Investment Banks – Just What Are They?
We hear the term “investment bank” on a daily basis. These banks are vilified for their role in the financial crisis and criticized for the profits they reap and the large compensation packages for their employees. But many people have no idea what they are or what they do. Let’s take a look at the role i-banks play in the financial services industry and the economy at large.
So what is an investment bank? First of all, they are very different than the commercial banks we are all familiar with. They do not take deposits like the retail bank on the corner. Instead, they primarily assist in the buying, selling and issuing of securities – that is stocks, bonds and similar financial instruments.
They assist companies and institutions on “buy side” and “sell side” activities. The buy side refers to the advising of institutions concerned with buying assets and securities. Entities that engage in buy side activities include private equity funds, mutual funds, hedge funds, pension funds and proprietary trading desks. The sell side refers to a broad range of activities, including broking and dealing securities, investment banking, advisory functions and investment research.
The core functions of an i-bank include investment banking – otherwise known as corporate finance – sales and trading and research. Some larger investment banks also perform other services like investment management or merchant banking, but let’s take a closer look at the core three.
Investment Banking (Corporate Finance)
Investment banking can be a confusing term because many people use it to refer to any activities performed by an i-bank. More specifically, though, investment banking refers to assisting companies with raising capital and giving advice on mergers and acquisitions.
The corporate finance department of a bank is the group that works with a company to put together an initial public offering (IPO). Or, if a company already has public stock outstanding, they might put together a follow-on offering, which is simply an additional issuance of stock shares. The corporate finance department can also help companies raise capital through private placements, which often involve securing capital from private equity groups.
Should the ownership of a company seek to sell the entire enterprise, the corporate finance department can also advise on M&A transactions. They can help identify potential buyers and negotiate a sale of the entire company. Likewise, if a company is in the market for acquiring other enterprises, this group can advise on acquisitions.
Another service that the corporate finance department might offer is the delivery of fairness opinions. In a fairness opinion, an investment bank will perform an analysis of a potential acquisition and render an opinion as to whether a reasonable price is being offered for the target company.
Sales and Trading
Sales and trading is perhaps the primary service that an i-bank can offer. There are often two major divisions within sales and trading – institutional and retail. The institutional division buys and sells financial products for institutional clients such as mutual funds, pension funds, etc. The retail division buys and sells financial products for retail investors. Stock brokers fall into this area.
The sales and trading department engages in market making. Market making involves buying and selling financial instruments in order to make an incremental profit on each trade.
Sales and trading can also engage in proprietary trading. Proprietary trading involves a special group of traders who do not work with clients. These traders take on “principal risk”, which involves buying or selling a product and does not hedge his total exposure. By managing the amount of risk on its balance sheet, an investment bank can maximize its profitability.
The sales and trading department also interacts with the corporate finance department on the issuance of IPOs and follow-on offerings. It is the sales and trading department that builds a book for a particular stock by calling up institutional and retail investors to judge the interest for the offering. They then price the initial sales value on the day of the offering and begin selling the new shares to their clients.
Depending on the size of an offering or the desired mix of investors for the offering, several investment banks may be involved in issuing shares to the public. This group of banks constitute the syndicate and are responsible for selling the shares involved in the offering.
The research department is staffed by research analysts. These are the people who often appear on business news programs and talk about the performance of a particular company or stock. The role of the research department is to analyze companies and writes research reports that discuss their performance potential. These reports often include a “buy” or “sell” recommendation.
The research department on its own does not generate a lot of …