Investment and Commercial Banking A Comparison and Contrast Assessment

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Investmentand Commercial Banking: A Comparison and Contrast Assessment

Investmentand Commercial Banking: A Comparison and Contrast Assessment

1.0Introduction

Inthe current globalised markets, the role of the banking sector ingeneral on economic performance is of high importance. Banking ismainly a tool for financial intermediation where assets aretransformed into other forms of assets or liabilities. As Driga andIsac (2014) simplifies it, banks channel funds from savers toborrowers, therefore, connecting surplus and deficit economic agents(p.52). In the process of offering this facilitation of business, thebanking sector has transformed in many ways in how financial,economic and marketing processes are being undertaken (Rewilak, 2013,p.1452). Various studies have continued to draw increased interest inproviding insight on the specific roles of the two fundamentaldivisions of the banking sector, which are investment banking andcommercial banking. According to Bextley, James and Haberman, (n.d),the direction of the two activities in the modern markets has comeunder intense scrutiny, especially after the 2008 global economicplunge (p.2). The need to identify actual similarities anddifferences between the two distinct banking activities regardingtheir functions and importance in the economy forms the basis andfocus of this paper. As such, the assessment explores specificfeatures of the two financial bodies looking into similarities anddifferences in financing, managerial compensation, risk management,and financial supervision, analyzing the three issues from theviewpoint of finance, economy, and marketing.

Therehave been arguments as to whether it is appropriate for the functionsto be undertaken by the same company. As discussed by Levin (2010) inhis arguments on the possible causes of the 2008 global financialcrisis, the debate on whether the two were responsible has continuedto draw various reactions. This can, however, be confirmed onlythrough detailed analysis of the financial patterns, a process thataccording to Watzman (2011) is yet to prove any valid answers. Fromrecent statistics, investment banks are recording impressiveperformances in the global markets financial charts with leadinginvestment banks in the U.S. market being led by Goldman Sachs havingclosed Mergers and Acquisitions (M&ampA) banking fees worth $560.22billion followed by Morgan Stanley $542.95 billion and JP MorganChase $470.44 billion in the fiscal year 2012. This was against atotal of $14.5 trillion worth of assets forming the world largesteconomy (Thomson, 2014). In the global platform, investment bankingfees alone reached $77.4 billion in 2012 a slight increase of 2.3%from 2011 performance. Bonds and M&ampA took 30% each while Loansand Equity took 21% each of the total global investment banking fees.Commercial banks on the other side have been struggling to maintaintheir profitability above the surface. This is following the 2008historic collapse of U.S. housing value that resulted in mega lossesin mortgage-backed securities (Sutton and Jenkins, 2007, p.1).

2.2 Similarity and Differencesbetween Commercial Banks and Investment Banks 2.2.1Financing

Puri(1996) and Kurt (2014) strongly support the fact that commercialbanks main activities differ from those of the investment banks,which involve providing expertise to business products and servicesin regards to developing creative financing solutions to customers.However according to Obamuyi (2013), as much as some banks havespecialized either on one of the two, others have diversified toincorporate investment banking into their operations. Hughes (2014)and Ferreira et al. (2014) agree that both commercial banks andInvestment banks carry out their services through building mutualrelationships between businesses and their financiers and ensuringtransactions being executed are successful. Walter, Yawson and Yeung(2008) singles out the functions of Investment banking being mainlyassociated with structuring and execution of complex financing andhigh-risk management transactions for corporate institutions,financial sponsors, and governments (345).

Accordingto Hughes (2014) both commercial banks and investment banks productsprovide funding solutions to their customers, however, for investmentbanks advising and arranging for the financing of those transactionsis important while commercial banks providing of funds through creditadvancing is the main focus. This involves issuing funds in the formof loans thatare in return paid at high-interest rates forms the mainsource of revenue (Khaliun, 2015, p.144). The fundamental functionsof commercial banks are to work directly with individuals andcompanies as accounts accepting deposits such as current account ordemand deposits and fixed deposits (Peek and Rosengren, 2013, p.4).For investment banks, as described by Chiteli (2013), they mainlymediate for corporate derivatives, which help corporations to come upwith risk management strategies (p.312).

Incommercial banks, advancing loans is one of its income mainstreams.Balances kept by banks from the deposits that customers make areissued out as loans with interest (Sign, 2013, p.48). Some of theloans include cash credit loans, which are given to customers againstcollateral, and demand loans are loans given to customers, but thebank can demand the cash back at any time (Chiteli, 2013, p.316).Investment banks have for year’s undertaken important M&ampAdeals. This ranges from local companies to multinational corporationsthat either consolidates as Bafna and Singh (2015) terms it. The roleof investment banks in undertaking mergers include advising onwhether the decisions to combine with other companies is profitableand undertaking relevant market research to determine the viabilityof such deals. In acquisitions, companies buy off other companies.The processes are also initiated and undertaken by investment banksas mediators in all the processes involved (Chiteli, 2013, p.316).

