There are two broadly recognized functions of investment banks: capital market intermediation and trading. These are distinct and separate from the functions typically associated with commercial banks, which accept deposits and make loans. Investment banks are critical agents of capital formation and price setting. They also help to coordinate present and future consumption.
Even though the functions of investment banking and commercial banking are different, the distinction between investment and commercial banks is more meaningful in the United States than in the rest of the world.
Investment Banks Vs. Commercial Banks
In 1933, the U.S. Congress passed the Glass-Steagall Act. One of the main provisions of the Act created a legal distinction between the operations of an investment bank and commercial bank. Moreover, it became illegal for any one company to perform both or for any holding company to hold associate companies of both kinds.
Investment banks could no longer accept deposits or make loans. Commercial banks could no longer have security interests in the U.S., although no such restrictions applied to foreign investments. These barriers eased with the Gramm-Leach-Bliley Act of 1999.
The U.S. remains the only country to have ever legally separated investment and commercial banking in such a way.
Investment Banking and Capital Development
In contemporary mixed economies, both governments and large companies rely on investment banks to raise funds. Historically, investment banks match those selling securities with those investors. This is known as "adding liquidity" to a market.
There is some debate about why the cost of financial intermediation rose during much of the 20th century. The costs of most other forms of business declined during the same period, yet the percentage of financial transactions going to investment bankers rose. This seems to indicate that the industry became less efficient.
Coordinating Past and Future Consumption
Investment banks work with commercial banks to help determine prevailing market interest rates. Even though there are different interest rates for commercial and investment products, all interest rates influence each other.
For example, if it were possible to earn 2% interest on a two-year certificate of deposit or 4% interest on a two-year Treasury, investors would drive up the price of Treasurys (reducing the yield) and move away from bonds (driving up the rate that banks would have to offer). In this way, interest rates always tend to move toward each other.
The market rates of interest also determine how profitable it is to save and how expensive it is to borrow. This helps coordinate the use of resources across time. When interest rates are high, more money is saved for future consumption. The opposite is true when rates are low.
The more efficiently investment banks establish market rates of interest, the more efficiently resources can be coordinated between present and future needs.