MB102 Principles of Investment Banking

INTERNATIONAL FINANCE

• INVESTMENT BANKING & the financial sector
• CORPORATE FINANCE & INVESTMENTS

INVESTMENT BANKING

• FUNDAMENTALS
• RISK MANAGEMENT
• BUSINESS DEALS
• REGULATION
• MANAGERIAL CHARACTERISTICS

FUNDAMENTALS

REGULATION of which country?

(These represent the legal frameworks that other countries are going to implement)

EUROPEAN UNION

• Official group around 34 countries
• INSPIRED BY CIVIL CODE

USA + UK (common law)

Countries outside these groups are adopting one of such legal frameworks (China, India...)

EUROPEAN UNION REGULATION

Rationale: compliance with 2 DIRECTIVES

BANKING DIRECTIVE (1988-1990) to be implemented in 90-92

FINANCIAL SERVICES DIRECTIVE (developed in 1996, implemented July 97’/98’)

BANKING DIRECTIVE: contents

1. definition of banking
2. definition of bank
3. other intermediaries
4. Supervisors (linkage with political system)

Definition of Banking

Joint exercise of collecting money from the market (through deposits) and giving money through loans

CREDIT ➔ LOANS ➔ DEPOSITS ➔ CAPITAL MARKET ➔ SAVINGS

Banking is crucial to the economy because

• INVOLVES WEALTH (SAVINGS)
• FUELS THE ECONOMIC SYSTEM (moves money through time and space)
• CREATES MONEY (credit)

POLITICAL CONTROL

Law defines the only institution that can manage banking

SPECIFIC REGULATION

NB: other institutions can manage the 2 activities separately

BANKS

The only type of institution that can manage banking (but not just that)

Banks can do just banking? The answer depends on the ideological viewpoint of the social importance of banking

UNIVERSAL vs SPECIALIZED BANKS

• PROS
  • better customer satisfaction
  • exploit synergies
• CONS
  • conflict of interest

• UNIVERSAL BANK - banking + other financial services
• PROS
  • Safer, no conflict of interest
• CONS
  • Less synergies

EUROPE

1936 - 1992

UNIVERSAL - SPECIALIZED - UNIVERSAL

USA

1933 - 1999

UNIV - SPECIALIZED - UNIV

CONFLICT of interest

HIGHER RISK

POTENTIAL lack of control

ECONOMICS of scale

UNIVERSAL offering synergies

ACTIVITIES THAT CANNOT BE MANAGED BY BANKS

(CANNOT BE PRODUCED)

• INSURANCE - double risk for depositors
• ASSET MGMT - manage individual wealth in pool => too risky for depositors
• NON FINANCIAL ACTIVITIES - manufacturing, trade...

NB: such activities cannot be included in the balance sheet. A bank can be a shareholder of firms performing these activities

• 100%: equity, asset mgmt
• Limited percentage in insurance and commercial activities

political/social/strategic division

Asset Mgmt Companies

(CANNOT BE A BANK and viceversa)

• Management in pool of wealth coming from several customers

• Advantage: diversification
• Economies of scale
• Bargaining power

• Disadvantage: not tailored services

Consultancy services for funds -> FUNDS vehicles used to pool individual wealth

Categories of Funds

• Open-end: Investors can enter or exit at their will. No time constraint.
• Closed-end: Finite lifetime. Customers cannot have their money back till the end, they can invest in time zero. They can sell the certificate.
• Alternative

Hedge can leverage

NO SECURITIES (real estate, commodities, fine arts...)

3-SUPERVISIONS (specific for each category of actors of the financial serv. system)

• Task: efficiency/probability + control (monitoring)
• Controlled and nominated by government, parliament or independ. authority
• Tools - for control
• Punctual supervision - Flex change according to the target of the supervision
• For crises

F.S. intermediaries

• Control over shareholders, directors, and entrance (e.g., no cap for individual shareholders)
• Punctual supervision -> capital adequacy
• Resolution of crises -> monitoring info flows

Financial market

* Cannot be owned by public authority, must be owned & managed by private institutions

• Before 1988 the shares of Ita, Fr, Ger stock exch were the governments
• Now a stock exchange is subject to the regulation of its major shareholders
• Criteria for selecting traded companies are defined by the management of the stock exchange

Role of supervisors in the finance market

• Control over shareholders, directors and entrance
• Involved in supervision of monitoring and info flows
• Supervisors can force the manager (company) to leave.

RISK MANAGEMENT & PROFIT MODELS

(within regulatory frameworks posed by the authorities)

• PRELUDE. Starting of regulatory models and prudential supervision (BASEL I)
• MOVING from past to the present of prudential supervision
• Present of prudential supervision (BASEL II)
• The main characteristics of BASEL I
• Years of BASEL II
  • Calculation of regulatory capital
  • Processes are different but the regulation capital depends on the risk (how on the value of assets)
• Future of prudential supervision (BASEL II) - changing some paragraphs of Basel II

HISTORY OF PRUDENTIAL SUPERVISION

1974 | Basel Committee: Governors of the Central Banks e.g. of the G7 countries. ↳ 10 years later governors became 100

1986 | Basel Committee: CAPITAL ADEQUACY FRAMEWORK. A document to give inspiration to governments to implement prudential supervision.

1988 | 120 countries took the CAF and transformed it in local law. Basel Committee became centre of international regulation and coordination of the banking system ON A GLOBAL SCALE.

1992 | Banking directive included the Cap. Ad Framework.

Contents of BASEL I

REGULATORY CAPITAL (Equity of a BANK) COST OF CORPORATE: 0 - 0.5 risk weight (0.2 < w < 1)

GIVE THE BANKING SYSTEM INTRINSIC STABILITY

BANK ASSETS

• LOANS
• DEPOSITS

MARK−UP

MARKET VALUE OF COLLATERAL

It is necessary to have a list of possible collateral.

Deal making is deciding what collateral should be used to integrate the credit profiles of the customers.

Collateral

• Financial
• Credit Derivatives & Personal Guarantees
• Non Financial

FINANCIAL COLLATERALS

• Securities - High recovery rate because of a cheap quick and highly successful recovery

Constraints

• Financial instruments used must have a rating (S&P or Moody's) of minimum rate (BBB+)
• No correlation between the company issuing the securities and the customers who is using them as collateral
• Value of security (collateral) ≥ 100% value of the deal (Exposure at default not FVP)
• Value of collateral must be recalculated periodically (Long term perspective about the value of collateral)

CREDIT DERIVATIVES & PERSONAL GUARANTEE

A financial contract in which two players Buyer and Seller

SWAP, FUTURES, FORWARD

A gamble related to the default of someone (uncertain event).

Fee depends on

• Volatility of the uncertain event (example: credit rating of target company)
• Time length of the gamble
• Supply and demand of derivatives

3 CONSTRAINTS

• Seller must be a financial institution (governmental and corporate)
• Cover 100% of EAD
• Seller is rated (S&P or Moody's) at least A-

Such constraints must be respected all together and for the whole length of the contract.

Risk of Arbitrage

INSURANCE companies outside the regulation of BASEL II