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10 key concepts to understand in investment banking

With lots to learn about investment banking, we provide some of the key building blocks needed to gain a better understanding of this complex industry
Investment banking
Introducing investment banking

Unless you’re actually worked in an investment bank, you’d be forgiven for not understanding exactly what the industry does, how it all fits together, or what makes a bulge bracket bank different to a boutique. 

There’s a lot to get your head around, but fear not – we’re here to help. Here we explain some of the key concepts to help get you started as you take your first steps towards an investment banking career. 

1. Debt finance

  • Debt is any finance raised through borrowing, generally from banks. The borrower must repay the full amount on an agreed timescale and must also pay interest (service the debt).
  • Many companies choose to finance their businesses through debt because, unlike dividend payments to equity investors, the interest is tax-deductible (can be subtracted from tax payable).
  • A lender doesn't take any share in the borrower's business when issuing a loan, so by borrowing, owners of a business don't dilute their ownership of it.
  • In order to guarantee the debt, the borrower may be asked to pledge some or all of their assets as collateral (known as giving security for the loan). If they fail to pay back the money on time, the assets may be seized by the lender.
  • Debt financing leaves borrowers more exposed to macroeconomic headwinds, like interest rate rises or economic downturns. These events can quickly and severely affect the debtor’s ability to make repayments and jeopardise the stability of their businesses, especially if their loan is secured by assets such as property or equipment.

2. Equity finance

  • Equity is finance raised from investors in exchange for a share of the business.
  • For small businesses, the main sources of equity finance are business angels (who invest in young, high growth businesses, à** **la Dragons' Den) and venture capitalists (who often invest large sums ahead of a potential sale of a growing business, or the flotation of its shares on the stock markets). Larger and more established businesses (especially those likely to benefit from cost-cutting or reorganisation) may attract investment and input from private equity funds. Very large and successful businesses can obtain equity investment through listing their shares for sale on the financial markets – these companies are known as public companies.
  • The major advantage of equity finance over debt finance is that, unlike with debt finance, companies are not required to make regular repayments to their investors. However, investors may be entitled to dividend payments.
  • Equity financing is usually more difficult to obtain than debt because the risks to an investor are generally considerably greater. Securing investment can therefore be time consuming and costly.
  • Since equity investors are partial owners of the company, they can often have a say in business decisions, which can sometimes lead to disputes and conflict. Public companies are also subject to extensive regulation.

3. Bulge bracket banks

  • The term ‘bulge bracket’ was first used on Wall Street to denote the group of investment banks awarded top billing on the ‘tombstone’ – a financial advertisement used to notify the public of an important transaction like a share issue.
  • These days, the term is commonly used in the finance sector to describe the largest and most well known investment banks in the world.
  • Bulge bracket banks are far more likely to get involved in transactions where they use their own capital (rather than just giving advice) than boutique banks, because their greater size and their links to commercial banks means that they tend to hold significant pools of capital.
  • Since the government bailouts of the financial crisis, bulge bracket bank have been subject to much stricter regulation in areas such as banking bonuses and salaries, trading on their own behalf, and how much capital they hold.
  • Most of the bulge bracket banks have become household names and include Bank of America Merrill Lynch, Barclays Capital, , Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Morgan Stanley and UBS.

4. Boutique banks

  • Boutique banks are often considerably smaller in size than the bulge bracket. They sell themselves to clients, and potential recruits, on the basis of their flexibility, independence and freedom from the conflicting interests that sometimes affect larger institutions.
  • Rather than offering the entire range of services, the boutiques often choose to focus on doing the things they are especially good at – e.g. providing a specific solution, like M&A advisory, or serving a specific marketplace such as oil and gas.
  • Without piles of cash at their disposal, most boutiques don't invest or trade with their own money, instead concentrating on offering advisory services.
  • Often, a boutique bank is driven by a strong personality who may have cut their teeth at a bulge bracket before going solo, for example, Robert F. Greenhill and Ken Moelis, founders of Greenhill and Moelis & Company, respectively.
  • Other well-known boutique investment banks include Jeffries, Hawkpoint, Seymour Pierce and Rothschild.

