Chapter 4

Financial Services: Securities

Brokerage and Investment Banking

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 Overview

• This chapter discusses securities brokerage

firms and investment banks
– Activities of securities firms and investment
banks
– Size, structure, and composition
– Balance sheets and recent trends
– Regulation of securities firms and investment
banks
– Global issues

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Securities Firms and Investment
Banks (1 of 2)
• Securities firms
– Specialize in the purchase, sale, and
brokerage of existing securities
– Retail
• Investment banks
– Specialize in originating, underwriting and
distributing issues of new securities
– Advising on M&As and restructuring
– Commercial

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Securities Firms and Investment
Banks (2 of 2)
• Growth in domestic M&A:
– Less than $200 billion in 1990
– $1.83 trillion in 2000
– In US: bottomed out at $458 billion in 2002
($1.2 trillion worldwide)
– Topped $1.7 trillion 2007 ($4.5 trillion
worldwide)
– Effects of financial crisis: fell to $687 billion
in 2010 ($1.8 trillion worldwide)
 Worst financial crisis since 1930s, but M&A
activity still greater than early 2000s

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Mergers and Acquisitions, 1990-
2015

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Structural Changes in Recent Years

• Acquisition of Bear Stearns by J.P. Morgan

Chase
• Bankruptcy of Lehman Brothers
• Acquisition of Merrill Lynch by Bank of
America
• Only two remaining major firms:
– Goldman Sachs and Morgan Stanley
 Converted to commercial bank holding
companies in 2008

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Largest M&A Transactions (1 of 2)

Rank Deal Price ($ billions) Year

1 Citicorp merges with Travelers (which owned Smith

$83.0 1998
Barney and Salomon)

2 J.P. Morgan acquires Bank One* 60.0 2004

3 Bank of America acquires Merrill Lynch 50.0 2008
4 Bank of America acquires FleetBoston* 49.3 2003
5 Bank of America acquires Merrill Lynch 47.1 2008
6 Chase acquires J.P. Morgan* 35.0 2000
7 Bank of America acquires MBNA* 35.0 2005

8 Wachovia acquires Golden West Financial* 25.5 2006

9 Wachovia acquires Southtrust* 14.3 2004

10 BlackRock Inc. acquires Barclays Global 13.5 2009

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Largest M&A Transactions (2 of 2)

Rank Deal Price ($ billions) Year

11 UBS acquires Paine Webber Group 12.0 2000
Credit Suisse First Boston acquires Donaldson Lufkin 11.5  2000
12 Jenrette

13 Dean Witter merges with Morgan Stanley† 10.2 1997

14 Deutsche Bank acquires Bankers Trust* 10.1 1998
15 Region's Financial acquires AmSouth* 10.0 2006
16 CME Group acquires NYMEX Holdings 9.5 2008
17 Travelers acquires Salomon Inc. 9.0 1997
18 Intercontinental Exchange acquires NYSE 8.2 2012
19 Goldman Sachs acquires Spear, Leeds & Kellogg 6.5 2000
20 J.P. Morgan acquires Bear Stearns 0.2 2008

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 Size, Structure and Composition
(1 of 2)
• Dramatic increase in number of firms from
1980 to 1987
• Decline of 37% in the number of firms
following the 1987 crash, to year 2006
• Concentration of business among the largest
firms

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Size, Structure and Composition
(2 of 2)
• Many recent interindustry mergers (i.e.,
insurance companies and investment banks)
– Role of Financial Services Modernization Act,
1999
• Lehman Brothers, Bear Stearns, Merrill
Lynch, Goldman Sachs, and Morgan Stanley
gone by end of 2008

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Types and Relative Sizes of Firms
(1 of 2)
• National full-line firms are largest
– Service retail and corporate clients
– Three categories: commercial bank holding
companies, national full-line firms, and large
investment banks
– BOA (via acquisition of Merrill Lynch);
Morgan Stanley
• National full-line firms specializing in
corporate finance are second in size
– Goldman Sachs, Salomon Brothers/Smith
Barney (Citigroup)

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Types and Relative Sizes of Firms
(2 of 2)
• Remainder of industry:
– Regional securities firms (subdivided into
large, medium, and small)
– Specialized discount brokers
– Electronic trading firms
– Venture capital firms
– Other firms
 E.g., research boutiques, floor specialists, etc.

