What is the Role of an Investment Bank?

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How an Investment Bank Works

The advisory division of an investment bank is paid a fee for its services. The trading
division earns commissions based on its market performance. As noted, many also have
retail banking divisions that make money by loaning money to consumers and businesses.
Professionals who work for investment banks may have careers as financial advisors,
traders, or salespeople. An investment banking career is lucrative but typically comes with
long hours and significant stress.

The Intermediary Role

Investment banks are best known for their work as intermediaries between a corporation
and the financial markets. That is, they help corporations issue shares of stock in an IPO or
an additional stock offering. They also arrange debt financing for corporations by finding
large-scale investors for corporate bonds. The investment bank's advisory role begins with
pre-underwriting counseling and continues after the distribution of securities. The
investment bank is responsible for examining a company’s financial statements for
accuracy and publishing a prospectus that describes the offering in detail to investors
before the securities are available for purchase.

Investment bank clients include corporations, pension funds, other financial institutions,
governments, and hedge funds.

Size is an asset for investment banks. The more connections the bank has within the global
financial community, the more likely it is to profit by matching buyers with sellers,
especially for unique transactions. Investment bank operations can be roughly divided into
three main functions.

I. Financial Advisors

As a financial advisor to large institutional investors, an investment bank may provide

strategic advice on a variety of financial matters. They accomplish this mission by
combining a thorough understanding of their client's objectives, industry, and global
markets with the strategic vision necessary to spot and evaluate short- and long-term
opportunities and challenges.

Deciding how to raise capital is a major decision for any company or government. In most
cases, they lean on an investment bank—either a large Wall Street firm or a “boutique”
banker—for guidance.

Taking into account the current investing climate, the bank will recommend the best way
to raise funds. This could entail selling an ownership stake in the company through a stock
offer or borrowing from the public through a bond issue. The investment firm can also help
determine how to price these instruments by utilizing sophisticated financial models.

In the case of a stock offering, its financial analysts will look at a variety of different
factors—such as earnings potential and the strength of the management team—to
estimate how much a share of the company is worth. If the client is offering bonds, the
bank will look at prevailing interest rates for similarly rated businesses to figure out how
much it will have to compensate borrowers.
Investment banks also offer advice in a merger or acquisition scenario. For example, if a
business is looking to purchase a competitor, the bank can advise its management team on
how much the company is worth and how to structure the deal in a way that’s favorable to
the buyer.

II. Mergers and Acquisitions

Facilitating mergers and acquisitions is a key element of an investment bank's work. The
investment bank estimates the value of a potential acquisition and helps negotiate a fair
price for it. It also assists in structuring and facilitating the acquisition to make the deal go
as smoothly as possible.

Mergers and acquisitions (M&A) advisory is the process of helping corporations and
institutions find, evaluate, and complete acquisitions of businesses. This is a key function
in i-banking. Banks use their extensive networks and relationships to find opportunities and
help negotiate on their client’s behalf. Bankers advise on both sides of M&A transactions,
representing either the “buy-side” or the “sell-side” of the deal.

III. Equity Research

Investment banks have research divisions that review companies and write reports about
their prospects, often with buy, hold, or sell ratings. This research may not generate
revenue directly but it assists its traders and sales department. The research division also
provides investment advice to outside clients who can complete a trade through
the trading desk of the bank, which would generate revenue for the bank. Larger
investment banks have large teams that gather information about companies and offer
recommendations on buying or selling their stock. They may use these reports internally
but can also generate revenue by selling them to hedge funds and mutual fund managers.

Research maintains an investment bank's institutional knowledge of credit research, fixed-

income research, macroeconomic research, and quantitative analysis, all of which are used
internally and externally to advise clients.

Equity research professionals are responsible for producing analyses, recommendations,

and reports on investment opportunities that investment banks, institutions, or their
clients may be interested in. The Equity Research Division is a group of analysts and
associates at an investment banking (sell-side), an institution (buy-side), or an independent
organization.

The main purpose of equity research is to provide investors with detailed financial analysis
and recommendations on whether to buy, hold, or sell a particular investment. Banks often
use equity research as a way of “supporting” their investment banking and sales &
trading clients, by providing timely, high-quality information and analysis.

Other Activities

While advising companies and helping them raise money is an important part of what
investment banks do, most perform several other functions as well. Most major banks are
highly diversified in terms of the services they offer. Some of their other income sources
include:

 Trading and Sales: Most major firms have a trading department that can execute stock
and bond transactions on behalf of their clients. In the past, some banks have also
engaged in proprietary trading, where they essentially gamble their own money on
 securities; however, a recent regulation known as the Volcker Rule has clamped down
on these activities.
 Asset Management: The likes of J.P. Morgan and Goldman Sachs manage enormous
portfolios for pension funds, foundations, and insurance companies through their asset
management department. Their experts help select the right mix of stocks, debt
instruments, real estate trusts, and other investment vehicles to achieve their clients’
unique goals.
 Wealth Management: Some of the same banks that perform investment banking
functions for Fortune 500 businesses also cater to retail investors. Through a team of
financial advisors, they help individuals and families save for retirement and other long-
term needs.
 Securitized Products: These days, companies often pool financial assets—from
mortgages to credit card receivables—and sell them off to investors as fixed-income
products. An investment bank will recommend opportunities to “securitize” income
streams, assemble the assets, and market them to institutional investors.

The term “investment bank” is something of a misnomer. In many cases, helping companies
raise capital is just one part of a much bigger operation.

Underwriting-2

Underwriting is the process through which an individual or institution takes on financial

risk for a fee. This risk most typically involves loans, insurance, or investments. The term
underwriter originated from the practice of having each risk-taker write their name under
the total amount of risk they were willing to accept for a specified premium.

