The good, bad and ugly of investment banking
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In the City of London, October 27th 1986 was a momentous day. In order to become more competitive in financial services, the UK government deregulated and internationalized the industry. The result — known as the Big Bang — was that London experienced huge growth in the banking sector, and became an international financial center to rival Wall Street.
The ‘Big Bang’ could also describe banking in the 1980s more generally. The advent of new technologies and increasingly open markets meant that the industry was booming as never before — exactly like this happened in the data room industry. And a job in finance was considered a glamorous pathway to untold riches.
Thirty years later, investment banking’s star has well and truly fallen on both sides of the Atlantic. Whether it’s Bernie Sanders building his campaign around anti-Wall Street messages, or the British public distrusting bankers almost as much as politicians, finance’s reputation looks to be at an all-time low.
But is investment banking really that bad? Or are critics — angered by high-profile scandals and stories of astronomical bonuses — ignoring the key role that it plays in today’s economy?
Before answering these seemingly tricky questions, brush up on the basics of the investment banking industry.
Origins
Merchant banking first appeared in Medieval Italy, and existed to provide credit, underwriting, and depositing services to merchants (the clue’s in the name). That helped to keep the mercantilist economies of the time ticking over — so it was fairly clear that without these institutions, trade and expansion would be far more difficult, if not impossible.
What is an investment bank?
An investment bank is a financial services company that organizes large and complex financial transactions such as initial public offerings or mergers and acquisitions for corporate clients.
Investment banks are responsible for raising money for enterprises, in particular through selling securities to investors, including high net-worth individuals and organizations such as pension funds. They can also manage initial public offerings and advise clients on mergers and acquisitions and reorganizations.
Essentially, investment bankers are financial intermediaries between a corporation and the financial markets, proficient in the current investment climate. With their assistance, it is easier for clients to navigate the complexities of high finance.
Investment professionals’ clients typically include corporations, governments, pension funds, private equity firms, institutional investors, and hedge funds.
How do investment bankers work?
The investment banking advisory division receives a fee for the services it provides. The trading division, for its part, gets commissions based on market performance.
Besides, many investment banks also have retail banking divisions that loan money to businesses and consumers to make a profit.
Individuals working in the investment banking industry may pursue careers as financial advisors, salespeople, or traders.
Although an investment banking career is stressful and comes with extended hours, it is pretty lucrative.
What is the difference between investment banks and commercial and retail banks?
Both retail and commercial banks accept cash deposits and lend them out to borrowers. However, the depositors of commercial banks are enterprises, not individuals.
As for the investment bank, it doesn’t accept deposits but is engaged in raising capital through the sale of securities. The proceeds fund projects for entrepreneurs or help them expand into new markets.
Thus, as a rule, the clients of investment bankers are large organizations looking for complex funding solutions.
What do investment banks do?
Before naming the services, we first need to identify the difference between an investment bank and an investment banking division.
So, the investment banking division carries out underwriting and lends its corporate finance services mostly to private equity firms and corporate clients.
In turn, investment bankers offer services such as arranging financing, equity financing, underwriting, arranging private placements, and negotiating M&A.
You may want to check more details on each of the services provided by investment bankers below.
Arranging financing
If a company plans to build a factory and needs more money, it can issue corporate bonds to proceed with the project with the money raised. In this case, the cost of the bonds is paid off by increasing production at the new factory.
The investment banker’s task is to plan a bond issuance, set the appropriate price, complete the required U.S. Securities and Exchange Commission (SEC) documents, and assist in selling the bonds.
Equity financing
When a young organization launches an initial public offering (IPO) for expansion, the investment banker plays a critical role at every stage of the operation.
First, an investment banker draws up a prospectus for potential investors, explaining the terms of the transaction and the risks.
The next step is to regulate the deal through investor marketing, media clarification, and securing approval from the SEC.
And finally, how an investment banker prices an offer is critical. If the share price is too high, the deal fails because it doesn’t generate interest from investors. If it is too low, the investment banker allocates the amount of money the client could have received in the event of a successful transaction.
Underwriting deals
Investment bankers often take over the underwriting of deals for their customers when arranging capital markets financing. In other words, they take on most of the risk by buying shares from issuers directly and then selling them to institutional clients or the public.
Sometimes an investment banker acts as an intermediary and moves the deal forward without taking on the underwriting risk. In such a situation, bankers can sell securities and profit from the commission.
