What Is Investment Banking?
Remember how there was always at least one character in a 90s television show that worked as an investment banker? The popularity of the job petered out by the mid to late 2000s when the world started paying attention to all the shenanigans happening in the financial sector. As a result, you may still be wondering, “What is investment banking?”
Investment banking entails the creation of capital for a number of entities, ranging from corporations to governments. An investment banking definition would primarily refer to the sector of banking related to capital creation. However, in order to properly understand how investment banking works, one needs a foundational understanding of capital and securities.
Capital can be a confusing term. Oftentimes, its definition depends on the context. Basically, it means the financial assets or resources that can be used. It is different from money because it is meant to grow through investments instead of being immediately used.
Securities are rights of partial ownership to an entity, whether it’s to a publicly-traded corporation through stocks or a private company through bonds. It would be difficult to craft a comprehensible investment banking definition without a proper discussion of these elements.
What Is an Investment Bank?
Image Source: Investment Banking
Simple banking, like depositing checks and withdrawing money, is not what investment banks do. Instead, they deal with companies and governments and certain investors to facilitate complicated, large-scale transactions. Many of these investment banks are affiliated with colossal banks whose names you are most likely familiar with:
You may be wondering, “Okay, so then what does an investment bank do exactly?” Facilitating large-scale transactions is all well and good, but what is it that makes these transactions so complicated? The thing is that corporations, for instance, are often undergoing transformations. This could be in the form of a merger, an acquisition or a sale.
- Merger: the combination of two companies
- Acquisition: a company buys ownership of another company
- Sale: a company is sold to another owner or company
How investment banking works, in the case of these three things, can be understood with everyday examples. A marriage is a merger of assets. If you buy someone else’s car, that’s an acquisition. And if you decide you no longer need a car, you sell it to someone else. The difference is that when it comes to publicly-traded companies, they are not only owned by one person, making things more complicated and investment banks necessary.
How Investment Banking Works for Publicly-Traded Companies
The securities from different entities have specific names:
- Publicly-traded corporations issue stocks
- Government bodies and corporations issue bonds
We hear about the first one almost every day on the news via updates on the stock market and the ticker listing stock prices located at the bottom of the screen. Managing a company’s stocks is one of the basics of investment banking. Only publicly-traded companies have their stocks listed on the stock market.
When a company decides that it wants to go public, it hires an investment bank. This is one of many answers to the question, “What do investment banks do?” Going public allows a company to grow by acquiring capital through other parties who essentially buy a piece of the company, but this opens up the company to regulation and accountability to its investors.
When a company chooses to go public, it makes an initial public offering (IPO). An IPO is the first batch of stock a private company offers to the public, and investment banks play a crucial role in this step. What do investment banks do to facilitate an IPO? They do the underwriting, which means they:
- Establish how much the company wants to raise
- Figure out what kind of securities the company wants to issue
- Seek investors to raise the necessary amount
In some cases, what investment banks do is guarantee that a certain percentage of the desired amount will be raised. They can do this by buying all or part of the offering and then selling it to the public themselves.
What does an investment bank do once it has established the details of the public offering with the company? It has to register with the U.S. Securities and Exchanges Commission (SEC), which is the federal government’s regulatory body for securities. Any and all relevant and important information about the company is disclosed here, such as:
- Any legal issues
- Information and biographies of management
- Management’s compensation
- Details of the securities offered
The job isn’t done once the necessary information has been filed with the SEC. So what do investment banks do after they’ve done their due diligence with the federal regulatory body? Well, this is where the real fun begins.
There is what’s known as a cooling off period, where the SEC investigates the company to ensure all the information it’s received is accurate. During this time, investment banks go around hyping up the stock and getting the interest of the big players. An effective date is set once the SEC gives its approval.
In the time leading up to the effective date, what investment banks do is work with the company to decide on a price. Naturally, both parties are eager to fetch the highest price, but determining the price relies on a number of factors, including:
- The company’s reputation
- How much interest has been generated
- The market
In the case of IPOs, what is investment banking to the everyday person? Not very much. Investment banks do not pay much mind to individual investors when it comes to underwriting an IPO. Instead, they’re more interested in hedge funds or the high-flyer account holders at big investment banks.
What Is Investment Banking, and How Is It a Bridge Between Individuals and Companies?
In the context of companies and individuals, an investment banking definition would be: banking related to facilitating the buying and selling of a company’s stocks and bonds. (A bond is money that an investor loans to a company or a government for a fixed term in exchange for interest.)
