To attract or place capital, corporations and large investors turn to investment banks. While traditional banks are engaged in lending and placing deposits on deposit accounts, the activities of investment banks are carried out in another area. Which one exactly? This will be discussed below.
Investment banking: valuation, leveraged buyouts, and mergers and acquisitions
To attract or place capital, corporations and large investors turn to investment banks. While traditional banks are engaged in lending and placing deposits on deposit accounts, the activities of investment banks carry out entirely different activities. Which one exactly? This will be discussed below.
What is an investment bank?
There is a number of well-known textbooks for professionals and executives — Investment Banking by Joshua Rosenbaum is probably the most commonly used. But how to understand the basics without diving deep? Well, an investment bank is a financial institution that helps corporations and large private investors enter the stock, currency and commodity markets of the world. Consequently, almost any bank of this type performs the functions of a broker.
Similarly, it can be said that an investment bank is a financial intermediary between consumers and suppliers of capital. Bank intermediaries unite those who need money (for example, for the modernization of production or construction) with those who have the opportunity to invest capital, i.e. perform the functions of a stock exchange.
Intermediary banks receive remuneration in the form of commission for the organization of transactions. They only work with large transactions such as:
- introduction to the securities market;
- release of derivative products;
- long-term lending to large businesses;
- investing in large projects;
- reorganization of companies;
- risk management
Placement of securities is often the main investment operation of banks, which is called underwriting. The collection of applications for the purchase of securities during the initial placement is carried out by investment banks, called bookrunners.
However, it is worth noting that in addition to this activity useful for the economy, the largest investment banks often sell not only stocks and bonds, but also derivative products called derivatives. Investment banking books tend to share a view that derivatives have little wider public benefit, since many derivatives are actually bets on this or that event, reinforced by leverage. The bank also acts as a croupier between the two sides of the transaction, receiving a commission, i.e. earnings without risk.
Investment banks also act as advisers on private mergers & acquisitions between large players. A merger is a huge undertaking that requires specialist regulatory or operational know-how, across multiple parrelel workstreams for a short period. Therefore it’s not surprising that corporations turn to consultants for help. M&A books suggest that investment banks are playing a greater role in M&A than they did 10 years ago. The due diligence is often outsourced to a professional services firm, leaving the more lucrative work for the bank.
How do investment banks differ from commercial ones?
Investment banking institutions differ from commercial ones in that they redistribute risk: they bring securities or derivative products to the market, bring buyers and sellers together, and also act as a party to the transaction themselves. Commercial banks attract funds from individuals and companies, issue consumer loans, mortgages, loans.
Bankers become the client’s advisor, accompany transactions, talk about investment opportunities and risks. And since the bank’s task is to earn money, the opportunities often look very promising, and the risks are small. Bank specialists prepare market analytics for investors, provide legal support.
Another difference: commercial banks are regulated by the central bank of the country. In Russia, the Central Bank has also been a mega-regulator of the entire financial market since 2013. Banking books explain that foreign investment banks are regulated by special agencies: for example, in the USA it is the Securities and Exchange Commission (SEC). In Europe, in addition to the general supervision of the ECB, there is the Federal Supervisory Authority for Financial Services (BaFin), the Prudential Control and Dispute Resolution Authority (ACPR), etc.
Usually investment banks do not participate in transactions with individuals, but they can provide services to large individual investors. For example, to form private investment portfolios of securities.
Large corporate transactions such as IPOs or corporate bond issues are “piece goods”. Because of this, the struggle for a client in investment banks is even more fierce than in commercial ones. Investment banks are forced to constantly lure the client into their circle of influence by organizing conferences, training and similar networking events.
The name of the intermediary, for example, during the initial public offering of the company’s shares, plays an important role in how this issue will be perceived by the players and the market as a whole. Therefore, investment banks invest a lot in maintaining their image of “high-class professionals” and the prestige of the industry as a whole. Since their main capital is specialists and experts who are attracted by clients to implement a particular project, investment banks guarantee them a very high level of income and often pay for professional development costs (for example, obtaining an international CFA certificate, which, however, is not mandatory for obtaining a good position in investment banking).
In addition, investment banks regularly publish their analytical reviews and forecasts on the dynamics of market quotations and the economy in order to maintain their importance, and their opinion also influences the perception of certain events by the market.
The largest investment banks in the financial world are also called bulge bracket (BB). Often, banks related to BB work not only with large corporations but also with states and act as primary dealers of Treasury bonds.
Investment banking in the UK, Europe and United States
American investment banks are most focused on large transactions and markets. In 1933, they were separated from traditional client banks when a ban was introduced in the United States on combining trading on stock exchanges with attracting deposits from individuals. The ban was due to high risks for depositors and the situation with the stock market falling by 90% in 1929-1932. Today there are more than 3,000 investment banks and investment corporations in the USA.
But in other countries, such a division is not always traced and an investment commercial bank can place deposits of corporations and investors. For example, in Europe, some investment banks are commercial, as they specialize in supporting small and medium-sized businesses.