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ECONOMICS FOCUS BANKING AND COMMERCIAL BANKING 15

INVESTMENT BANKING AND COMMERCIAL BANKING

INVESTMENT BANKING AND IN CONNECTION WITH ACTIVITIES OF CERTAIN NON-BANKING ENTITIES • INVESTMENT AND COMMERCIAL BANKING, MODELS FOR THEIR SET-UP • SITUATION IN THE EU AND IN SLOVAKIA

JUDr. Ján Vyhnálik, National of Slovakia

Certain corporations in Slovakia, to whom a banking license has not been granted, offer services of investment banking and private banking. We therefore deem it necessary to define the relationship of both of the mentioned categories to the currently applicable Banking Act and other relevant laws. In this context, it is also desirable to clarify the relationship between investment banking and commercial banking.

Investment Banking rations, , mergers & acquisitions, assets , financing using , Investment banking (hereinafter the "IB") is an eco- merchant banking and securities transactions for insti- nomics category, but a completely unequivocal definiti- tutional investors. This concept of IB does not include on of its nature is not simple even for any theory of eco- e.g. retail securities transactions and trading in insu- nomics. Investment banking is not a legal term and as rance products. such this concept is neither defined nor used in appli- 3. Selected operations with emphasis cable laws or other statutory regulations. It was coined on issuing operations, mergers & acquisitions and in response to the specific activity of investment con- merchant banking. ducted by notably in the securities markets. This 4. The narrowest definition is historically rooted, was as a result of a prevailing focus on performance of where once in the past issuing operations and broke- investment activities and a specific group of investment rage or dealer trading in secondary markets were dee- banks were profiled within the banking systems of cer- med to constitute IB. tain countries. Nevertheless, investment activities were P. Musílek defines investment banking as transacti- also carried out by other specialised institutions, apart ons in securities, financial derivatives and other instru- from banks, whereas the term of investment banking ments of private financial markets. In his understan- came to be generally used to refer to this type of ser- ding, IB comprises: issuing operations, own and vice, regardless of the type of licensed entities provi- intermediary trading in investment instruments, custo- ding them. dy, assets management and mergers & acquisitions. Several definitions of investment banking are in use Investment banking primarily encompasses intermedi- in the theory of economics. ary for the clients' account, with the main source For example, Petr Musílek1 quotes that according to of profits being brokerage commission, and/or a diffe- R. Kuhn2 the following four definitions of IB are possib- rence between the bid and asked prices (unlike com- le, starting from the broadest to the narrowest one: mercial banking with prevailing trading for one's own 1. All the activities of major Wall Street firms - from account and at one's own risk and the main source of international issuing operations to retail business, inc- profits consisting of an interest margin between len- luding real estate business and trading in insurance ding and -taking business bearing interest). products. Under the Slovak legislation currently in place, 2. All the activities in capital markets, i.e. issuing ope- investment banking actually is a set of activities regu- lated under the term of investment services by Act No. ––––––––––––––– 1 Musílek, P.: Finanční trhy & investiční bankovnictví (Financial 566/2001 Z.z. on Securities and Investment Services Markets & Investment Banking), Prague, ETC Publishing, s.r.o. and the Amendment of Certain Laws, as amended 1999. (hereinafter the "Securities Act"). The conduct of such 2 Kuhn, R.: Investment Banking. New York, Harper and Row, 1990. activities is preconditioned by a license for the provisi-

