Investment banking is an advisory-based financial service primarily for corporations, governments, and institutional investors. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client's agent in the issuance of debt or equity securities. An investment bank may also provide services to companies involved in mergers and acquisitions (M&A). These services may include market making, trading of derivatives and equity securities, FICC services (fixed income instruments, currencies, and commodities), or research (macroeconomic, credit, or equity research). Most investment banks maintain prime brokerage and asset management departments alongside their investment research businesses. The industry is broken into the Bulge Bracket (upper tier), Middle Market (mid-level businesses), and boutique market (specialized businesses).
Unlike commercial banks and retail banks, investment banks do not take deposits. The revenue model of an investment bank comes mostly from the collection of fees for advising on a transaction, contrary to a commercial or retail bank. From the passage of Glass–Steagall Act in 1933 until its repeal in 1999 by the Gramm–Leach–Bliley Act, the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G7 countries, have historically not maintained such a separation. As part of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank Act of 2010), the Volcker Rule requires some institutional separation of investment banking services from commercial banking.
All investment banking activity is classed as either "sell side" or "buy side". The "sell side" involves trading securities for cash or for other securities (e.g., facilitating transactions, market-making), or the promotion of securities (e.g., underwriting, research, etc.). The "buy side" involves the provision of advice to institutions that buy investment services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the most common types of buy-side entities.
An investment bank can also be split into private and public functions with a screen separating the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas, such as stock analysis, deal with public information. An advisor who provides investment banking services in the United States must be a licensed broker-dealer and subject to U.S. Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulation.
History Early history The Dutch East India Company was the first company to issue bonds and shares of stock to the general public. It was also the first publicly traded company, being the first company to be publicly listed. The activity of investment banking derived from merchant banks, who financed global trade ventures and were underwriting (putting their name under) large shipping projects to finance them. Most of this underwriting activity took place at Lloyd's Coffee House in London. This eventually became Lloyd's of London, the global insurer and place to pool insurance for unusual risks.
Further developments
Investment banking has changed over the years, beginning as a partnership firm focused on underwriting security issuance, i.e., initial public offerings (IPOs) and secondary market offerings, brokerage, and mergers and acquisitions, and evolving into a "full-service" range including securities research, proprietary trading, and investment management. In the 21st century, the SEC filings of the major independent investment banks such as Goldman Sachs and Morgan Stanley reflect three product segments: investment banking (mergers and acquisitions, advisory services, and securities underwriting), asset management (sponsored investment funds), and trading and principal investments (broker-dealer activities, including proprietary trading ("dealer" transactions) and brokerage trading ("broker" transactions)).
In the United States, commercial banking and investment banking were separated by the Glass–Steagall Act, which was repealed in 1999. The repeal led to more "universal banks" offering an even greater range of services. Many large commercial banks have therefore developed investment banking divisions through acquisitions and hiring. Notable full-service investment banks with a significant investment banking division (IBD) include JPMorgan Chase, Bank of America, Citigroup, Deutsche Bank, UBS (Acquired Credit Suisse), and Barclays.
After the 2008 financial crisis and the subsequent passage of the Dodd-Frank Act of 2010, regulations have limited certain investment banking operations, notably with the Volcker Rule's restrictions on proprietary trading.
The traditional service of underwriting security issues has declined as a percentage of revenue. As far back as 1960, 70% of Merrill Lynch's revenue was derived from transaction commissions while "traditional investment banking" services accounted for 5%. However, Merrill Lynch was a relatively "retail-focused" firm with a large brokerage network.
Organizational structure
Core investment banking activities Investment banking is split into front office, middle office, and back office activities. While large service investment banks offer all lines of business, both "sell side" and "buy side", smaller sell-side advisory firms such as boutique investment banks and small broker-dealers focus on niche segments within investment banking and sales/trading/research, respectively.
For example, Evercore (NYSE:EVR) acquired ISI International Strategy & Investment (ISI) in 2014 to expand their revenue into research-driven equity sales and trading.
Investment banks offer services to both corporations issuing securities and investors buying securities. For corporations, investment bankers provide information on when and how to place their securities on the open market, a highly regulated process by the SEC to ensure transparency for investors. Therefore, investment bankers play a very important role in issuing new security offerings.
Front office Front office is generally described as a revenue-generating role. There are two main areas within front office: investment banking and markets. Investment banking involves advising organizations on mergers and acquisitions, as well as a wide array of capital raising strategies.IBCA To Lead, To Follow or to Respond- An Investment Banking Strategist's Playbook Retrieved 24 January 2020 Markets is divided into "sales and trading" (including "structuring"), and "research".
Corporate finance Corporate Finance transactions Mergers and acquisitions (M&A), and demergers involving private companies. Mergers, demergers and takeovers of public companies, including public-to-private deals. Management buy-outs, buy-ins or similar of companies, divisions or subsidiaries—typically backed by private equity. Equity issuance by companies, including the listing of companies on a recognised stock exchange by way of an initial public offering (IPO) and the use of online investment and share-trading platforms; the purpose may be to raise capital for development or to restructure ownership. Financing and structuring joint ventures or project finance. Raising infrastructure finance and advising on public-private partnerships and privatisations. Raising capital via the issuance of other forms of equity, debt, hybrids of the two, and related securities for the refinancing and restructuring of businesses. Raising seed, start-up, development or expansion capital. Raising capital for specialist corporate investment funds, such as private equity, venture capital, debt, real estate and infrastructure funds. Secondary equity issuance, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above. Raising and restructuring private corporate debt, or debt funds.
Corporate finance is the aspect of investment banks which involves helping customers raise funds in capital markets and giving advice on mergers and acquisitions (M&A); transactions in which capital is raised for the corporation include those listed aside.Shaun Beaney, Katerina Joannou and David Petrie What is Corporate Finance? , Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011 and September 2020)
This work may involve, subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. A pitch book, also called a confidential information memorandum (CIM), is a document that highlights the relevant financial information, past transaction experience, and background of the deal team to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client.
Recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions.
Companies operating in this area may specialize in particular segments of corporate and project finance. VINGA Securities AG, a Swiss financial-services company, provides services in corporate and project finance and serves professional investors. The company states that its investment-banking services include matching Nordic companies seeking growth funding with investors, with a focus on Nordic private high-yield, fixed-income and equity markets.
Sales and trading
On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products.
Sales is the term for the investment bank's sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on a caveat emptor basis) and take orders. Sales desks then communicate their clients' orders to the appropriate bank department, which can price and execute trades, or structure new products that fit a specific need. Sales make deals tailored to their corporate customers' needs, that is, their terms are often specific. Focusing on their customer relationship, they may deal on the whole range of asset types. (In distinction, trades negotiated by market-makers usually bear standard terms; in market making, traders will buy and sell financial products with the goal of making money on each trade. See under trading desk.)
Structuring has been a relatively recent activity as derivatives have come into play, with highly technical and numerate employees working on creating complex financial products which typically offer much greater margins and returns than underlying cash securities, so-called "yield enhancement". In 2010, investment banks came under pressure as a result of selling complex derivatives contracts to local municipalities in Europe and the US.
Strategists advise both external and internal clients on the strategies that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place companies and industries within a quantitative framework, with full consideration of the macroeconomic environment. This strategy often affects the way the firm operates in the market, the direction it seeks to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products.
Banks also undertake risk through proprietary trading, performed by a special set of traders who do not interface with clients and through "principal risk"—risk undertaken by a trader after he buys or sells a product to a client and does not hedge his total exposure. Here, and in general, banks seek to maximize profitability for a given amount of risk on their balance sheet.