Guide to Understanding Investment Banks

Don’t know what investment banks do? Our easy-to-understand guide simplifies this complex topic.

Investment banks are some of the oldest financial institutions in the United States, responsible for managing complex financial transactions involving billions of dollars.

You might recognize a few investment banks like Bank of America or JPMorgan Chase as household names.

You might even rely on one of these banks for non-investment banking services like maintaining your checking and savings accounts.

From a big picture perspective, these institutions can directly or indirectly influence your 401k, pension, or other investments.

That makes it important to understand what it is exactly that an investment bank does.

By knowing how these banks work, you can decide whether or not you need their services to help you manage your wealth, build a solid investment portfolio, or accomplish other financial goals.

Defining Investment Banks

Investment banks differ from consumer banks in a few key ways.

For one, they don't make most of their money from charging interest on loans they issue.

Instead, investment banks earn by serving as financial middlemen and advisors.

Investment banks work with governments, corporations, and funds

As their name implies, investment banks largely help organizations manage their investments.

This can involve anything from assisting a private company that wants to go public through an initial public offering, or IPO, to helping a city raise money with a municipal bond.

Mostly not for individuals. That means most people won't ever interact directly with an investment bank.

Well, at least not for personal banking.

2017 Leading Investment Banks Worldwide

Their services are aimed at institutions, not people.

Consumer banks help people manage their money

If you have a checking account or mortgage, you've probably used a consumer bank's services.

Knowing about this kind of bank's role in the finance industry can help you better understand investment banks.

Paying and charging interests. The way consumer banks make money is simple.

People receive a small amount of interest when they deposit money with a bank.

Investment bankers then loan this money out to other customers and charge them a large amount of interest.

For instance, say someone has $20,000 in a savings account paying 0.06% in monthly interest.

That person would earn $12 in one month.

The bank, on the other hand, could use half of that $20,000 to make a $10,000 car loan that charges 12% interest per month, earning the bank $1,200 every month.

Overall, that means the bank earns a net total of $1,188 in one month off of the original $20,000 deposit.

Many large banks offer both investment and consumer banking services

The line between investment banks and commercial banks used to be firmly defined.

However, this separation isn't as distinct as it once was in the past.

Changing regulations. Following the Great Depression, the Banking Act of 1933 prevented financial institutions from offering investment and consumer banking services under one roof.

This was done to cut down on the risk of a bank losing its consumers deposits due to poor investments.

By the time the 1990s came around, much of the anger directed toward the big banks on Wall Street had since cooled down.

That part of the regulation preventing investment and commercial banking to be done in one place was repealed, and banks were free to pursue both activities once again.

That's why a bank like Barclays is able to offer savings accounts to average consumers while still helping corporate clients raise millions in capital.

Limits on investments. Banks that perform both investment and consumer banking services still have some limits on how they can invest their accounts due to the Volcker Rule.

Passed following the financial crisis of 2008, the Volcker Rule limits banks from making certain types of high-risk investments if such investments are made for their own profit, rather than the profit of their customers.

That means that you can instruct your bank to make a high-risk investment with your own money if you feel like taking a gamble.

However, your bank can't make certain kinds of risky trades with its accounts just to pad its bottom line.

Your money is safe. Even if a bank offering both investment and consumer services were to fold due to mismanaging funds, that doesn't mean all the money in your checking account would necessarily disappear.

That's because the Banking Act of 1933 also created the Federal Deposit Insurance Corporation, or FDIC.

This organization insures each depositor for up to $250,000 per institution for checking, savings, money market accounts, and certificates of deposit.

Any account with money below that amount is safe, even if your bank goes under.

For instance, say you had $20,000 in checking and $100,000 in savings with an FDIC-insured bank.

If that bank went under for any reason, you'd still be able to get all your money back.

What Investment Banks Do

As mentioned earlier, investment banks are mainly financial middlemen and advisors for companies, governments, and other organizations.

Their services can be broken down into a few areas.

Helping private companies go public through IPOs

Companies that want a lot of money fast might issue an IPO if they think it will help them grow and expand.

Investment banks can help these companies decide whether the time and conditions are right for them to become publicly traded on the stock exchange.

Doing the research. One of the first steps an investment bank will take in an IPO is putting together a prospectus.

