What is the role of an Investment Bank?
Different Investment Banks would have a variant of the following generic business structure. Investment Banks in simplest terms help match investors and institutions who need capital, and then help bring together buyers and sellers in the financial markets. They typically would have a Research division providing analysis of companies, their financial situations etc. to all the internal businesses as well as to the external clients. Corporate Advisory business also known as Investment Banking would basically help companies raise and spend money. This is done through primary issuance of Debt (loan), Equity (shares) and other related securities, and Mergers and Acquisition activities. The Capital Markets business of Investment Bank helps investors buy and sell securities (like bonds, equities etc.). Asset Management division assist in managing client (clients including Institutions, High Net worth Individuals, etc.) assets and invest them into the financial markets. Proprietary investments would invest in different financial assets to generate returns for the bank (is typically never client driven business). There is supposed to be a Chinese wall (physical barriers) separating the proprietary investment traders from the client facilitation businesses like corporate advisory and capital markets (so that the client’s trading information is not leaked to the prop traders)
The Corporate Advisory group basically helps companies raise money, and then helps them spend the same. This group is invariably called IBD (Investment Banking Division). They help companies raise money through the issuance of Stocks and Bonds. Stock refers to a share or the ownership of the company. Bond refers to a kind of debt / loan that the holder provides to the company. Most large public companies raise money through a combination of Stocks and Bonds issuance, and Investment Banks assist companies in doing that (the process also known as securities underwriting). Investment Banks find the optimal Equity / Debt structure (simple example 60% equity, 40% debt) for the company and guide them with restructuring / financing from time-to-time. Investment Banks also help companies in spending their money through Mergers and Acquisitions. They would advice different firms in finding them other companies that could strategically help in their growth plans and help finance the acquisition for them. They would do entire company valuations, as well as sub-parts valuations as appropriate in the transaction. They would also finance the deals and / or help find financing partner institutions / investors.
Once the companies’ Equity and Debt securities are issued (called Primary Issuance) by Corporate Advisory group, they get traded in the secondary markets. The Capital Markets division provides clients the ability to buy and sell these securities in the market. The Investment Banks are also sometimes referred to as Securities firms as they help issue the securities (securities underwriting) and help trade in securities (brokerage). Typically in each sub-division there are different Sales, Trading, Research and Structuring teams. These are typically called Front-office / business teams. Around these teams there exist different control and support functions including Technology, Operations, Finance, Audit, Legal, Human Resources, etc.
The Equities division provides services related to purchase and sale of stocks. The stocks are typically listed on the exchange, but for anyone to buy and sell those stocks they need to go through a member of the exchange who acts in the brokerage capacity. Besides Stocks, they also deal with Equity derivatives like Futures and Options and any combination of such derivatives. All this includes also the transfer of risk, helping clients manage their portfolio with some advisory services as well.
Hedge Funds are unregulated investment funds that can buy or sell assets and use some leverage to provide return when overall markets are going up or down. Hedge Fund investors typically include High Net Worth Individuals (HNWIs), Investment Banks, Institutional Investors (through fund of funds) and Family offices. For leverage (meaning additional loans to invest more, the term explained in detail later), they get the financing from Prime Brokers, who also help provide other custodian and administrative services. A Hedge Fund typically would have few brokers with whom they would execute the trades and then few Prime Brokers who would clear and custody those trades for the Hedge Fund. This has been a growing business for Investment Banks with the revenue pool from Hedge Funds to Investment Banks was estimated around $10bn in 2007
In the Fixed Income division, they help clients trade debt related securities (bonds, swaps, credit, etc.). These instruments are typically not traded on the exchange, so the Investment Banks help bring together buyers and sellers through OTC (over the counter) markets. Mortgage Backed Securities and Credit related products are also typically managed within Fixed Income division of Investment Banks. Fixed Income assets used to be considered as less risky, compared to Equities, but with time and financial innovation, Fixed Income assets became so complex that the underlying risk in extreme events was not well understood across the financial institutions. This has led to the Sub-Prime and Credit crisis we witnessed in 2007 onwards, which is developed further in following sections of the book.
The role of Research division is to analyze different companies and different assets for their valuation, expected performance etc. Research analysts publish reports covering different companies, industry sectors as a whole (like telecoms, utilities, financials, etc.) as well as providing macro-economic research cover regions across the globe. Research is used by employees of the Investment Bank across Capital Markets and Corporate Advisory for their business, as well as the clients to get investment ideas, valuations, etc.
Asset Management helps manage clients assets and invest into certain securities and strategies as desired by the client. Typically the clients would comprise of Institutional and HNWIs. Asset managers invest according to their clients’ risk return profile, by managing assets into different types of equity, fixed income, derivative etc. instruments.
Investment Banks also have proprietary investments businesses in which they chose to invest in different financial assets to generate returns for themselves (and not for clients). This division is kept physically separate from the rest of the bank, so that they could not benefit from client trading information, insider trading, front running client transactions etc.