It seems as if there is a special niche for everything in finance - and banking is no exception. If a company, corporation, or the government has special banking needs, why not have an entire sect of banking dedicated to them? Well, that seems to be the rationale behind investment banking. But what exactly is investment banking? And how is it different from regular banking?
Investment Banking Definition
Put simply, investment banking is dedicated to helping large companies or institutions manage their money - whether that be by helping them create capital, underwriting debt or equity securities, or helping with mergers and acquisitions. Investment banks can also help with issuing stock and other transactions a corporation may need help with.
Investment banks operate as a way for large entities (which could either be companies, corporations, governments, or other such institutions) to make big financial transactions with a little extra help. Along those lines, investment banks will often help facilitate the finances surrounded mergers and acquisitions, and, perhaps most importantly, help connect corporations to investors through the issuing of bonds or stocks. To that extent, investment banks often help companies issue their initial public offerings, IPOs. In these cases, the investment bank will sell the shares on behalf of the company on the market.
Among other things, investment banks work as financial advisors to large companies or entities, especially in advising sales and trading between buyers and sellers of companies, and recently began offering commercial banking services (since the repeal of Glass-Steagall in 1999).
Investment banks operate on two different groups: Product groups and industry groups.
Investment Bank Product Groups
As part of their structure, investment banks offer different product groups. While the three main product groups investment banks offer are mergers and acquisitions, restructuring and leveraged finance, they encompass a bit more than that. The typical main product groups reportedly are:
- Mergers and Acquisitions, M&A: The investment bank will advise or facilitate the mergers of companies with one another.
- Leveraged Finance, LevFin: Investment banks will finance corporate activities through issuing high-yield debt.
- Equity Capital Markets, ECM: The investment bank will advise companies or corporations on the release and management of IPOs, stocks, bonds and shares, as well as raises and other equity concerns.
- Restructuring: Investment banks will often help restructure companies or corporations in order to increase profitability and economy within the entity.
Investment Bank Industry Groups
Additionally, investment banks offer what are called industry groups, which cover different industries like financial sectors, healthcare sectors, etc. Some of the principle industry groups reportedly include:
- Financial Institutions Group, FIG
- Technology, Media & Telecommunications, TMT
- Real Estate Investment Banking
Although investment banks cover more areas than the aforementioned, they generally focus around these principle sectors. Investment bankers working in industry groups generally have more of a marketing bent when working with different sectors compared to their advising-heavy counterparts in product groups.
Investment Banking vs. Commercial Banking
The main difference between investment banking and commercial banking is that investment banking typically deals with purchasing and selling bonds and stocks for companies, and also helping them issue IPOs, while commercial banks primarily deal with deposits or loans for companies or individuals.
So, basically, investment banks deal with trading securities, whereas commercial banks do not.
However, there are still several other key differences between investment banking and commercial banking that have to do with regulation, risk level, and benefits.
During the Great Depression, both investment and commercial aspects of banks were combined, which was seen as a negative thing that may have contributed to the depression itself. Once the Glass-Steagall Act was instituted in 1933 as part of the Banking Act to separate the two sides of banking (investment and deposit management), the divide was created.
However, when the Glass-Steagall Act was repealed in 1999 by the Gramm-Leach-Bliley Act, banks were once again given the freedom to merge the investment and commercial sides together. However, despite this newfound leeway, many large banks have decided to keep their investment and commercial banks separate.
Risk and Regulation
Another big difference is that commercial banks have stricter regulation. Commercial banks must be regulated by several government entities to include the Federal Deposit Insurance Corporation, or FDIC, whereas investment banks only need be regulated by the Securities and Exchange Commission, SEC - the latter of which allows for more freedom in making decisions and investments.
Because of this difference in regulation, commercial banks are often less risky than investment banks (because they are backed by the federal government) - but, on the flip side, investment banks provide more room to maneuver strategic decisions than commercial banks do.
Still, the banks who have decided to combine have several pros.
While not many large banks combine their divisions, some of the benefits of combination include banks being able to issue companies IPOs (using its investment bank capabilities) and then extend lines of credit to them (using the commercial bank side) - which would allow the banks to then receive benefits from doling out a hefty sum and in return, get higher commissions and trading revenue from the stock.
By having both the issuing securities and extending lines of credit sides covered, combination banks are able to bolster the growth of companies and reap the rewards.
However, concerns still remain over the temptation of combination banks to keep undeserving companies afloat - which was a major aspect of the bubble/burst cycle seen during the depression.
What Do Investment Bankers Do?
As the title would suggest, an investment banker helps raise capital for companies or other large entities who are clients of the bank. The bankers often work in the investment arms of larger banks like JPMorgan Chase (JPM) and Goldman Sachs (GS) .
As part of their duties, managing companies' securities, investment bankers are responsible for advising companies on several fronts, including pricing and helping the company navigate various regulations.
Investment bankers will also often help facilitate the bank's purchase of all or some of the company's shares when an IPO is released - but, if the financial analysts at the investment bank overvalue the stock, the bank can take heavy losses.
History of Investment Banking
Investment banking had its inception after the Wall Street Crash of 1929, when banks and investors alike suffered devastating losses. As one of his first acts as president, Franklin D. Roosevelt instituted the Glass-Steagall Act of 1933 as part of his New Deal. This act separated investment banking from deposit banking, and sought to restore faith in the American banking system, detailed in the act's Article 20.
Under the blanket of the Banking Act, President Roosevelt sought to curtail the previously all-powerful banks by ensuring they managed risk and protected their depositor's money. However, following the boom that occurred post-1933, banks began bending the rules of the Glass-Steagall Act and started blending commercial and investment banking activities - leading President Clinton to repeal the act in 1999 via the Gramm-Leach-Bliley Law.
This repeal led to the acquisition of JP Morgan (a mega investment bank of the time) by Chase Manhattan (a major commercial bank) in 2000.
However, this was seemingly the beginning of the end for investment banks.
Controversies in Investment Banking
In 2008, the banking industry loomed on the edge of total collapse as the United States economy plummeted into the Great Recession.
After banks made too many risky loans, Bear Stearns, one of the largest investment banks at the time, fell to the financial crisis - forcing the Federal Reserve to sell it to J.P. Morgan. Others followed, as more banks declared bankruptcy (including long-time staple of the financial sector Lehman Brothers).
Then-president Barack Obama put precautions in place to attempt to revive the economy - namely, the Dodd-Frank Law in 2010. The bill limited banks' sizes and laid out more precautions to keep investment and commercial banking more separate.
However, many banks still have investment bank branches alongside commercial branches.
Best Investment Banking Options
There are dozens of good investment banks available, but many of the most revered ones come from the top banks in general.
Among others, Goldman Sachs, JPMorgan Chase, Bank of America (BAC) , Barclays (BCS) , Morgan Stanley (MS) , Citigroup (C) , Credit Suisse (DHY) and UBS Group AG (UBS) are some of the most popular investment banking options.
Additionally, check out TheStreet's take on the best investment bank stocks to buy right now.