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Investment Banks: How does an Investment Bank work?

Investment banks are the physical and digital hubs within the financial services industry. They specialise in various activities, including offering financial products and services to investors, businesses and consumers; underwriting new securities offerings, acting as financial advisors to companies seeking financing or selling debt to institutional investors; and helping companies with mergers and acquisitions and business growth. 

But how do investment banks work, what are their core functions, where can you find them, and how can they work for you? This comprehensive guide explains it all.

Investment Banks: How does an Investment Bank work?

What is an Investment Bank?

Investment banks are businesses that facilitate the flow of capital among lenders, borrowers, and investors. They facilitate financial transactions and provide clients with a range of financial advisory and advisory services. Investment banks are different from commercial banks in a variety of ways, including the following: – 

  • They offer a wider range of financial products, including debt, equity, asset-backed securities, and derivatives.
  • They focus exclusively on financing transactions and provide a wider range of advisory services than commercial banks.
  • They are regulated and supervised at two levels, federal and state, and often by a combination of federal, state and international standards.
  • They are more sophisticated and are engaged in more complex activities, including derivatives. 
  • They are often more technologically advanced, with more advanced risk management capabilities, platform and data capabilities and the ability to process more transactions per day.
  • They are more likely to engage in foreign exchange trading.

You’ve probably heard of some sizable leading investment banks, such as JPMorgan Chase, Goldman Sachs, CitiGroup, the Bank of America, Deutsche Bank, and Morgan Stanley.

How does an Investment Bank work?

Investment banks are complex businesses that engage in various financial activities, including managing money, providing brokerage and trading services, advising companies on mergers and acquisitions and providing debt financing. 

The core of an investment bank’s business is the flow of capital between lenders, borrowers and investors. Investment banks are organised into three main units: the equity research department, the trading unit and the asset management unit.

The trading unit engages in the trading of financial products, such as stocks and bonds, and offers customers a range of services, including brokerage, trading, and underwriting. 

The asset management unit invests the bank’s funds and provides financial products, such as funds that invest in stocks, bonds and various financial products. 

The equity research department researches stocks, looking for trading opportunities and information about corporate activities that could impact the value of a company’s securities.

What’s more, investment banks charge an advisory fee for their services and profit from their trading activities. In addition to loaning money to consumers and businesses, retail banking divisions of investment banks generate profits. The trading division makes money based on the success of its market operations.

However, on top of all this, investment banks are perhaps best known for their roles as acting intermediaries. This means they work with the financial markets but also bridge this gap between businesses, companies, corporations, and other forms of organisation. For example, if a company wants to go public and share more shares of stock in their IPO, an investment bank will organise this procedure. Investment banks are also a popular choice for providing debt financing services and can help companies find larger investors for bonds.

Other services you will find at an investment bank include;

  • Mergers and acquisition processes
  • Market and financial research
  • Financial advice services

What are the types of Investment banks?

The types of investment banks are:

Brokerage Investment Banks

Investment banks that provide brokerage services focus primarily on trading financial products like stocks and bonds. Investment banks in this category are known as broker-dealers.

Regional Boutique Banks

These are known as the smallest types of investment banks and will usually handle the smallest kind of transaction and operate on, as the name suggests, a regional level. These banks are literally so small they will usually hire no more than five to twelve people and will usually hyperfocus on a select range of dedicated services rather than offering a broad range of global services.

For example, they may operate within a single sector of business or operate within and provide services for a specific region or geographical location. In such a case, there may be a small investment bank that handles mergers and acquisitions for only energy companies. This would be a clear example of a regional boutique bank.

Elite Boutique Banks

A step up from regional boutique banks, elite boutique banks are actually fairly different, despite their progressive names. These investment banks are most similar to the large global banks in terms of the kind of deals they manage, most will work with over a billion dollars at a time, but that’s not to say they won’t dip into smaller deals if they need to.

