An investment bank is typically a private company that provides various financial-related and other services to individuals, corporations, and governments such as raising financial capital by underwriting or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities, and FICC services (fixed income instruments, currencies, and commodities).
Unlike commercial banks and retail banks, investment banks do not take deposits. From the passage of Glass–Steagall Act in 1933 until its repeal in 1999 by the Gramm–Leach–Bliley Act, the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G7 countries, have historically not maintained such a separation. As part of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act of 2010), the Volcker Rule asserts some institutional separations of investment banking services from commercial banking.
The two main lines of business in investment banking are called the sell side and the buy side. The "sell side" involves trading securities for cash or for other securities (e.g. facilitating transactions, market-making), or the promotion of securities (e.g. underwriting, research, etc.). The "buy side" involves the provision of advice to institutions that buy investment services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the most common types of buy-side entities.
An investment bank can also be split into private and public functions with a Chinese wall separating the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas, such as stock analysis, deal with public information.
An advisor who provides investment banking services in the United States must be a licensed broker-dealer and subject to U.S. Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority(FINRA) regulation.
What is 'Investment Banking'
Investment banking is a specific division of banking related to the creation of capital for other companies, governments and other entities. Investment banks underwrite new debt and equity securities for all types of corporations, aid in the sale of securities, and help to facilitate mergers and acquisitions, reorganizations and broker trades for both institutions and private investors. Investment banks also provide guidance to issuers regarding the issue and placement of stock.
BREAKING DOWN 'Investment Banking'
Many large investment banks are affiliated with or subsidiaries of larger banking institutions, and many have become household names, the largest being Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch and Deutsche Bank. Broadly speaking, investment banks assist in large, complicated financial transactions. This may include advice as to how much a company is worth and how best to structure a deal if the investment banker’s client is considering an acquisition, merger or sale. It may also include the issuing of securities as a means of raising money for the client groups, and creating the documentation for the Securities and Exchange Commission necessary for a company to go public.
Investment banks employ investment bankers who help corporations, governments and other groups plan and manage large projects, saving their client time and money by identifying risks associated with the project before the client moves forward. In theory, investment bankers are experts in their field who have their finger on the pulse of the current investing climate, so businesses and institutions turn to investment banks for advice on how best to plan their development, as investment bankers can tailor their recommendations to the present state of economic affairs.
Essentially, investment banks serve as middlemen between a company and investors when the company wants to issue stock or bonds. The investment bank assists with pricing financial instruments so as to maximize revenue and with navigating regulatory requirements. Often, when a company holds its initial public offering (IPO), an investment bank will buy all or much of that company’s shares directly from the company. Subsequently, as a proxy for the company holding the IPO, the investment bank will sell the shares on the market. This makes things much easier for the company itself, as they effectively contract out the IPO to the investment bank. Moreover, the investment bank stands to make a profit, as it will generally price its shares at a markup from the price it initially paid. Yet, in doing so the investment bank also takes on a substantial amount of risk. Though experienced analysts at the investment bank use their expertise to accurately price the stock as best they can, the investment bank can lose money on the deal if it turns out they have overvalued the stock, as in this case they will often have to sell the stock for less than they initially paid for it.
For example, suppose that Pete’s Paints Co., a chain supplying paints and other hardware, wants to go public. Pete, the owner, gets in touch with Jose, an investment banker working for a larger investment banking firm. Pete and Jose strike a deal wherein Jose (on behalf of his firm) agrees to buy 100,000 shares of Pete’s Paints for the company’s IPO at the price of $24 per share, a price at which the investment bank’s analysts arrived after careful consideration. The investment bank pays $2.4 million for the 100,000 shares and, after filing the appropriate paperwork, begins selling the stock for $26 per share. Yet, the investment bank is unable to sell more than 20% of the shares at this price and is forced to reduce the price to $23 per share in order to sell the remaining shares. For the IPO deal with Pete’s Paints, then, the investment bank has made $2.36 million [(20,000 x $26) + (80,000 x $23) = $520,000 + $1,840,000 = $2,360,000]. In other words, Jose’s firm has lost $40,000 on the deal because it overvalued Pete’s Paints.
Investment banks will often compete with one another for securing IPO projects, which can force them to increase the price they are willing to pay to secure the deal with the company that is going public. If competition is particularly fierce, this lead to a substantial blow to the investment bank’s bottom line. Most often, however, there will be more than one investment bank underwriting securities in this way, rather than just one. While this means that each investment bank has less to gain, it also means that each one will have reduced risk.
What is Investment Banking?
So what does an investment bank actually do? Several things, actually. Below we break down each of the major functions of the investment bank, and provide a brief review of the changes that have shaped the investment banking industry through the aftermath of the 2008 financial crisis. Click on each section to learn more.
Raising Capital & Security Underwriting. Banks are middlemen between a company that wants to issue new securities and the buying public.
Mergers & Acquisitions. Banks advise buyers and sellers on business valuation, negotiation, pricing and structuring of transactions, as well as procedure and implementation.
Sales & Trading and Equity Research. Banks match up buyers and sellers as well as buy and sell securities out of their own account to facilitate the trading of securities
Retail and Commercial Banking. After the repeal of Glass-Steagall in 1999, investment banks now offer traditionally off-limits services like commercial banking.
Front office vs back office. While the sexier functions like M&A advisory are “front office,” other functions like risk management, financial control, corporate treasury, corporate strategy, compliance, operations and technology are critical back office functions.
History of the industry. The industry has changed dramatically since John Pierpont Morgan had to personally bail out the United States from the Panic of 1907. We survey the important evolution in this section.
After the 2008 financial crisis. The industry was shaken to the core during and after the financial crisis that gripped the world in 2008. How has the industry changed and where is it going?