5. Traditional trading

  • "Traditional" trading is the sale and purchase of actual securities (shares, currency, commodities, debt).
  • Trading, in a financial context, usually refers to investments changing hands on the financial markets, these are regulated exchanges which enable buyers and sellers to interact and do business.
  • The major trading platforms around the world are, in order of size, NYSE (USA), NASDAQ (USA), Tokyo Stock Exchange (Japan), and the London Stock Exchange (London).
  • Trades are arranged by a broker, who can act as the go-between for a buyer and seller, and effected by a trader.
  • Investment banks are heavily involved in various aspects of the trading cycle, including advising on the issuance of securities by their clients, researching issuances, advising clients on what securities they should buy or sell, and trading itself, both on their clients behalf and for themselves.

6. Derivatives

  • Derivatives are financial products whose value is based on (derived from) the value of an underlying asset, for example shares, bonds, or a revenue stream from interest payments on a loan.
  • Derivatives first originated as bolt-on products to protect investors who’d already purchased the underlying assets to which they relate; however,  they are now also traded as independent financial products.
  • Popular types of derivatives include:
  • Swaps: for example, my loan has a fixed rate of interest, but I would like to pay a variable rate. I can buy a "swap", which means I will pay a variable rate, while the counter party to the swap will pay my fixed rate interest payments.
  • Forwards: for example, I don't know what the demand for my product will be in the future so I buy a forward, which means agreeing with a purchaser that they will buy my product at a predetermined price in a number of months time. If the market price has gone up, the investor benefits; if it's gone down, I benefit.
  • Options: for example, I am worried about the future value of some shares I hold, so I buy an option, which means I gain the right (but am not obliged) to sell them at a particular price on a particular date, theoretically insuring me against the risk of significant losses.

7. Investment banks

  • These institutions provide advice to large corporate clients – and sometimes governments – about borrowing money, selling their shares or bonds (slices of corporate debt) on the financial markets, mergers and acquisitions and where to invest their money.
  • They also help their clients to buy and sell securities – shares, bonds and other investments traded on the financial markets.
  • They may provide all or part of the funds that corporate clients wish to borrow or, in the case of a securities offering, may act as an underwriter, meaning that they guarantee to their client to pay them for any of the securities issued by that company that are not sold on the markets.
  • Investment banks may also buy and sell securities on their own behalf to generate profits for the bank (known as proprietary trading).
  • After a period of consolidation in the banking sector following the financial crisis, most large investment banks are now linked to commercial banks, giving them greater stability, and more capital (the deposits in commercial banks) to invest – but in return, must submit to greater regulation.

8. Commercial banks

  • These are the banks we see on our high streets, and most ordinary individuals and businesses will have an account with one of them.
  • They take deposits, provide loans and hold savings, charging interest on the loans they offer and paying out smaller rates of interest on savings.
  • Commercial banks' main profit stream is the interest on the loans they make, and so outstanding loans are their principal assets, whereas the deposits they hold on behalf of customers (and pay interest on) are their liabilities.
  • Loans can be made to individuals (retail banking) or to companies and governments (wholesale or corporate banking).
  • Every regulated UK account in a commercial bank is guaranteed by the government backed Financial Services Compensation Scheme (FSCS) up to £85,000 – this means that if a commercial bank were to collapse financially (as Northern Rock came close to in 2007), any deposits up to that level would be refunded by the government.

9. Buy-side

  • Financial organisations on the buy-side of the market buy assets or securities, and include companies like mutual and pension funds, etc. Individuals may also participate on the buy-side.
  • The goal of those working on the buy-side is to make a financial return through their purchases for the holders of the funds invested. Returns could come from interest payments on debt investments, dividend payments from equity investments, or from an increase in value of the investments they hold.
  • Individuals working in this sector include fund managers, research analysts (who provide managers with recommendations) and sales and marketing professionals (who distribute the investments).
  • The buy-side plays a key role in corporate activity, since large funds often hold prime stakes in target businesses. Large funds also play a significant role in the finances of individuals, as they manage savings and pension funds.
  • Buy-side firms are active in a lower number of transactions than sell-side ones, and generally look to accrue profit from holding investments long-term.

10. Sell-side

  • The sell-side is the part of the market that sells securities. It comprises of companies and governments (both of whom issue shares and bonds) and the investment banks and brokers that advise on these issues, underwrite them (guarantee the revenues from their sale to the issuer), and market them to the buy-side.
  • Those working on the sell-side at investment banks advise the buy-side on the financial products they think they should invest in, and may be involved in effecting the purchase.
  • The sell-side put a great deal of effort into marketing and try to secure the maximum price for the products they sell.
  • In contrast to the buy-side, those on the sell-side are involved in facilitating a high volume of transactions day-to-day, often at great speed.