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Top BHCs, 2014 (by brokerage fee
income)
Bank Holding Company Securities Brokerage Fee
Income
Bank of America $ 1.30
Morgan Stanley 0.68
Wells Fargo 0.51
Goldman Sachs 0.34
J.P. Morgan Chase 3.36
All bank holding companies $ 10.42

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 Key Activities (1 of 2)
• Investment banking
– Activities related to underwriting and
distributing new (IPOs) and secondary
(seasoned) issues of debt and equity
 Public and private offerings
• Venture Capital
• Market making
– Involves creating a secondary market
– Increasing importance of online trading
 Technology risk

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 Key Activities (2 of 2)
• Trading
– Position trading, pure arbitrage, risk
arbitrage, program trading, etc.
• Investing
• Cash management
• Mergers and Acquisitions (M&As)
• Back-office and service functions

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 Recent Trends (1 of 2)
• Decline in trading volume and brokerage
commissions
– Particularly since crash of 1987, although
some recovery since 1992
– Record volumes 1995-2000
• Resurgence in market values and
commissions during mid-2000s
• New market value lows in 2008-2009
– Commission income also declined

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 Recent Trends (2 of 2)
• Pretax net income over $9 billion per year
between 1996 and 2000
• Pretax profits soared to $31.6 billion in 2000
– Curtailed by economic slowdown and
September 11, 2001 terrorist attacks
• Worries over securities law violations and
loss of investor confidence
– E.g., Enron, Merck, WorldCom, etc.
• Financial crisis, 2008
• Profits recovered, 2009

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Securities Industry Pretax Profits,
1990-2014

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 Balance Sheet (1 of 2)
• Key assets:
– Reverse repurchase agreements
– Receivables from other broker-dealers
– Long positions in securities and commodities
• Subject to high levels of market and interest
rate risk

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 Balance Sheet (2 of 2)
• Key liabilities:
– Repurchase agreements are major source of
funds
– Payables to customers
– Payables to other broker-dealers
– Securities and commodities sold short
• Capital levels much lower than in depository
institutions

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 Regulation (1 of 3)
• Primary regulator is the Securities and
Exchange Commission (SEC)
– Reaffirmed by National Securities Markets
Improvement Act (NSMIA) of 1996
– Prior to NSMIA, regulated by SEC and each
state in which the firm operated

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 Regulation (2 of 3)
• Early 2000s saw erosion of SEC dominance
– Increased vigilance by state attorney
generals
 Criminal cases brought mainly by states
against securities law violators
o New York State versus Merrill Lynch
 Spring 2003, $1.4 billion in penalties over
investor abuses
 New rules brought by SEC for greater
disclosure by analysts of potential conflicts of
interest

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 Regulation (3 of 3)
• Financial Industry Regulatory Authority
(FINRA)
– Handles day-to-day regulation
– Independent, not-for-profit
– Authorized by Congress
– Writes and enforces rules governing security
firm activities
– Enhance transparency in the market
– Dark pools

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 Extension of Oversight (1 of 2)
• Additional oversight from US Congress
– Hearings focused on role of investment banks
in the financial crisis
 Goldman Sachs bundling of toxic assets

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 Extension of Oversight (2 of 2)
• 2010 Wall Street Reform and Consumer
Protection Act
– Financial Services Oversight Council
– New authority for Federal Reserve to supervise
systemically important firms
– Registration limits for advisors changed
– Regulation of securitization markets; stronger
regulation of credit agencies
– Authority for government to resolve nonbank FIs
• Kenneth Feinberg (“pay czar”) given voice as to
executive compensation packages

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 Investor Protection and Other
Monitoring
• Securities Investor Protection Corporation
(SIPC)
– Protection level of $500,000
• October 2003 implementation of provisions
of Patriot Act to combat money laundering
– Scrutiny of individual identities and
affiliations with terrorists

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 Global Issues
• Global nature of securities firms
– Competition between US and European firms
– Foreign investors’ transactions in US
securities and US investors’ transactions in
foreign securities exchanges increased
– Global concern about capital, liquidity, and
leverage following the financial crisis
 Implications for global competitiveness
o Strategic alliances
o Exit from foreign markets

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 Pertinent Websites
• Federal Reserve www.federalreserve.gov
• NYSE www.nyse.com
• SEC www.sec.gov
• Securities Industry Association www.sifma.com
• SIPC www.sipc.org
• FINRA www.finra.org

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 End of Presentation

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. 4-29