What is an Investment Bank and How Does it Work?
A slew of companies are coming out with IPOs. Each of these has over 500 paged-prospectus with details of the company’s valuation, industry analysis, and competitor analysis, among other calculations. Ever wondered who was behind it? Investment bankers.
Before we delve into what is investment bank, let’s know what it entails.
Investment banks entail a specialized segment of banking operations that deal with raising funds for organisations and individuals and offering ancillary services. This can include financial services, advisory services and proprietary trading.
In order to understand the intricacies of investment banking, let’s understand what an investment bank is and how it operates.
What is an Investment Bank?
An investment bank is a financial institution that assumes the role of an intermediary in elaborate and big-ticket monetary transactions. These include IPOs, mergers and acquisitions, liquidation and even a take-over. These entities also act as financial advisors or brokers for large institutional clients.
Therefore, investment banks help businesses to raise funds via capital markets. Typically, they facilitate:
- Raising capital debt
- Acquiring equity capital
- Insuring bonds
- Launching new products
A few notable investment banks include Morgan Stanley, JPMorgan Chase, Credit Suisse, Citigroup, Goldman Sachs, Deutsche Bank, and the Bank of America.
In India, some of the leading investment banks include Avendus Capital, IDBI Capital, Edelweiss Financial Services Limited, JM Financial Institutions Securities, and MAPE Capital Advisors.
How Do Investment Banks Differ from Commercial Banks?
To understand what investment banking is, one must be able to distinguish investment banks from commercial banks. The table below highlights the key differences between these two financial institutions:
| Basis of Comparison | Commercial Banks | Investment Banks |
| Meaning | Commercial banks are financial institutions that offer services such as lending money, accepting deposits, and making payments on standing orders. | Investment banks are those financial institutions that provide brokerage services and underwriting of securities, among others. |
| Type of service | Standardised services | Client-specific services |
| Customer base | Millions of customers | A few hundred clients |
| Key role | Enable a country’s demand for credit and economic growth. | Facilitate the performance of a nation’s financial market. |
| Type of clientele | Caters to all citizens | Offers services to corporations, individuals, as well as Governments |
| Means of income generations | Fees and interests | Commissions, fees, and profit from trading activities |
| Services offered (primary) | Mortgaging loans, lending, and allowing deposits | Buying and selling of stocks and bonds |
| Services offered (secondary) | Issuing promissory notes, overdrafts, internet banking, locker facilities, card facilities, mobile banking, etc. | Asset management, raising funds, brokerage services, underwriting of securities advisory services, mergers and acquisitions, etc. |
How Does an Investment Bank Work?
Investment banks can be categorised into two:
- Sell-side
- Buy-side
The sell-side engages in selling the shares of freshly issued IPOs, market-making services, placing new bond issues, and assisting clients with transactions.
On the other hand, the buy-side is involved in trading securities, such as bonds and stocks, with a goal to maximise returns. It works alongside mutual funds, pension funds, and hedge funds.
Let us understand better with an example.
Let’s say a company XYZ is buying its competitor ABC. But, XYZ is unable to determine the actual worth of ABC. XYZ also wants to know the future prospects post the acquisition.
So this is where investment bankers step in. XYZ approaches an investment bank not only for advisory but to handle the entire transaction. Starting with an analysis of ABC, arriving at valuation, competitor analysis and future growth.
The investment bank, thereafter, will undertake the entire process. Further, it will contribute towards settling this deal by assisting XYZ with the required paperwork. It will also suggest an appropriate time for the deal to take place.
Also, one must note that in this example, the investment bank is working on the buy-side. There will be other investment banks that are involved on the sell-side in the same transaction.
The bigger the deal size is, the higher the commission for investment banks.
Investment banks play a critical role in helping various organisations obtain capital financing and make educated financial decisions. They also analyse the financials of the companies to help in future decisions of their clients.
Based on this information, they create a statement on a company’s plans to utilise proceeds. An investment bank plugs in the gap that usually exists between investors and large corporations.
You may also want to know How Do Banks Make Money?
Segmentation of an Investment Bank
One can further divide an investment bank into divisions based on services offered:
- Back Office
- Front Office
- Middle Office
Back-office Services
- Ensuring the functioning of the software and other platforms for traders.
- Making sure that the right securities are sold, bought, or settled for an adequate amount.
- Developing new trading algorithms.
Front Office Services
- Assisting corporations with mergers and acquisitions.
- Professional management of investments for high net-worth individuals and institutions.
- Formulation of strategy.
- Capital market research and analysis.
- Corporate finance.
Middle Office Services
- Ensuring capital flow.
- Adherence to Government regulations and restrictions.
Summing Up
So this was all about the role of investment banks and how they really work. We hope you got a clear understanding of the same and understood how investment banks differ from commercial banks based on several criteria.
Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.