When the credit crisis unfolded, I heard a lot of investors asking the question “What is an investment bank and how does it differ from a regular commercial bank?” Unless you work in finance, the term “investment bank” likely did not present itself in your day-to-day life until the 2008-2009 global meltdown began. If you find your self asking the same question, in this article I’ll explain the basic definition for you, give you a brief overview of what an investment bank does, help you understand the reasons investment banks are so important to the economy, teach you how investment banks make their money, and tell you why they helped cause one of the greatest financial meltdowns in history.
What Is the Definition of an Investment Bank?
To put it simply, an investment bank is nothing like the corner institution you’re used to dealing with to get a business loan or deposit your paycheck. Instead, an investment bank is a special type of financial institution that works primarily in high finance by helping companies access the capital markets (stock market and bond market, for instance) to raise money for expansion or other needs. If Coca-Cola Enterprises wanted to sell $10 billion worth of bonds to build new bottling plants in Asia, an investment bank would help it find buyers for the bonds and handle the paperwork, along with a team of lawyers and accountants.
Sometimes, investment banks come up with novel solutions to solve difficult problems. Several decades ago, holding company Berkshire Hathaway had only a single class of stock. Due to the fact that its controlling shareholder, billionaire Warren Buffett, had refused to split the stock, the shares had grown from $8 to $35,400; far out of the reach of the typical investor.
Money managers were creating mutual fund-like structures to buy these shares and then issuing shares in themselves, taking a fee, to make the firm accessible to ordinary families. Buffett didn’t like these middlemen making wild promises about the potential returns he could generate when he had nothing to do with it, so to take away their business, he worked with his investment bank to create a dual class capital structure.
In May of 1996, Berkshire Hathaway had an IPO for the Class B shares, which traded at 1/30th the value of the Class A shares (the old stock) but had only 1/200th the voting rights. The Class A stock could be converted into the Class B stock at any time but you couldn’t convert the Class B stock into Class A stock. This allowed investors to effect what amounted to a do-it-yourself stock split, while making cheaper shares wildly available.
Later, when Berkshire Hathaway bought the railroad Burlington Northern Santa Fe, the board of directors split the Class B stock so that it now represents 1/1,500th of the Class A stock. This resulted in the company being added to the S&P 500.
None of it would have been possible had investment banks not been working their magic. When well-regulated, and prudently managed, they add a lot of value to civilization.
The Two Sides of an Investment Bank: Buying and Selling
Investment banks are often divided into two camps: the buy side and the sell side. Many investment banks offer both buy side and sell side services. The sell side typically refers to selling shares of newly issued IPOs, placing new bond issues, engaging in market making services, or helping clients facilitate transactions.
The buy side, in contrast, works with pension funds, mutual funds, hedge funds, and the investing public to help them maximize their returns when trading or investing in securities such as stocks and bonds.
Three Main Offices of an Investment Bank
Many investment banks are divided into three categories that deal with front office, middle office, or back office services.
Front Office Investment Bank Services: Front office services typically consist of investment banking such as helping companies in mergers and acquisitions, corporate finance (such as issuing billions of dollars in commercial paper to help fund day-to-day operations, professional investment management for institutions or high net worth individuals, merchant banking (which is just a fancy word for private equity where the bank puts money into companies that are not publicly traded in exchange for ownership), investment and capital market research reports prepared by professional analysts either for in-house use or for use for a group of highly selective clients, and strategy formulation including parameters such as asset allocation and risk limits.
Middle Office Investment Bank Services: Middle office investment banking services include compliance with government regulations and restrictions for professional clients such as banks, insurance companies, finance divisions, etc. This is sometimes considered a back office function. It also includes capital flows. These are the people who watch money coming into and out of the firm to determine the amount of liquidity the company needs to keep on hand so that it doesn’t get into financial trouble. The team in charge of capital flows can use that information to restrict trades by reducing the buying / trading power available for other divisions.
Back Office Investment Bank Services: The back office services include the nuts and bolts of the investment bank. It handles things such as trade confirmations, ensuring that the correct securities are bought, sold, and settled for the correct amounts, the software and technology platforms that allow traders to do their job are state-of-the-art and functional, the creation of new trading algorithms, and more. The back office jobs are often considered unglamorous and some investment banks outsource to specialty shops such as custodial companies. Nevertheless, they allow the whole thing to run. Without them, nothing else would be possible.
Typical Investment Bank Activities
A typical investment bank will engage in some or all of the following activities:
Raise equity capital (e.g., helping launch an IPO or creating a special class of preferred stock that can be placed with sophisticated investors such as insurance companies or banks)
Raise debt capital (e.g., issuing bonds to help raise money for a factory expansion)
Insure bonds or launching new products (e.g., such as credit default swaps)
Engage in proprietary trading where teams of in-house money managers invests or trades the company’s own money for its private account (e.g., the investment bank believes gold will rise so they speculate in gold futures, acquire call options on gold mining firms, or purchase gold bullion outright for storage in secure vaults).
Up until recent decades, investment banks in the United States were not allowed to be part of a larger commercial bank because the activities, although extremely profitable if managed well, posed far more risk than the traditional lending of money done by commercial banks. This was not the case in the rest of the world. Countries such as Switzerland, in fact, often boasted asset management accounts that allowed investors to manage their entire financial life from a single account that combined banking, brokerage, cash management, and credit needs.
Most of the problems you’ve read about as part of the credit crisis and massive bank failures were caused by the internal investment banks speculating heavily with leverage on collateralized debt obligations (CDOs). These losses had to be covered by the parent bank holding companies, causing huge write-downs and the need for dilutive equity issuances, in some cases nearly wiping out regular stockholders. A perfect example is the venerable Union Bank of Switzerland, or UBS, which reported losses in excess of 21 billion CHF (Swiss Francs), most of which originated in the investment bank. The legendary institution was forced to issue shares as well as mandatory convertible securities, diluting the existing stockholders, to replace the more than 60% of shareholder equity that was obliterated during the meltdown.