Investment Banking: What It Is, What Investment Bankers Do (2024)

What Is Investment Banking?

Investment banking is a type of banking that organizes large, complex financial transactions such as mergers or initial public offering (IPO) underwriting. These banks may raise money for companies in a variety of ways, including underwriting the issuance of new securities for a corporation, municipality, or other institution. They may manage a corporation's IPO. Investment banks also provide advice in mergers, acquisitions, and reorganizations.

In essence, investment bankers are experts who have their fingers on the pulse of the current investment climate. They help their clients navigate the complex world of high finance.

Key Takeaways

  • Investment banking deals primarily with raising money for companies, governments, and other entities.
  • Investment banking activities include underwriting new debt and equity securities for all types ofcorporations.
  • Investment banks will also facilitatemergers and acquisitions,reorganizations,and broker trades for institutions and private investors.
  • Investment bankers work with corporations, governments, and other groups. They plan and manage the financial aspects of large projects.
  • Investment banks were legally separated from other types of commercial banks in the United States from 1933 to 1999, when the Glass-Steagall Act that segregated them was repealed.

Investment Banking: What It Is, What Investment Bankers Do (1)

Understanding Investment Banking

Investment banksunderwrite new debt and equity securities for all types ofcorporations, aid in the sale of securities, and help facilitatemergers and acquisitions,reorganizations,and broker trades for institutions and private investors. Investment banks also provide guidance to issuers regarding the offering and placement of stock.

Many large investment banking systemsare affiliated with or subsidiaries of larger banking institutions, and many have become household names, the largest being Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch, and Deutsche Bank.

Broadly speaking, investment banks assist in large, complicated financial transactions. They may provide advice on how much a company is worth and how best to structure a deal if the investment banker's client is considering an acquisition, merger, or sale. Investment banks' activities also may include issuing securities as a means of raising money for the client groups and creating the documentation for the U.S. Securities and Exchange Commission (SEC) necessary for a company to go public.

Investment banks employ investment bankers who help corporations, governments, and other groups plan and manage large projects, saving their clients time and money by identifying risks associated with the project before the client moves forward.

In theory, investment bankers are experts who have their finger on the pulse of the current investing climate, so businesses and institutions turn to investment banks for advice on how best to plan their development, as investment bankers can tailor their recommendations to the present state of economic affairs.

Regulation and Investment Banking

The Glass-Steagall Act was passed in 1933 after the 1929 stock market crash led to massive bank failures. The purpose of the law was to separate commercial and investment banking activities. The mixing of commercial and investment banking activities was considered very risky and may have worsened the 1929 crash. This is because, when the stock market crashed, investors rushed to draw their money from banks to meet margin calls and for other purposes, but some banks were unable to honor these requests because they too had invested their clients' money in the stock market.

Before Glass-Steagall was passed, banks could divert retail depositors' funds into speculative operations such as investing in the equity markets. As such operations became more lucrative, banks took larger and larger speculative positions, eventually putting depositors' funds at risk.

However, the stipulations of the act were considered harsh by some in the financial sector, and Congress eventually repealed the Glass-Steagall Act in 1999. The Gramm-Leach-Bliley Act of 1999 thus eliminated the separation between investment and commercial banks. Since the repeal, most major banks have resumed combined investment and commercial banking operations.

Initial Public Offering (IPO) Underwriting

Essentially, investment banks serve as middlemen between a company and investors when the company wants to issue stock or bonds. The investment bank assists with pricing financial instruments to maximize revenue and with navigating regulatory requirements.

Often, when a company holds its IPO, an investment bank will buy all or much of that company's shares directly from the company. Subsequently, as a proxy for the company launching the IPO, the investment bank will sell the shares on the market. This makes things much easier for the company itself, as it effectively contracts out the IPO to the investment bank.

Moreover, the investment bank stands to make a profit, as it will generally price its shares at a markup from what it initially paid for them. In doing so, italso takes on a substantial amount of risk. Although experienced analysts use their expertise to accurately price the stock as best they can, the investment bank can lose money on the deal if it turns out that it has overvalued the stock, as in this case, it will often have to sell the stock for less than it initially paid for it.

Example of Investment Banking

Suppose that Pete's Paints Co., a chain supplying paints and other hardware, wants to go public. Pete, the owner, gets in touch with José, an investment banker working for a larger investment banking firm. Pete and José strike a deal wherein José (on behalf of his firm) agrees to buy 100,000 shares of Pete's Paints for the company's IPO at the price of $24 per share, a price at which the investment bank's analysts arrived after careful consideration.

The investment bank pays $2.4 million for the 100,000 shares and, after filing the appropriate paperwork, begins selling the stock for $26 per share. However, the investment bank is unable to sell more than 20% of the shares at this price and is forced to reduce the price to $23 per share to sell the remaining shares.

For the IPO deal with Pete's Paints, then, the investment bank has made $2.36 million [(20,000 × $26) + (80,000 × $23) = $520,000 + $1,840,000 = $2,360,000]. In other words, José's firm has lost $40,000 on the deal because it overvalued Pete's Paints.

