How do Investment Banks Make Money?

Investment banks perform a wide variety of activities. As we have explained in previous articles, the work performed by investment banks overlaps with the work performed by a lot of other financial institutions. Hence, they also make money in a wide variety of ways. They sell their services to large corporations and even governments.

Over the years, investment banks have been under the scanner since it is believed that they make large amounts of money and give out obscene bonuses to their top management while acting unethically. Investment banks are able to make huge sums of money since they have multiple revenue streams.

In this article, we will have a closer look at some of the revenue streams which are generated by investment banks.

1. Underwriting Income: The primary job of big investment banks is to help private companies go public. This means that they help sell the shares of these private companies on the open market. While doing so, they underwrite all the shares. This means that they take the risk that if these shares are not sold to the common public, then they will buy the shares themselves. Public issues generally run into millions of dollars. Investment banks charge a hefty commission on the issue size. Hence, their commissions also run into millions of dollars. However, it needs to be noted that while going public, only the services of the biggest and the most reputable banks are taken. Hence, the underwriting income is concentrated within a few companies.

2. Advisory Fees: Investment banks are supposed to have the best knowledge about the status of the financial markets. This is the reason that when a company wants to raise capital either via a pubic issue or otherwise, they often take the advice of investment bankers.

   Investment banks have entire departments that are dedicated to the advisory practice. Big corporations and even governments consult these banks about the best way to raise finance. They advise on which instruments can be used, which markets can be tapped, and even when the appropriate timing is to bring out a public issue.

   Since the advice is provided by some of the most seasoned investment bankers, the investment banks often charge a high consulting fee, which varies with the number of hours of work that the investment banker had to put in.

3. Trading Income: There are many investment banks around the world that have very active trading desks. These investment banks often invest some money on behalf of their clients. If the client makes an above-average return based on their advice, then the investment banks take a small percentage of the above-average return. This is often called asset management fees.

   Similarly, many large investment banks around the world have their own proprietary trading desks. This means that they invest their own money and not the money owned by the clients. In these cases, since they are investing their own money, they are obviously the beneficiaries of the profits that they generate from such trading. Proprietary trading banks at investment banks often look at arbitrage opportunities. They try to generate risk-free profits by using their advanced know-how while investing their money. This trading income also becomes an important source of income for these companies.

4. Securitization: In recent years, investment banks have discovered new sources of income. This has largely been because of the financial innovation that they have brought in. For instance, many investment banks sell securitized assets. This means that they buy pools of loans or assets from commercial banks. Then, once the pool is ready, the use of tranching and other credit enhancement techniques is done in order to make the securities more palatable to high-grade investors.

   Investment banks have been making huge profits by buying assets, pooling and tranching them, and then selling them for a much higher price. However, this approach also carries some risks. For instance, during the subprime mortgage crisis of 2008, many investment banks were not able to sell the assets that they had on their books. They had held these assets temporarily only for the purpose of sale. However, due to the credit freeze, they were not able to offload the assets on time. Many investment banks came to the verge of bankruptcy because of the losses incurred as a result of these assets.

5. Research Fees: Lastly, investment banks hire a lot of research analysts. This is done to ensure that they provide the most up to date reports to the clients of these investment banks. Also, as mentioned above, these banks do proprietary trading too. Hence, they also need to use this advice a lot of times. These research reports created by investment banks have a lot of value in the outside world because of their expertise in this domain. Companies, as well as individuals, are willing to pay fees in order to access these reports. This is the reason why investment companies are often willing to pay this fee. This becomes another source of income for investment banks.

The bottom line is that investment banks have several sources of income. Hence, even if one of the sources of income dries up, it does not mean that the entire operation of the investment bank will be affected. Because of these diversified sources of income, investment banks see a stable flow of income.