investment banking business can be passed to the bank’s payment ability. - In Germany, universal banking was already commonplace in the 19th century. As Germany was lagged behind the industrial revolution, the government supported banks in order to meet the corporate demand for funds, and universal banking system was settled.- In Britain, before Big Bang, there separated two kinds of banks; one was a clearing bank that played short-term retail banking for enterprise; the other was merchant bank that played wholesale banking from long-term financing, securities underwriting, to investment advisory Merchant Bank switched to a comprehensive securities company since Big Bang in 1986.

Trends of Global Financial Banks(3)- In Japan, banks and their subsidiaries were banned to operate investment banking business. Banking Act was amended in 1962 to allow banks to enter securities industry through their subsidiaries. In 1980s, Japan tried to foster investment banks since Japan had the world's top 10 banks in terms of asset size, and there was a surge of lending to support yen carry trade abroad. Japan tried acquisition of overseas small investment banks. Through 1990s, Japanese banks rapidly lost its competitiveness due to corporate restructuring against yen appreciation, economic recession, rapid increase of NPLs, and unreasonable financial system. During 1996-2001, Japan carried out financial reform and thanks to that, banking giants like Nomura Holding, and Daiwa Securities Group, launched. * In Japanese domestic market, the share of the US and European banks is substantial in M&A, while in IPO, Japanese banks dominates. - Difficulties of Japanese financial sector come from the following factors; (i)past malpractices which still remain such as relationship-oriented lending and mortgage-oriented lending, which makes competitiveness of large banks weakened and deters development of risk hedge market; (ii)too strict firewall between commercial bank and investment bank, which prohibits information sharing; (iii)opaque regulations; and (iv)lack of professionals.

Case of global IB: The US- In 1933, Glass-Steagall Act allowed development of brokerage type IB.- In 1999, Glass-Steagall Act was abolished and substituted by Financial Services Modernization Act, which allowed development of holding company type IB

• Number 1 in equity underwriting and M&A arrangements(2006)• Merged Pear, Leeds & Kellogg, entering asset management market (2000)• Enlarged business from brokerage and M&A to LBO, real estate, PI → Due to financial crisis, turned to holding company → Still number 1 in the league

• In 2004, purchased brokerage from ABN AMRO, and strengthened retail banking including credit card business(ranked at top until 2006.

• Merged to Blackrock and strengthened asset management business(asset size reached $0.9 trillion) → Due to financial crisis, merged to BOA.

• Ranked at top 1 in bond underwriting (2006)• Took over Travelers group in 1998 and created a financial holding company

• Strengthened PEF sector, and established a large subsidiary dedicated to emerging markets.

• Operated fund of fund(Tribeca Global Management).

http://www.ml.com/

http://www2.goldmansachs.com/

- No discrimination between domestic and foreign IB; global IB actively advanced.

Financial Big Bang(1986)

Case of Global IB: UK

Thanks to that, London’s competitiveness strengthened as an international financial market: UK financial sector’s employment and value added substantially increased.

- Wimbledon effect: global IB merged many UK banks. * Deutsche Bank's acquisitions of Morgan Grenfell(1989), UBS group’s acquisitions of SG Warburg (1995), Citigroup's acquisitions of Schroders PLC (2000), etc.

• Number 1 in asset management• Take over ABN AMRO• IB and related fund revenue increased by 35% yoy in 2006 (₤7.14 billion as pre-tax earnings)

League Table(1st Half 2012)

Rank Equity underwriting Bond underwriting M&A

1 JPMorgan JPMorgan Morgan Stanley

2 Morgan Stanley Citi Goldman Sachs

3 Citi Barclays JPMorgan

4 BOA Merrill Lynch BOA Merrill Lynch Citi

5 Goldman Sachs Deutsche Bank BOA Merrill Lynch

6 Deutsche Bank HSBC Credit Suisse

7 Credit Suisse Goldman Sachs UBS

8 UBS Morgan Stanley Barclays

9 Barclays UBS Deutsche Bank

10 Nomura Credit Suisse Lazard

* Source: Equity, bond underwriting- Bloomberg, M&A- F.T.

investment banking ii fall 2012 global development institute okyu kwon

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