These banks usually operate on a countrywide level but can operate internationally in many cases, but don’t have the global presence that the largest banks have. Again, elite boutique banks don’t tend to offer a full range of services to their customers but rather will specialise in several dedicated services, usually restructuring or asset management.

Middle Market Banks

Middle-market investment banks operate in the middle ground between regional investment banks and bulge-bracket investment banks, therefore specialising in offering investment banking services from the regional to the bulge-bracket level.  Interestingly, middle-market banks are typically found in the middle ground regarding geographical reach, as bulge-bracket banks have a much broader presence than regional boutiques. They also fall short of the multinational scope of bulge-bracket banks.

Middle-market firms tend to provide a very similar services list as bulge-bracket banks, including a full array of investment banking services that include equity capital markets and debt capital markets, a full array of financing and asset management services, M&A, restructuring services, equity financing, and asset management services.

Bulge Bracket Banks

The bulge bracket banks are the biggest in the world, and when you hear the term’ investment banks’, these are the banks people think of the most. Some of the world’s most well-known investment banks include Goldman Sachs, Deutsche Bank, Morgan Stanley, and Bank of America.

Since these investment banks handle some of the largest and most significant transactions ever in human history, they naturally have the biggest corporate clients, have the greatest numbers of employees and operate the most offices on a worldwide scale. For example, Goldman Sachs carried out over $4 billion in bank deals alone in just nine months back in 2021. When you add in mergers and acquisitions and related investments and deals, this figure exceeds a staggering $5 trillion. Bulge bracket investment banks typically handle billion-dollar M&A transactions, but depending on the economy or a client’s needs, they might handle deals worth hundreds of millions.

Which investment bank is the best?

To answer this question, you need to think about how you define the best. You’ll need to think about varying terms and aspects, like which offers the best service, has the most investments and handles the most deals, or which is the best investment bank to work for. The criteria could be ever-changing.

However, there’s no doubt that Goldman Sachs is hailed by many as the best investment bank in the world. Not only did they exceed $5 trillion in deals in 2021 alone, making them the highest transactional investment bank in the world, but they have also ranked as one of the most prestigious firms in the world to work for three years in a row, and advised on over $1 trillion worth of deals around the world.

What are the regulations of Investment Banks?

The regulations surrounding investment banks will depend on which banks you’re looking at and where they operate in the world. If a company is based in the US, it will follow US rules and regulations. In the UK, it follows the UK, and if it operates worldwide, then the bank will need to make sure that operations are legal in the countries where the operations are taking place.

Since some of the largest bulge bracket banks operate in the US, let’s focus on the rules and regulations here. Investment banks are required to comply with a complex set of regulations. Government agencies, like the Securities and Exchange Commission (SEC), enforce these regulations, and self-regulatory organisations, like the Financial Industry Regulatory Authority (FINRA). 

Multiple agencies regulate investment banks, like the SEC and the Financial Industry Regulatory Authority (FINRA). That’s not all. Banks must also adhere to the rules laid out in regulations like The Sarbanes-Oxley Act.

The Sarbanes-Oxley Act is the most important regulation governing the business practices of investment banks. It was enacted by Congress in 2002 and mandated the practices of financial record keeping and reporting for businesses, which is obviously very important when managing and overseeing trillions of dollars worth of international corporation deals and M&As.

Another is known as The Gramm-Leach-Bliley Act. This is the most important regulation governing the business practices of commercial banks that engage in investments. It was enacted in 1999 by Congress and applied to banks engaged in commerce as well as banks engaged in the securities business. 

There is also the Commodity Exchange Act. This is a law that governs the trading of commodity futures and options. Investment banks that engage in foreign exchange trading are subject to the regulations of the Commodity Exchange Act.

In the UK, investment banks are mainly authorised and regulated by three leading organisations. These are;

  • The Bank of England
  • The Prudential Regulation Authority
  • Financial Conduct Authority (FCA)

The Prudential Regulation Authority regulates over 1,500 banks, credit unions, building societies, and other major investment firms and banks to ensure they are operating within the confines of the law. It doesn’t matter if you’re a small investment bank or a global entity, the rules still apply.

