Changes in the Structure of Investment Banking in the UK: 1985 - 2005 - Essay Example

Running head: Investment Banking An examination of changes in the structure on investment banking in the UK: 1985 - 2005 -Literature Review ___________ ________________________ ________________ An examination of changes in the structure on investment banking in the UK: 1985 - 2005 -Literature Review Introduction Investment Banking can be defined as the process of advising and transacting for corporate and non corporate clients in respect of IPOs, mergers& acquisitions, security trading, portfolio management, venture capital financing, cross border financing, hedging of variety of products and or broking in several other bulk banking transactions. An organization, typically a banking organization, which specializes in imparting such services, is termed as carrying on investment banking. While an entire entity may be devoted to investment banking, hallmarked by bulk banking, it is not unusual to observe investment banking arms within umbrella banking setup. In UK the investment banking scenario has undergone radical transformation in the two decades covering the period 1985-2005.In the following paragraphs we probe available literature in order to outline main drivers of this transformation and emerging scenario. Drivers of Change There have been very many drivers determining the landscape of investment banking activities in UK.Principal among them are new paradigms in regulation and supervision over investment banking activities and changed due to high risk assumption by agents as traders and investment banking failures, US influence through take over, merger and acquisitions of British investment banking activities, increasing importance of relationship banking and radically altered scale of FDI activity in UK area since late 1980s reflective of hastening pace of globalization and relationship relocations. The trading theory in finance exclusive reliance is placed on expected utility theory (Bernstein, 1996). Even agency theory of trading like expected utility theory, has, since Williamson (1963), assumed consistent risk aversion of agents acting for risk neutral principals. Principals, are assumed to be risk neutral as they can diversify their share holding across firms, are forced to either incur opportunity costs in monitoring agent activities or give agents bonuses/ incentives to equal agents' and their risk appetites. (Eisenhardt, 1989;Tosi and Gomez-Meija, 1989; Beatty and Zajac, 1994; Jensen and Meckling, 1976).Similarly both expected utility and Agency theories assume perfect rationality .However Agency theory has defined aggregate irrationality in the form of Noise trading. Dow and Gorton (1997) state that traders have problems taking rational decisions between 'simply doing nothing', 'actively doing nothing' and the need to avoid contracts which give incentives for inactivity. In dilemma, agents may get in ex ante unprofitable trades that have some chance of being profitable ex post' (Dow and Gorton ,1997).Market turns more liquid and trades entered in far exceed principals' requirements. In case ex-post profit expectations come untrue-widespread trading losses are experienced. Sociological and psychological approaches have also explained irrational trading behavior and unnecessary risk assumption and realized trading losses leading to malfeasance charges. Among them important are irrationality causing factors such as trading on the basis of personal familiarity (Baker, 1986),herding (Adler and Adler, 1984), and decision making affected by stress (Kahn and Cooper, 1993), prospect theory defined as a preference for the avoidance of loss, even at higher risk (Kahneman & Tversky, 1979, Tversky and Kahneman, 1986), judgmental biases in decision making (Bazerman, 1998) , imputed rather than measured - decision making bias by individual traders(Thaler, 1991, 1993; Shefrin, 2000).This sets the theoretical foundation for high risk assumption and losses in trading activities by investment bankers agents. High bonus payments (incentives) to traders in investment banking sector and resultant depressed profits have made regulatory authorities sit up and seek additional capital requirements for investment bankers relying on such contingent bonus payments as operational risk is perceived to have increased in such instances. Similarly trader tendencies to conceal trading losses which has caused investment banking failures has resulted in regulatory intervention and caused public uproar on financial malfeasance.UK supervisory controls have turned stricter. In the UK, the FSA (then BoE) has moved towards a rigorous risk-based approach to supervision which, in addition to assessing capital, liabilities, earnings and market risk, seeks to evaluate controls and management structures within firms (BoE, 1997-i). Management of traders is a regulatory concern, specifically to 'consider management's appetite for risk and its attitudes towards controls' as part of a wider risk-based approach to the assessment of firm behaviour '(BoE, 1997-ii). Management failures of various forms were identified as significant reasons in several high profiled cases of malfeasance at Barings, Morgan Grenfell, Daiwa and Sumitomo. In the case of