What do Investment Banks Actually Do? 5 Ways Investment Banks Make Money
Your Complete Guide to Investment Banking: What are they? How do IB's make money? What role do they play?
Morning Tendies
April 12, 2023
When I say investment banking, what do you think of?
Finance Bros? Patagonia Vests? 80-Hour Workweeks?
Spot on. Kinda.
So what is it?
Let’s lift up the curtain and uncover one of the most mysterious financial institutions there is.
After reading this article, you’ll be able to answer these questions:
What Are Investment Banks?
How Do Investment Banks Make Money?
What Role Do Investment Banks Play?
What Are Investment Banks?
By dictionary definition, investment banks are described as “a bank that provides financial services for corporations and institutional customers”.
Well, that’s vague.
Here’s how we describe them:
Investment banks are financial institutions that provide a wide variety of financial services. The majority of profits for IB’s come from earning commissions and fees on the services they provide to their customers.
Still kinda vague. Let’s just get into it
5 Ways Investment Banks Make Money
1. Market Making
Market making involves creating a secondary market in an asset. Market making can involve either agency or principal transactions.
Agency transactions: Two-way transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee or commission.
Ex. On the Nasdaq, a market maker in a stock such as Tsla receives an order from one customer for $190 then immediately resells it at $191 to another customer. The $1 difference between the buy and sell price is typically called the “bid-ask spread” and represents a large portion of the market maker’s profit.
Principal Transactions: The market maker seeks to profit on the price movement of securities and takes one of three positions for its own account.
Long: Purchase of a security or derivative with the expectation it will rise in value
Short: Sale of a security first with the intention of repurchasing (or covering) it later at a lower price
Inventory: Position taken to stabilize the market in the securities
Market making is an extremely profitable business, but in times of market stress or high volatility these profits can rapidly disappear.
2. Investing
Investing is probably the most straight-forward and easy to understand function of investment banks.
Investing for investing banks involves managing pools of assets such as mutual funds, pension funds, etc.
The primary objective in funds management is to choose asset allocation to beat some return-risk performance benchmark such as the S&P 500. This business also generates fees based on the size of the pool of assets managed, so it tends to generate a more stable flow of income than traditional investment banking or trading (discussed later on).
3. Trading
Trading is closely related to market-making activities, where a trader takes an active position in an underlying financial instrument.
There are at least four types of trading activities:
Position trading: Purchasing large blocks of securities on the expectation of a favorable price move.
Pure arbitrage: Buying an asset in one market at one price and immediately selling it in another market at a higher price.
Risk arbitrage: Buying blocks of securities in anticipation of some information release, such as a merger, Federal Reserve announcement, etc.
Program trading: Program trading is defined by the NYSE as the purchase or sale of a portfolio of at least 15 different stocks valued at more than $1 million. This type of trading is done by computer-generated algorithms.
Trading can be conducted on behalf of a customer as an agent, or on behalf of the firm as a principal.
4. Investment Banking
An Investment bank is an institution that has full line of service - primary and secondary.
Investment bank’s role can differ based on the market they are operating in.
What do I mean by this?
Primary Market: An Investment bank facilitates financial transactions such as IPO’s and seasoned security Issuance.
Secondary Market: Assisting in the trading of existing securities, investing, and cash management.
One of the major businesses of investment banks is underwriting.
What is underwriting?
Underwriting typically takes place in the primary market and is the assistance in the issue of new securities for a fee.
What are the roles played by IB’s in the process of a security issue?
Help a firm file registrations documents
Due-diligence, prepare prospectus
Determine offer price, offer size
Stabilize price after trading
Provide analyst coverage
5. Mergers and Acquisitions
Investment banks are often involved in providing advice or assisting in mergers and acquisitions.
What does this assistance look like?
Investment banks can offer their help in ways such as:
Assist in finding merger partners
Underwriting new securities to be issued by the merged firms
Assessing the value of target firms
Recommending terms within the merger agreement
Investment banks can provide services for either the buyer or the seller.
What Role Do Investment Banks Play?
IB’s operate in many different areas within the world of finance.
As you just read, some of the different areas include:
Market Making
Investing
Trading
Traditional Investment Banking
Mergers and Acquisitions
However, investment banks are not limited to just these functions. Investment banks can also provide other services such as small business lending, escrow services, clearance and settlement services, and other research and advisory services.
Some of the largest investment banks include:
JPMorgan Chase
Goldman Sachs
Bank of America Securities
Morgan Stanley
Citigroup
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