Investment banks assist corporations in raising funds in the public markets (both equity and debt), as well as provide strategic advisory services for mergers, acquisitions and other types of transactions. Investment banks differ from Commercial Banks which serve to directly take deposits and make loans.
In the United States, the Glass-Steagall Act prohibited banks from offering both commercial and investment services. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act in 1999.
Investment Banks may sometimes be confused with brokerages, which are firms which assist people in choosing and buying stocks, bonds, and mutual funds. (Of course, it is possible for a brokerage and an investment bank to share common ownership, and some brokerage companies also do investment banking and some investment banks also do some brokerage.)
The tools of investment banking
Investment banks can raise money from the stock markets or they can raise money for corporations using advanced products called derivatives. Investment banks can invest their own money directly into a company, project, etc., as a direct investment for which they carry the full risk (known as merchant banking). An investment bank can raise money for the corporation from a high net worth individual and that investment is known as private equity. An investment bank can raise money for a corporation from a hedge fund that is dedicated to making direct investments in corporations, which is usually referred to as venture capital, or as loans with collateral as security to reduce risk. A combination of equity and loans also exist, such as mezzanine.
The main activities and units
Investment banks will typically be concerned with several business units, including Corporate Finance (concerned with managing the finances of corporations, including mergers, acquisitions and disposals), often called the Investment Banking Division of the firm; Research (concerned with investigating, valuing, and making recommendations to clients--both individual investors and larger entities such as hedge funds and mutual funds--regarding shares and corporate and government bonds); and Equities or Sales and Trading (concerned with buying and selling shares both on behalf of the bank's clients and sometimes also for the bank itself). Management of the bank's own capital, or Proprietary Trading, is often one of the biggest sources of profit; for example the banks may arbitrage in huge scale if they see a suitable opportunity and/or they may structure their books so that they profit from a fall of bond yields (a rise of bond prices).
Possible conflicts of interest
Because potential conflicts of interest may arise between different parts of a bank, the authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall which prohibits communication between Investment Banking on one side and Research and Equities on the other.
These are some of the conflicts of interest involved in investment banking:
- The fact that most stock research companies (companies which are supposed to do research on a business and tell investors to buy or sell a company) are owned by investment banks can create a large conflict of interest. Historically, many investment banks seeking to be allowed to underwrite a company's IPO or debt offering have said to that company that they would tell their research division to rate that company a buy in order to convince them to do a deal. Most observers allege that during the bull market of the 90's this would occur with almost every deal. The companies would choose the investment bank who had a large research division which would rate them a "buy", because that would likely increase the stock price of the company, which would increase the amount of money made by the companies' CEO's since they were primarily paid by stock options, meaning they make more money the higher the stock price goes.
- The fact that many investment banks also own retail brokerages can cause a conflict of interest. Besides the research division rating the stock a buy the Investment bank may tell its brokers to try and convince their customers to buy the stock as well. This would occur not only as a thing to clinch the deal, but may also occur when the company might be performing badly and the Investment Bank might have a large supply of stock in its inventory. The investment bank can instruct the retail stock brokers to tell clients to buy the stock so that the investment bank can get the poor performing stock off its hands. This "offloading of inventory" conflict of interest more often affects the larger institutional clients of an investment bank.
Some of the major global public and private investment banks include: