Investment Banking For Dummies. Matthew Krantz

help companies and other large borrowers sell securities to raise money. But large investment banks are also frequently involved in extending loans to their customers, often short-term loans (called bridge loans) to tide a company over while another transaction is in the works.

       Sales and trading: Investment bankers are a creative and innovative lot, in the business of constructing financial instruments to be bought and sold. It’s natural for investment bankers to also buy and sell stocks and other financial instruments either on the behalf of their clients or using their own money.

       Brokerage services: Some investment banking operations include brokerage services where they may hold clients’ assets or help them conduct trades.

       Research: Investment banks not only help large institutions sell securities to investors, but also assist investors looking to buy securities. Many investment banks run research units that advise investors on whether they should buy a particular investment. The terms investments and securities are pretty much interchangeable.

       Investments: Investment banks typically serve the role of a middleman, sitting between the entities that need money and those that have it. But periodically, units of investment banking operations may invest their own money in promising companies or projects. This type of investment, often made in companies that don’t have investments that the public can buy, is called private equity.

      

Investment banking operations at one firm may be engaged in some of the preceding activities, but not all. There’s no rule that demands investment banking operations must perform all the services described here. As investment firms grow, though, they often add functions so they’re more valuable to their clients and can serve as a common source for a variety of services.

      How investment banking differs from traditional banking

      The critical part of the investment banking process is in the way cash is funneled from the people who have it to the people who need it. After all, traditional banks do essentially the same thing investment banks do — get cash from people who have excess amounts into the hands of those who have productive uses for it.

      Traditional banks take deposits from savers with excess cash and lend the money out to borrowers. The main types of traditional banks are commercial banks (which deal primarily with businesses) and retail banks (which deal mostly with individuals).

      The difference between traditional banks and investment banks, though, is the way money is transferred between the people and institutions that need it and the ones who have it. Instead of collecting deposits from savers, as traditional banks do, investment bankers usually rely on selling financial instruments (such as stocks and bonds), in a process called underwriting. By selling financial instruments to investors, the investment bankers raise the money that’s provided to the people, companies, and governments that have productive uses for it.

      Because banks accept deposits from Main Street savers, those deposits are protected by the Federal Deposit Insurance Corporation (FDIC), which guarantees bank deposits. To protect itself, the FDIC along with the federal government puts very strict rules on banks to make sure they’re not being reckless.

      On the other hand, investment banks, at least until the financial crisis of 2007 (see the appendix), were free to take bigger chances with other people’s money. Investment banks could be more creative in inventing new financial tools, which sometimes don’t work out so well. The idea is that clients of investment banks are more sophisticated and know the risks better than the average person with a bank account.

The meaning of the term investment bank got even more unclear after the financial crisis that erupted in 2007. Due to a severe shock to the bond market, many of the dedicated investment banks went out of business, including venerable old-line firms such as Lehman Brothers and Bear Stearns, or were bought by banks. Many of today’s largest investment banks are now units of banks or technically considered commercial or retail banks, although they still perform investment banking operations. Meanwhile, these banks will often say they perform investment banking functions. The term investment bank is somewhat of a misnomer, because the major financial institutions are now technically considered banks.

      Now that you see that the chief role of investment banks is selling securities, the next question is: What types of securities do they sell? The primary forms of financial instruments sold by investment banks include the following:

       Equity: If you’ve ever bought stock in a company, be it an individual firm like Microsoft or an index fund that invests in companies in the Standard & Poor’s (S&P) 500, you’ve been on the investor end of an equity deal. Investment bankers help companies raise money by selling ownership stakes, or equity, in the company to outside investors. After the securities are sold by the investment bank, the owners are free to buy or sell them on the stock market. Equity is first sold as part of an equity offering called an initial public offering (IPO).

       Debt capital: Some investors have no interest in owning a piece of the company, but they’re more than willing to lend money to it, for a price. That’s the role of debt capital. Investment banks help companies borrow money by issuing bonds, or IOUs, that are sold to investors. The company must pay the prearranged rate of interest, but it doesn’t give up any ownership of the company. If a company falls onto hard times, though, the owners of the debt have a higher claim to assets than do the equity owners if a liquidation of the company is necessary.

       Hybrid securities: Most of what investment banks sell can be classified as either debt or equity. But some securities take on traits of both, or are an interesting spin on both. One example is preferred shares, which give investors an income stream that’s higher than what’s paid on the regular equity. But preferred shares don’t come with as high a claim to assets as bonds, and this income stream can be suspended by the company if it chooses.

      The services investment banks provide

Investment banks do much more than just raise capital by selling investments. Although selling securities to raise money is arguably the primary function of investment banks, they also serve several other roles. All the functions of investment banks typically fall into one of two primary categories: selling or buying.

       The sell side: Investment banks are best known for the part of their business that sells securities, or the sell side. This function of the investment bank is responsible for finding investors to buy the securities being sold, which raises the money needed by businesses and governments to grow and prosper.

       The buy side: Investment banks may also take the role of advising the large investors who are interested in buying financial instruments. Serving in its role on the buy side, the investment bank can offer suggestions to large institutional investors like mutual funds, pension plans, or endowments on which securities may be appropriate for it to buy in order to meet return targets.

      

The dual role played by investment banking operations, serving both buyers and sellers of securities, raises constant worries of double dealing and conflicts of interest. Some people rightly question whether it’s possible for the same investment bank that makes money selling shares of an IPO, for instance, to give honest and unbiased investment advice to investors trying to decide whether they should buy or sell. The question of conflicts of interest in investment banking operations has become paramount since the financial crisis began in 2007.

      How investment banks are organized

      Investment banks may seem like financial behemoths that have their hands in just about any matter that involves