Similarly,commercial banks also have asecondary set of functions in which theyundertake on behalf of their customers (Banks, n.d). Agency functionsof commercial banks involve acting as agents of their customers inperforming various business deals. According to Chiteli (2013)commercial banks, collect cheque and bills of exchange on behalf oftheir customers. Banks (n.d) also identifies income collection onbehalf of customers as one major function of commercial banks. Thisincludes acollection of salaries, pensions, rents and even intereston investments. Commercial banks also pay expenses for theircustomers for various bills (Kuhn, 2011). Investment banks utilizeapproaches such as leverage financing in helping organizations raisefunds through debts to finance assets. As Chiteli (2013) andObamuyi, (2013) say, investment finance that involves using borrowedcapital to and investment’s return for firms that have high debtsthan their equity is highly leveraged.

Oneway investment banks raise capital for clients is through privateplacement and equity capital markets. Investment banking, private andpublic companies, government entities and financial sponsors rely oninvestment banks into structure and execute equity financings such asIPOs and convertibles (Kuhn, 2011 Bafna and Singh, 2015). Withcommercial banks, there are some utility functions, which theyprovide extra services such as locker facilities where customers keeppersonal items safely in the banks safes. In addition, they providetravellers cheques for customers operating overseas and foreignexchange services, which involve providing foreign exchange tobusinesses and transferring funds from one bank to another asinstructed by customers (Banks, n.d Kuhn, 2011).

2.2.2Managerial Compensation

Investmentbanking managerial compensation is structured as salary and annualbonus depending on performance (Levina, 2014). In some banks, newlyemployed associates and analysts are provided a sub-bonus in everyfiscal year that is prorated on a monthly basis (Bebchuk, 2012).Salaries in investment banks for junior employees are normally fixed,but the rate depends on specific banks, type of position andexperience at the banks. Investment banks in pay almost similar ratesto retain top talents (De Young, Peng and Yan, 2010, p.4).

Incommercial banks, management compensation is totally different as DeYoung et al. (2009) put it. Following the 2008 financial plunge,politicians and policy makers immediately followed by limitingexecutive compensation in the commercial banking companies (Dunn,2014). Limits were maintained below $500k per year, and the PresidentObama Administration further instructed Treasury Department to blockall bonuses that were due to executives and various other financialprofessions in major banks (De Young et al., 2009, p.16). Incommercial banks as at 2013, Credit Analyst salary in the U.S banksrated $48k, Loan officer, and commercial officers earn $74k,portfolio managers earn $72k, Senior Vice president and CommercialLending earn $132k to $230k while Senior Credit Analyst earn around60k in average per year. Annual cash bonus for some of the companiesthat still offered them to their executives ranged from $28k for VicePresident, which is in average 22.5% of their base salary. SeniorVise President Level received in average $42k bonus that is 25% oftheir base salary (Luhan, 2012 Sidel, 2012, p.2).

Bonuspools in investment banks are based on overall market performance. Instrong markets where more deals are undertaken which translates tomore fees, the benefits trickle down to employees increasing theircompensation (Homburger, 2012, p.326). Investment banks also allocatecompensation packages based on performances on individual divisions.Bonuses for analysts range from 50% to 100% of salary in most bulgebracket investment banks. Varying market conditions cause the largefluctuations. Associate, on the other hand,earn compensation rangingfrom $55k to $145k annually on top of their salaries that range from$110k to 125k for first year associates. The investment banksdirectors are salaried from $175k to $200k and the rates may differdepending on the number of years they have worked in the bank. Theirbonuses range from $150k to $500k. Senior vice presidents ofexecutive director’s total earnings mostly range from $300k to over$1 million. Managing directors get the highest salaries ranging from$300k to over $3 million (Hogson, 2004 iBanking, 2013).

Theonly similarity between commercial banks and investment bankscompensation strategies for management is that larger companies tendto give more upscale rates as compared to middle and lower tierbanks. The two sectors were all affected by the 2008 economic crisis,and they are recovering progressively (Barsch, 2012, p.24).

2.2.3Risk Management and Financial Supervision

Whileinvestment banks greatest risk involves technology used in monitoringand managing risk, commercial banks are more exposed to the creditrisk. Commercial banks heavily rely on paid loans from lenders thatmust be made on time. As investment banks heavily rely on dataquality and management of their data, which is their only tool inmaking profitable decisions for their customers, commercial banks,depend on accurate estimates of repayment information. Any disparityand if the price and rate of losses are not correctly estimated, theyare prone to a shrinking capital reserve to unacceptable levels(Lucifora, Murphy, 2013, p.3).

