Understanding Investment Banks: Functions, Examples, and Key Roles

What Is an Investment Bank?

An investment bank facilitates large financial transactions and offers advisory services for IPOs and mergers. With major players like JPMorgan Chase and Goldman Sachs, these banks serve corporations, pension funds, and governmental entities by underwriting securities and offering strategic financial advice.

The Functioning of Investment Banks

The advisory division of an investment bank is paid a fee for its services. The trading division earns commissions based on its market performance. As noted above, many also have retail banking divisions that make money by loaning money to consumers and businesses.

Professionals who work for investment banks may have careers as financial advisors, traders, or salespeople. An investment banking career is lucrative but typically comes with long hours and significant stress.

Investment Banks as Financial Intermediaries

Investment banks are best known for their work as intermediaries between corporate clients and the financial markets. For example, they help corporations issue shares of stock in an initial public offering (IPO) and additional stock offerings. They also arrange debt financing for corporations by finding large-scale investors for corporate bonds.

The investment bank's advisory role begins with pre-underwriting counseling and continues after the distribution of securities.

Investment banks check a company's financial statements and publish a prospectus for investors before securities are sold.

Investment bank clients include corporations, pension funds, other financial institutions, governments, and hedge funds.

Size is an asset for investment banks. The more connections the bank has within the global financial community, the more likely it is to profit by matching buyers with sellers, especially for unique transactions. Investment bank operations can be roughly divided into three main functions.

Strategic Financial Advice from Investment Banks

As a financial advisor to large institutional investors, an investment bank aims to provide strategic advice on a variety of financial matters. The bank uses its understanding of clients' goals and markets to offer strategic advice on opportunities and challenges.

Investment Bank Roles in Mergers and Acquisitions

Facilitating mergers and acquisitions is a key element of an investment bank's work. Large banks like Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Citibank work with various industries. Smaller investment banks such as Greenhill & Co. (GHL) and Guggenheim Partners and often focus on a single sector, like healthcare.

The investment bank estimates the value of a potential acquisition and helps negotiate a fair price for it. It also assists in structuring and facilitating the acquisition to make the deal go as smoothly as possible.

Insights from Investment Bank Research Divisions

Investment banks have research divisions that review companies and write reports about their prospects, often with buy, hold, or sell ratings. This research might not directly generate revenue, but it helps the bank's traders and sales teams. The sales department typically oversees the buying and selling of financial products such as stocks, bonds, commodities, and other securities.

The research division also provides investment advice to outside clients who can complete a trade through the trading desk of the bank, which would generate revenue for the bank.

Research maintains an investment bank's institutional knowledge of credit research, fixed-income research, macroeconomic research, and quantitative analysis, all of which are used internally and externally to advise clients.

Challenges and Criticisms Facing Investment Banks

Investment banks advise external clients in one division and trade their own accounts in another. That is a potential conflict of interest.

To prevent conflicts, investment banks maintain an "ethical wall" between divisions. This figurative barrier is meant to prevent the sharing of information that would allow one side or the other to unfairly profit at the expense of its own clients.

Retirement Security Rule: What It Is and What It Means for Investors

The new Retirement Security Rule, also known as the fiduciary rule, is intended to protect investors from conflicts of interest when receiving investment advice that the investor uses for retirement savings.

The rule was issued by the U.S. Department of Labor (DOL) on Apr. 23, 2024. It takes effect on Sept. 23, 2024. However, a one-year transition period will delay the effective date of certain conditions to 2025.

If an advisor is acting as a fiduciary under the Employee Retirement Income Security Act (ERISA), they are subject to the higher standard—the fiduciary "best advice" standard rather than the lower, merely "suitable advice" standard. The designation can limit the products and services advisors are allowed to sell to clients who are saving for retirement.

The Bottom Line

Investment banks are key players in the financial world, specializing in managing complex transactions like IPOs and mergers. They serve as intermediaries between corporate clients and financial markets, providing financial advice, facilitating mergers and acquisitions, and conducting in-depth research. While they must navigate potential conflicts of interest and maintain ethical walls between divisions, investment banks are crucial for matching buyers and sellers globally. Understanding the roles and functions of investment banks can empower individuals and businesses to make informed financial decisions.