FINANCIAL INSTITUTIONS AND CAPITAL MARKETS
Investment banking
Investment bank is a banking institution that performs various functions not limited to the following: advising, administration, underwriting, and distribution. These services are performed as part of the basic investment
banking business and are central to any firm. A detailed description of these functions is clearly outlined below.
a) Advising Function
In advising a corporate or government client, an investment bank will first assist its customer in making an assessment of its funding needs. Then, the investment bank will acquaint the client with the respective costs and benefits of various alternatives for raising funds. They will provide advice regarding current market conditions and the timing of any one option that may emerge as most advantageous. The process should lead to the investment bank
suggesting a funding mechanism and structure that it feels will best fit the client’s needs. It may, at this point, also recommend a team of institutions that could assemble the package that would address the funding needs.
b) Administrative Function
Once a financial strategy has been adopted, the investment bank can perform a vital administrative function. This service involves a myriad of details associated with a new issue, such as recordkeeping, title transfer, and tax and
regulatory filing on behalf of the issuing firm. Because financial covenants and regulatory structures of the securities business are routine considerations for the investment bank but obscure issues for the general business community,
the investment bank can provide valuable administrative services.
It aids its client in traversing waters that, to the client, are uncharted. For this service a fee is paid, while these fees may seem high, they are typically far cheaper than the disaster that could result if the client attempts to traverse the
regulatory morass and financial market place on its own.
Among the administrative functions that an investment bank can render is assistance in the completion of the legal documents, including the creation of a prospectus associated with any new issue. Indeed, the investment bank
shares responsibility with the issuer for ensuring that everything is done in compliance with relevant securities laws. Intimate knowledge of both law and procedures is critical. The client expects its underwriter to know the in and out of the administrative procedures associated with any offer. Certain small issues and private placements are generally exempted from registration. This is all part and parcel of the knowledge of law and process that clients expect
their investment bank to employ in providing this administrative function.
c) Underwriting Function
The underwriting function is provided by an investment bank when it agrees to bring an issue to the market on behalf of its client. When an investment bank guarantees a fixed price to the security issuer in exchange for its
securities, it is said to have “underwritten” the security offering. The underwriter is at risk if it sets the guarantee too high because it may be unable to resell the securities at a price sufficient to cover the guarantee, however, if it
sets too low a guarantee, it may lose the underwriting business to a competitor. Thus, proper valuation of a security is extremely important to an underwriter.
One way for the investment bank to reduce the underwriting risk is to delay, as long as possible, the price-fixing date. This allows the syndicate time to test the market for the new shares and line up purchasers at the proposed price.
However, the client may not be happy with such a delay. Nonetheless most underwriters will try to wait and set the guaranteed price at the end of the registration period, which could be as little as a day or two before the actual
security flotation takes place. By choosing a pricing date close to the flotation date, the underwriter has more up-to-date information on which to base a guarantee price, and it has some knowledge of the demand for the
issue. While overpricing an issue can be disastrous to profitability, underpricing a security can also have bad consequences for the underwriter, even if it wins the bid to serve as the underwriter. A reputation for under-pricing a
security, as evidenced by a repeated pattern of securities’ prices climbing rapidly after the commencement of the offerings, can lead prospective corporate issuers to seek alternative investment banking firms. Obviously, it is
in the corporation’s interest to obtain as much cash from its securities offerings as possible while still maintaining the goodwill of its investors. The investment bank makes its profit by selling the new securities at a price higher
than the net price that is guaranteed to the issuing firm. It is widely considered that a successful pricing and offering results in a rapid sale of securities, within a day or two after the offering begins, and involves a modest
appreciation of the securities’ prices in the weeks immediately following the offering. This modest appreciation pleases the investors in the company and fosters goodwill. Many securities are not brought to the market in this
manner. These securities are not formally purchased by the investment banker; instead they are merely distributed through either a best-efforts-basis public offering or through a private placement to a select group of investors.
In these cases, the investment bank does not incur the risks of an underwriter, and it is compensated through fees for bringing buyer and seller together. This fee is lower than that associated with a price guarantee, at least on a risk adjusted basis. For some firms, only a best-efforts underwriting is possible because of the high risk or limited market recognition of the institution seeking financing. For others, private placement is a cleaner alternative and one that is easily accomplished by an investment banker with good contacts.