Barings, the failure of managers to analyze 'large (reported) profits from activities perceived to be essentially risk free.was a serious lapse' according to a post facto statement by the supervisor. In 2004-05 FSA has not only set about making instructions more clear on capital requirements for all categories of investment bankers but also on issues pertaining to market research, proposals on analysts, conflict of interests and unbundling of fees.FSA has also began a robust consultation process in arriving at cost-benefit analysis on matters relevant to international business undertaken by firms in London's has also been in dialogue with market participants on enforcement and service standards issues and about the role of "Dear CEO" letters as a method of communicating regulator's priorities.FSA did not renew "waiver with consent" forcing market participants to seek stand alone waivers for exceptional and rule bending transactions.FSA further built on Arrow process on risk based supervision and may have some modifications on capital adequacy requirements for smaller investment banks, within this process's also announced in October 2004 its policy on 'Fighting Fraud in Partnership'(LIBA,2004). Implication from the above is fairly clear malfeasance in investment activities not only made some major UK players suffer huge losses and become targets for US takeovers but also stricter UK regulatory regimes emerged which was more than palatable to new US and trans-European owners as they had already nurtured substantial regulatory memory in their own sophisticated regulatory jurisdictions. Glass Steagall Act separated investment banking from commercial banking in US. This separation gave sufficient time to investment bankers to reorganize and strengthen their operations and in particular make management function fairly robust. "There is a self-selection and a management process to the American (investment) firmsthat gave the investment banks great management in depth"(Augar, 2001).Partial deregulation of Glass Steagall Act and globalization when combined with emergence of take over targets in UK,the US investment banks began to expand overseas. In UK the US investment banks began dominating through a combined strategy of natural organic growth and acquisition. Goldman Sachs, Merrill Lynch and Morgan Stanley lead all investment banking activities with a few other American firms completing the full US influence. US investment banks primarily follow an investment banking model centered on the two parameters of "integration" and "scale". Even European and Asian investment banks, having presence in UK, go about the investment banking following the US model focused on integration and scale. Integration essentially means having a variety of activities which are often in conflict with each other is carried out within the legal framework of a single entity. For instance investment bankers advise IPO issuers as well as subscribers and even may even underwrite such issues themselves. Similarly they buy securities as portfolio managers and may buy same securities on their own accounts. Unhealthy advisory arbitrage is always a possibility. . While the entity has a set of internal rules to partition such conflicting activities it is the regulators who have various codes of conduct to prevent conflict from producing unreal gains for a few and huge losses for other resulting in systemic instability. As a consequence of distributing the shares in an initial public offering, the lead underwriter knows where the shares are placed, which gives a natural advantage for making a market later on, since the underwriter knows whom to call if there is an order imbalance (Ellis and O'Hara, 2000). Despite such conflicts global structure of investment banking is primarily an integrated one. Scale considerations have assumed survival proportions. Customers of investment bankers have turned global and prefer to transact frequently in global markets. As organic compulsions investment bankers have to follow their major corporate customers and globalize. Any demurring to provide less than global scale services is considered as equivalent to being below requisite scale. Some European investment firms like ING, Dresdner and ABN had sub scale experiences. Scale considerations have brought about more structural changes in investment banking in form of new partnerships and consolidation. For instance Goldman Sachs went public and Morgan Stanley and Dean Witter had to merge despite respectable individual pre-merger sizes. US banks like Citibank have moved to universal banking by acquiring several investment advisory and broking firms and bringing them under one umbrella to offer "all products sold under one canopy" experience to its customers. It is understood well that information asymmetries are main theme of the literature on financial intermediation as seen in Diamond (1984), Bhattacharya and Thakor (1993). Relationship banking addresses directly the context of asymmetric information. This view of relationship banking takes us on along journey much beyond the confines of commercial banking and all the way to various nuances of investment banking and activities of non-bank financial intermediaries and in general, all service providers in private