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on of investment services from the to the execution of the client's order to acquire or sell Authority, which authorises the establishment of an investment instrument, providing that the lender is a securities dealer or a branch of a foreign securities a party to this deal and the conditions as per the Ban- dealer within the territory of the SR (§ 54 of the Secu- king Act have been met; rities Act). • giving advice on business strategy and consulting Pursuant to § 6 of the Securities Act, investment ser- and services concerning the company amalgamation, vices (both principal and auxiliary ones) shall be provi- merger, changeover or division or the purchase of an ded to clients in handling investment instruments under enterprise; the conditions set forth thereunder. • taking care of the issuance of securities for issuers Investment instruments comprise: shares, bonds, and services associated with the , place- equity certificates, the so-called substitutable securiti- ment, the payment of earned income and redemption es with the attached right to acquire shares and bonds, of investment instruments; or giving rise to the right to settlement in certain instru- • advisory services relating to investment in invest- ments of payment, securities issued beyond the Slovak ment instruments; territory, to which similar rights are attached as to the • receiving payments from the client and trading in previously mentioned securities, market instru- foreign exchange assets in accordance with the Fore- ments denominated in both the Slovak and foreign cur- ign Exchange Act in the scope needed for the provisi- rencies, futures contracts also allowing for the financi- on of major investment services; al settlement of obligations arising thereunder, and • conducting similar activities as in the case of prin- related to investment instruments, interest rates, cipal investment instruments provided securities and instruments of payment in both the Slovak and foreign derivatives are involved that are not investment instru- currencies or financial market indices, options for the ments. purchase or sale of underlying investment instruments From the above mentioned one can infer that invest- and instruments equivalent to them also allowing for ment services are not those activities that may only be the financial settlement (options relating to the Slovak performed on the basis of a banking license, i.e. money and foreign currency funds, i.e. currency options, and deposit taking (associated with the provision of interest interest rates options), interest rate, currency and equ- or other considerations constituting a tax expense) and ity swaps. making and advances (based on repayable The principal investment services include: monies obtained from other persons). On the other • the acceptance of the client's order for the acqui- hand, the Act No. 483/2001 Z.z. on Banks and the sition, selling, or another kind of handling of investment Amendment of Certain Laws, as amended (hereinafter instruments and the subsequent transfer of the clien- the "Banking Act") allows banks and branches of fore- t's order with a view to its execution; ign banks (hereinafter the "bank") to carry out certain • the acceptance of the client's order for the acqui- investment activities subject to an authorisation to be sition or selling of an investment instrument and its obtained from the Financial Market Authority pursuant execution for an account other than the service provi- to the Securities Act in the capacity of securities dea- der's account; lers, provided that subsequently those activities are • the acceptance of the client's order for the acqui- also stated in the banking license. However, even in the sition or selling of an investment instrument and its Banking Act the concept of "investment banking" is not execution for one's own account; employed, but the term "investment operations" is • the management of a portfolio formed of one or used instead. several investment instruments as mandated by the cli- The comparison between the content of investment ent under a contract on the securities portfolio mana- banking and the currently applicable legislation clearly gement separated from the portfolios of other clients; indicates that IB does not comprise those (typically) • arranging the sale of investment instruments for the banking activities that may only be performed on the issuer when they are issued (i.e. flotation); basis of a banking license. Activities expressed by this • the acquisition of investment instruments from their term are in fact activities governed by the Securities issuer when they are issued with a view to their selling, Act under the name of investment services and that including an obligation to buy from the issuer not pla- may be performed solely on the basis of an authorisa- ced investment instruments (i.e. underwriting). tion granted by the Financial Market Authority. Alt- Auxiliary investment services include: hough the expression of "investment banking" has alre- • custody or management of one or several invest- ady established itself, its use in advertising offers of ment instruments; entities that are not banks cannot be considered as • making loans or advances to the client with a view appropriate or right for the following reasons:

