Finance: From Business to Business

Today's large financial firms are hosting various and sometimes complex activities. They are rarely can be considered  as banks in a classic definition of the term. Indeed many financial institutions are involved in commercial and investment banking, capital management and sometimes even insurance business. Let's have a look into the structure of a typical financial institution and try to understand how all its parts are fitting together.

Commercial Banks

Commercial banks are the banks having the most traditional role of taking deposits and making loans while loans interest is greater than the interest paid on deposits. So the main source of revenues for a commercial bank is a spread between the cost of funds and the lending rate. Depending on the clients and amounts implied, commercial banking can be classified as retail banking or wholesale banking. Retail banking deals with private individuals and small businesses while wholesale banking provides banking services to medium and large corporations, investment funds and other financial institutions. Obviously the amounts of loans and deposits much higher in wholesale banking than in retail banking.

Investment Banking

This is probably the most obscure business in the banking sector. This obscurity is not necessary related to a lack of transparency but because the investment banking is holding a lot of various activities underneath. Public media are often presenting the investment banks as a group of conceited and insatiable traders who are capable to drive the world's economy to a collapse just to increase their own profits. Such persons certainly exist in the investment banking but fortunately this is not what the business is targeting for.

The main activity of investment banking is raising debt and equity financing for corporations or governments. The typical scenario is when a corporation approaches an investment bank when it needs to raise additional capital. This raise of capital can be achieved by issuing of a corporate debt, public offering of common stocks or some hybrid instruments such as convertible bonds. Basically investment bank can be seen as a mediator between a corporation which needs extra capital and investors who are happy to invest in it via capital markets.

Another important role of the investment bank is to offer advice to corporations in terms of merges and acquisitions, corporate restructuring etc. They will assist in finding mergers, takeovers, break down corporation into divisions to sell them separately to other corporations.

Investment banks can even design and sell to its clients custom financial products. These products can be standardized or not. The examples of these products are the warrants, options, ABS, CDO, CFD etc. Not standardized products are often called structured products and they are designed to address concrete client's needs, usually to hedge from some specific risks. Often investment banks are providing liquidity for these products in order to allow investors buying or selling them at any time. This liquidity management activity is often referred as market making.

Prop Trading

Proprietary trading refers to an activity when a bank takes a speculative position in the hope of making a profit. In other words it trades for its own account. The trading firm can trade stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money. They may use a variety of strategies including very aggressive ones much like a hedge fund. Large investment banks often have this activity along with brokerage business. This is probably the most famous and contested activity that we can come across in various Hollywood movies about traders and large investment banks. For that many people have a wrong impression that this is the only activity of the investment banking business. The reason of criticism come from the definition of the "own account". For a large financial institution that has an investment banking activity the "own account" often means "depositors money"....

Brokerage

Brokerage firms are facilitating the buying and selling of financial securities between a buyer and a seller. Brokerage firms don't have any particular investment strategy, they are just processing client orders. Brokers can be considered as a middleman between client and the capital markets where clients can be asset managers, hedge funds, institutional investors, pension funds or individuals. Brokerage firms are taking profits from the commissions charged to their clients. In practice the real brokerage firm suggests many other services to its clients like researching the markets, recommendations of what to buy or sell etc.

Worth noting that brokerage firms are not just forwarding the orders to the market. It can be the case for some small orders. But the main chunk of the added value of the broker relies in the large orders and order baskets processing. Indeed very large orders cannot be directly sent to the market as they are likely to unbalance supply and demand (order book) and the price of the instrument will jump or fall drastically. This is where various trading algorithms are coming into play. Brokers are trying to provide a better price to its clients so they are usually splitting large orders into smaller parts and sending them to the market at an appropriate time defined by the strategy. Sometimes brokers are providing custom trading algorithms to their clients who are interested in some specific trading of their orders.

Asset Management

The objective of an asset manager is to invest client's money in the most efficient way. In the most of the cases asset managers suggest collective investment schemes like mutual funds, pension funds, exchange traded funds etc. to their clients. Asset managers are mainly targeting small and medium investors who are looking for broader diversification with a minimum costs. Indeed it can be difficult for a small investor to hold enough stocks to be well diversified and maintaining a well-diversified portfolio can lead to high transaction costs. As long as asset managers are mostly targeting small investors their business is pretty much standardized and overseen by financial regulators.

