With that said, nearly all major investment banks divide their operations into several key areas, including the front office, middle office, and back office. When you talk to someone about investment banking, or even listen to the heads of investment banks talk, they’ll often refer to these three common parts of a traditional investment bank:
The front office: The front office is exactly what it sounds like. It’s not only the part of the investment bank that sells investments, but also the part that courts companies looking to do deals. Traditionally, companies that are looking to find a fast way to turbo-charge growth may think about buying another company (say, a rival with similar customers or complementary technology).From the front office, investment banks help usher along the M&A process by pairing up buyers and sellers. The front office is also the part of the investment bank that conducts trading (frenetic buying and selling of securities to take advantage of any mispricings — even if the holding period is for only a few seconds). Investment banks used to do some trading using complicated mathematical formulas and using the firm’s money (not the clients’ money). This type of trading is often called proprietary trading. Many investment banks used to operate a business where they bought and sold securities themselves. Proprietary trading was quite profitable for investment banks. But most types of so-called prop trading by investment banks were abolished in mid-2015 by the Volcker Rule. The rule is named after former Federal Reserve Board Chairman Paul Volcker. Volcker said risky trading put large financial institutions at risk. Such trading was blamed in part for the financial crisis of 2008. Investment banks will continue to wind down this part of their businesses into the early 2020s. Another part of the front office is the part of the business involved in conducting research on companies. The front office often employs sell-side analysts, whose job it is to closely monitor companies and industries and produce reports used by large investors trying to decide whether to buy or sell particular securities. (You can find out more about research analysts in Chapter 2.)
The middle office: The middle office of an investment bank is generally out of the limelight. It’s the part of the bank with the job of cooking up new types of securities that can be sold to investors. Some innovations in investment banking are useful, but others can wind up putting investors and the markets in general in an unfavorable light. Some of the infamous financial instruments cooked up in the middle office of investment banks that came back to haunt the system include auction-rate securities and credit default swaps. Auction-rate securities are debt instruments that promise investors higher rates of return than are available in savings accounts. Instead of selling debt at a prearranged interest rate, the investment bank would conduct auctions, and the rate would be set by a bidding process. That’s great as long as there are willing buyers and sellers. But the auction-rate market relied on auctions, many of which weren’t successful during the financial crisis that erupted in 2007. Many investors holding the securities found they couldn’t sell them because the market had dried up, causing a huge headache for the investors and investment banks. Credit default swaps are tools that allow lenders to sell the risk that borrowers won’t be able to meet their obligations. Credit default swaps operate as a form of unregulated insurance policies. These instruments got so complicated, though, that they exacerbated the financial interdependencies between giant financial firms, worsening the financial crisis that erupted between 2007 and 2009.
The back office: The back office is the part of the investment bank that is far from the glamour of the front office. It’s primarily made up of the systems and procedures that allow investment bankers to gather the data they need to do their jobs well. The back office, for instance, maintains the computer systems used by investment bankers to gauge interest in certain securities and provides traders the ability to make short-term bets on market movements. The parts of investment banking considered more operational in nature tend to fall into the back office.
The current lay of the investment banking land
After the tumultuous changes in the investment banking business following the financial crisis of 2007 through 2009, the entire landscape changed. Following the banking crisis, investment banks needed capital. Some of the most storied investment banks, unable to raise money, merged with other banks or became commercial banks themselves. Suddenly, the financial system was comprised of behemoth banks that have the deposit-taking abilities of banks but also engage in investment banking. The result is the formation of several mega-institutions that many people fear are “too big to fail,” including the ones shown in Table 1-1.
TABLE 1-1 Among the Last Banks Standing
| Firm | 2018 Revenue ($ billions) |
| JPMorgan Chase | 104.0 |
| Bank of America | 88.7 |
| Wells Fargo | 84.7 |
| Citigroup | 65.5 |
| Morgan Stanley | 40.1 |
| Goldman Sachs | 35.9 |
Source: S&P Global Market Intelligence
Types of investment banking operations
Insiders in the investment banking business use all sorts of terms, some decidedly derogatory, to classify the players in the business. Some classifications that investment banks fall into include the following:
Bulge bracket: Bulge bracket investment firms aren’t the ones that ate too many slices of cheesecake. Instead, bulge bracket is a commonly used slang term to describe the biggest of the big investment banking operations. The bulge bracket firms are the behemoths, like the ones in Table 1-1. They have their hands in most areas of investment banking.
Boutique: Boutique investment firms are smaller investment banks and traditional banks that choose to focus on one or a select few areas of the business. Some firms, for instance, focus on selling securities for smaller companies.
Regional: Regional firms typically focus on a particular part of the country. Whereas the bulge bracket firms continually try to grow and take market share from rivals, there seems to be plenty of room for smaller players like these. Some regional firms also often concentrate on a particular type of investment banking service, be it trading services or underwriting of securities.
How investment banks get paid
As you can imagine, although investment banking plays an important role in funding economic progress, there’s also lots of money to be made. Investment