Essentials of the Capital Markets Industry

Industry basics

Investment banking is by no means a new concept. In fact, it's been around in one form or another since the ancient civilizations, including Greece and Rome. In the 1500s, merchant banks and acceptance houses were some of the earliest investment banking institutions in England. London eventually became the dominant financial center for the western world in the early nineteenth century.

In the US, the industry developed during the Civil War in the 1860s to meet the need for money to fund both the war and the construction of railroads. By the early twentieth century, New York City became a dominant global financial center for the capital markets industry.

Until 1933, investment banking was done at commercial banks in the US. However, financial fears during the Great Depression led to the separation of investment and commercial banks. Lawmakers worried that deposits made to consumers' personal accounts would be used to bail out unwise investments if the two remained combined. The Great Depression and resulting separation of capital market players from banks in the US was a major event that influenced the industry on a global scale. The global capital markets industry was basically demolished during World War II, and even in the 1950s, the only trade arrangements that existed among the world's major economies were very rudimentary. However, the capital markets industry was revitalized in the 1960s and 1970s, and by the 1990s the industry was once again flourishing. In 1999, regulations that separated investment banking activities from commercial banking were repealed, and banks were once again free to combine these activities in the same institution.

The financial industry faced a significant crisis from 2007 to 2010, which was mainly caused by the US housing bubble bursting. Up until this point, mortgages were cheap and relatively easy to get, and many consumers took on larger mortgages than they could afford. But the combination of rising interest rates and falling house prices meant financial disaster for many, and the number of defaults and foreclosures increased dramatically. When the housing market crashed, the values of securities tied to real estate pricing also took a nosedive. Financial institutions all over the world were affected; international trade slowed down and credit was tightened, impacting the economies of many countries. The financial crisis had several effects on the capital markets industry. Many banks consolidated – for example, Merrill Lynch was purchased by the Bank of America. Several firms that had seemed untouchable before the crisis declared bankruptcy, including Lehman Brothers, which became the largest bankruptcy filing in US history. Hoping to avoid the same fate, many Wall Street firms converted themselves into bank holding companies in order to gain eligibility for federal aid.

So what role do companies in the capital markets industry play? They can be thought of as intermediaries – for instance, banks – that help borrowers find lenders through the use of financial markets. The primary role of the capital markets industry is to help businesses raise capital for their operations. They do this by selling investment securities to institutional investors, such as pension funds and the general public.

The capital markets industry, as it currently exists and with the services it provides, can be divided into three key sectors:

1. investment banking – Investment banks are unlike commercial banks in that they don't take deposits from customers. Instead, they provide services such as underwriting and trading. Investment banks also act as agents for clients seeking to raise funds on equity or debt markets.
2. corporate finance advisory – Many investment banks provide corporate finance advisory services, which include financial advising related to mergers and acquisitions, business operations and services, and generating funds.
3. sales and trading – Investment banks have sales and trading divisions that provide services such as market making, brokerage and securities trading, and research.

The major players in the capital markets industry are multinational banks and securities firms, which are both vertically integrated entities that operate in all of the industry's sectors. But these aren't the only players in the industry. Banks and securities firms also face competition from smaller boutique companies that specialize in a particular sector and provide niche market services to their clients.

In terms of global size, the total financial assets of the capital markets industry is over $175 trillion USD. However, following the US sub-prime securities investment crisis, many investment banks all over the world experienced large losses in their revenues. The US market has, in recent times, accounted for over half of the global capital market industry revenues, but this is changing as emerging markets, especially in the Asia Pacific region, continue to make larger use of the services and products offered by industry players.

Industry drivers

The capital markets industry is subject to several business drivers, which are influences, both internal and external, that significantly impact the direction of an industry.

The key business drivers of the capital markets industry today are:

• economic growth and globalization – The capital markets industry depends on economic growth and globalization. Nations that enjoy advanced economies and financial systems are better integrated with other economies, and engage in much more trade than those with more basic economies. Thus, there's a positive correlation between domestic financial development and a country's participation in global capital markets.
• growth of emerging market economies – The growth of emerging market economies, such as Asia and Latin America, is happening at a faster rate than in more mature economies. This is a result of large government debt loads in developed nations.
• changing industry regulations – Two recent changes to industry regulations have had an impact on the capital markets industry. The first, which removed barriers to geographical expansion, stimulated mergers and acquisitions. As a result, the number of banks in operation is about 30% lower than it was 20 years ago.
• innovations in technology and financial products – Innovations in technology and financial products have significant benefits for the capital markets industry, as well as the financial services industry in general. Technological advances mean that firms are able to offer their customers new or extended services, such as e-mail funds transfers and online transactions.

In this topic, you've learned about the history of the capital markets industry, the services it provides, and the key drivers affecting the industry today.

The key business drivers of the capital markets industry are economic growth and globalization; the growth of emerging market economies; changing industry regulations; and innovations in technology and financial products.