Usually asset managers have a benchmark that is clearly mentioned for each product being commercialized. This benchmark can be a broad index like S&P 600, Dow Jones, Dax, some bond or commodities index etc. Asset manager can commercialize funds with active management and/or index funds. Funds with active management are trying to beat the benchmark with respect of the fund's risk profile. Index funds and Exchange Traded Funds (ETF) are just following benchmark without applying any extra investment analysis. ETFs become more and more popular as they are traded on the market as usual common stocks while traditional mutual funds are not traded on the market and using subscription approach based on some fixed price per fund's share. Index funds and ETFs are much cheaper in terms of management fees than actively managed funds what partially explains their success. However actively managed funds allow investors benefiting of the manager's experience and knowledge.
Asset mangers earn money with management fees. Each year fund manager charges some percentage of assets to its clients. These fees are deduced from fund's overall performance. Some funds have extra entry fees and even exit fees but it becomes less and less. Actively managed funds can charge around 2%-5% per year while index funds and ETFs are usually charging around 0.2%-1.5% plus eventual leverage costs if fund is using leverage.

Criticism
There is a lot of criticism towards asset management in general and especially actively managed funds. Due to the strong regulation of the actively managed funds they are often constrained to implement the most efficient strategy. For example even if a fund manager is expecting stock market downturn, he can be forced to be invested at some level of its assets by regulators. This level can reach 90% in some cases! Another point of criticism is that asset manager always wins. Sounds funny but it is true. Even is the benchmark fell of 40% and the fund indexed on this benchmark fell "just" 30% the asset managers did a great job and they will still charge fees to their clients. Another VERY annoying point about actively managed funds is that subscription becomes valid in some period of time after client had requested it. Usually the subscription is validated next day for the next day price! With current market volatility it can be very risky to subscribe this way. Taking into account this criticism many investors consider that benefits of active management by professionals are offset by higher fees, regulatory constraints and funds subscription specific risks. Even worse statistic shows that actively managed funds are very rarely beating the broad market in the long term.
Index funds and especially ETFs are becoming more and more popular. They are widely used by investors implementing diversified strategies. The only criticism I'd mention that sometimes investors are buying several index funds holding same instruments. For instance both French CAC40 ETF and Eurostoxx 50 ETF are likely to hold Total and Sanofi stocks. So this is an example of the false diversification.

Hedge Funds (Alternative Investments)

Hedge funds are different from the asset managers in that they are subject to very little regulation as they are targeting financially sophisticated individuals and organizations. Hedge Funds can design their own strategies and take profits from both bullish and bearish markets. They don't have a strict benchmark but they can have a general investment direction like American stock market, commodities trading, fixed assets, currencies etc. But from the investor's perspective, even if a hedge fund is labeled American stock market fund, it doesn't mean that if market would fall the fund is likely to loose money. Hedge fund managers are expected to benefit from all opportunities even while market crash. Another difference between traditional asset manager and a hedge fund is that the latter is likely to use leverage. It means that hedge funds are often borrowing money to increase their performance.
Obviously hedge funds are much more expensive. They are charging fees to investors not only for usual management, entry/exit fees, but also they are taking a significant percentage of fund's performance. So hedge funds are always winning but after a good year they are winning even more! Investors giving their money to a hedge fund are strongly exposed to the manager's competencies and experience. Many hedge funds are going bankrupt every year especially during financial crisis. For this reason financial regulators are absolutely right in limiting the access to these sometimes very efficient investment schemes.

Private Banking

This is a special form of relationship between a bank and its client, usually a wealthy individual. This relationship includes premium services and a form of custom asset management designed to the specific client needs. For wealth management purposes, individuals have accrued far more wealth than the average person, and therefore have the means to access a larger variety of conventional and alternative investments. Private banks aim to match such individuals with the most appropriate options. In addition to providing exclusive investment-related advice, private banking goes beyond managing investments to address a client's entire financial situation. Services include: protecting and growing assets in the present, providing specialized financing solutions, planning retirement and passing wealth on to future generations. Private Banking business is very developed in Switzerland.

Private Equity Firms

A private equity firm is an investment manager that makes investments in the companies that are not traded on the stock exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.