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The topic of investment banking is fascinating. This is because some of the biggest banks in the world i.e., Barclays, JP Morgan, Citi, Morgan Stanley, etc. all have investment banking divisions. In fact, they have had investment banking divisions for a very long time. The average age of these investment banks is often said to be over 150 years! Although investment banking institutions have existed for a very long time, the public, at large does not understand its functioning.
Hence, investment banking is not a recent profession. It has been providing some of the highest paying jobs in the world for a long time now. However, the scope of their activities is wide and often interfaces with the activities of other financial institutions. This is the reason why the activities which define investment banking are not understood by the public at large. In this article, we will make an attempt to explain the activities of investment banks in plain English.
It is no secret that the industrial sector of the economy is always in need of funds. This means that companies want to build factories, plants, and offices but do not have the money to do so. On the other hand, the household sector has extra savings. Each person saves a small percentage of their income. Individually, they cannot invest their money productively. They have no option but to let their money stay idle. However, when they pool their resources, the resultant pool becomes big enough to fund these companies. Hence, the basic job of investment banks is to mobilize savings and enable the better functioning of companies.
Now, with the advent of time, national boundaries have started blurring. The world of finance has become integrated, regardless of geographical lines. This has opened up many opportunities for investment banks as well. Now, the savings of people are not only channelized across different sectors but also across different companies. This is why we see many companies raising money from international financial markets.
Investment banking plays a very important role in the growth of the economy. This is because they enable the household sector to obtain the highest return possible for their investment. At the same time, they also enable the industrial sector to obtain financing at the lowest cost.
Capital intermediation is not performed by investment banks alone. It is also performed by commercial banks as well. This is why many people get confused about the difference between the two. There is actually a very thin line that separates the activities of the two institutions.
Firstly, commercial banks only provide debt finance. That, too, the debt finance provided by them is short term and medium-term in nature. On the other hand, investment banks provide both equity and debt finance. They provide a wider range of debt i.e., from the very short term in nature to very long term in nature
Secondly, commercial banks take ownership of the funds that they lend. This means that if the loan that they have taken is not paid back, commercial banks are responsible. On the other hand, investment banks operate as pure-play agents. They ensure that lenders and borrowers meet. However, they do not take ownership of funds. Thus, if there are any bad loans, the investment bankers take no ownership. They simply operate on a commission basis.
In many parts of the world, the same institutions are not allowed to undertake commercial banking as well as investment banking activities.
Investment banks perform many other activities. These activities are all ultimately related to the raising of capital.
For instance, many investors now invest in equity shares all over the world. This is the reason why investment banks often have equity research desks that provide detailed buy-side and sell-side analysis to these investors. This area of investment banking overlaps with the activities of many mutual funds and credit rating agencies.
Also, many times, the capital being raised is in foreign currency. This creates a need for investment banks to hedge currency and other risks. This can be done with the help of derivative instruments. Investment banks provide over the counter services for such derivatives. This means that investment banks act as agents. If one party wants to sell a particular currency, they use their network to find a counterparty that needs to buy that currency. They buy and sell complex contracts like futures and swaps.
Similarly, they help a company to issue securities. This means that they underwrite the issue of shares. Hence, if the shares are not sold to the common public at a certain price point, they will be purchased by investment banks. This helps the issuing company to be certain that they will be able to sell their securities. Then, they can focus on their core business.
The bottom line is that investment banks are allowed to undertake any activity which is directly or indirectly related to the raising of capital. A lot of their activities overlap with the activities performed by other financial institutions as well. However, these services are often sold as a bundle to the customers, which is the reason that they avail of some of these services from investment banks.
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