What is Investment Banking?

May 22, 2023
Investment banking is a sector within the financial industry that specializes in raising capital and managing the combination of two entities. Their services typically include the underwriting of new equities, financing of debt, and facilitation of mergers and acquisitions (M&As). Investment banking is a very lucrative business, and its clients are generally major organizations such as corporations, governments, and other institutions.

Investment banking should not be confused with investment management. Investment managers work with clients (both individuals and organizations) to invest their assets and grow their portfolios.  While some banks within the financial industry provide both investment banking and investment management services, it’s important to understand the difference between the two.

What Do Investment Banks Do?

Essentially, investment bankers act as advisors and intermediaries. When it comes to issuing new debt or equities, they serve as the middlemen between the organization and its investors. They can also provide guidance and assist in the restructuring of companies that wish to buy one another or merge into a single entity.

Here is a closer look at each of these services.

Underwriting Initial Public Offerings (IPOs)

An initial public offering (IPO) is when a private company decides to issue new stock and sell them to the general public. In the news, you’ll often hear this referred to as “going public” because anyone can buy these equities in the open stock market and become a partial owner of the business. Companies frequently make this transition from private to public because it can provide them with a large influx of capital from investors which then helps them to grow.

To protect the public and avoid scams, companies in the U.S. must meet several stringent requirements set by the Securities and Exchange Commission (SEC) before they can hold an IPO. In addition to these rules being complex, the company also risks potential failure if they over-value or under-value the price of these new stock shares. Hence, this is where investment banking can be of service.

Investment bankers will know how to arrange the IPO so that it complies with SEC requirements. At the same time, their involvement can also be to become a proxy for the IPO itself. The investment bank will underwrite (i.e., access the health and risk of the company) and make a recommendation for the price of the new shares. They will then often buy all or the majority of the company’s shares directly and then resell them at a higher price.

For example, let’s assume a company wants to issue ten million new shares of stock. The investment bank values them at $50 and buys them all. They next turn around and sell them for $52 per share in the open market. If all of the shares are sold, then the investment bank will make $2 per share or $20 million from the deal (before advisory fees).

One of the most famous IPOs in recent years was Facebook in 2012. They offered 421,233,615 shares at a price of $38 per share. The IPO raised $16 billion and was considered to be a record-breaking deal at the time. Morgan Stanley and several other big investment banks that underwrote the IPO made an estimated $100 million in profits.

Debt Financing

Another way that organizations can raise the capital they need is to borrow money. Borrowing money is less restrictive than issuing new equities because it does not involve the transfer of ownership or relinquishing control over business decisions.

Investment banks will help the organization shop around for the best deal and secure the financing they seek. Similar to any other loan, the organization will then agree to pay back the money over time with interest. For its role in this transaction, the investment bank will collect an advisory fee.

Mergers and Acquisitions (M&A)

Mergers and acquisitions are the consolidation of the financial assets of two or more companies.

  • In a merger, generally two companies will combine for strategic reasons. An example of a merger is when Exxon and Mobil united to become Exxon Mobil in 1998.
  • In an acquisition, one company will buy another with the purpose of expanding its revenue potential. An example of an acquisition is when Disney bought Marvel for $4 billion back in 2009.

Due to the complex nature of these deals, investment bankers will serve as advisors in M&As. They will consult the companies and help ensure that they stay compliant with antitrust laws, securities regulations, corporate law, tax implications, accounting issues, etc.

Commercial vs Investment Banking

Investment banks are not the same as commercial banks. Also known as retail bankers, these types of financial institutions hold the deposits of individuals and businesses and offer them the ability to write checks. They also provide their clients with loans and investment services.

Before the Great Depression of 1929, investment bankers and commercial bankers could be the same thing. Some historians attribute the stock market crash that ended the Roaring 20s to the banks of the time overleveraging the risk involved with diverting retail depositors' funds into speculative operations. Additionally, it's arguable that there could be bias involved with the recommendation of these new equities to its retail investors by the bank which is also responsible for underwriting its IPO and assigning a valuation.

As a result, the Glass-Steagall Act was passed in 1933 which legally split commercial and investment banking activities. For over sixty years, it was believed that the separation would lead to a healthier financial system. However, the banks continued to challenge the authority of Glass-Steagall blurring the lines between banking and securities activities. Eventually, Congress repealed the Glass-Steagall Act in 1999.

Who are Investment Banks?

Many investment banks are over one hundred years old and well-known household names. Some of the most prominent ones include:

  • BofA Securities (formerly Bank of America Merrill Lynch)
  • Credit Suisse
  • Deutsche Bank
  • Goldman Sachs
  • JPMorgan Chase
  • Morgan Stanley

Who Can Have a Career as an Investment Banker?

Investment banking is often a highly sought-after career by many in the financial industry. Though it often requires long work hours and can be stressful, the pay may be substantially higher than in alternative fields. Entry-level professionals can reportedly earn between $150,000 and $200,000 per year.

Graduates who are interested in becoming investment bankers must adhere to the following:

  • Education - Most investment banks require applicants to have a bachelor’s degree, preferably in finance. Higher-level positions often require an MBA (Master of Business Administration).
  • Certifications - Depending on their role within the organization, investment bankers may also need to pass certain certification requirements. These may include certified public accountant (CPA) or financial risk management (FRM) certifications.
  • Licensing - Due to the intense nature of government regulations, investment bankers also must meet licensing requirements facilitated by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC).

The Bottom Line

Investment banking is a field of finance that focuses on raising and facilitating the consolidation of companies, governments, and other entities. Their most common function is the underwriting of IPOs and providing advisory services in M&As. By acting as the middleman to bridge the gap between an organization and its goals, the investment bank helps them to ensure they are compliant with all the latest SEC regulations and laws.