This is a document that lists information including what a company does, how many shares will be offered, and any risks involved with investing in the company.

The Securities Exchange Commission, or SEC, requires a prospectus to exhibit a high degree of depth, which is why companies seek out help from investment banks.

Getting the price right. Banks also determine how much each share will cost and then underwrite the deal.

Here's an illustration of what that might look like.

After examining a company's financial information and the market, the bank decides on a certain amount of money that people would likely be willing to pay per share.

The bank will buy a set amount of stock at that price and then turn around and sell it on the stock exchange.

For instance, say an investment bank helping take Company X public decides the shares could sell for $15 each.

It buys 100,000 shares at $14 per share, then sells them on the stock exchange for $15.

If all goes well, Company X would raise $1.4 million, while the bank would net $100,000 from the deal.

However, say the bank overestimated how much the public was interested in the company's offering, and the shares dropped in price to $13 each, the bank would lose $100,000 instead.

Finding the right target for mergers and acquisitions

Another option for organizations looking to grow quickly is to buy, or be bought by, another company.

For large deals, many companies will seek to partner with an investment bank. Especially one that specializes in their industry type.

An advisory role. The first step in helping a company with a merger or acquisition is for an investment bank to do a deep dive into that company's financial information.

Value of Investment Banking Fees Worldwide

This will help it determine how much a company is worth and which organizations the bank should approach about the deal.

Buying or selling a company. Most companies will approach an investment bank already with a specific target in mind.

This can be an organization they hope to purchase or be bought by.

The investment bank will then approach that company, lay out their client's offer, and help broker the transaction.

If the purchasing company needs some assistance coming up with the funds to buy their target, the bank may help the buyer generate the necessary cash by issuing bonds.

Bonds let companies take on debt in exchange for cash

Unlike consumer banks that loan money directly to customers, investment banks usually take on a middleman role when it comes to helping their clients borrow cash.

This is done through the issuance bonds.

Raising and selling debt. In a nutshell, bonds are a type of debt that is bought and sold.

The process for issuing bonds is similar to helping a company with an IPO.

An investment bank will do its research, file a prospectus with the SEC, then sell the bonds on the relevant financial markets.

Unlike stocks, bonds don't grant the buyer an ownership stake in the company.

Instead, the buyer will own part of the total debt.

The owner gets paid when the bond comes due, or matures, at a predefined time.

How it works. Here's a simplified example.

Let's say Company X wants to buy Company Y.

Company Y costs $5.4 million, but company X only has $3.2 million.

It contracts an investment bank to help it issue $2.2 million in bonds by underwriting the deal.

The buyer company agrees that it will pay the purchasers of the bonds $3 million total after one year.

After examining the market, the investment bank thinks it can sell these bonds for $2.4 million and agrees to the deal.

If everything goes right, then Company X gets its much-needed funding, the investment bank earns $200,000 from the deal, and the purchasers of the bond earn their share of $600,000 when the bond matures.

However, say Company X goes bankrupt and can't pay back the purchasers of the bonds.

As the underwriter, the bank has to pay back the $3 million itself.

That means they'll end up losing $600,000 on the deal.

Raising capital fast with private placement

Both issuing bonds and IPOs require an investment bank to file a prospectus with the SEC.

That can take a lot of time and effort.

For a faster route to raising money, investment banks can turn to private placements.

No prospectus required. Private placements occur when banks issue bonds to specific investors, rather than to the public.

This could include other banks, insurance companies, or retirement funds.

The SEC believes that these institutional investors generally know what they're doing, better than most people, in fact.

As a result, they place fewer rules and regulations on private placements, which makes them a faster way of raising money.

High-net-worth individuals get the deluxe treatment through private wealth management services

As mentioned earlier, investment banks don't cater to the individual, except in special cases.

Those special cases occur when the individual in question is exceptionally rich.

Wealth management and private banking. If you've got the money, investment banks will gladly help you manage your wealth and finances.

This could include helping reduce your tax burden, providing investment advice and opportunities, and generally putting your money to work for you.

However, some of these services are also fairly ordinary.

For instance, private banking institutions can offer checking and savings accounts, albeit with slightly higher interest rates and employees dedicated to servicing their account.

It takes lots of money. Investment banks have a high bar for the amount of money it takes to be considered a high-net-worth individual.