Arranging private placements
Investment bankers also help companies raise capital through private placements since some organizations don’t want to go public. In that case, the benefit of involving investment bankers is that they have the contacts and credibility to complete the sale successfully.
For example, an entity may sell its entire bond offering to an insurance company or pension fund. This option doesn’t imply registering the placement with the SEC, so it can be a convenient and quick way to raise money.
Negotiating mergers and acquisitions
Mergers and acquisitions are a long process involving much planning and negotiation. An essential role in this transaction is assigned to investment bankers since they negotiate a fair price for the deal.
In addition, they support structuring and facilitating the procedure and improving the potential success of the M&A.
What role do investment banks play in the economy?
After studying what investment banking business services are, see how investment banks’ work is affecting the economy:
- Capital formation
Investment banking eliminates the shortage of capital and stimulates investment. Specifically, financial advisors mobilize the small and scattered savings of retailers and high-net-worth individuals and then make them available for investment in the capital market. - Gross domestic product growth
A country improves its economic well-being from direct and indirect investments from the investment banking business. And while the amount that an investment bank generates increases gradually, a country receives a significant contribution to its GDP. - Infrastructure development
Countries typically need funds and feasibility studies to implement infrastructure development projects. And yet again, investment bankers are helpful as they generate funds and carry out these studies. - Employment opportunity creation
As the volume of the investment banking business grows, new job opportunities are created. And this, in turn, contributes to the state’s overall development. - Liquidity
By matching sellers and investors, investment bankers help broad financial markets by adding liquidity. Being an intermediary, an investment banker buys all or part of the shares of an organization conducting an initial public offering, then sells them on the market, creating immediate liquidity.
Top investment banks in the world
Here is a list of some of the largest investment banks catering mostly to governments, large corporations, and institutional investors worldwide.
Besides, each example of investment banks below is commonly considered a bulge bracket bank, meaning each has a global presence and provides a full range of investment banking services:
- Bank of America Merill Lynch
- Deutsche Bank
- Citigroup
- Barclays
- JPMorgan Chase
- Credit Suisse
- UBS
- Morgan Stanley
- Goldman Sachs
The Good
Investment banks still carry out many of the useful — and vital — functions that their predecessors did. Most obviously, they help companies to raise capital through issuing equity or debt in capital markets, giving businesses access to sources of finance. The continued functioning and growth of the economy relies on enterprises being able to invest in their operations. For example, electric car manufacturer Tesla raised $738 million by selling stock — with the help of six of the biggest investment banks in the world.
Investment banks have another crucial job: acting as market-makers. This involves guaranteeing to buy or sell a stock or bond, so that the market in question remains liquid, and orders that are filed can be fulfilled. Without this, liquidity would drop and markets would seize up — with potentially catastrophic consequences.
Another important service that investment bankers provide is providing financial advice and expertise to companies looking to carry out a merger or acquisition. If you ever asked them for advice, one of the things they would definitely recommend is to use a virtual data room on M&A deals. And even if it’s difficult to argue that every M&A deal is a net positive, they’re still an important part of modern capitalism, so bankers’ know-how is clearly of value.
The Bad
However, investment banks do other things that call their usefulness into question. One worry among commentators, including the former head of Britain’s regulatory authority, is that many financial institutions don’t create real value for the economy — they may even siphon it away. They say that financial players like investment banks and asset managers tend to collect ‘rent’ payments for manipulating money, but don’t provide an equally valuable service in return.
It’s also often claimed that a runaway bonus culture incentivizes bankers to focus on their own short-term gains, rather than their client’s best interests. The selling of subprime mortgage derivatives before the crisis is a perfect example — as expertly demonstrated by Ryan Gosling, the banks were hawking instruments to clients that weren’t a safe investment. The investment banks were more interested in making quick money than selling high-quality products — and some claim that they still are.
The Ugly
As if that weren’t enough, the banking world has given rise to numerous scandals and unsavory characters. From Jordan Belfort, the so-called Wolf of Wall Street, to rogue traders like Jerome Kerviel and Nick Leeson, finance seems to give unscrupulous figures the chance to enrich themselves by defrauding others. Nor is it just isolated individuals — as the Libor scandal demonstrates, corruption can often extend across departments and institutions.
Overall, it’s clear that investment banks play a crucial role in the economy — but the financial sector doesn’t always generate value, and seems particularly susceptible to manipulation and unethical behavior. Preserving its useful functions while preventing harmful and deceitful practices will be the biggest challenge of the coming years — for regulators, but also for the banks themselves.