Management of Risks Associated with Investment Banking Business of Securities Companies

Establish Sound Internal Control Architecture, Mechanisms, and Procedures

Improving Internal Architecture of Investment Banking Business Sound internal structures and internal control mechanisms must be established in order to shift the core competitive strength of investment banking business from the ability to communicate with the regulators to the ability to provide high quality execution in the early stage of the project and high quality issuance and pricing in the late stage. Stock underwriting business involves not only the investment banking division and the capital market division, but also relevant divisions responsible for research, sales, risk control, and compliance. Labor division, coordination, and checks and balances between various divisions should be emphasized throughout project implementation. In order to maximize interdivision synergic effects, there must be a capital market division, research division, sales division, and trade division that can cooperate seamlessly with the investment banking division. In terms of enhancing the internal control mechanisms and risk-management construction of the lead underwriter and intermediaries, the market mechanism should be allowed to play its role. Internal control measures such as foreground/ background separation and firewalls must be brought into full play.

The focus of division construction and HR resources allocation should be shifted from forefront divisions to middle and background divisions. These divisions mainly include the capital market division, the research division, the sales division, and the trade division. The capital market division is a very important forefront business division. It straddles the Chinese wall and is located between the investment banking project team at the front end and the sales, trade, and research divisions at the rear end. It plays a leading and driving role in the project issuance phase. In the issuance pricing process, it controls corporate underwriting risks and effectively balances the interests of the issuer and the investors.

Investment Banking Business Internal Control Design Step Optimization

The following are the major steps for internal control design:

- Determine control targets

- Integrate control processes

- Identify control links

- Determine control measures

- Represent design result through process diagrams, survey forms, and internal control mechanisms

- Finalize the internal control cycle

Construction of Full-Coverage Risk Control Models

Improving Early-Stage Project Implementation Capability The execution ability in the early phase of the project will become part of the core competitive strength in investment banking business. In addition to issues repeatedly emphasized by the regulators, such as due diligence and information disclosure in the prospectus, the investment bank also needs to dedicate more energy into the preparation phase before the launch of the project. Before formally taking on the project, the investment bank should assess its own capability, making sure it has sufficient human resources and experience in terms of early stage execution, research coverage, market promotion, sales, and post-listing maintenance to ensure successful issuance. Improvement should be made as soon as possible when a weak spot has been found. A preliminary evaluation should also be made on the conditions of the company and the industry to determine whether the issuer meets the criteria for public listing, and whether its developmental stage is ready to enter into the capital market. The investment bank should decide whether to formally launch the project based on considerations of the company's positioning and its own strength, and provide services that are designed specifically for the issuer.

Flexible Pricing and Selling Methods Helping the issuer come up with reasonable price expectations is step one. Sufficient preparation is needed before issuance, including materials such as PowerPoint slides for a series of investor presentations, often called the road show, to fully exploit the company's bright spots and investment value. Before the road show, training should be arranged for the management. Using road show rehearsals, management members learn how to conduct themselves with decorum and communicate with institutional investors in capital market language. During the issuance stage, the communication strategies should be regularly adjusted according to feedback from investors.

In order to avoid major disagreements, issuer expectation management should be strengthened ahead of time. It should be made clear to the issuer that the pricing of new shares must leave some room for second-tier market trade prices. Financing efficiency and post-listing performance should be considered, so that there is room for growth after listing. Through evaluation models, peer comparisons, and similar methods, the issuer may have a more thorough and realistic understanding of its own value. The value of the issuer should be fully elaborated on in the prospectus and in other materials. Research reports from analysts and their views on comparable companies should be provided to help the issuer realize its own investment value. The investment bank should convey investor's feedback on the issuer's investment value to the issuer in a timely fashion to enhance the issuer's understanding of its own value, and to satisfy the need for reasonable self-positioning. The investment bank should guide the issuer to look at new share pricing from a strategic perspective. It should also help the issuer maximize profits while respecting investor demand for reasonable returns and giving consideration to the company's financing needs.

Strengthening communication between the sponsor and inquiry recipients and value guidance for the latter is critical. Great effort should be made to build up the research team. The value exploration role of the investment value report should be accentuated in the issuance of new shares in the future. A high-quality investment value report should be compiled to give a thorough description of the issuing company's strategic positioning, profitability, competitive advantages, and challenges to provide a basis for the inquiry recipient to give their quotations.

It is also very important to build up the sales team. Under the new share issuance system, there should be logical consistence between the inquiry quotation and the subscription quotation. To ensure successful subscription, institutional investors will communicate with the sponsor more actively. The sales team of the sponsor may help find the point of market balance by communicating with institutional investors and providing reasonable price guidance.

Distributors should be rigorously vetted and controlled. Generally speaking, at the beginning of subscription, the lead underwriter signs a lock-up agreement with distributors and strategic investors with an allotment option. Selling securities within the lock-up period (usually a half year) is prohibited. In order to prevent the opening of the floodgate, the underwriter may implement "privilege abolishing" measures. This means that if an investor sells off its shares right after the issuance, its allotment option for future shares will be abolished. If a distributor engages in similar sell-offs, the lead underwriter will apply "buy back punishment," by reducing the distributor's commission income based on the extent of the sell-off.

The right selling points should be chosen to pique investors' interest. In the U.S. and E.U . markets, investors are most interested in the market advantages and core technologies of the issuer. That was epitomized by China National Offshore Oil Corporation's (CNOOC) two attempts to get publicly listed overseas. The first time, CNOOC's selling point was its offshore petroleum franchise, which in the eyes of overseas investors is the biggest risk; its monopolistic advantages will no longer exist in the event that the franchise is abolished. Therefore, in its second road show, CNOOC shifted the focus to the company's core technologies in offshore exploration and production. Investors' expectations for the company changed, and the shares were successfully issued.

Hedging with Derivative Instruments In overseas markets, people pay great attention to the use of corresponding methods to hedge risks in case the underwritten securities are not sold out. In particular, the use of derivative instruments is extremely important to investment banking risk control. For example, the use of financial futures and options may avoid potential price losses. In terms of allotment, when large cap stocks are expected to trend upward, underwriting risks are relatively low. When large cap stocks slump during the process of allotment implementation, underwriting risks are rapidly magnified. As a high risk business, allotment deserves extra caution. In terms of allotment timing, the trend of large cap stocks should be carefully studied to implement share allotment while the large cap is on the rise, thus reducing issuance risks.

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