Investment Banking 101

How These Financial Powerhouses Make Markets and Money

Investment Banking 101
August 22, 2014

You have probably heard and read about investment banks and investment banking. But if you’re like most people, you may be a little fuzzy about exactly what an investment bank is and how the world of investment banking works.

If that is true, here is a brief primer to help you better understand the sometimes confusing and misunderstood world of investment banking — including how these financial powerhouses make markets and money.

What Is Investment Banking?

An investment bank is a unique kind of bank that specializes in large, complex financial transactions mostly revolving around financing and the creation of capital for companies. Unlike commercial and retail banks you are probably more familiar with, investment banks do not accept deposits from individuals and businesses. Instead, they primarily focus on underwriting debt and equity securities for institutional clients — mostly large corporations and governmental entities (ranging from municipal authorities to states and nations).

Among the major investment banks in the U.S. today are Bank of America Merrill Lynch, Barclays, Goldman Sachs, JP Morgan, Morgan Stanley, Deutsche Bank, Salomon Brothers, Credit Suisse, Citibank and UBS. These and other investment banks help companies raise capital via mergers and acquisitions (or M&A), leveraged finance, and the debt and equity markets. They also help companies with internal restructuring in order to improve profitability and efficiency. Additionally, they advise governmental entities on the raising or restructuring of debt securities.

The best way to understand the role of an investment bank when it comes to helping their clients raise capital is to picture the investment bank as a middleman between the client and the investing public. Let’s suppose that the client wants to issue bonds in order to pay for an acquisition. The investment bank would price and underwrite the bonds based on its assessment of the value and riskiness of the business and then sell the bonds to institutional investors (e.g., mutual funds and pensions).

An investment bank can serve the same role in pricing and underwriting stock when a company issues an initial public offering (IPO) or secondary public offering. In this role as a market maker, the investment bank serves an important function: It ensures that there is a market to buy the securities of public companies that are offered for sale.

For example, have you ever wondered how it is possible to buy or sell shares in a public company at any time simply by placing an order with a stockbroker or executing the trade yourself online? In any transaction, there must be a buyer and a seller — so who exactly is it that is on the other side of your stock purchases and sales?

As market makers, investment banks set firm ask and bid prices for public company stocks and then buy and sell shares from the investing public. That is how you are able to buy or sell any number of shares in any public company at any time that the stock exchange is open. Market makers will purchase your shares, regardless of whether or not they have a buyer lined up at that time, thus making a market for the stock.

Investment Banking Risks and Rewards

There is potential risk and reward for investment banks in their role as market makers, since the price of shares they buy from you could rise or fall before they are able to find a buyer. To minimize their risk and potentially maximize their return, investment banks maintain a spread between their ask and bid prices.

For example, supposed an investment bank buys shares of stock at the ask price of $100. It could then offer them for sale at a bid price of $100.05, for a spread of 5 cents. While a nickel might not sound like much profit, remember that investment banks are trading millions of shares of stock every day.

Just like any investor, the investment bank’s goal is to “buy low and sell high.” Successful investment banks make more good buy and sell decisions than bad ones — day in and day out, every trading day of the year.

However, making markets isn’t the only way that investment banks make money. They also provide M&A advisory services to companies looking to buy or sell other businesses, for which they charge fees that are often substantially higher than the underwriting fees they charge when making markets. These advisory services include business valuation, due diligence, negotiation, pricing, structuring and implementation of M&A transactions. Investment banks also make money by buying and selling securities out of their own accounts, and they provide equity research and analysis to institutional investors.

Impact of the Financial Crisis

Some investment banks were hit hard by the financial crisis. Most notable were Lehman Brothers, which went bankrupt, and Merrill Lynch, which was acquired by the smaller Bear Stearns. In the aftermath of the crisis, many investment banks received government loans through the Troubled Asset Relief Program (TARP), which was heavily criticized by many as an unwarranted government bailout.

Despite the criticism that some have heaped on the industry, though, investment banks serve an important role. Maintaining a healthy investment banking industry is in the best interest of the overall U.S. and global economy.

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