Key Takeaways
- Investment banks help corporations access capital markets.
- Some companies use investment banks for their initial public offerings (IPOs).
- Investment banks typically handle a company’s mergers and acquisitions.
- Commercial banks focus on deposits and loans but have some investment capabilities; investment banks aren’t as restricted in their investment activities.
Definition and Examples of Investment Banks
An investment bank is a financial institution that specializes in meeting the needs of business clients. A typical investment bank may be able to do some or all of the following:
- Raise equity capital
- Raise debt capital
- Insure bonds or assist in launching new products
- Engage in proprietary trading. Teams of in-house money managers may invest or trade the company’s own money for its private account.
- Offer advice or services for mergers and acquisitions
- Provide payment and transactional services
- Research and develop solutions to challenging financial issues
For instance, suppose XYZ Manufacturing wants to sell $10 billion worth of bonds so it can build new plants in Asia. An investment bank would help it find buyers for the bonds and also handle the paperwork; it would do so along with a team of lawyers and accountants.
Investment banks can also assist with initial public offerings (IPOs), where a private company transitions from private to public ownership and becomes listed on an exchange.
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Well-known investment banks include financial institutions such as Goldman Sachs, Bank of America, and Citigroup.
How Do Investment Banks Work?
Investment banks are often divided into two camps: the buy side and the sell side. However, many offer both buy-side and sell-side services. The sell side of the bank is involved in selling shares of newly issued IPOs, placing new bond issues, engaging in market-making services, or helping clients facilitate transactions.
In contrast, the buy side of the bank generally works with pension funds, mutual funds, hedge funds, and the investing public. The aim is to help them maximize their returns when trading or investing in securities, such as stocks and bonds.
Many investment banks are divided into three divisions, based on the services provided and the employees’ responsibilities:
- Front office
- middle office
- Back office
Front Office Services
Front-office services typically consist of:
- Helping companies in mergers and acquisitions
- Corporate finance (such as issuing billions of dollars in commercial paper to help fund day-to-day operations)
- Professional investment management for institutions or high-net-worth individuals
- Merchant banking
- Investment and capital market research reports prepared by professional analysts
- Strategy formulation
Middle-Office Services
Middle-office investment banking services include compliance with government regulations and restrictions for professional clients such as banks, insurance companies, and finance divisions, as well as capital flows.
These are the people who watch the money coming into and going out of the firm, helping to determine the amount of liquidity the company needs to keep on hand so that it won’t get into financial trouble. The team in charge of capital flows can use that information to restrict trades by reducing the buying and trading power available for other divisions.
Back Office Services
The back-office services include the nuts and bolts of the investment bank:
- Ensuring that the correct securities are bought, sold, and settled for the correct amounts
- Seeing the software and technology platforms that allow traders to do their jobs are state-of-the-art and functional
- Creating new trading algorithms
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Back-office jobs are often seen as unglamorous. Some investment banks outsource them to specialty shops, such as custodial companies. However, back offices keep the entire operation running.
Investment Bank vs. Commercial Bank
| Investment Bank | Commercial Bank |
| Doesn’t accept deposits | Accept deposits |
| Doesn’t provide loans | Provides loans |
| Targets larger corporations and high-net-worth individuals | Targets all consumers, small to large corporations, and governments. |
| Regulated by the country’s securities enforcement agency | Regulated by the country’s central bank |
One main difference between investment and commercial banks is that investment banks focus on helping businesses access capital markets. Commercial banks primarily deal with deposit accounts and loans for individuals and smaller companies.
Investment banks in the US were not allowed to be part of commercial banks after 1933. Banks that performed investment and commercial services were viewed as one of the main contributors to the stock market crash of 1929, because banks could offer commercial and investment services. However, under a modified version of Section 619 of the Dodd-Frank Act—called the Volcker Rule—commercial banks can now participate in specific investing activities.
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