What Is Investment Banking and How Does It Work?
Investment banking specifically deals with the creation of capital for the government, corporations, and institutions. Some of the more well-known investment banks are:
- Bank of America
- Goldman Sachs
- J.P Morgan
- Barclays Capital
Although these may sound familiar, you may be unclear as to how investment banks function, because they operate differently than typical banks used largely by society.
Investment banks are unique because they are engaged more so on the corporate level of finances. Despite this, they will provide individual services to non-corporates entities as well. The intention behind investment banking is to raise capital for corporations in order to keep the business afloat financially.
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What Is Investment Banking?
Investment banking is a classification of banking that deals with consultative-based financial ventures for the sake of governments, corporations and sometimes individuals. An investment banker fundamentally acts as a financial advisor and mediator between investors, and those who require funding in order to develop their business. To elaborate, investment banks are in the middle of corporations/institutions looking to issue stocks or bonds in the company and investors looking to purchase stocks or bonds in a company. The investment bank facilitates control of the complicated contractual duties during the investment transaction.
Contrary to day-to-day banking, investment banks do not take any form of deposits. Commercial banks offer financial advice, checking and savings account services, and provide personal, business and mortgage loans. The main contrast between investment banking and commercial banking is that investment banks are loosely regulated by the Securities and Exchange Commission (SEC) while commercial banks are tightly regulated by the Federal Deposit Insurance Corporation (FDIC).
Investment Banking Services
Corporations and institutions contract investment banks for specific services in order to obtain investors that will, in turn, secure financing and grow capital. There are multiple different kinds of services that investment bankers offer to those seeking help, including:
Investment banks offer underwriting services that virtually eliminate any risk during an initial public offering. When a company decides to grow and go public, the issue/offer securities in the company that is sold to individuals or institutional buyers. Investment banks diminish the risk of going public, by buying all of the securities from the issuer and selling them with some sort of markup in price in order to facilitate profitability with risk factors. This is called the firm commitment approach to underwriting.
There is another way to approach underwriting without taking on the amount of risk above. The method is called the best efforts approach to underwriting. The underwriter acts as a salesman by marketing the securities from the issuer, but not initially buying them outright. This keeps risk low but keeps the investment banker making a percentage of the transaction, similar to a commission.
Asset management, in relation to investment banking, applies to the control of the investments for a corporation or institution. This responsibility tasks investment bankers with stringent research in order to analyze which investments to make and others to dodge in order to expand that corporation or institution. This research includes any sort of information that backs asset development. Asset management includes informing companies on the tangible and intangible assets they are personally liable for, and how to measure the success of those assets through market research.
Sales & Trading
Sales and trading go into the ventures that an investment banker performs in order to buy or sell securities. Although lumped together, sales and trading operate on two different levels.
Sales refers to individuals in the investment bank that call institutions and investors in order to facilitate trading ideas. Trading refers to a financial analyst that advises and supports clients in support of sales or trades. Investment banking provides services for clientele and also market making for the bank itself. The banks will buy and sell stock on a reoccurring agenda to facilitate clientele and additional profit.
Mergers & Acquisitions (M&A)
Mergers and acquisitions (M&A) is essentially the combination of multiple corporate entities over a period of time. A merger is the combination of two entities into one. An acquisition is when one of the entities takes over the ownership that the other entity had in the company.
It is important to understand the two terms on a separate basis because there is a difference between the two, and they are often blended together. This is the process of banks utilizing their networks in order to find potential financial ventures for clientele. This process is seen through the banks “buy-side,” but also the “sell-side.”
Examples of Mergers:
- Vodafone and Mannesmann;
- America Online and Time Warner;
- Pfizer and Warner-Lambert;
- Exxon and Mobil.
Examples of Acquisitions:
- Google buys Android;
- eBay buys Paypal;
- Facebook buys Instagram;
- Disney buys Pixar.
Equity research is an analysis of a company and its coinciding financial situation, with the intent to buy or sell stock investments. Equity research is fundamentally searching for the value of a company, and this is done by a research analyst. This is based on a few different measures:
- Research of the industry, competition, and growth rates;
- Financial analysis of profitability;
- Predicting the potential revenues;
- Calculating the fair buy or sale price with the stock exchange price.
For buyers, if the fair price is more than the current market price, then it is recommended to buy. For sellers, if the fair price is less than the current market price, then it is recommended to sell.
The Role of an Investment Banker
An investment banker has many hats that they wear when helping corporations, governments, and individuals.
Reasons that investment bankers may be contracted are:
- Creating capital;
- Underwriting debt;
- Underwriting securities;
- Issuing stock(s);
- Facilitating mergers and acquisitions.
Investment bankers use their expertise on the market and analyze opportunities in a way that presents the potential risk and rewards of investing in a company. This analysis includes understanding Wall Street and the overall current climate of investing alongside the ability to communicate the state of the proposed investment.
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This post was updated August 28, 2019. It was originally published August 28, 2019.