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An investment bank, which includes the likes of Bank of America, JPMorgan Chase, and Goldman Sachs, finances or facilitates trades and investment on a large scale for institutional clients. But that is an overly simplistic view of how investment banks make money. There are, in fact, several facets to what they do.
Key Takeaways
- Investment banks provide a variety of financial services, including research, trading, underwriting, and advising on M&A deals.
- Proprietary trading is an effort to make profits by trading the firm’s own capital.
- Investment banks earn commissions and fees on underwriting new issues of securities via bond offerings or stock IPOs.
- Investment banks often serve as asset managers for their clients as well.
Brokerage and Underwriting Services
Like traditional intermediaries, large investment banks connect buyers and sellers in different markets. For this service, they charge a commission on trades. The trades range from simple stock trades for smaller investors to large trading blocks for big financial institutions.
Investment banks also perform underwriting services when companies need to raise capital. For example, a bank might buy stock in an initial public offering (IPO), and then market the shares to investors. There is a risk that the bank will be unable to sell the shares for a higher price, so the investment bank might lose money on the IPO. To combat this risk, some investment banks charge a flat fee for the underwriting process.
Mergers and Acquisitions
Investment banks charge fees to act as advisors for spinoffs and mergers and acquisitions (M&A). In a spinoff, the target company sells a piece of its operation to improve efficiency or to inject cash flow. On the other hand, acquisitions occur whenever one company buys another company. Mergers take place when two companies combine to form one entity. These are often complicated deals and require a lot of legal and financial help, especially for companies unfamiliar with the process.
In hostile takeovers, they may assist either the acquiring or target company in crafting strategies to defend or advance the deal. Investment banks leverage their financial expertise, industry knowledge, and relationships to guide clients through the process to both maximize value as well as minimize regulatory/reporting risks.
Creating Collateralized Products
Investment banks might take lots of smaller loans, such as mortgages, and then package those into one security. The concept is somewhat similar to a bond mutual fund, except the collateralized instrument is a collection of smaller debt obligations rather than corporate and government bonds. Investment banks must purchase the loans to package and sell them, so they try to profit by buying cheap and selling at higher prices on the market.
Proprietary Trading
With proprietary trading, the investment bank deploys its own capital into the financial markets. Traders that risk the firm’s capital are typically compensated based on performance, with successful ones earning large bonuses and unsuccessful traders losing their jobs. Proprietary trading has been much less prevalent since new regulations were imposed after the 2007-2008 financial crisis.
Investment banks had a part to play in the Global Financial Crisis in 2008. It’s widely believed that poor credit risk assessment and accountability was a contributing factor in the crash.
Dark Pools
Suppose an institutional investor wants to sell millions of shares, a size that’s large enough to impact markets right away. Other investors in the market might see the big order and this opens the opportunity for an aggressive trader with high-speed technology to front-run the sale in an attempt to profit from the coming move. Investment banks established dark pools to attract institutional sellers to secretive and anonymous markets to prevent front-running. The bank charges a fee for the service.
Swaps
Investment bankers sometimes make money with swaps. Swaps create profit opportunities through a complicated form of arbitrage, where the investment bank brokers a deal between two parties that are trading their respective cash flows. The most common swaps occur whenever two parties realize they might mutually benefit from a change in a benchmark, such as interest rates or exchange rates.
Securities Lending
Investment banks often lend stocks or bonds to institutional investors, hedge funds, and traders for short selling or other investment strategies. In return, they charge fees or interest. For example, an investment bank may be holding securities on behalf of a client. Instead of having that security simply sit, they can lend that security to other parties. In exchange for returning that security at a specific time, the investment can get a fee and the original security holder will never notice “their share” was lent out.
Market Making
Investment banks often have market-making operations that are designed to generate revenue from providing liquidity in stocks or other markets. A market maker shows a quote (buy price and sale price) and earns a small difference between the two prices, also known as the bid-ask spread. They are the “middle man” to make a financial transaction happen as they can help match buyers and sellers.
Investment Research
Major investment banks can also sell direct research to financial specialists. Money managers often purchase research from large institutions, such as JPMorgan Chase and Goldman Sachs, to make better investment decisions. These investment banks can publish information on economic forecasts, industry analysis, or specific company research.
Asset Management
In other cases, investment banks directly serve as asset managers to large clients. The bank might have internal fund departments, including internal hedge funds, which often come with attractive fee structures. Asset management can be quite lucrative because the client portfolios are large.
Investment banks sometimes partner with or create venture capital or private equity funds to raise money and invest in private assets. The idea is to buy a promising target company, often with a lot of leverage, and then resell or take the company public after it becomes more valuable.
Wealth Management
Wealth management is similar to asset management but focuses on individual clients. Investment banks provide tailored financial planning, estate planning, and tax strategies for wealthy individuals. Relationship managers will meet with these high-net-worth individuals periodically to assess their financial goals and targets. Fees are charged based on AUM, commissions on investment products, or advisory fees.
How Do Investment Banks Make Money Through Underwriting?
Investment banks earn money through underwriting by facilitating the issuance of stocks or bonds for corporations and governments. They purchase these securities at a discounted rate and resell them to investors at a higher price, making a profit on the spread.
What Is the Role of Investment Banks in Mergers and Acquisitions?
Investment banks act as advisors in mergers and acquisitions, helping companies identify suitable targets, negotiate deals, and structure transactions. They provide valuation expertise, due diligence, and strategic insights to ensure successful mergers or acquisitions.
How Do Investment Banks Profit From Trading and Market Making?
Investment banks act as market makers by buying and selling financial securities to provide liquidity to markets. They profit from the bid-ask spread—the difference between the price they buy and sell securities for. Additionally, they may charge commissions or fees for executing trades on behalf of institutional and retail investors.
How Do Investment Banks Make Money From IPOs?
When a company goes public, investment banks manage the IPO process, determining the share price, marketing the stock to institutional investors, and facilitating the sale. They earn underwriting fees and a percentage of the total capital raised. Since IPOs can generate millions in fees, they can be a major source of income.
The Bottom Line
In a capitalist economy, investment bankers play a role in helping their clients raise capital to finance various activities and grow their businesses. They are financial advisory intermediaries who help price capital and allocate it to various uses.
While this activity helps smooth the wheels of capitalism, the role of investment bankers has come under scrutiny because there is some criticism that they are paid too much in relation to the services they provide.