Goldman Sachs requires its clients to have $10 million in investable assets in order to become a customer of its private banking services.

Similarly, JPMorgan also requires $10 million for its services in this area as well.

Benefits and Drawbacks of Investment Banks

Upon first glance, it wouldn't seem like the fact a financial institution offers investment banking services should affect your decision when choosing a bank.

After all, no one is going to issue bonds or an IPO for themselves or their family.

However, choosing a bank that offers these types of services can come with several pros and cons.

Investment banks usually offer more services than smaller banks

Dealing with corporations, governments, and other institutions requires huge amounts of money.

That means that banks offering both consumer and investment services are typically huge, and so they will often offer several advantages as well.

Multiple services. Most investment banks offer their consumer customers a wide array of products.

Go with a bank like Wells Fargo, and you can get your credit card, checking and savings account, IRA, and other services all in one place.

Meanwhile, a local bank or credit union may only cover the basics like checking and savings accounts, mortgages, and auto loans.

Many locations. The nature of investment banking almost requires these banks to have locations all over the globe.

To generate the greatest returns for their clients and compete against other banks, they have to be plugged directly into the world's most important markets, like in Tokyo, Singapore, New York, and other financial hubs.

As a result, you probably won't struggle to find a branch if you choose something like Citi as your bank.

Drawbacks of investment bank can include lower interest rates

The fact that most investment banks are so big comes with a set of disadvantages.

It's riskier. Investment banks are involved in bigger deals and therefore take on bigger risks.

After all, a financial institution underwriting a $5 billion-dollar IPO is going to be taking on a larger risk than a credit union that's only issuing auto and home loans.

This probably isn't that big of a risk for those with under $250,000 in an FDIC-insured account.

It's also not likely that we'll experience massive bank failures any time soon.

However, the riskier nature of choosing an investment bank is still something to consider.

Higher interest rates for loans. Investment banks are for-profit institutions.

Global Market Share of Revenue of Leading Investment Banks

That means they're trying to make the most money possible when setting their interest rates for mortgages and other loans.

Meanwhile, choosing a not-for-profit credit union can mean you get a much lower interest rate on these products compared to a large financial institution.

Worse customer service. Again, investment banks are huge.

That means reaching out for help usually involves speaking with a random person at a call center, rather than speaking with someone who knows your name and needs.

Choosing a smaller financial institution can often result in building up a more personalized connection with tellers, advisers, and other employees that get to know you over time.

Investment banks focus on corporations over people

In a nutshell, investment banks help corporations and governments get the money they need.

That means, unless you are a corporation, you shouldn't count on big names like Bank of America or Credit Suisse to help you issue a bond when you need some cash.

Many large banks offer both consumer and investment banking services, though these are usually riskier and can't always provide you the best deal as an individual customer.

My thoughts on investment banks. Personally, I think investment banks are a huge help to many industries.

They've helped companies like Facebook, Google, and Tesla raise the money they needed to provide world-changing services.

However, seeing the way investment banks played a role in the 2008 financial crisis showed what can happen when these companies fail to provide their services responsibly.

That's the big-picture view, both the good and the bad.

Getting personal. The more detailed view is that most investment banking services shouldn't affect how you make financial decisions, like getting a loan.

I know the importance of being able to get money when you need it.

If your car breaks down, and you need immediate funds to get it repaired so you have a way to get to work, investment banking services really can't help you.

But a personal loan can.

That's why I started over 15 years ago, and it still exists today, to help consumers when unexpected financial needs arise.

Your choice. Investment banks play an important role in the world's economy by brokering deals and making mergers and IPOs happen for businesses and large corporations.

But for you as a consumer, the decision to go with a bank that offers investment services in addition to consumer options ultimately comes down to preference.

If you're looking for a multinational bank with a wide array of wealth-management services, then going the investment banking route could be a great option for you.

If you want lower interest rates, better customer service, and a more personal connection with your bank, you should consider credit unions or local commercial banks.

Have you ever used an investment bank?

Are you considering it?

Let us know what you think in the comments below!

Learn More About Banking

Learn More About Banking

  • Get help navigating complicated consumer finance issues
  • Increase your credit level
  • Accomplish your financial goals

Leave a Comment