Investment Banking

What is Investment Banking?

Investment banking refers to financial services concerning large and complex transactions, investment advice, capital raising, risk management, and other financial solutions. Some investment banks are universal banks, acting as a conglomerate of commercial and investment banking services simultaneously.

An investment banking entity is a bridge between businesses seeking capital and investors, ready to use the funds to reap profitable returns. These banks purchase securities from different entities and sell them to interested investors, keeping the market active and efficient. However, the reputation of the banks plays a great role in attracting more and more investors to a project.

• Investment banking is a division of financial corporations that creates new debt and security instruments, underwrites IPO processes, offers advice on mergers or acquisitions, and helps high-net-worth individuals and banks facilitate high-value investments.
• Investment banks are a mediator between businesses and investors, carrying all the risks and acting as a shield to both parties.
• It helps businesses build capital by raising funds from investors based on the years of reputation that they have built.
• The services offered to customers depend on the type of investment bank, be it bulge bracket, middle market, or boutique bank.

Investment Banking Explained

Investment banking emerged as a concept in the early 19th century when commercial banks dealt with the investment banking requirements of various entities. However, the emergence of the American Civil War made financier Jay Cooke start the first investment bank to fund the US war efforts.

The US government became the first client and started issuing bonds through investment banks to interested investors. The funds raised help the authorities fund their fundamental requirements and pay off investors with a share of the profit earned once the projects were accomplished.

The bonds served as an IOU, a payback promise in writing. Per this, the investment banks bought the bonds and sold the same to investors for profits. The banks continue doing the same even today. However, these banks attract clients and investors based on the reputation they have built over a period. Their history plays a vital role in making the stakeholders trust the businesses they collaborate with.

Types

The banking services are classified based on the types of banks providing them. The first one is the bulge bracket bank which forms the largest part of the investment banking field. They operate around the world and offer investment and advisory services efficiently.

Middle-market banks are the next on the list, which are comparatively smaller and operate on a limited scale. On the contrary, boutique banks, the third on the list, segment the customers before offering their services. These banks are for elite, regional, and industry-specific clients. While the elite banks take care of the major asset management, mergers and acquisitions, and other bigger deals, the rest two are restricted to offering services to specific regions and industries.

Functions

Trading is one of the least talked-about functions of investment banking. The salespeople work as analysts and approach investors with investing opportunities. In turn, traders take up trades and convey to the client when to consider entering and exiting positions.

Underwriting, the next one, makes these banks buy assets and securities having monetary value and sell the same to investors. The parties get involved in such deals as they have a middleman to take care of the risks and become their shield against the losses incurred. This makes the banks keep the securities to themselves until sold as they have already paid the clients for them.

Investment banks offer asset management services through which it helps clients manage their investment funds. The assets are managed using individual accounts for stocks, fixed-income stocks, derivatives, etc.

One of the most vital services of these banking institutions is their advisory functions. They help clients with valuable advice related to major business dealings, especially M&A. In addition, the ones into investment banking jobs help buyers and sellers of entities intending to merge with or acquire/being acquired by businesses.

Examples

The examples below help us understand the investment banking meaning and its functions better:

Example #1

Stella sets up a start-up. However, she is still searching for investors to raise capital. Being a novice in the market, she connects with an investment banking firm, A, which has an established history of helping businesses to operate well. The firm buys the securities from Stella and sells the same to investors to raise funds.

Example #2

Being the risk-taking middleman, the investment bankers played a crucial role in the Subprime Mortgage Crisis of 2008. As the Federal Reserve increased the bank's liquidity, it lowered the funds' rate, leading to commercial banks offering home loans without any strict criteria. With more and more home seekers taking up loans, commercial banks started selling the old financial obligations to investment banks, selling them to investors, and making them appear as secured investments. This allowed them to offer more home loans over time.

This cycle continued for consecutive years until the interest rates started rising, causing borrowers to default and affecting the banking sector. Though the investment bankers were found responsible for creating the bubble that burst, causing the collapse of the American economy, the same entities helped build it again with a far better and more stable infrastructure and economic foundations. Hence, even though it's a complicated field, investment banking holds a bright future ahead.

