An investment bank, which includes Bank of America, JPMorgan Chase, and Goldman Sachs, finances or facilitates large-scale transactions and investments for institutional clients. But that’s an overly simplistic view of how investment banks make money. There are, in fact, many facets to what they do.
Key points to remember
- Investment banks provide a variety of financial services, including research, trading, underwriting, and advice on mergers and acquisitions.
- Proprietary trading is an effort to make a profit by trading a company’s own capital.
- Investment banks receive commissions and fees on the subscription of new issues of securities through bond offerings or stock IPOs.
- Investment banks also often serve as asset managers for their clients.
Brokerage and underwriting services
Like traditional intermediaries, large investment banks connect buyers and sellers in different markets. For this service, they charge a commission on the transactions. Transactions range from simple stock market transactions for small investors to large blocks of transactions for large financial institutions.
Investment banks also provide underwriting services when companies need to raise capital. For example, a bank can buy shares as part of an initial public offering (IPO) and then market the shares to investors. There is a risk that the bank will not be able to sell the shares at a higher price, so that the investment bank could lose money on the IPO. To combat this risk, some investment banks charge a fixed fee for the underwriting process.
Mergers and Acquisitions
Investment banks charge a fee for acting as advisers for spin-offs and mergers and acquisitions (M&A). In a spin-off, the target company sells part of its operation to improve efficiency or to inject cash. On the other hand, acquisitions happen every time a business buys another business. Mergers take place when two companies combine to form a single entity. These are often complicated deals that require a lot of legal and financial help, especially for companies unfamiliar with the process.
Creation of guaranteed products
Investment banks can take many small loans, such as mortgages, and then consolidate them into one security. The concept is somewhat similar to that of a bond mutual fund, except that the guaranteed instrument is a collection of smaller debt securities rather than corporate and government bonds. Investment banks have to buy the loans to package them and sell them, so they try to profit by buying low and selling higher in the market.
With proprietary trading, the investment bank deploys its own capital in the financial markets. Traders who risk the capital of the business are usually paid based on performance, those who succeed earn large bonuses, and traders who fail lose their jobs. Trading on account is much less common since new regulations were imposed after the financial crisis of 2007-2008.
Suppose an institutional investor wants to sell millions of stocks, a size large enough to have an immediate impact on the markets. Other investors in the market might see the big order opening up the possibility for an aggressive trader with high speed technology to initiate the sell with the aim of profiting from the coming move. Investment banks have set up dark pools to lure institutional sellers into secret and anonymous markets in order to prevent the race to the forefront. The bank charges a fee for the service.
Investment bankers sometimes make money with swaps. Swaps create profit opportunities through a complicated form of arbitrage, where the investment bank negotiates an agreement between two parties who negotiate their respective cash flows. The most common swaps occur whenever two parties realize that they could mutually benefit from a change in a benchmark, such as interest rates or currency exchange rates.
Investment banks often have market-making operations designed to generate income by providing liquidity in stocks or other markets. A market maker posts a quote (buy price and sell price) and gets a small difference between the two prices, also known as the bid-ask spread.
Large investment banks may also sell research direct to financial specialists. Fund managers often buy research from large institutions, such as JPMorgan Chase and Goldman Sachs, to make better investment decisions.
In other cases, investment banks serve directly as asset managers for large clients. The bank may have internal fund departments, including internal hedge funds, which often come with attractive fee structures. Asset management can be quite lucrative because client portfolios are large.
Finally, investment banks sometimes team up or create venture capital or private equity funds to raise funds and invest in private assets. The idea is to buy a promising target company, often with a lot of leverage, and then resell or take the company public once it becomes more valuable.
The bottom line
In a capitalist economy, investment bankers play a role in helping their clients raise capital to finance various activities and develop their businesses. They are financial advisory intermediaries who help assess capital and allocate it to various uses.
While this activity helps smooth the cogs of capitalism, the role of investment bankers has come under scrutiny as some complain that they are overpaid for the services they provide.