Investment Banks

Investment banks get their name from their role as financial intermediaries that serve the investment world. While retail banks do dabble in investments, and in particular, provide access to investment products to their clients as well as a variety of other wealth management services, with investment banks, dealing with investment related transactions is all they do, and therefore what they specialize in.

Much of what investment banks do are beyond the scope of the retail banking market, and investment banking is also known as wholesale banking, and this is actually a pretty good way to describe what they do, with most of their activities on a wholesale level. This involves their being an intermediary between large institutions and the end users of their financial products, the investors.

Investment banks are most famous for their handling of new issues of stocks and bonds, particularly stocks, where they manage and distribute new shares with new companies, known as initial public offerings or IPOs.

Investment banks also manage new stock issues for existing companies, and companies will issue or buy back stock at various times, and of various types, common stock or preferred shares for instance. The companies give up certain percentages of the ownership in their companies in exchange for cash, and investment banks will make this all happen for them.

Investment banks also manage the issuance of debt, in the form of bonds, and while bonds are traded as stocks are, like stocks, they need to be first issued and taken to the market and this is where the issuer collects the initial price.

This involves dealing with both corporations and governments, whoever is looking to sell new issues of financial securities. While this is the main function of an investment bank, they are involved in a number of other activities, all related to investments and all designed to leverage their expertise in financial markets.

The Issuance of New Securities

Issuing and marketing new securities is a very complex proposition, and this is also a highly specialized business proposition. So rather than conduct these transactions themselves, institutions turn this over to investment banks to perform these duties for them.

Investment BanksAside from the complexities involved in bringing these issues to the market, there is a lot of paperwork involved, things like writing prospectuses and filing the proper documents with regulatory agencies. Regulators understand this and require that these new issues be handled by accredited investment banks, so everyone is on board with this method of doing it and it is a necessity.

So there is a lot of research involved, and investment banks specialize in this sort of research, and one of the several other things they do is provide investment research, both for their own investment as well as for the benefit of mutual fund and hedge fund managers, which they sell the information to.

Aside from all the analysis and number crunching, and predictions that are involved in new stocks or bonds, investment banks also play the role of intermediary. Companies for instance don’t sell their stocks directly to investors, even large ones, they are in the business of something else, and the investment bank is in the business of distributing stocks and bonds so they are hired to serve that function.

In doing so, the bank will take on part or all of the risk involved, as this involves setting a target price and often purchasing the securities from the issuer for that price, to be sold on the market. It needs to be sold at a high enough price for the bank to show a profit, and depending on the demand for it, and how well they have done their homework, they may even have to sell it at a lower price than they paid for it.

In some cases, the issuer has to take on part of the risk themselves, but the banks do bear at least part of this themselves, and often will form a syndicate of investment banks with an issue, all bearing part of the risk and all distributing part of the stock or bond issue.

Banks don’t mind working together here because it does make the affair less risky for them and the risk with these transactions is pretty significant, especially when you’re talking about transactions in the billions of dollars.

It’s not just a matter of whether they have overpriced it, market risk also can play a big role, for instance a downturn in the market generally from the time they priced it to when it becomes sold to investors.

This is especially the case with stocks, but this can even affect bonds, which are less market sensitive than stocks due to lower volatility but still have this risk present. During down markets, there is less demand for the type of security in general, as evidenced by the very fact that a down market is present, and this means that the price obtained will often be lower than it otherwise would have been.

The potential for all risks needs to be factored into the equation though, and there are several types of risks with pricing investments, and this is a big reason why investment banks handle these transactions. It may seem like having syndicates handle these deals would restrict competition, but this is offset at least somewhat by having more interest in the deals from keeping the risks in line with the risk appetites of banks, and in practice, banks teaming up may even make the market for new issues more rather than less efficient, by having more rather than less competition for an issue then may be the case if banks had to bear the entire burden themselves.

Other Functions of Investment Banks

Investment banks also trade their own capital, called proprietary trading. In order to prevent a conflict of interest between a bank’s own interest with their funds and the interests of those whose funds they are managed, regulations serve to separate these functions in something known as the “Chinese Wall.”

In other words, there is a firewall between a bank’s own trading interests and those of their clients, to an acceptable degree anyway.

Regulators have had a preference for separating investment banks and retail banks, and for instance legislation in the U.S. prohibited a bank from serving both markets, although this has been eased. Investment banks now provide wealth management services to individuals as well as institutions, and some retail banks in the U.S. now offer investment banking as well, as has been customary for a long time in several other countries.

Institutions still comprise the bulk of an investment bank’s business, and they manage some huge portfolios for them, dealing with hedge funds, mutual fund companies, foundations, government agencies, pension funds, and other big volume players in the investment world.

