Capitalizing on Capital Markets

By Furash, Edward E. | The Journal of Lending & Credit Risk Management, August 1996 | Go to article overview

Capitalizing on Capital Markets

Furash, Edward E., The Journal of Lending & Credit Risk Management

Regional banks are becoming increasingly active in the trading, selling, and underwriting of securities for corporate clients. A survey reveals that they are still struggling to find the most effective way to integrate institutional capital markets activities with their overall corporate market strategies.

During the first quarter of 1996, Furash & Company interviewed the heads of institutional capital markets at 13 of the largest players in this business among regional banks. These banks were a representative sample drawn from banks with $10 to $50 billion in assets. The results of this survey revealed both the promise and the challenge of incorporating trading, sales, and underwriting of securities into banks' approach to serving their corporate customers.

Market Making

A major requirement for active participation in institutional capital markets is the ability to act as a market maker for customers. When a bank decides to make markets in securities, it makes three significant commitments:

1. It is indicating to its customers that it stands ready to give bid or offer prices for the securities it deals in regardless of market conditions or volatility. A bank that fails to honor this commitment (for example, by not making reasonable bids to customers that want to sell securities while markets are dropping) risks serious damage to customer relationships.

2. It has decided to place the bank's capital at risk by holding a securities inventory. While many bank dealers limit their risks in certain products by acting as agents or by matching trades "back-to-back," institutional market makers in liquid instruments with a high degree of price disclosure must carry inventory to be competitive and profitable.

3. By acquiring an inventory of trading positions, it has committed to the bank's shareholders to manage the market risk that goes with holding securities.

The banks in the survey act as market makers in an average of five different products. Municipal bonds and U.S. Treasury securities were the most common products for market making activities, followed by repurchase agreements (repos), mortgage-backed securities, swaps and other derivatives, asset-backed securities, and foreign exchange. When asked whether their trading volume had increased or decreased in the past three years, more banks reported increases than decreases for every one of these products.

The mix of products at the sample banks testifies to the variety of services provided by bank capital markets operations. While municipals provide a tax-exempt investment option for retail customers, Treasuries and other taxable fixed-income instruments are the staple investment of corporations. Repo trading offers short-term borrowing and lending capability to institutions, while swap trading gives customers the ability to hedge and manage cash flow.

Especially noteworthy is the nearly even split of the banks surveyed on making markets in technically complex derivatives and mortgage-backed securities (seven are market makers, six are not in each case). These products offer valuable investment and risk management options that corporate customers demand. But they also require an advanced trading technology infrastructure (for market making and for managing market risk), as well as heightened vigilance over the activities of salespeople for compliance with securities regulations. Furthermore, revenues from these products tend to be extremely volatile. Nonetheless, only two of seven dealers making markets in derivatives said that their volume is less than it was three years ago, and only two of seven mortgage-backed securities market makers have cut back their volume.

It appears that the banks in the survey are split into two factions: One group believes that they must offer derivative and mortgage-backed securities products to corporate customers, and they have come to terms with the risks and the volatility. …

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