What Is an Investment Bank?
An investment bank is very different from your neighborhood bank—it doesn’t make loans, nor does it accept deposits. While investment banks assist individuals with wealth management and provide financial advice to institutions, their main function is to help companies with complex financial transactions, from facilitating mergers and acquisitions to creating initial public offerings (IPOs), guaranteeing securities, insuring bonds, and much more.
Investment banks work with everyone from high-net-worth individuals to governments, corporations, pension funds, hedge funds, and other financial entities. In a nutshell, they serve as the bridge between a business and its investors.
Examples of What Investment Banks Do
If you are wondering “what exactly does an investment bank do?” The answer is a variety of things. Here are examples of three of its functions:
- Say a company needs to build a new factory. An investment bank can help find underwriters for its expansion through the issuance of stocks and bonds.
- Investment banks also assist with IPOs (initial public offerings). An investment bank helps a company “go public” by making sure that all of its transactions are legal and compliant with the SEC. It also helps to determine IPO stock prices.
- In the case of mergers and acquisitions, i.e., when one company buys out another company, an investment bank often formulates the valuations that help to determine how much a company is worth.
How Do Investment Banks Work?
There are two sides to an investment bank: The buy-side provides money management services and makes buy-hold-sell decisions. It serves as a broker to large institutional investors like mutual funds. The sell-side is involved with liquidity, specifically trading securities for cash, selling shares of IPOs, and facilitating mergers and acquisitions. It also conducts research and engages prospective new business.
In order to prevent the spread of information that is not publicly available, and thus limit the chance of conflicts of interest, a partition usually separates the buy-side from the sell-side—it’s known as a Chinese wall.
Types of Investment Banking Activities
Investment banking activities are categorized in three ways:
TheStreet Dictionary Terms
- Front office activities involve direct interaction with the public by working directly with clients or by trading on behalf of an individual or a corporate client. Sales, trading, research, and M&A jobs are all considered part of the front office.
- Middle office activities, just like their name implies, are situated between the investment bank’s client-facing activities and its more behind-the-scenes work. These jobs include compliance and risk management.
- Back office activities are far from the trading floors of the investment bank. They might not be as glamorous, but they are just as important to its business. Back office jobs include settlements, payment processing, technology support, and human resources.
How Do Investment Banks Make Money?
Investment banks earn underwriting commissions. They also make money from the advisory fees they charge clients for managing their assets, which can range in the millions of dollars. According to SEC filings, the majority of their revenue is made from brokerage commissions and proprietary trading. Before the financial crisis of 2007–2008, investment banks earned revenues from securitizing debt, such as from mortgage-backed securities; however, the implosion of this asset class resulted in tighter regulation from the U.S. government, which limited speculative trading.
What are the Top 5 Largest Investment Banks? Where Are They Located?
A few cities, such as New York, London, Hong Kong, and Tokyo, are known as global investment banking centers. Some of the world’s largest investment banks include JPMorgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, and Citigroup.
Size matters when it comes to investment banks. The largest investment banks are considered part of the bulge bracket, which is a small group of very big companies that controls most of the world’s financial transactions. Smaller investment banks are known as middle-market, or boutique, banks.
Is an Investment Bank a Bank?
Yes and no. You can’t obtain a mortgage from an investment bank—actually, investment banks don’t provide any type of loan. The Glass-Steagall Act of 1933 had kept investment banks and commercial banks separate. However, the act was repealed in 1999, and thus large commercial banks were able to create investment banking divisions.
How Is an Investment Bank Different from a Commercial Bank?
This chart outlines some of the ways investment banks and commercial banks differ:
|Commercial Banks||Investment Banks|
Focuses on all individuals
Provides individual attention to high-net-worth individuals ($1 million+) only
Serves corporations, institutions, and government entities
Regulated by the Federal Reserve
Regulated by the SEC
Who Is in Charge of Investment Banks?
Investment banks are privately managed entities, although the U.S. Securities and Exchange Commission (SEC) is responsible for regulating their activities. It provides oversight over nearly every facet of their business in order to mitigate risk.
Can an Investment Bank Experience a Run?
An investment bank is not a commercial bank, but it can witness bank runs. In fact, the collapse of an investment bank sets in motion a dangerous game of dominoes for the entire financial industry. One example is the implosion of Bear Stearns during the 2007–2008 financial crisis. Once the fifth-largest investment bank in the world, Bear Stearns was overexposed to toxic subprime mortgage securities, which experienced heavy losses and eventually received credit rating downgrades. In response, investors tried to collect their investments, and a bank run ensued in March 2008. The company was acquired at a steep discount by JPMorgan Chase not long thereafter.