Although the mechanics have changed over time, underwriting continues today as a key
function in the financial world.

How Underwriting Works

Underwriting involves conducting research and assessing the degree of risk each applicant
or entity brings to the table before assuming that risk. This check helps to set fair
borrowing rates for loans, establish appropriate premiums to adequately cover the true cost
of insuring policyholders, and create a market for securities by accurately pricing
investment risk. If the risk is deemed too high, an underwriter may refuse coverage.

Risk is the underlying factor in all underwriting. In the case of a loan, the risk has to do
with whether the borrower will repay the loan as agreed or will default. With insurance, the
risk involves the likelihood that too many policyholders will file claims at once. With
securities, the risk is that the underwritten investments will not be profitable.

Underwriters evaluate loans, particularly mortgages, to determine the likelihood that a

borrower will pay as promised and that enough collateral is available in the event
of default. In the case of insurance, underwriters seek to assess a policyholder's health
and other factors and spread the potential risk among as many people as possible.
Underwriting securities, most often done via initial public offerings (IPOs), helps
determine the company's underlying value compared to the risk of funding its IPO.

Underwriting Stocks and Bonds

If an entity decides to raise funds through an equity or debt offering, one or more
investment banks will also underwrite the securities. This means the institution buys a
certain number of shares or bonds at a predetermined price and re-sells them through
an exchange.

Suppose Acme Water Filter Company hopes to obtain $1 million in an initial public offering.
Based on a variety of factors, including the firm’s expected earnings over the next few
years, Federici Investment Bankers determines that investors will be willing to pay $11
each for 100,000 shares of the company’s stock. As the sole underwriter of the issue,
Federici buys all the shares at $10 apiece from Acme. If it manages to sell all 100,000 at
$11, the bank makes a nice $100,000 profit (100,000 shares x $1 spread).

However, depending on its arrangement with the issuer, Federici may be on the hook if the
public’s appetite is weaker than expected. If it has to lower the price to an average of $9 a
share to liquidate its holdings, it’s lost $100,000. Therefore, pricing securities can be
tricky. Investment banks generally have to outbid other institutions that also want to
handle the transaction on behalf of the issuer. But if their spread isn’t big enough, they
won’t be able to squeeze a healthy return out of the sale.

In reality, the task of underwriting securities often falls on more than one bank. If it’s a
larger offering, the managing underwriter will often form a syndicate of other banks that
sell a portion of the shares. This way, the firms can market the stocks and bonds to a more
significant segment of the public and lower their risk. The manager makes part of the profit,
even if another syndicate member sells the security.

Investment banks perform a less glamorous role in stock offerings as well. It’s their job to
create the documentation that must go to the Securities and Exchange
Commission before the company can sell shares. This means compiling financial
statements, information about the company’s management and current ownership, and a
statement of how the firm plans to use the proceeds.

Investment Banking vs. Commercial Banking-2

Commercial and investment banks are both critical financial institutions in a modern
economy, but they perform very different functions. Commercial banks are what most
people think of when they hear the term "bank." Commercial banks accept deposits, make
loans, safeguard assets, and work with many different types of clients, including the
general public and businesses.

On the other hand, investment banks provide services to large corporations and
institutional investors. For example, an investment bank may help in merger and acquisition
(M&A) transactions, issue securities, or provide financing for large-scale business projects.
Commercial Banks

Commercial banks usually have tellers, sales associates, trust officers, loan officers,
branch managers, and technical programmers. You find many commercial banks in your
town operating as local businesses. Commercial banks give loans, take deposits, and
provide other account and banking services for their customers. These banks also offer
services to small and medium-sized businesses, such as business loans and lines of credit.

Investment Banks

Investment banks include consultants, banking analysts, capital market analysts, research
associates, trading specialists, and many others. There are several types of investment
banks, each directing their services toward different audiences.

Key Differences

Clientele and Services

A key difference between commercial and investment banks is their clients. Commercial
banks serve consumers and small and medium-sized businesses, providing loans, bank
accounts, and credit cards. They can also offer online banking, real estate loans, and
limited investment opportunities.

Investment banks cater to investors, governments, and corporations. They provide services
for corporations and wealthier individuals, such as wealth and asset management, merger
and acquisition services, security underwriting, and financial advisory and auditing
services.

Financial Differences

Commercial banks provide services to small and medium-sized businesses and consumers
and earn money through interest and fees. For example, a commercial bank might issue a
loan to a small business and charge it interest, which represents revenues for the bank.

Investment banks make money on the investment services they provide. For instance, an
investment bank might help a company issue stocks in an initial public offering (IPO) and
assist it during the IPO process. The bank would charge the company for its services.

How do Investment Banks Help the Economy?-2

There are two broadly recognized functions of investment banks: capital market
intermediation and trading. These are distinct and separate from the functions typically
associated with commercial banks, which accept deposits and make loans. Investment
banks are critical agents of capital formation and price setting. They also help to
coordinate present and future consumption.

Even though the functions of investment banking and commercial banking are different,
the distinction between investment and commercial banks is more meaningful in the United
States than in the rest of the world.

Investment Banking and Capital Development

In contemporary mixed economies, both governments and large companies rely on

investment banks to raise funds. Traditionally, investment banks match those selling
securities with those investors. This is known as "adding liquidity" to a market. For their
role, investment bankers are rewarded as intermediaries or middlemen. By matching
producers with savers, financial development becomes more efficient and businesses grow
more quickly.

There is some debate about why the cost of financial intermediation rose during much of
the 20th century. The costs of most other forms of business declined during the same
period, yet the percentage of financial transactions going to investment bankers rose. This
seems to indicate that the industry became less efficient.