Investment Banking vs. Commercial Banking
Traditionally, the term Investment banking or I-banking is used to describe the business of raising capital for companies and advising them on financing and merger alternatives. In order to raise this cash, investment banks sell securities of stocks and bonds to investors, which will later be traded in global financial markets. Commercial banking in contrary, loans your deposit money to consumer and companies in need for capital. Today however, the traditional lines and culture of commercial banking and investment banking are blurring. Laws requiring the separation of investment banking and commercial banking have been reformed and synergies gained. Investment banking however is not one specific service or function. It rather encompasses a range of functions. Reporting on all investment bank activities is beyond the scope of this short introduction. Therefore a brief description will follow.
The capital markets division, often split in equity capital markets and debt capital markets, is involved with the traditional business of investment banking. This means raising either debt or equity capital for firms. Investment banks underwrite and distribute new issues of debt and equity for these firms. New equity issues include primary, initial offerings of companies (IPOs), or secondary, seasoned equity offerings. Debt underwriting involves new issues of debt such as bonds. Securities underwritings can be undertaken through either public offerings or private offerings. In a private offering, the investment banker acts as a private placement agent for a fee, placing the securities with one or a few large institutions. In a public offering, the securities may be underwritten on a best-efforts or a firm commitment basis to the public at large. In firm commitment underwriting, the investment banker acts as a principal, purchasing the securities from the issuer at one price and seeking to place them with public investors at a slightly higher price.
Investment banks provide advice and assist in mergers and acquisitions. They can for example, assist in finding merger partners, underwriting new securities to be issued by the merged firms, assessing the value of target firms, recommending terms of the merger agreement, and even helping target firms to prevent a merger. Setting up deals where one company buys another is an important source of fee income for many investment banks; it has been a hot area on Wall Street in the 1990s and is likely to continue through the next century.
Sales are another core component of any investment bank. Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson or 3) the private client service representative. Retail brokers develop relationships with individual investors, selling stocks and stock advice to the average Joe. Institutional salespeople develop business relationships with large institutional investors. Institutional investors, like pension funds, mutual funds or large corporations, manage large groups of assets. Private client service (PCS) representatives lie somewhere between retail brokers and institutional salespeople, providing brokerage and money management services for extremely wealthy individuals. Salespeople make money through commissions on trades made through their firms or, increasingly, as a percentage of their clients’ assets with the firm.
A trader plays two distinct roles for an investment bank: (1) providing liquidity: Traders provide liquidity to the firm’s clients (that is, they give clients the ability to buy or sell a security on demand). Traders do this by standing ready to buy the client’s securities (or sell securities to the client) if the client needs to place a trade quickly. This is also called making a market. Traders performing this function make money for the firm by selling securities at a slightly higher price than they pay for them. This price differential is known as the bid-ask spread. (2) Proprietary trading: In addition to providing liquidity and executing trades for the firm’s customers, traders also may take their own trading positions on behalf of the firm, using the firm’s capital and hoping to benefit from the rise or fall in the price of securities. This is called proprietary trading.
Asset management is the professional management of securities and other assets (real estate, etc.) on behalf of clients. That may be institutions (insurance companies, pension funds, corporations, etc.), or private investors (individuals or groups of individuals, such as mutual funds). The Asset Management division is sometimes called Investment Management. The provision of ‘investment management services’ includes elements of financial analysis, asset selection, stock selection, plan implementation and ongoing monitoring of investments. Investment management is a large and important global industry in its own right responsible for caretaking of trillions of dollars, euros, pounds and yen. Coming under the remit of financial services many of the world’s largest companies are at least in part investment managers.
Equity and fixed income research
Research is the division which reviews companies and writes reports about their prospects, often with “buy” or “sell” ratings. While the research division generates no revenue, its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers in covering their clients. There is a potential conflict of interest between the investment bank and its analysis in that published analysis can affect the profits of the bank. Therefore in recent years the relationship between investment banking and research has become highly regulated requiring a Chinese wall between public and private functions.
The term merchant banking refers to the negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies. Both commercial and investment banks engage in merchant banking. Although the fine lines that separate the functions of merchant banks and investment banks tend to blur and even in the United Kingdom the term merchant bank refers to an investment bank they perform different functions. As a general rule, investment banks focus on initial public offerings (IPOs) and large public and private share offerings. Merchant banks tend to operate on small-scale companies and offer creative equity financing, bridge financing, mezzanine financing and a number of corporate credit products. While investment banks tend to focus on larger companies, merchant banks offer their services to companies that are too big for venture capital firms to serve properly, but are still too small to make a compelling public share offering on a large exchange. In order to bridge the gap between venture capital and a public offering, larger merchant banks tend to privately place equity with other financial institutions, often taking on large portions of ownership in companies that are believed to have strong growth potential.