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Investment Banking

Background

Investment banks as we know them today have their roots in the merchant bankers of the 19th century. The merchant bankers dabbled in foreign exchange trading for clients, but also handled project financing, pooling their own capital alongside contributed funds from wealthy individuals. The merchant bankers of that era, inspired by their counterparts in Great Britain and Europe—Barings Brothers, Morgan Grenfell, and the Rothschilds—financed the building of the Erie Canal, the early railroads, and other infrastructure projects. Investment firms like J. P. Morgan & Co., Dillon Read, and Drexel & Co. were major players in raising and deploying investment capital.

Later, in the post-Civil War era, the modern investment bank began to take shape, led by financiers Jay Cooke, J. P. Morgan, and others. A new business model came on the scene. Companies interested in raising capital began selling securities in the public markets. Investors holding common stock had a fractional ownership interest in the issuing company and the right to sell their stock shares to other investors through an organized securities exchange like the New York Stock Exchange. The financial firm became an active partner of the issuing company: acting as underwriter of the financing, distributor of the resulting public offering, and a jack-of-all-trades attending to the miscellaneous transaction details. Firms like Goldman Sachs, Lehman Brothers, Salomon Brothers, and Bache & Co. became household names during this period. Some firms, like J. P. Morgan & Co., ventured into commercial banking. These banks accepted deposits from bank customers and made business loans.

The early 20th century witnessed some huge financings and mega-fortunes on Wall Street. In 1901 J. P. Morgan astounded the financial world by cobbling together a number of steel manufacturers, creating U.S. Steel Corporation in a billion-dollar merger. Creation of the Federal Reserve System in 1913, following the banking panic of 1907, gave the nation a strong central bank for the first time in U.S. history.

In the early decades of the 20th century, investment banking grew tremendously, riding the surge in stock ownership by the investing public. By the 1920’s stock prices had reached unsustainable “bubble” heights. The stock market crash in 1929 and the Great Depression that followed convinced many in government that the financial marketplace, lightly regulated through much of its history, needed stronger supervision to protect the interests of average Americans.

In the 1930s, financial market reforms fundamentally reshaped the industry, with investment banking formally separated from commercial banking by the Glass-Steagall Act of 1933. Today, the very largest banks in either category compete directly with one another for business. Additionally, the Securities Act of 1933 became the blueprint for how investment banks underwrite and distribute securities to the public.

Banks on the investment side of the business helped finance the post-World War II industrial boom. Among these were Morgan Stanley, Goldman Sachs, First Boston, and Lehman Brothers. On the commercial banking side, First National City Bank (later Citibank), Bank of America, Chase Manhattan, and Wells Fargo were the leading players.

In the last half of the 20th century investment banks gradually shed their stodgy “white shoe” image. Banks that started out as private firms owned by senior partners switched to public ownership to tap the surging equity markets. The repeal of fixed-price brokerage commissions in 1975 was a turning point for the industry, accelerating the adoption of a new business model: the integrated investment bank. The integrated bank combined sales, trading, research, and investment banking—all under one roof. The 1980s and 90s were heady times, capped by an eye-popping number of initial price offerings in 1999—548 IPO’s, many by start-up Internet companies.

The first decade of the 21st century witnessed another surge in investment banking activity, followed by a bust—the 2008 financial crisis, which is considered the worst financial crisis since the Great Depression. The Depression era Glass-Steagall separation of commercial banking from investment banking was finally removed in 1999. In more recent history, though, the defining event is the financial crisis of 2008 and its aftermath. Pure investment banks like Goldman Sachs and Morgan Stanley converted to bank holding companies—at the expense of more supervision by banking regulators—to get government bailout money.

Following the events of 2008, investment banking is in the midst of a transition period. Some banks have retreated from their trading activities, instead focusing on expanding their wealth management divisions. Employment of investment bankers, sales workers, research analysts, and traders has declined by 20 percent since 2010, according to Coalition Ltd., a London-based research firm, but new opportunities have emerged for quantitative analysts, programmers, risk managers, compliance professionals, and information security specialists.

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