What is the difference between Investment Banks and Commercial Banks?

Most banks, including commercial banks, serve a wide range of clients, including the general public and businesses. In addition to safeguarding assets and making loans, commercial banks accept deposits. On the other hand, investment banks serve large corporations and institutional investors.

Investment banking is also designed to help large, publicly traded companies make smart investments, issue company stock, and assist with acquisitions and mergers. Commercial banking supports small and medium-sized business clients, typically privately owned, with day-to-day banking and credit services, including working capital, capital expenditure, and spending for growth. 

Investment and commercial banking are distinct in that investment banks handle much bigger transactions, while commercial banks meet the capital demands of mostly non-public, corporate borrowers.

Take a moment to think about your commercial bank. These will offer services like personal loans and mortgages, savings accounts, credit and debit cards, ATM transactional services, online banking and so on. This is very different from the services investment banks offer, as we’ve explored above, which are many large and public business-oriented services.

How will investment banking change in the future?

Investment banks will likely continue to evolve in response to the changing financial landscape and customer needs. Some of the most notable changes will be related to technology, risk management, transparency and regulatory compliance.

In the years to come, investment banking will continue to change in response to the ever-changing financial landscape. One of the most notable changes will be the increasing role of technology in the industry. Investment banks will need to adopt new technologies to stay competitive and meet the demands of their customers.

In addition, risk management will become even more important in the wake of the global financial crisis. Investment banks will need to be more transparent and compliant with regulations to win business and protect their reputations.

Lastly, customer service will remain a key differentiator for investment banks. Those that can provide a superior level of customer service will be able to win and retain business in the years to come.

So far, the technology adoption rate in the investment banking sector has been rapid, especially in the area of trading and data management. Investment banks have also been investing heavily in risk management solutions, such as trading platforms and compliance solutions, helping ensure they are managing the risk of their activities in an appropriate manner. Transparency has also been a major focus for investment banks.

The Dodd-Frank Act, an act that was invoked after the financial crisis of 2008, helped make significant progress toward improving transparency in the financial services industry.

With the implementation of the Covered Code and the implementation of the new credit-rating system, investors will have a much clearer view of the creditworthiness of investment banks. Investment banks also need to continue to evolve their compensation models to remain competitive in an increasingly erratic industry.

From offering equity-based compensation to giving employees a defined benefit pension plan, investment banks will need to continually adapt to remain relevant in the financial services industry.

In short, investment banks need to remain nimble to adapt to the ever-changing financial landscape. By staying ahead of the curve and investing in the latest technologies, investment banks can continue to thrive in the years to come.

Is investment banking worth it?                              

Yes, but also no. This is a difficult question to answer. It depends on your individual goals and objectives. If you are looking to make a lot of money and you’re running a public company that trades in stocks and shares, investment banking may be a good option for you and your business.

After all, the top investment banks in the world can generate billions of dollars in revenue each year.

Do investment banks engage in foreign exchange policy?

Yes, both investment banks and conventional banks, and even other forms of financial institutions from hedge funds and governments engage in foreign exchange markets and therefore operate under the regulation of foreign exchange policy.

However, there’s no denying that commercial and investment banks combined trade the largest volume of currency and currency volume trade out of all financial institutions. While reserved for most smaller banks, there are some investment banks that will have their own trading desks and may facilitate forex transactions, but these kinds of transactions are mainly reserved for smaller banks and commercial banking organisations.

Is a bridging loan available from an investment bank?

Yes, investment banks are heavily involved in the bridging loan market and, in many cases, fund bridging loan lenders. They usually offer large-scale funding to lenders rather than individual loans to individuals or companies, however, meaning you can’t usually borrow from them directly. These large tranches of funds are then split into individual loans by the bridging loan lender, who also profits by adding a mark up to the interest charged by the investment bank. The bridging loan market is very attractive to investment banks due to the high returns available and security offered by charges over borrowers’ properties.

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