equity and debt markets. Immediate question that arises is as to what are the specific sources of benefits from a relationship situation with a banker. There are some factors which make this relationship with a lender special and there are several value-enhancing features attached to a contractual relationship with lender. One major point is however clearly available at once viz.dominance of relationship lending may resolve Grossmann and Hart (1980)-type free-rider problems and facilitate information reusability over time. The term "relationship banking" is not specifically and sharply defined in the literature. Apart from references to "close bank relationships," no definition is provided as in Petersen and Rajan (1994) and Berger and Udell (1995).Such a definition may include the provision of financial services by a financial intermediary with specific investment of time and efforts in obtention of customer-specific information, often proprietary and sensitive in nature and evaluation of the returns from such investments through multiple interactions with the same customer over time and/or across differing financial products and services. This definition clearly indicates that intertemporal interactions with the customer can build up a stock of customer information-some of which may undergo change at the latest interaction-while a good portion of it may remain reusable thus creating an opportunity to benefit from intertemporal information reusability (Greenbaum and Thakor, 1995). This implies that hallmark of a relationship banking is comprised of three conditionalities one, that the financial intermediary gathers customer information and as well information for customer beyond readily available public information; two, information gathering takes place over time through multiple interactions with the customer, often through the provision of multiple financial products and services and three, the information remains confidential (proprietary)Berger (1999).Though investment banking is essentially broking function a strong relationship orientation may be noted in varying in degrees according to different investment activities. For instance public debt issues may be relatively staid and highly structured transactions with little interaction between financiers and borrowers over time (Berlin and Mester, 1992; Rajan and Winton, 1995) while the same may be overly strong in private equity and private debt markets (Fenn et al., 1997) and (Carey et al., 1993). Similarly as lead banker and investment banking relationship may fall in the region of strength that may be required for a bank loan and a public debt issue (Dennis and Mullineaux, 1999). Importance of relationship banking in London investment banking market may be seen from the following literature quote: "Here is a lesson that even the biggest of the big-league investment banks are learning: to succeed in London's equity capital markets, first cultivate a thriving practice in corporate broking. A peculiarly British custom, corporate broking is an advisory relationship between banker and client in which the banker assesses the market's perception of the client and advises on future strategy, including financing needs. ...relationship between lists of the top 10 corporate brokers and the top 10 UK book runners from 1999 to 2003 shows the importance of establishing such a relationship. In the United Kingdom, most capital-raising business, from the initial public offering onward, goes exclusively to corporate brokers. In 1996, Merrill Lynch became the first US bank to enter the corporate-broking club. Over the years, Merrill's efforts have resulted in a list of 62 broking clients, the number two spot for UK corporate bond issues, and the number three place for equity issues (excluding IPOs)......................... US investment banks are beginning to realize that a solid corporate-broking list is a prerequisite for doing capital-markets business in Great Britain. Brokers enjoy access to corporate strategy and to board-level executives, and they usually receive a flow of trading in a company's shares. However, the author observes, finding corporate-broking clients is not easy................. Morgan Stanley is the latest major investment bank to attempt a beachhead in UK corporate broking, as big-league investment banks begin to create or enlarge their corporate broking departments. After poaching seven bankers from Merrill Lynch, hiring two senior bankers from CSFB, and grabbing two others from UBS, Morgan Stanley added two of its own and wants one more to round out its new 15-member team. This effort represents a substantial investment for Morgan Stanley, a late arrival at the corporate-broking table. The objective is to improve a relatively poor performance in the United Kingdom, the largest investment-banking market outside America"(Euromoney, 2004). Thus relationship banking considerations and treatment of asymmetric advantages with corporate and non-corporate clients have forced US investment banks to expand operations to UK.Such clients have been propelled by pulls of globalization to expand their transactions to multiple foreign jurisdictions. Another evidence in support of this relocation can be seen in the form of Mergers and Acquisitions (M&A) transactions between the UK and the USA corporates. Mergers and acquisitions are being increasingly resorted by the corporate entities the globe over to restructure and harness business synergies. Data reveals that a good number of such deals concern corporates located in the USA and the UK. Acquisitions by UK corporates have been only less than the acquisitions by US corporates in value terms. The US businesses remain the most significant targets for UK bidders (Cosh and Hughes, 1996). The merger activity has fluctuated substantially in the past century, and its recent hastening of growth is associated with the emergence of globalization, information technology and high paced growth of the financial and capital markets in both the US and the UK. In both these countries the large merger activity raised the debate about the monopolistic objectives, the supposed benefit in terms of economies of scale and if this would benefit the public. The merger activity has developed over time to numerous cross border transactions. However the basic reasons for the cross border transactions are about the same as have been identified, some100 years ago, for domestic mergers and acquisitions. A typical phenomenon of the recent M&A activity wave is that the acquisitions are now larger in size and tend to be global (cross border) (Cosh and Hughes, 1996). However it must be clearly understood that of late there has been a tidal wave of merger activity on both sides of the Atlantic. Particularly when, the UK's approach to M&A tended to be more flexible. For example, the Panel on Takeovers and Mergers (the UK's counterpart to the SEC) usually takes a more workable, less rigid approach than the US Securities and Exchange Commission. Meetings with the Panel lead to a spirit of give-and-take largely missing from the US process. Colin Meyer, a professor at Oxford University's Business School was asked why British and American companies are so keen to buy each other. He propounded a very effective argument when he stated that "In part, because they can. The shares of British and American Companies are much more likely to be listed and traded on a stock exchange than, say, French or German ones. This makes it easier to build a stake and launch a bid". Stephen Barret of KPMG followed up this question with" The Anglo-Saxon approach is much more transparent, we buy and sell in plain vanilla fashion. The French and Germans prefer alliances and partnerships, and there are similar obstacles in Asia" (The Economist 1999). Thus with such a robust M&A activity between the two countries and a relatively easy M&A UK regime prima facie investment bankers, chief brokers of such deals ,are likely to be locate more in these two countries. However the integration and size and scale, on the one hand, of the US investment bankers and the malfeasance of the UK investment bankers have tended to make the US investment bankers dominant players in this activity as well and there was good amount of US taking over activity in the investment banking industry itself. This is large explanatory variable of the shape, the investment banking industry has acquired in UK in the period 1985-2005. Another variable which points to globalization is the flow of FDIs.Globalization has occurred in part due to emergence of common markets -particularly in Europe. In fact emergence of EU has been seen both as a cause as well an effect of globalization. Structural changes have occurred in the flow of FDIs as a result of globalization. For one, such flows have grown in sizes and for two their directions are specific viz.in the regions where maximum returns could be expected. As an instance we can see the structural changes in the UK outward FDI.Economic integration in Europe since the last two decades has seen a rising level of foreign direct investment (FDI) within the European Union (EU) economies. In almost all EU countries, the real levels of inflows and outflows of FDI after the mid- 1980s had peaked since the initial formation of the Common Market, with intra-EU flows of FDI rising from $3.2 billion in 1984 to $58.73 billion in 1992 The ongoing drift of UK outward FDI towards continental Europe also appeared to have hastened during this period, with over a third of all existing investments now placed within the EU member countries, compared to a little over 20 per cent in 1981 and around just15 per cent in the late 1960s. This surge in cross border investment had happened primarily as a result of the Single European Act of 1986/7, during the graduated implementation of the measures required to complete the Internal Market within the European Union. At face value this appears to suggest that moves towards greater European integration have generated a structural change in the pattern of intra-EU investment (Hoeller and Louppe, 1994).Research studies have revealed that outward UK FDI has been directed more towards intra EU destinations than elsewhere since 1990.A reason forwarded for this is the steps being taken within EU to strengthen the common market. As much as there is some evidence of the US being a net looser of UK outward FDI since 1990s.Evidently FDI activity spurs investment banking activity as well. 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