Conflict of Interest in Investment Banking
February 12, 2025
In the previous article, we have already learned about the repo market. We learned about how the repo market is one of the most important segments of the money market. We also learned about the large volumes of transactions that take place in the repo market. We already know that about $2 trillion to $4 […]
Investment banking has traditionally been a lucrative business. Investment bankers have always been in the news for the excessive amount of money that they made while the rest of the world was struggling. However, the relentless negative publicity that the industry has received in the past has changed the way it functions. Also, external circumstances […]
Commercial banks all over the world have been forced to adapt to increasing changes in technology. This is because technological changes are shaking the very foundation of the commercial banking industry. However, since commercial banks have been reactive i.e. they have been responding to changes in the environment instead of proactively accepting them, a lot […]
Investors are used to looking at projections of future events. They commonly use projections about future cash flows, future profits, and even future dividends in order to make investing decisions. However, a lot of the time, the projections that they use are overly optimistic. This leads them to make bad investing decisions. This problem of […]
In every public-private partnership, it is the job of the public party to provide remuneration to the private party. There are various mechanisms in which this payment can be provided. In this article, we will discuss the mechanisms which are commonly used in public-private partnerships. User Charges User charges are a commonly used mechanism when […]
The derivatives department is a highly specialized department in the modern-day investment bank. This is because, in terms of size, the derivatives department easily dwarfs all other departments in the investment bank.
For instance, the worldwide market for derivative contracts is said to be valued at $79 trillion! This is definitely a notional value since it is more than all the money present in the world. This notional value is generally used to calculate the actual value, which changes hands. Even though that amount is much smaller than $79 trillion, it is still the biggest market in the world. Needless to say, investment banks all over the world have interests related to this market.
In this article, we will explain how investment bankers utilize their other businesses to generate more business for themselves in the derivatives department.
The investment banking team has a team of specialized people called “quants.” These people are able to understand the risks which accrue when several investment banking products are clubbed together to create a new financial product. These types of products are often called structured products. They have been at the center of many debates, particularly after they were blamed for the downfall of the financial markets in 2008.
Securitized products such as mortgage-backed loans, collateralized debt obligations, etc. all fall under the category of structured products.
The trading desk of the investment bank provides continuous buy-sell quotes. Needless to say that there is a bid-ask spread present in all quotes so that the investment banker is somewhat compensated for the risk that they undertake. This market-making takes up a lot of capital from the trading desk of the investment bank. However, it is important since it provides an exit route to the investors.
Investment bankers also gain from this transaction. This is because firstly, they earn an origination fee when the securities are created and then earn a bid-ask spread when they make the market. Investment banks have deep networks and hence are able to sell out these securities to other counterparties and hence unlock their capital.
Hence, the financials of the investment bank can be severely impacted in the event of a downturn. Investment bankers hire special risk analysts to manage the risks that they undertake during this trading.
These risks analysts use complex mathematical techniques to understand the quantum of risks as well as the financial impact it may have. In many cases, if the investment bank finds the risk to be too much, it takes it off its books by buying other derivatives products that might be sold on the exchange.
The bottom line is that trading and selling of derivatives has become an important business of investment banks. In fact, this is what investment banks are now largely known for. This line of business has also brought a lot of disrepute to investment banking as too many scandals have emerged within a short period of time.
Your email address will not be published. Required fields are marked *