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How does an investment bank work?

Want to understand the nuts and bolts of the investment banking business? Here we tell you what you need to know
Investment banking
Introducing investment banking

If you know nothing about investment banks, here you'll find the key facts you need to start with if you're interested in working in this world. And even if you think you know a thing or two about banks and their work, it's worth forgetting about getting to grips with synthetic CDOs or discounted cashflow models for a moment, and making sure that you're clear on the underlying machinery.

Here we've set out who investment banks are, why they exist, and some important points about what they do, so that you have a solid foundation for further research into the business.

What is an investment bank?

Essentially, investment banks provide advice and funding to corporate and other clients, and engage in trading activities for their clients and sometimes their own behalf.

Investment banks were historically distinguished from retail banks, that is, banks which take deposits from consumers and provide them with services such as loans, mortgages and credit cards. However, nowadays many major financial services institutions – the likes of Citi, Barclays and UBS to name but a few – operate in both markets and are known as "universal" banks.

As well as the large universal banks, other types of institution found within the sector include elite pure investment banks, "boutique" advisory-only investment banks, and banks which focus on mid-market deals or on particular geographies.

You can read more about the different types of investment banks and what differentiates them here.

Who owns investment banks?

Many of the leading European and US investment banks are public companies, meaning that their shares trade on stock exchanges and anyone who purchases these shares owns a piece of the bank.

However, note that many investment banks are controlled by a handful of investors who own large slices of the available shares. Major investors in public or private investment banks could include other financial institutions, governments through sovereign wealth funds, wealthy individuals, family groupings, and even directors of the bank.

Some smaller investment banks remain privately owned or are structured as partnerships.

Who are an investment bank's main clients?

An investment bank's main clients are:

  • Corporates: operating companies in sectors including energy, retail, construction, technology, media, healthcare, food and drink and chemicals - and other financial services organisations.
  • Funds: investment vehicles which pool investors' assets and follow a particular investment strategy, including pension funds, hedge funds, and private equity funds.
  • Sovereigns: governments, but also quasi-governmental institutions such as export credit agencies and sovereign wealth funds.
  • High net worth individuals: usually defined as those with investable assets worth over $1 million.
  • The bank itself: some of a bank's trading and investment activities are conducted not for an external client but to make profits for itself, or to protect the bank against risks.

What do investment banks do for their clients?

An investment bank's main activities are as follows:

  • Giving advice: advising clients on buying and selling companies, the structuring of their financial affairs, raising money, economic risk management and the purchase of financial products.
  • Investment management: advising on and managing the investment of assets for corporates and individuals.
  • Providing financing: making loans to and purchasing the shares of corporates, and assisting corporates in finding other parties to do so.
  • Trading: buying and selling shares, debt products, commodities, derivatives and related products on behalf of clients and to make money for the bank.
  • Research: Monitoring industry trends and economic developments for the bank's own purposes and for clients.

How do investment banks make money from offering these services to their clients?

Investment banks get their income from the following sources:

Fees: charged for advice, providing finance, keeping money available for clients, arranging financing for clients from other parties, trading services, investment services, and research.

Dividends: income from investments made in shares.

Interest: income from loans made.

Investments: profits from investments made.

Trading: profit made from buying and selling securities.

How are their activities regulated?

Many aspects of an investment bank's operations are closely monitored by governments and independent regulators, particularly the following areas:

  • Capital adequacy: Banks must comply with strict rules governing how much capital they hold in reserve and how easy it is to access so that they have an adequate financial cushion to fall back on at all times.
  • Activities undertaken: Whether certain parts of a bank can undertake particular activities, and how these different parts are separated, is subject to regulation to prevent problems in one area of a bank spreading to other parts.
  • Trading on their own behalf: In the US, the extent to which banks can trade with the capital they hold is heavily restricted, and some in the industry feel that similar rules should be implemented in Europe too.
  • Insider dealing: Regulations prevent banks unfairly profiting from information revealed to them by their clients which is not in the public domain.
  • Money laundering: Banks are closely monitored to ensure that criminals do not use their activities and systems to hide illegal activities.
  • Transparency: Banks are required to disclose detailed information about their activities and their finances.
  • Pay: How much, and in what ways, banks are permitted to pay their staff is now subject to scrutiny by regulators in the interests of discouraging excessive risk-taking.

Why does the global economy need investment banks?

Investment banks are an integral part of the global financial ecosystem – so much so that most economies would quickly collapse without the services they provide. Here's why they're so essential:

  • Provision of finance: Investment banks provide money and access to other sources of money, such as pension funds, to businesses. Without this money, these businesses couldn't function.
  • Advice: Investment banks advise corporates, other financial institutions, governments and individuals on the best ways to use their money and to conduct transactions, which helps to foster economic growth and stability.
  • Risk management: Investment banks provide advice and services which allow companies and governments to effectively manage risks such as price fluctuations, economic changes and political instability, ensuring that the effect of these issues on the real economy is minimised.
  • Information: Investment banks provide analysis of corporate activity and economic trends, disseminating critical information to the financial sector, government policy makers, businesses and ordinary people.