Regulation

With its evolution, two types of banks started – investment banks and commercial banks. While commercial banks dealt with the daily deposits and withdrawals and other simple banking services, investment banks were responsible for bigger financial affairs, including mergers and acquisitions (M&A), underwriting, etc. Then, some conglomerates acted as both investment and commercial banks and came to be referred to as universal banks.

When the functions collided, the universal banks had details of investors, who were also borrowers, which made it convenient for them to sell risky positions out of bias. These concerns made the authorities introduce the US Glass-Steagall Act of 1933, which prohibited commercial banks from offering investment banking facilities. In 1999, however, the act was repealed and replaced with the Gramm-Leach-Bliley Act, allowing commercial banks to offer investment banking services again. This led to mergers, forming global conglomerates like HSBC, J.P. Morgan Chase, etc., while some, like Goldman Sachs, and Morgan Stanley, preferred to function as pure investment banks.

Frequently Asked Questions (FAQs)

Investment Banking Video Tutorials

To understand Investment Banking functions and their roles in detail, I have prepared 14 parts video tutorial series on “What is Investment Banking?” to help you jump-start on this topic.

Part 1 - Introduction

Part 2 - Investment Banking vs. Commercial Banking

This part 2 video tutorial on Investment Banking vs. Commercial Banking discusses the following important basics-

• What is an investment bank?
• What is a commercial bank?
• Investment banking vs. commercial banking.

Part 3 - Equity Research

This part 3 video tutorial Equity Research discusses the following: -

• What is equity research?
• How equity research makes money?
• What is a typical Equity Research job profile?
• Who are the clients of the equity research department?

Part 4 - What is an Asset Management Company

In this part 4 video tutorial on Asset Management Company(AMC), we will discuss the following: -

• What is the Asset Management Company or AMC?
• How does an asset management company work?

Part 5 - Buy Side vs. Sell Side

This part 5 video tutorial on Buy-Side vs. Sell Side, we discuss the following: -

• What is the sell-side?
• What is the buy-side?
• Key differences between sell-side and buy-side

Part 6 - Sales and Trading

In this part 6 video tutorial on Sales and Trading, we discuss: -

• What are sales and trading?
• Sales function
• Trading function

Part 7 - Raising Capital

In this part 7 video tutorial on raising capital – how investment bankers help raise money through private placements of shares, IPOs, and FPOs: -

• How do companies raise capital?
• Role of investment bankers in raising capital.
• What is Initial public Offer (IPO) and Follow-on Public Offering or FPO?
• What are private placements? 

Part 8 - Underwriters

In this 8th part on Underwriters, we discuss the following:-

1. What is Underwriting
2. Role of investment bankers in underwriting IPOs

Part 9 - Market Making

In this part 9 on market-making by investment banks, we discuss the following: -

• Market making
• Role of investment bankers in market-making activities

Part 10 - Mergers and Acquisitions

In this part 10 video tutorial on Mergers and Acquisitions, we discuss the following –

• What are Mergers and Acquisitions or M&A?
• How do investment bankers help in M&As?
• Due diligence for M&A.
• Investment Banking PitchBook

Part 11 - Restructuring and Reorganization

In this part 11 video tutorial on Restructuring and Reorganization, we discuss:-

• What is restructuring?
• What is reorganization?
• Investment banker’s role in Restructuring and Reorganization.

Part 12 - Roles, Positions, and Hierarchy

This part 12 video on Investment Banking Roles and responsibilities discusses this job’s key roles and responsibilities.

• Analyst
• Associate
• Vice President
• Managing Director

Part 13 - Front Office vs. Back Office vs. Middle Office

In this part 13, we discuss the following -

• What is a front office?
• What is a back office?
• What is a Middle office?
• Front office vs. Middle Office vs. Back Office

Part 14 - Conclusion

Recommended Articles

This article is a guide to what is Investment Banking and its meaning. Here, we discuss its types, roles, functions, and regulations, along with examples. You can learn more about tax from the following articles –

• Investment Banking Interview Questions with Answer
• Investment Banking Analyst