Investment Banking: What It Is, What Investment Bankers Do

What Is Investment Banking?

Investment banking is a type of banking that organizes large, complex financial transactions such as mergers or initial public offer (IPO) underwriting.  These banks may raise money for companies in a variety of ways, including underwriting the issuance of new securities for a corporation, municipality or other institution. They may manage a corporation's initial public offering (IPO). They will provide advice in mergers, acquisitions, and reorganizations. In essence, investment bankers are experts who have their fingers on the pulse of the current investment climate. They help their clients navigate the complex world of high finance.

Key Takeaways

  • Investment banking deals primarily with raising money for companies, governments, and other entities.
  • Investment banking activities include underwriting new debt and equity securities for all types of corporations.
  • Investment banks will also facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors.
  • Investment bankers work with corporations, governments, and other groups. They plan and manage the financial aspects of large projects.
  • Investment banks were legally separated from other types of commercial banks in the U.S. from 1933 to 1999, when the Glass-Steagall Act that segregated them was repealed.
1:47

Investment Banking

Understanding Investment Banking

Investment banks underwrite new debt and equity securities for all types of corporations, aid in the sale of securities, and help facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors. Investment banks also provide guidance to issuers regarding the offering and placement of stock.

Many large investment banking systems are affiliated with or subsidiaries of larger banking institutions, and many have become household names, the largest being Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch, and Deutsche Bank.

Broadly speaking, investment banks assist in large, complicated financial transactions. They may provide advice on how much a company is worth and how best to structure a deal if the investment banker’s client is considering an acquisition, merger, or sale. Investment banks' activities also may include issuing securities as a means of raising money for the client groups and creating the documentation for the Securities and Exchange Commission (SEC) necessary for a company to go public.

Investment banks employ investment bankers who help corporations, governments, and other groups plan and manage large projects, saving their clients time and money by identifying risks associated with the project before the client moves forward.

In theory, investment bankers are experts who have their finger on the pulse of the current investing climate, so businesses and institutions turn to investment banks for advice on how best to plan their development, as investment bankers can tailor their recommendations to the present state of economic affairs.

Regulation and Investment Banking

The Glass-Steagall Act was passed in 1933 after the 1929 stock market crash led to massive bank failures. The purpose of the act was to separate commercial and investment banking activities. The mixing of commercial and investment banking activities was considered very risky and may have worsened the 1929 stock market crash. This is because when the stock market crashed, investors rushed to draw their money from banks to meet margin calls and other for other purposes, but some banks were unable to honor these requests because they too had invested their clients' money in the stock market. Before Glass-Steagall was passed, banks could divert retail depositors' funds into speculative operations such as investing in the equity markets. As such operations became more lucrative, banks took larger and larger speculative positions, eventually putting depositors' funds at risk.

However, the stipulations of the act were considered harsh by some in the financial sector and Congress eventually repealed the Glass-Steagall Act in 1999. The Gramm-Leach-Bliley Act of 1999 thus eliminated the separation between investment and commercial banks. Since the repeal, most major banks have resumed combined investment and commercial banking operations.

Special Considerations

Essentially, investment banks serve as middlemen between a company and investors when the company wants to issue stock or bonds. The investment bank assists with pricing financial instruments to maximize revenue and with navigating regulatory requirements.

Often, when a company holds its initial public offering (IPO), an investment bank will buy all or much of that company’s shares directly from the company. Subsequently, as a proxy for the company launching the IPO, the investment bank will sell the shares on the market. This makes things much easier for the company itself, as it effectively contracts out the IPO to the investment bank.

Moreover, the investment bank stands to make a profit, as it will generally price its shares at a markup from what it initially paid for them. In doing so, it also takes on a substantial amount of risk. Though experienced analysts use their expertise to accurately price the stock as best they can, the investment bank can lose money on the deal if it turns out it has overvalued the stock, as in this case, it will often have to sell the stock for less than it initially paid for it.

Example of Investment Banking

Suppose that Pete’s Paints Co., a chain supplying paints and other hardware, wants to go public. Pete, the owner, gets in touch with Jose, an investment banker working for a larger investment banking firm. Pete and Jose strike a deal wherein Jose (on behalf of his firm) agrees to buy 100,000 shares of Pete’s Paints for the company’s IPO at the price of $24 per share, a price at which the investment bank’s analysts arrived after careful consideration.

The investment bank pays $2.4 million for the 100,000 shares and, after filing the appropriate paperwork, begins selling the stock for $26 per share. Yet, the investment bank is unable to sell more than 20% of the shares at this price and is forced to reduce the price to $23 per share in order to sell the remaining shares.

For the IPO deal with Pete’s Paints, then, the investment bank has made $2.36 million [(20,000 x $26) + (80,000 x $23) = $520,000 + $1,840,000 = $2,360,000]. In other words, Jose’s firm has lost $40,000 on the deal because it overvalued Pete’s Paints.

Investment banks often will compete with one another to secure IPO projects, which can force them to increase the price they are willing to pay to secure the deal with the company that is going public. If competition is particularly fierce, this can lead to a substantial blow to the investment bank’s bottom line.

Most often, however, there will be more than one investment bank underwriting securities in this way, rather than just one. While this means that each investment bank has less to gain, it also means that each one will have reduced risk.

What Do Investment Banks Do?

Broadly speaking, investment banks assist in large, complicated financial transactions. They may provide advice on how much a company is worth and how best to structure a deal if the investment banker’s client is considering an acquisition, merger, or sale. Essentially, their services include underwriting new debt and equity securities for all types of corporations, providing aid in the sale of securities, and helping to facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors. They also may issue securities as a means of raising money for the client groups and create the necessary SEC documentation for a company to go public.

What Is the Role of Investment Bankers?

Investment banks employ people who help corporations, governments, and other groups plan and manage large projects, saving their clients time and money by identifying risks associated with the project before the client moves forward. In theory, investment bankers should be experts who have their finger on the pulse of the current investing climate. Businesses and institutions turn to investment banks for advice on how best to plan their development. Investment bankers, using their expertise, tailor their recommendations to the present state of economic affairs.

What Is an Initial Public Offering (IPO)?

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors. Companies must meet requirements set by exchanges and the SEC to hold an IPO. Companies hire investment banks to underwrite their IPOs. The underwriters are involved in every aspect of the IPO due diligence, document preparation, filing, marketing, and issuance.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. J.P. Morgan. "Investment Banking."

Take the Next Step to Invest
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Service
Name
Description