It sounds simple enough, but carrying this out is a complicated process. Assisting in this process are the investment banks. The investment banks offer advice to companies and businesses on how to best address their financial problems as well as assisting them in obtaining financing.
Understanding investment banking is a great way to understand how stocks are initially priced. Determining how to price a stock is a large part of what investment banks do in the early stages. They also provide vital assistance in helping companies navigate the rules and regulations if they decide to go public.
So if you were wondering what does an investment bank do in relation to you, if anything, the answer is that it acts as the middleman. They are the go-between for companies and individual investors by helping to set the price and ensuring publicly-traded companies are following the rules that will allow you, as an investor, to make informed choices.
Related: How to Become a Financial Advisor
What Does an Investment Bank Do About Stocks?
Image Source: Investment Bank on Stocks
If a company decides that it wants to offer an ownership stake, it means it will need to make an initial public offering that is facilitated by the investment bank. What an investment bank does, in this case, is look at the earning potential of the company to see how much the stock will be worth. It also does what the U.S. Securities and Exchanges Commission (SEC) will also do and takes a look at management to see how strong it is.
What Does An Investment Bank Do About Bonds?
In the case of bonds, a private company or a government seeks loans from the public. What do investment banks do for entities hoping to do this? They take a look at the interest rate of bonds issued by other businesses with a similar standing to determine what they will have to offer lenders.
Popular Article: Key Questions to Ask a Financial Advisor Before Using Their Services
How Investment Banking Works When It Comes to Making a Profit from Underwriting
As explained earlier, if an investment bank decides to underwrite a bond or stock offering, it may guarantee the amount of money the company is hoping to acquire. What investment banks will do is buy some or all of the stock a company is offering, but they do so strategically.
Understanding investment banking and the tricks involved is a helpful stepping stone to eventually understanding how hedge funds and other aspects of the financial system work. After assessing the future potential earnings of a bank and the strength of its management, an investment bank will have a picture of how well that stock will do.
If the investment bank thinks that Company A’s stocks will do well, it will buy 100,000 of that company’s shares at $11 a piece. It knows from its analysis that investors are willing to purchase them at $12 a piece. After buying it, it will sell the shares for $12 and make a $100,000 profit. This is how investment banking works in order to also make a profit.
What Is Investment Banking, and How Is It Different From “Regular Banking”?
An investment banking definition that solely addresses this question would be that investment banks don’t take deposits. This is what differentiates them from retail banks and commercial banks.
Retailing banking (or consumer banking) is what individuals are most familiar with. These kinds of banks provide everyday, individual services like:
- Checking and savings accounts
- Personal loans
- Debit cards
- Credit cards
- Lines of credit
Commercial banks provide loans, accounts for depositing, and more for business banks. The definition of a commercial bank is a little hazy since it is a fuzzy middle version of what retail banks do and what investment banks do. The term was created to distinguish commercial banks from investment banks, which deal with corporate markets.
Understanding Investment Banking, Retail Banking, and Government Regulations
The Glass-Steagall Act, otherwise known as the U.S. Banking Act of 1933, created a barrier between commercial banks and investment banks. This was meant to protect deposited money from use in capital markets. One of the basics of investment banking is engaging in risk based on the expected success of a company and its securities.
By the 1960s, a number of interpretations allowed commercial banks to engage in some form of securities trading, particularly through affiliates. This led critics to question the usefulness of the remaining regulations created by the act. The government repealed most of the provisions in 1999 under President Bill Clinton. Some observers claim this repeal led to the types of investment banking practices that lead to the financial crisis in 2008.
If you found yourself asking, “What is investment banking?” don’t be embarrassed. The complexity of the financial system has baffled a number of smart people. In fact, it was so confusing that most experts didn’t even predict the meltdown in 2008. An investment banking definition can be tricky to piece together considering all the moving parts. Yet, as we’ve found, when it comes down to it, the basics of investment banking are the management of companies’ and governments’ securities for capital gains.
AdvisoryHQ (AHQ) Disclaimer:
Reasonable efforts have been made by AdvisoryHQ to present accurate information, however all info is presented without warranty. Review AdvisoryHQ’s Terms for details. Also review each firm’s site for the most updated data, rates and info.
Note: Firms and products, including the one(s) reviewed above, may be AdvisoryHQ's affiliates. Click to view AdvisoryHQ's advertiser disclosures.