By SANJIVANI NATHANI
Seldom passes a day wherein we don’t find Goldman Sachs, Citi Group, Deutsche Bank (these Wall Street regulars) in the headlines. Who are exactly these players? These are investment banks. The Internet describes investment banks as – financial services companies or corporate divisions that engage in advisory-based financial transactions on behalf of individuals, corporations, and governments. But this wasn’t always their definition – over the centuries the scope, goals, and meaning of investment banks and banking have evolved and diversified to incorporate the functions we see today. The original structures were much primitive.
What led to the emergence of such practices? Well, tracing back the evolution, in the early 19th century in the USA saw fast and high economic growth which commercial banks (which contrary to investment banks perform only the functions of accepting deposits and forwarding loans) could not sufficiently accommodate and support. Government entities continuously needed money and capital for expansionary purposes and investors having such money were also looking out for opportunities. The government required money and financing and hence issued bonds, which it sold to investors in order to raise capital. The government was supposed to repay its loan with interest after a certain amount of time – this is the basic working of a government bond as well.
This was a tricky procedure, as usual, the government officials had no financial and technical knowledge of stocks, etc. On the other hand investors (lenders, basically) were skeptical to engage directly in business with the government as it could default on its debt (stop repaying) or could try to renegotiate the terms of debt (such as the interest rate over the bond, time of maturity, etc.). Hence entered the middlemen – the investment bankers. They were market professionals who had appropriate knowledge, but more importantly, they had resourceful contacts. They knew people from big business houses who had the right kind of resources and money which could be used in the government’s interest. Investment bankers hence acted as middlemen who acted as a link between demand (government) and supply (investors). Hence, the problem was solved on both sides. The government could now deploy professional assistance and the investors were at rest that their money was in safe hands. In the year 1842, 8 American states defaulted on their borrowings as their economies were cotton-centric while their prices remained at an all-time rock bottom level.
These states could not repay their loans and refused to do it which put at risk the capital of the investors who bought these securities. It was in such a situation the role or participation of the middlemen was highlighted. All the attempts of these states to raise new capital bore no success. James Rothschild was quoted as saying to the representatives of the federal government – “You may tell your government that you have seen the man who is at the head of the financiers of Europe and that he has told you that they cannot borrow a dollar, not a dollar.” Intimidated and inspired by the confidence and expertise of the middlemen, the defaulted states agreed upon amends and formulated an appropriate restructuring plan which ultimately satisfied the investors by returning their money/capital. This episode reflects the germane importance of investment bankers on finance and decision making.
Such episodes elevated their reputation which allowed them to enhance their clients and hence were able to attract white-collar and blue-blooded investors. Yet, these investment banking services were born solely due to the needs of financiers and investors wouldn’t be an appropriate inference. These so-called middlemen delivered to the table something vital – their reputation – the standard of security was related to the name of the underwriter who sold it to the market. As a result, the interests of investors and investment bankers were aligned. Investors wanted to maximize their returns while investment bankers needed to keep their investors happy and keep their business.
To elaborate more upon the Rothschild family– the Rothschilds have been one of the historical grandees in the domain of investment banking. They were aware of Napoleon’s defeat at Waterloo even before the government – owing to their fast and efficient network of informants. Nathan Rothschild acted decisively and kept this information a secret and started purchasing British government debt. Given the fact that Napoleon was defeated, when this fact became common knowledge, the prices of British government bonds soared the very next day. The deal enabled Nathan Rothschild to sell the bonds at a profit of 40% after a span of 2 years.
Lord Walter Rothschild was a fanatical zoologist and an immensely wealthy person. He is famous for driving a carriage of six zebras to Buckingham Palace. Lord Walter wanted to prove that zebras might be tamed.
AUTHOR
Sanjivani is a second year Statistics student at Kirori Mal College, University of Delhi. She is immensely interested in the fields of finance and economics and hopes to continuously expand her knowledge horizon. When not stressing about academics and placements, she likes to read and paint.
Disclaimer: The views expressed in this article are the author’s own and do not necessarily reflect the views of the organization.
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