Investment funds also will package derivatives, particularly those that deal with the repackaging of debt. This does serve to add liquidity to these debt products, which include things like mortgages, loans, credit card debt, interest rate swaps, and other financial securities that involve debt instruments.

The idea here is to take these income streams, from debt as well as from things like real estate, and spread the risk through the combining of this debt, so that a certain percentage of defaults for instance won’t impact one’s holdings like if you held the entire debt. They are still subject to considerable market risk though, like a downturn in the housing market or a recession, but provided that the risks are transparent, this should not be an issue.

However, with the mortgage backed securities problem that we recently saw during the so called great recession of late, many investors had the perception that these securities were considerably less risky then they were, and only learned of their true risk when the bottom fell out.

Many investment banks underestimated this risk as well, and this caused the death of Lehman Brothers, and almost took down Bear Stearns, both among the largest investment banks in the world.

Investment banks also provide liquidity to trading by serving as market makers. Banks buy securities to be sold later, often very soon afterward, and this serves to make it easier to buy and sell the securities. The need for this goes back to floor trading, where an intermediary was necessary to ever do a trade, as individual investors did not have the means to interact with one another, and that’s what the exchange floor and exchange traders were for.

A lot of securities are still traded on exchange floors though, and even with electronic trading, banks will still play a role, and banks will actually pursue every opportunity here, and even engage in computerized trading that may only hold stocks for as little as fractions of a second to get a little edge on trades.

So investments do far more than just underwrite new securities, although that’s still a large part of their business and revenue. We’ve moved more and more away from this in the last while though and investment banks are well diversified and are well leveraged to use their investment expertise to assist in many processes and transactions that form the investment experience.

Investment Banks FAQs

  • What does an investment bank do?
    Investment banks perform a variety of activities related to the investment industry, such as helping companies raise money through the issuance of stock or bonds or derivatives. They also provide wholesale operations and clearing to the investment industry, and also trade their own money with a team of in-house traders.
  • Which is the best bank for investment?
    When people invest, they invest in certain assets such as the stock of companies or bonds issued by companies or governments, which are facilitated by brokers. Investment banks instead serve large clients who choose them based upon their ability to effectively perform the financial services that they require.
  • What are the biggest investment banks?
    JPMorgan, the investment banking part of JPMorgan Chase, is the world’s largest investment bank with 8% of the global market share. Next in line is Goldman Sachs, who make over $5 billion a year in investment banking fees. Bank of America Merrill Lynch comes in third, followed by Morgan Stanley in fourth and Citigroup in fifth.
  • How do investment banks make money?
    Investment banks make most of their money by providing investment services to companies, such as handling initial public offerings, mergers and acquisitions, bond issuance, derivatives, or other functions related to their financial well-being. They also make money trading their own accounts where they look to make profits by holding them for various lengths of time.
  • How can I learn investment banking?
    The first thing that we need to do in order to learn investment banking is to study it, which can include both formal study in an institution as well as self-study. Self-study isn’t accredited though so you do need to prove that you have learned enough to get your foot into the door, but after that, the rest of the learning comes on the job.
  • Why is investment banking important?
    Placing assets into the market in order for people to invest in them takes real planning and effort, and those who wish to place them lack the expertise and organization to do so. They hire investment banks to perform these services for them, which allows the assets to be properly launched and brings the issuers of securities and those who wish to trade them together.
  • What are the products of investment banking?
    You can pick any security in the market, whether it be stocks in a company, corporate bonds, right up to the most exotic derivatives and you can count on the fact that investment banking has had a hand in their being available to trade and invest in. Investment banking provides the launching pad for these investments to be offered.
  • What are the types of investment banking?
    Investment banking offers several types of services to their clients. They advise and assist on the implementation of new securities such as new and secondary public offerings, the issuance of debt instruments such as bonds, as well as in the launching of new derivative instruments. They also perform various other financial services to their clients.
  • What is investment banking process?
    The investment banking process depends on the type of service that is being provided by them. Overall though, investment banking acts as an intermediary between the issuers of securities and their end purchasers. They act to ensure that the securities are placed in their markets in an effective and timely manner.
  • What does an investment banking analyst do?
    Investment banking analysts look at things pertaining to the underlying businesses of the clients that they serve to come up with valuations and forecasts, as well as assessing market conditions. This is done to assess the overall financial health of a business as well as making predictions on how the business may do in the future or what their stock may do.

References & Scholarly Articles on Investment Banks

Books on Investment Banking

  • Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions (Authors: Joshua Pearl and Joshua Rosenbaum, Originally published: 2009)
  • Investment Banking For Dummies (Authors: Matthew Krantz and Robert R. Johnson, Originally published: January 28, 2014)
  • The Accidental Investment Banker: Inside the Decade That Transformed Wall Street (Author: Jonathan A. Knee, Originally published: July 27, 2006)
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