exchange (i.e., a certain number of shares in Company A in exchange for each share of Company B). What should the initial offer be? What does it expect the final offer that will close the deal to be? It must assess the best way to approach the senior managers of Company B and consider what the motivations of the managers will be. Will the takeover be a hostile one (opposed by the management of Company B) or friendly one (supported by the management of Company B)? In some instances there will be antitrust issues and approval from some branch of government may be required.
BUSINESS SNAPSHOT 2.2
PeopleSoft's Poison Pill
In 2003, the management of PeopleSoft, Inc., a company that provided human resource management systems, was concerned about a takeover by Oracle, a company specializing in database management systems. It took the unusual step of guaranteeing to its customers that, if it were acquired within two years and product support was reduced within four years, its customers would receive a refund of between two and five times the fees paid for their software licenses. The hypothetical cost to Oracle was estimated at $1.5 billion. The guarantee was opposed by PeopleSoft's shareholders. (It appears to be not in their interests.) PeopleSoft discontinued the guarantee in April 2004.
Oracle did succeed in acquiring PeopleSoft in December 2004. Although some jobs at PeopleSoft were eliminated, Oracle maintained at least 90 % of PeopleSoft's product development and support staff.
2.5 SECURITIES TRADING
Banks often get involved in securities trading, providing brokerage services, and making a market in individual securities. In doing so, they compete with smaller securities firms that do not offer other banking services. As mentioned earlier, the Dodd–Frank act in the United States does not allow banks to engage in proprietary trading. In some other countries, proprietary trading is allowed, but it usually has to be organized so that losses do not affect depositors.
Most large investment and commercial banks have extensive trading activities. Apart from proprietary trading (which may or may not be allowed), banks trade to provide services to their clients. (For example, a bank might enter into a derivatives transaction with a corporate client to help it reduce its foreign exchange risk.) They also trade (typically with other financial institutions) to hedge their risks.
A broker assists in the trading of securities by taking orders from clients and arranging for them to be carried out on an exchange. Some brokers operate nationally, and some serve only a particular region. Some, known as full-service brokers, offer investment research and advice. Others, known as discount brokers, charge lower commissions, but provide no advice. Some offer online services, and some, such as E*Trade, provide a platform for customers to trade without a broker.
A market maker facilitates trading by always being prepared to quote a bid (the price at which it is prepared to buy) and an offer (the price at which it is prepared to sell). When providing a quote, it does not know whether the person requesting the quote wants to buy or sell. The market maker makes a profit from the spread between the bid and the offer, but takes the risk that it will be left with an unacceptably high exposure.
Many exchanges on which stocks, options, and futures trade use market makers. Typically, an exchange will specify a maximum level for the size of a market maker's bid-offer spread (the difference between the offer and the bid). Banks have in the past been market makers for instruments such as forward contracts, swaps, and options trading in the over-the-counter (OTC) market. (See Chapter 5 for a discussion of these instruments and the over-the-counter market.) The trading and market making of these types of instruments is now increasingly being carried out on electronic platforms that are known as swap execution facilities (SEFs) in the United States and organized trading facilities (OTFs) in Europe. (See Sections 5.1, 16.4, and 18.3.)
2.6 POTENTIAL CONFLICTS OF INTEREST IN BANKING
There are many potential conflicts of interest between commercial banking, securities services, and investment banking when they are all conducted under the same corporate umbrella. For example:
1. When asked for advice by an investor, a bank might be tempted to recommend securities that the investment banking part of its organization is trying to sell. When it has a fiduciary account (i.e., a customer account where the bank can choose trades for the customer), the bank can “stuff” difficult-to-sell securities into the account.
2. A bank, when it lends money to a company, often obtains confidential information about the company. It might be tempted to pass that information to the mergers and acquisitions arm of the investment bank to help it provide advice to one of its clients on potential takeover opportunities.
3. The research end of the securities business might be tempted to recommend a company's share as a “buy” in order to please the company's management and obtain investment banking business.
4. Suppose a commercial bank no longer wants a loan it has made to a company on its books because the confidential information it has obtained from the company leads it to believe that there is an increased chance of bankruptcy. It might be tempted to ask the investment bank to arrange a bond issue for the company, with the proceeds being used to pay off the loan. This would have the effect of replacing its loan with a loan made by investors who were less well-informed.
As a result of these types of conflicts of interest, some countries have in the past attempted to separate commercial banking from investment banking. The Glass-Steagall Act of 1933 in the United States limited the ability of commercial banks and investment banks to engage in each other's activities. Commercial banks were allowed to continue underwriting Treasury instruments and some municipal bonds. They were also allowed to do private placements. But they were not allowed to engage in other activities such as public offerings. Similarly, investment banks were not allowed to take deposits and make commercial loans.
In 1987, the Federal Reserve Board relaxed the rules somewhat and allowed banks to establish holding companies with two subsidiaries, one in investment banking and the other in commercial banking. The revenue of the investment banking subsidiary was restricted to being a certain percentage of the group's total revenue.
In 1997, the rules were relaxed further so that commercial banks could acquire existing investment banks. Finally, in 1999, the Financial Services Modernization Act was passed. This effectively eliminated all restrictions on the operations of banks, insurance companies, and securities firms. In 2007, there were five large investment banks in the United States that had little or no commercial banking interests. These were Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers. In 2008, the credit crisis led to Lehman Brothers going bankrupt, Bear Stearns being taken over by JPMorgan Chase, and Merrill Lynch being taken over by Bank of America. Goldman Sachs and Morgan Stanley became bank holding companies with both commercial and investment banking interests. (As a result, they have had to subject themselves to more regulatory scrutiny.) The year 2008 therefore marked the end of an era for investment banking in the United States.
We have not returned to the Glass–Steagall world where investment banks and commercial banks were kept separate. But increasingly banks are required to ring-fence their deposit-taking businesses so that they cannot be affected by losses in investment banking.
2.7 TODAY'S LARGE BANKS
Today's large banks operate globally and transact business in many different areas. They are still engaged in the traditional commercial banking activities of taking deposits, making loans, and clearing checks (both nationally and internationally). They offer retail customers credit cards, telephone banking, Internet banking, and automatic teller machines (ATMs). They provide payroll services to businesses and, as already mentioned, they have large trading activities.
Banks offer lines of