BIATEC, Volume XII, 3/2004 ECONOMICS FOCUS INVESTMENT BANKING AND COMMERCIAL BANKING 17

– concerned is the provision of investment services, i.e. activities that may only be carried out based on an and not banking services or operations; authorisation granted pursuant to the Securities Act – the word "banking" invokes an idea that the adver- (see the text hereinbefore). tised activities are offered by an entity with a banking Offering private banking services in advertisement license granted to it, which in reality is not the case; campaigns of entities that are not banks may therefore – investment banking falls within the line of business be considered as inappropriate, even as verging on of separate specialised banks, and when it comes to admissibility, namely on the following grounds: universal or commercial banks, this type of business – private banking in the first place signifies the provi- (activities) there is separated, in terms of organisation, sion of typical banking services, i.e. the performance of accounting and information flows, from typically ban- operations requiring a banking license, even though, to king operations. a lesser degree, it concurrently also includes the provi- The publication of offers of investment banking ser- sion of investment services; from which it can be furt- vices by entities to whom a banking license has not her inferred that: been granted is therefore misleading, especially if such – such package of services may always be provided advertisements do not contain a closer specification of only by an entity to whom a banking license has been activities on the offer or at least a word of caution that granted, i.e. a bank; in fact they are activities as per the Securities Act and – in global terms, self-contained banks targeted at not activities (operations) as per the Banking Act. the most moneyed kind of clientele are engaged in private banking, and, as for a major part of other Private banking banks, the conduct of private banking business is Private banking (hereinafter the "PB") also is an eco- covered by specialised organisational subdivisions nomics and banking category used in connection with and employees. the conduct of banking activities with a historical The publication of any offers to provide the service of background to it. That is to say that it is not a legal cate- private banking by entities not holding a banking licen- gory, since the concept of "private banking" has not se is therefore a possible deception, since such entiti- been defined in the Slovak system of law or used in es are not authorised to perform activities requiring laws or other statutory provisions. a banking license. Private banking stands for the provision of banking In conclusion to this section we can briefly note that services notably to the most lucrative group of clients, the use of labels "investment banking" and particular- i.e. individuals or families whose net equity has rea- ly "private banking" in offered services produced as ched a certain required value.3 It is more about lending part of any advertising by entities missing a banking and less about deposit-taking in comparison to com- license not only has a misleading effect, but is even mercial banking, also encompassing the management a deception (§ 2(2) of Act No. 147/2001 Z.z. on Adver- of or investment funds of the said group of tisement and the Amendment of Certain Laws and § clients. It may be performed by a separate bank or 45 of the Commercial Code). Should one of such enti- a designated subdivision within a bank. In PB, banking ties actually conduct private banking, unauthorised operations account for a significant part of services business would be involved at the end of the day. provided to the given clientele compared to the volume Non-banking (licensed) entities should offer invest- of investment operations rendered (unlike investment ment services instead of investment banking and they banking). should not employ the notion of private banking in their By virtue of our applicable legislation, private ban- services offered at all. king first and foremost represents the conduct of those activities that in the SR may only be performed on the Institutional Arrangement of Investment basis of a banking license granted under the Banking Banking and Commercial Banking Act (making loans and taking of deposits). The notion of PB denotes to a decisive extent banking activities, When it comes to the institutional set-up of interme- whilst also encompassing certain investment services, diaries of investment business executing operations in the markets for securities and financial derivatives and ––––––––––––––– intermediaries of a typical banking business, a distin- 3 For example, according to Michael Atz (Emerging Issues ction between several models for arrangement of Series, Federal Reserve Bank of Chicago, 1999), in the investment banking and commercial banking can be U.S.A. this would mean persons or families with an income of at least USD 100 000 or the net equity of above USD 500 000. made. These models, which result from economic, his- Certain private banks demand assets suitable for investment torical, legislative and regulatory as well as political in the amount of at least USD 1 million. factors, are as follows: a model of universal banking,

