What Is An Investment Bank?

The Role That Equity Underwriters Play in the Financial Markets

Aug 26, 2009 James Brumley

Investment banking is the process of raising funds for companies by connecting those corporations with investors. There's more to it than just that, however.

Though the term 'investment bank' may sound somewhat intimidating to someone unfamiliar with Wall Street's common lingo, the reverence is mostly unmerited. Here's a quick but complete synopsis of what these specialized financial institutions do, and how they operate.

What Is An Investment Bank?

Despite the name, investment banking isn't 'banking' at all - at least not in the traditional sense. Investment banks are organizations through which companies can raise funds by selling stakes (stock) of the company in exchange for cash. In simpler terms, investment banks 'take companies public' by acting as middlemen; the investment bank provides cash from investors for the company, and in return provides new shares of that company to those investors.

The process is also called underwriting. Therefore, investment bankers are sometimes referred to as underwriters.

That said, very few investment banks simply act as fund-raising facilitators any longer. Services related to the stock issuance process (often called an IPO or initial public offering) are also offered to companies raising funds through an underwriter.

How Do Investment Banks Operate?

As with all business ventures, the purpose of providing an underwriting service is to create a profit. With most fund-raising efforts, whether they be through debt (bonds or notes) or equity (stock, or shares), the investment bank keeps for themselves a nominal percentage of the funds raised in the underwriting process. The amount of money retained as the underwriting fee can range anywhere from 3% to 20% (or more) depending on the risk or difficulty of the fund-raising process.

As stated above, however, investment banks can generate revenues and profits in several other ways.

The biggest ancillary revenues of investment banking are generated by offering consulting services to a company throughout the public stock offering process. Some investment banks, though fewer, offer bond insurance services, investment management, and proprietary trading services.

And, some investment banks even have traditional banking divisions that accept retail customer deposits, make loans, offer ATM services, etc. Their retail banking and investment banking divisions are quite distinct, however.

Each of these activities is a billable or revenue-bearing service provided by in investment bank, though none are actually considered to be under the umbrella of 'investment banking.'

The legal environment affecting these multiple business operations is always changing. In general though, the law requires clear fiscal distinction between investment banking funds, proprietary trading funds, loans, customer deposits, and any other services that may co-mingle client funds with bank funds. The enforcement and interpretation of these laws can vary, however, which generally leads to conflict-of-interest issues.

Access to Investors is Critical

It should be noted that one of the keys to being a successful investment bank or underwriter is being able to find enough willing investors to raise sufficient cash to meet a company's IPO/fund-raising needs.

Most investment banks can handle small to mid-sized IPO just using their own 'books' (a list of major clients or institutions that are apt to have a significant amount of idle cash). For some of the biggest public offerings though, an investment bank may need to enlist the help of other investment banks. Those recruited underwriters will get to keep most or all of the underwriting fees associated with the shares they are able to place (sell) using their own books of business.

Though an underwriter would prefer to place an entire IPO and keep all that income, should the investment bank be unable to raise all the required funds, it could be devastating to its reputation. If that were to happen, the bank may not be offered new IPO deals in the future.

Well-Known Investment Banks

Though the investment banking business' demand can ebb and flow considerably, most of the major underwriters have been around for quite some time. Some of the major investment banks are Goldman Sachs, Piper Jaffray, JP Morgan Chase, and Credit Suisse, just to name a few.

The copyright of the article What Is An Investment Bank? in Investment is owned by James Brumley. Permission to republish What Is An Investment Bank? in print or online must be granted by the author in writing.

Investment Banking