Investmentbanks largest risk is their overreliance on the management teams whoare responsible for analyzing and organizing risk data required.However as Colomiris and Herring (2002) explain, as the globalbanking infrastructure keeps changing, managerial positions areincreasingly becoming of high value and equally biggest weak pointsof the investment banking sector. As investment banks continue tofind ways to mitigate the risk of cyber security, in commercial banksthe biggest risk is frequent investment securities in commercialbanks balance sheet that expose them to higher risks of marketfluctuations. Many commercial banks put most of their reserves indebt instruments which according to Podoliakova (n.d) is consideredsafe. As Colomiris and Herring (2002) explain, debt reserves are athigh risk of plunging into market value decline that may result inbanks raising capital or resort to lend and result in unbearableinvestment losses in shareholders’ equity. Investment banks alsoface similar liquidity risks that require them to ensure investmentsare monitoredcontinuously, and investment strategies are structuredto prevent the risk of losing marketability of investors(Podoliakova, n.d, p.4).

Inthe 2008 economic crisis, the scourge hit both commercial banks andinvestment banks hard. However, only commercial banks were beinggiven bailout by thegovernment. This left pure investment banksexposed to the full effects of the crisis. Many banks transformedthemselves into bank holdings companies to benefit from governmentincentives to survive the crisis. This further subjected them tointense oversight especially by the Federal Department (Colomiris andHerring, 2002, p.22). Despite the recovery efforts being made byinvestment banks in the current market, they are still facing largechallenges such as high compensation rates compared to commercialbanking that have been regulated directly by policy and governmentefforts (Podoliakova, n.d, p.5). Commercial banks despite beingequally affected as their counterparts, they were able to receivevarious boosts from the Federal government to cushion them from totalcollapse. This has helped the U.S banking sector recover steadily inthe past 5 years. The responsibility of the 2008 financial crisisrests on investment banks as they are fully responsible for ensuringthat every offer they present to their customers regarding bonds mustbe safe and fully analyzed (Jenkins, 2015, p.12). This fault startedwith investment bankers and according to Levin (2011), they failedthe entire industry by being dishonest and ending up to offer badinvestment deals to clients.

Consideringthat the main failure in the 2008 financial crisis was caused byfailed regulation due to gaps in regulations and overlappingauthority. To increase limit on risk taking, new financialregulations have now been introduced in the U.,S market givingregulators explicit authority to reduce risk. Both commercial banksand investment banks are subject to federal regulations and federalagencies. The federal reserve acts like the last resort of lendingthrough discount windows for all state banks and foreign banks withU.S branches (Avraham et al., 2012, p.67). The Federal Reserve canalso extend the credit it offers to commercial banks that are notregistered under its insurance to maintain stability and provideliquidity to the financial system (Mayes and Wood, 2007, p.16).Commercial banks are also controlled by the office of the controllerof the currency (OCC). Both commercial and investment banks which areinsured by the Fed are also guarded by the Federal Deposit InsuranceCorporation (FDIC) which looks into the banking systems risk andengages in providing assistance which include debt guarantees(Homburger, 2012, p.9). Investment banks security exchanges aremonitored by the Securities and Exchange Commission (SEC) whichauthorises financial accounting standards for public traded firms andcontrols trading strategies in the market by suspending or evenclosing them. Investment banks are also controlled by CommodityFeatures Trading Commission (CFTC) when selling corporationssecurities to the public in analysing details on the registeredsecurities and financial disclosure (Sigh, 2007, p.24). Forcommercial banks offering mortgages and housing finance, the FederalHousing Finance Agency (FHFA) acts as a conservator for some banks.Commercial banks with assets worth over $10 billion are alsocontrolled by the Bureau of Consumer Financial Protection which setsrules and laws non bank mortgage providers but not bank creditissuers and banks products that deal with real estate brokerage andauto dealerships (Felsenfed &amp Glass, 2011, p.8).

3.0Conclusion

Inthe financial sector, the banking sector provides important servicesto both private and public institutions and individuals. Investmentbanking and commercial banking both have the same aim of ensuringthat their customers can safeguard and invest wisely. The twoplatforms in banking provide customers with various financialservices and products to choose from depending on their needs.Commercial banks are more focused on the small markets and are highlyregulated by the government and the Federal Department. Similarregulations apply to the investment banks but on a relaxed version.Commercial banks provide account management services to theircustomers and offer deposit and credit services. Both banks wereaffected by the economic crisis in 2008, but commercial banks weresafeguarded by the Federal Reserve’s incentives as opposed toinvestment banks that had to endure the aftermaths directly. Bothbanks have various risks in their operations, legal obligations, andare vulnerable to credit risks, reputation risks, and market risks.

3.1 Recommendations

Itis important that banks focus on their core businesses. Commercialbanks should focus on providing sound services and products to theircustomers and prevent engaging in activities that increase theircustomers and investors investments risks. This will preventtemptations for repackaging and reselling loans or over concentratingof capital into private equity. Regulations are the only control andguide in the financial industry. Abuse of rules and policies is themain cause of problems like the ones experienced during the 2008economic crisis. Putting in place rethought regulations and policieswith customer’s interest put at heart in critical. It is importantfor banks both commercial and investment banks to put invest intomore capital and liquid assets. Organizations operating inmultinational scale should restructure their global strategy byputting their countries best interest first through restricting thefree flow of capital across borders.

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