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| © Dmitry Demidko / Unsplash |
By Joshua Kennon, The Balance
An investment bank is a large financial institution that works primarily in high finance. They help companies access capital markets—like stock and bond markets—which helps corporations raise money for expansion or other needs.
Learn more about investment banks, how they work, and their role in financial markets.
What Is an Investment Bank?
An investment bank is a special type of financial institution that aims to help companies access capital markets to raise money and take care of other business needs. A typical investment bank will engage in some or all of the following activities:- Raise equity capital
- Raise debt capital
- Insure bonds or launching new products
- Engage in proprietary trading where teams of in-house money managers invest or trade the company's own money for its private account
For example, if Coca-Cola Enterprises wanted to sell $10 billion worth of bonds to build new bottling plants in Asia, an investment bank would help it find buyers for the bonds and handle the paperwork, along with a team of lawyers and accountants. Investment banks can also be involved in initial public offerings (IPOs) when a private market goes public and lists one of the exchanges.
How Investment Banks Work
Investment banks are often divided into two camps, the buy-side and sell-side, but many offer both buy-side and sell-side services. The sell-side typically refers to selling shares of newly issued IPOs, placing new bond issues, engaging in market-making services, or helping clients facilitate transactions.In contrast, the buy-side works with pension funds, mutual funds, hedge funds, and the investing public to help them maximize their returns when trading or investing in securities such as stocks and bonds.
Many investment banks are divided into three divisions, based on the services provided and the employees' responsibilities:
- Front office
- Middle office
- Back-office
Front office services typically consist of the following:
- Helping companies in mergers and acquisitions
- Corporate finance (such as issuing billions of dollars in commercial paper to help fund day-to-day operations)
- Professional investment management for institutions or high net worth individuals
- Merchant banking
- Investment and capital market research reports prepared by professional analysts
- Strategy formulation
Middle office investment banking services include compliance with government regulations and restrictions for professional clients such as banks, insurance companies, and finance divisions, as well as capital flows.
These are the people who watch the money coming into and out of the firm to determine the amount of liquidity the company needs to keep on hand so that it doesn't get into financial trouble. The team in charge of capital flows can use that information to restrict trades by reducing the buying and trading power available for other divisions.
The back-office services include the nuts and bolts of the investment bank. It handles things such as:
- Ensuring that the correct securities are bought, sold, and settled for the correct amounts
- Making sure the software and technology platforms that allow traders to do their jobs are state-of-the-art and functional
- Creating new trading algorithms
Note: The back-office jobs are often considered unglamorous, and some investment banks outsource to specialty shops such as custodial companies. Nevertheless, they allow the whole thing to run. Without them, nothing else would be possible.
Investment Banks vs. Commercial Banks
| Investment Bank | Commercial Bank |
| Doesn't accept deposits | Accepts deposits |
| Doesn't provide loans | Provides loans |
| Targets larger corporations and high net worth individuals | Targets all consumers, small to large size corporations, and governments. |
| Regulated by the country's security agency | Regulated by the country's central bank |
Until recent decades, investment banks in the United States were not allowed to be part of a larger commercial bank because the activities, although extremely profitable if managed well, posed far more risk than the traditional lending of money done by commercial banks.
Key Takeaways
- Investment banks help corporations access capital markets.
- Companies use investment banks for their initial public offerings (IPOs).
- Investment banks typically handle a company's merger or acquisitions.
- Commercial banks focus on deposits and loans; investment banks don't.
See more at The Balance
