Investment Bankers are often in the media and making headlines. But many people do not know what they actually do. Investment bankers are known to earn high salaries, and the banks themselves are known to hold significant amounts of power and wealth. However their operations are shrouded in mystery, or so it seems. In this blog post, I am going to do my best to explain what the investment banker does, and why they are important in the economy.
What is a bank?
I have another post that deals with this theme in a bit of depth. You can read this below. Put simply, though, a bank takes deposits from savers, and makes loans to spenders. This provides the movement of money through the economy that is vital for its healthy operation.
The investment bank, in its pure form does neither of these things. So what do they do, and why are they called a bank? The idea of the investment bank is a very old one. In fact, some of the functions of the modern investment bank can be traced back to the 14th century, in the Medici Bank of Italy. More modern developments in the industry include the issue of bonds and stock by the Dutch East India Company.
The word bank traces its roots meaning ‘bench’. This likely comes from the bench at the financial institution where people would handle their financial affairs. In a more general sense, a bank can be classified as an institution that provides financial services to clients. And that is where we get the investment bank.
Commercial Banks vs Investment Banks
Commercial banks deal with our normal deposits and loans as we normally associate banks with. Let’s consider the commercial bank’s client base.
We have depositors, who want interest earned on their money.
We also have borrowers, who are wanting to use money to invest in something else.
There is no difference between the clients of commercial and investment banks, apart from their size. Due to the size of investment banking clients, their financial needs are more complex, and therefore require access to more types of products. This is what the investment bank does.
The investment bank provides end-to-end solutions for clients in financing their operations. Clients will generally include corporations, governments and high net worth individuals.
Now, while broking is a large part of what the investment bank does, the nature of what the bank does in accessing exchanges, institutional investors and making markets, requires the bank to risk its own capital in service of its clients. I will now provide a brief description of the operations of investment banks.
Sales and Trading
Sales and Trading relates specifically to dealing in financial instruments. An important part of what investment banks do is provide liquidity in markets so that their clients can execute whatever trades they may need to. This is done both through traditional exchanges, and in off market operations such as dark pools.
This will include equities, fixed income, commodities and futures.
Mergers & Acquisitions
The M&A department of an investment bank is the flashy part that we get to see on TV. The one where deals get made and billion dollar companies join together to take over the world. While some part of this are true, other are of course over glamorised.
The M&A division of an investment bank advises clients in these transactions. This is a very lucrative business for investment banks, as the income made is from fees, and so is relatively low risk and does not require their own capital to be put into the market.
While it might seem weird for an investment bank to have an investment banking division, this is more of a historical artefact. The traditional investment bank from 300 years ago dealt in primary equity and debt offerings. This is what the investment banking division does. Debt offerings may include offerings of bonds for both companies and governments. Equity offerings can be Initial Public Offerings (IPOs) or capital raising through rights issues and similar products.
The investment bank will often underwrite the offering, and market the offering to investors. They will also handle the issuing of the securities. By underwriting, they take a large amount of risk in this operation.
While this isn’t considered to be a ‘core function’ of the investment banks, it is becoming a large part of the business. This will mostly deal with high net worth individuals, and will manage their portfolios.
Relationship Management is arguably the most important role in the bank. The relationship manager is the one who meets with clients and devises solutions for their needs. To the client, they represent the bank, and to the bank, they represent the client. Therefore, the relationship manager is extremely important in delivering the solutions to the client.
This has been a very simple overview of investment banks. Their roles have evolved and changes greatly over the decades and through different legislation changes. Below I will link a few books that if you want to understand further, I suggest you read.