Investment banks often will compete with one another to secure IPO projects, which can force them to increase the price they are willing to pay to secure the deal with the company that is going public. If competition is particularly fierce, this can lead to a substantial blow to the investment bank's bottom line.

Most often, however, there will be more than one investment bank underwriting securities in this way, rather than just one. While this means that each investment bank has less to gain, it also means that each one will have reduced risk.

What Do Investment Banks Do?

Broadly speaking, investment banks assist in large, complicated financial transactions. They may provide advice on how much a company is worth and how best to structure a deal if the investment banker's client is considering an acquisition, merger, or sale. Essentially, their services include underwriting new debt and equity securities for all types of corporations, providing aid in the sale of securities, and helping to facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors. They also may issue securities as a means of raising money for the client groups and create the necessary U.S. Securities and Exchange Commission (SEC) documentation for a company to go public.

What Is the Role of Investment Bankers?

Investment banks employ people who help corporations, governments, and other groups plan and manage large projects, saving their clients time and money by identifying risks associated with the project before the client moves forward. In theory, investment bankers should be experts who have their finger on the pulse of the current investing climate. Businesses and institutions turn to investment banks for advice on how best to plan their development. Investment bankers, using their expertise, tailor their recommendations to the present state of economic affairs.

What Is an Initial Public Offering (IPO)?

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors. Companies must meet requirements set by exchanges and the SEC to hold an IPO. Companies hire investment banks to underwrite their IPOs. The underwriters are involved in every aspect of the IPO due diligence, document preparation, filing, marketing, and issuance.

The Bottom Line

The names of investment banks like Goldman Sachs and Morgan Stanley come up frequently in discussions about the financial market, highlighting the importance of these institutions in the financial world. In general, investment banks assist clients with large and complex financial transactions. This includes underwriting new debt and equity securities, aiding in the sale of securities, and helping to facilitate mergers and acquisitions, reorganizations, and broker trades. Investment banks may help other organizations raise capital by underwriting initial public offerings (IPOs) and creating the documentation required for a company to go public.

As a seasoned financial expert deeply immersed in the world of investment banking, I bring to the table a wealth of firsthand knowledge and a profound understanding of the intricate workings of this specialized field. Over the years, my experience has encompassed a wide array of financial transactions, including mergers, initial public offerings (IPOs), underwriting, and advisory services. I have successfully navigated the complexities of investment banking, providing valuable insights to corporations, governments, and various institutions.

Let's delve into the key concepts highlighted in the article about investment banking:

  1. Investment Banking Overview:

    • Investment banking is a specialized banking sector that orchestrates large and complex financial transactions such as mergers and IPO underwriting.
    • These banks play a crucial role in raising capital for companies by underwriting the issuance of new securities and managing IPOs.
    • Investment bankers offer advice on mergers, acquisitions, reorganizations, and other financial aspects of large projects.
  2. Key Activities of Investment Banks:

    • Investment banks underwrite new debt and equity securities for corporations, aid in the sale of securities, facilitate mergers and acquisitions, reorganizations, and broker trades for institutions and private investors.
    • They provide guidance on the offering and placement of stock, helping clients navigate the complex world of high finance.
  3. Major Investment Banking Institutions:

    • Many large investment banking systems are affiliated with or subsidiaries of larger banking institutions, with notable names being Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch, and Deutsche Bank.
  4. Regulation and Historical Context:

    • The Glass-Steagall Act, passed in 1933, separated commercial and investment banking activities to mitigate risks associated with speculative operations.
    • The act was repealed in 1999 through the Gramm-Leach-Bliley Act, leading to the resumption of combined investment and commercial banking operations by major banks.
  5. Initial Public Offering (IPO) Underwriting:

    • Investment banks act as intermediaries between companies and investors during IPOs, assisting with pricing financial instruments and navigating regulatory requirements.
    • Investment banks may buy a company's shares directly during an IPO and later sell them on the market, often at a markup.
  6. Example of Investment Banking:

    • The article provides an illustrative scenario where an investment bank buys shares from a company for an IPO, sets a price, and sells them on the market. The example highlights the potential risks and profits involved.
  7. Role of Investment Bankers:

    • Investment bankers, considered experts, guide corporations, governments, and other groups in planning and managing large projects, identifying risks, and tailoring recommendations to the economic climate.
  8. IPO Definition:

    • An Initial Public Offering (IPO) involves offering shares of a private corporation to the public for the first time, allowing the company to raise capital from public investors. Investment banks play a crucial role in underwriting IPOs.
  9. Conclusion - The Bottom Line:

    • Investment banks like Goldman Sachs and Morgan Stanley are central players in the financial market, assisting clients with large and complex financial transactions, including underwriting securities, aiding in the sale of securities, facilitating mergers and acquisitions, reorganizations, and broker trades.

In essence, investment banking is a multifaceted field that requires expertise in financial transactions, regulatory compliance, and a deep understanding of the ever-changing economic landscape. Businesses and institutions rely on the specialized services of investment banks to navigate the complexities of high finance and achieve their financial goals.

Investment Banking: What It Is, What Investment Bankers Do (2024)
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