Industry Insight: Investment Banks' Bonanza

"Industry Insight" is a weekly series that examines sectors through what's known as the five forces of competition, which can help separate the winners from the losers. Come back every Monday at 6 a.m. to see which industries and companies will be put under review.

The fact that JPMorgan(JPM Quote) and Goldman Sachs(GS Quote) posted record profits in the second quarter during one of the worst recessions in American history is perplexing.

Understanding the business model and competitive forces influencing the investment banking industry is crucial for investors. Will earnings continue to grow now that the stock market appears to have rebounded for good? Will fewer competitors drive up revenue?

Investment banks traditionally helped companies raise money through debt or equity underwriting, and advised on mergers and acquisitions. Now they also engage in "proprietary trading," a fancy way of saying that firms use their own money to make bets on interest rates, currencies and commodities.

While such trading is highly lucrative, it's also a reason many banks have run into trouble. Those divisions are essentially large hedge funds where traders are rewarded handsomely for risky bets that pay off, and shareholders and the government are left holding the bill when things sour.

Goldman Sachs, JPMorgan, Citigroup(C Quote), Morgan Stanley(MS Quote) and Bank of America(BAC Quote) are the biggest players in the industry. Smaller niche firms such as Cowen Group(COWN Quote) are money machines too.

Here's how investment banks measure up:

Degree of Rivalry: Investment banks are a dime a dozen. Since the industry is so profitable, everyone wants in. Luckily for entrenched firms, the customer base is loyal. Investment banking relationships are much like a doctor-patient relationship. The investment bank is seen as a trusted expert that knows the customer better than a new firm would.

That said, there is still room for firms to add to or subtract from their client lists. Defections can cause much of the turnover, which is one reason compensation packages are so high. Clients who feel they have a strong relationship with their banker may decide to also jump ship and follow their man to his landing spot. Investment banks are, therefore, extremely motivated to retain top talent with heavy checks.