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a model of separate banking, a model of a holding ge), and bank holdings to hold investment firms as company and a model of a subsidiary.4 subsidiaries. Since then bank lobbyist groups exerted A universal banking model is represented by strong pressures to abolish the Glass-Steagall Act, a banking system in which universal banks concurrent- which to a certain extent disadvantaged American ly pursue both commercial banking (in the banking banks in international competition. The Financial Servi- intermediary market) and investment banking (opera- ces Modernization Act (the Gramm-Leach-Billey Act) ting as an investment firm in the securities market). of 1999 allowed for the cancellation of barriers betwe- Their universal nature is due to the fact that the banks en commercial banking, investment banking, collective take deposits, make loans, trade in securities for their investment and insurance business, permitting the own account, provide for issuing operations, manage conduct of these activities directly by a financial hol- their clients' assets and execute payments. In addition ding, that is, not just through subsidiaries as until that to universal banks, operators in the securities market time. also include independent investment firms. Commerci- In Japan, investment banking was separated from al banking is usually interconnected with investment commercial banking after the Second World War as banking in accounting terms and there is a free flow of a result of legislative changes following the American information between the two organisational subdivisi- example. There were differences compared to the ons of banks. This model is a prevailing model for ban- American model though. From the end of the 80 's of king in the continental Europe, also having been the last century there was a growing pressure to do accepted by Member States of the European Union. away with the separate banking model. In 1992, the The universal model is in principle embodied by a prin- Reform Law was passed, which ope- ciple of a uniform banking license covering both of ned a road to the model of universal banking. The these basic lines of business. separate banking model should be definitively termina- A separate banking model is marked by a distinct ted through the implementation of measures adopted division of commercial and investment banking. Deposit in 1998. and lending business is pursued and payments are exe- A holding model. A holding is a business corporati- cuted by commercial banks, whilst investment operati- on founded to perform control over one or several com- ons are performed by investment banks and likewise by panies. A bank holding (BH) controls a bank and other specialised entities. The separate banking model investment firm with a subsidiary relationship to each was formed because of market reasons (a market other. This means that investment activities are carried model) or as a result of regulation (a regulatory model). on by a separate legal entity. A commercial bank must In the past, a typical example of a separate banking be separated from the subsidiary investment firm by model was represented by British banking. In the a "wall" restraining personnel, information and trading 70's during the 20th century, a gradual transition to links between the commercial and investment banking. a universal banking model or a subsidiary model star- This model was most highly developed in the U.S.A., ted in British banking. where such companies were already formed during the A regulatory model of separate banking is characte- 19th century. They mainly served the purpose of cir- ristic of the U.S.A and Japan. As for the U.S.A., com- cumventing the ban on combination of commercial and mercial banking was separated from investment ban- investment banking. king pursuant to the Glass-Steagall Act of 1933, which The Act on Bank Holdings of 1956 (initiated by the was adopted following to a wave of bank bankruptcies FRS) set forth the rules for foundation and business of in 1929 to 1933. It strived to stifle a conflict of interest bank holdings, i.e. companies holding more than resulting from a united commercial and investment a 25% ownership interest in a bank's share capital. As banking and create a less risky banking system. a result, also bank holdings became subject to the Nevertheless, the borderline between commercial and Glass-Steagall Act of 1933 and bank holdings were not investment banking started to be disrupted in the permitted to acquire a direct or indirect controlling 80's of the past century. Regulators (the Office of the interest in non-banking entities, including investment Comptroller of the Currency, OCC and the Federal companies. In 1987, the FRS allowed adequately capi- Reserve System, FRS) permitted commercial banks talised bank holdings to own investment firms as their and bank holdings to conduct, to a limited extent, acti- subsidiaries, which could also perform operations for- vities relating to securities (operations in securities, bidden under the Glass-Steagall Act; the revenue from mortgage bonds, financial consultancy and brokera- such operations however could not exceed 25% of the total revenue of such subsidiaries. At the turn of the 80 ––––––––––––––– 4 Musílek, P.: Trhy cenných papírů (Securities Markets). Eko- 's and 90 's of the past century, large American ban- press, s. r. o., Praque 2002. king corporations practically transferred to the holding

