What Is an Investment Bank?

An open vault door at an investment bank
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Unless you work in finance, the term investment bank likely did not present itself until the 2008-2009 global meltdown began when many people began to ask what exactly were the entities. To put it simply, an investment bank is nothing like the corner institution you're used to dealing with. The bank you work with helps with business loans or the deposit of your paycheck.

Examining Investment Banks

Instead, an investment bank is a large financial institution that works primarily in high finance. They help companies access capital markets (stock and bond market, for instance). This allows corporations to raise money for expansion or other needs.

If Coca-Cola Enterprises wanted to sell $10 billion worth of bonds to build new bottling plants in Asia, an investment bank would help it find buyers for the bonds and handle the paperwork, along with a team of lawyers and accountants.

Investment banks can also be involved in initial public offerings (IPOs) when a private market goes public and lists one of the exchanges.

Warren Buffett and Investment Banks

Sometimes, investment banks come up with novel solutions to solve difficult problems. Several decades ago, holding company Berkshire Hathaway had only a single class of stock. Due to the fact that its controlling shareholder, billionaire Warren Buffett had refused to split the stock, the shares had grown from $8 to $35,400—far out of the reach of the typical investor.

Money managers were creating mutual fund-like structures to buy these shares and then issuing shares of the holding fund to investors. These managers would charge a fee to make a portion of a Berkshire holding accessible to ordinary investors.

Mr. Buffett didn't like these middlemen making wild promises about the potential returns Berkshire could generate when he had nothing to do with it. So, to take away the business of these middle-men, he worked with his investment bank to create a dual-class capital structure.

In May of 1996, Berkshire Hathaway had an IPO for the Class B shares, which traded at 1/30th the value of the Class A shares (the old stock) but had only 1/200th the voting rights of the original shares. The Class A stock could be converted into the Class B stock at any time but you couldn't convert the Class B stock into Class A stock. This allowed investors to effect what amounted to a do-it-yourself stock split while making cheaper shares wildly available.

Later, when Berkshire Hathaway bought the railroad Burlington Northern Santa Fe, the board of directors split the Class B stock so that it now represents 1/1,500th of the Class A stock. This resulted in the company being added to the S&P 500.

None of it would have been possible had investment banks not been working their magic. When well-regulated and prudently managed, they add a lot of value to civilization.

Buying and Selling

Investment banks are often divided into two camps: the buy-side and the sell-side. Many investment banks offer both buy-side and sell-side services. The sell-side typically refers to selling shares of newly issued IPOs, placing new bond issues, engaging in market-making services, or helping clients facilitate transactions. The buy-side, in contrast, works with pension funds, mutual funds, hedge funds, and the investing public to help them maximize their returns when trading or investing in securities such as stocks and bonds.

Three Main Offices

Many investment banks are divided into three divisions, based on the services provided and the responsibilities of the employees. These divisions are the front office, middle office, or back-office services.

Front Office Investment Bank Services

Front office services typically consist of investment banking such as helping companies in mergers and acquisitions, corporate finance (such as issuing billions of dollars in commercial paper to help fund day-to-day operations), professional investment management for institutions or high net worth individuals, merchant banking (which is just a fancy word for private equity where the bank puts money into companies that are not publicly traded in exchange for ownership), investment and capital market research reports prepared by professional analysts either for in-house use or for use for a group of highly selective clients, and strategy formulation including parameters such as asset allocation and risk limits.

Middle Office Investment Bank Services

Middle office investment banking services include compliance with government regulations and restrictions for professional clients such as banks, insurance companies, finance divisions, etc. This is sometimes considered a back-office function. It also includes capital flows. These are the people who watch the money coming into and out of the firm to determine the amount of liquidity the company needs to keep on hand so that it doesn't get into financial trouble. The team in charge of capital flows can use that information to restrict trades by reducing the buying/trading power available for other divisions.

Back-Office Investment Bank Services

The back-office services include the nuts and bolts of the investment bank. It handles things such as trade confirmations, ensuring that the correct securities are bought, sold, and settled for the correct amounts, the software and technology platforms that allow traders to do their job s are state-of-the-art and functional, the creation of new trading algorithms, and more. The back-office jobs are often considered unglamorous and some investment banks outsource to specialty shops such as custodial companies. Nevertheless, they allow the whole thing to run. Without them, nothing else would be possible.

Investment Bank Activities

A typical investment bank will engage in some or all of the following activities:

  • Raise equity capital (e.g., helping launch an IPO or creating a special class of preferred stock that can be placed with sophisticated investors such as insurance companies or banks)
  • Raise debt capital (e.g., issuing bonds to help raise money for a factory expansion)
  • Insure bonds or launching new products (e.g., such as credit default swaps)
  • Engage in proprietary trading where teams of in-house money managers invest or trade the company's own money for its private account (e.g., the investment bank believes gold will rise so they speculate in gold futures, acquire call options on gold mining firms, or purchase gold bullion outright for storage in secure vaults).

Up until recent decades, investment banks in the United States were not allowed to be part of a larger commercial bank because the activities, although extremely profitable if managed well, posed far more risk than the traditional lending of money done by commercial banks. This was not the case in the rest of the world. Countries such as Switzerland, in fact, often boasted asset management accounts that allowed investors to manage their entire financial life from a single account that combined banking, brokerage, cash management, and credit needs.

Most of the problems you've read about as part of the credit crisis and massive bank failures were caused by the internal investment banks speculating heavily with leverage on collateralized debt obligations (CDOs). These losses had to be covered by the parent bank holding companies, causing huge write-downs and the need for dilutive equity issuances, in some cases nearly wiping out regular stockholders. A perfect example is the venerable Union Bank of Switzerland, or UBS, which reported losses in excess of 21 billion CHF (Swiss Francs), most of which originated in the investment bank. The legendary institution was forced to issue shares as well as mandatory convertible securities, diluting the existing stockholders, to replace the more than 60% of shareholder equity that was obliterated during the meltdown.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.