BIATEC, Volume XII, 3/2004 ECONOMICS FOCUS INVESTMENT BANKING AND COMMERCIAL BANKING 19 model in order to incorporate investment banking. investment banking, the banking system in the Slovak In 1997, the FRS modified the "wall" system by new Republic also falls under the universal banking model, rules for operation. nevertheless taking into account the necessity of sepa- A subsidiary model is typified by the principle that rated conduct of these activities. 18 banks and 3 a parent bank only pursues commercial banking and branch offices of foreign banks with a universal ban- concurrently controls a separate legal entity, that is king license operate in Slovakia. In 2003, they conduc- a company which pursues investment banking. Such ted more than 90% of the total volume of investment a model can be formed either through regulatory or services6 on the top of banking operations. market action. By way of a banking license, the of The regulatory subsidiary model was introduced in Slovakia authorises a bank to pursue both lending and order to limit a conflict of interest between commercial investment business (§ 2(1&2) of the Banking Act). The and investment operations. There is a barrier restrai- granting of a banking authorisation to conduct invest- ning information, personnel and financial connections ment activities must however be preceded by the grant between a parent bank and an investment firm. This of an authorisation from the Financial Market Authority model for integrating the investment banking into for the provision of investment services under the a subsidiary investment firm was applied in Denmark Securities Act, i.e. for the establishment of a securities and Hungary. dealer. The market subsidiary model is a result of a ban- Under the Act, the term of lending business refers to k's decision, which prefers to transfer investment ban- activities relating to the provision of loans, including king or selected investment operations off to a subsi- guarantees (§ 34(3)). For these purposes, investment diary, which is a specialised investment firm. This is business is taken to mean activities related to invest- primarily driven by a wish for a more effective cost con- ment in securities, trading in securities, trading in the trol, the separation of investment risk from commercial rights attaching to securities or derived from securities, banking risks and enhancement of trustworthiness of participation in the issuance of securities and the pro- the business done by the entire financial group. Over vision of related services as well as the management the last years, this model started to be also employed of securities, including consulting (§ 34(4). by some European universal banks that have acquired Nevertheless, in order to prevent a potential conflict specialised investment firms (largely of Anglo-Saxon of interest between commercial banking and invest- provenience) through acquisitions and integrated them ment operations of the same bank, the Banking Act into their financial groups. imposes upon banks an obligation to separate lending operations from investment operations. It sets forth that Investment Banking under the Conditions of in its Articles a bank is obligated to lay down and divi- the European Union, Slovak legislation and de powers and accountability for separated conduct of the Banking System in the SR lending and investment business (§ 23(1e)). Unless publicly accessible information is involved, The concept of a selling a variety of a bank is not allowed to use information obtained in services is deep-rooted in Europe.5 connection with its lending business in conducting By virtue of the basic EU banking directive (Directive investment operations and conversely, it may not 2000/12/EC of the European Parliament and of the employ information acquired during investment opera- Council of 20 March 2000 relating to the taking up and tions in transacting the business of lending. Likewise, pursuit of the business of credit institutions), a univer- a bank is not allowed to use in-house any information sal model for banking was adopted. It is reflected in the gained in connection with investment operations per- principle of a single banking license under which licen- formed for the account of its client, and also may not sing (supervisory) authorities of Member States jointly use in favour of the client any information obtained as authorise banks to perform both lending and invest- part of investment operations conducted for its own ment activities. The list of such activities is annexed to account. In order to meet these requirements, a bank the directive. is obligated to take such measures with regard to its In terms of an institutional set-up of commercial and organisational, management and control system as to

––––––––––––––– ––––––––––––––– 5 For example, approximately 90% of mutual funds here were 6 The major black sheep have already vacated the market. A sold by universal banks, whilst in the U.S.A. universal banks quote from a comment made by S. Šťastný, the Vice-Presi- sold about 35% of such funds. (Ježek, K.: Dva modely ban- dent of the Board of the Financial Market Authority, concer- kovnictví v EÚ [Two models of banking in the EU], Bankov- ning the most frequented complaints in the area of invest- nictví, No. 6/99, p. 31). ment (Pravda, 19.2.2004).

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separate lending and investment business from each Owing to this development (especially the introduction other. Investment operations for the client's account of euro, declining interests and margins) certain large may only be conducted by a bank under the terms and European universal banks shifted their focus from who- conditions favourable for the client, especially at the lesale to and the winning of new markets price favourable for the client, and taking due professi- (e.g. in Central and Eastern Europe). As a result of onal care. A bank is also obligated to maintain separa- investment banking becoming more attractive, they te records on investments made for its own account concurrently tried to gain a more significant share in and for the account of its clients. the investment banking market by building up their own Recent years witnessed sustaining and strengthe- investment operations on the one hand and through ning tendencies towards universal banking in Europe. acquisition of smaller investment banks on the other.

BIATEC, Volume XII, 3/2004