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What is an Investment Bank Anyway?
I have heard a lot lately about failing investment banks on Wall Street. What is an 'investment bank' anyway?
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 Great question. Essentially investment banks are securities markets participants that help companies who want to raise money in the securities markets, such as the stock and bond markets. When a company or other entity wants to raise money, the company can issue stock or bonds or other securities in the securities market, and the investment bank facilitates this process by initially buying these securities from the issuer (commonly called underwriting the securities) and then attempting to resell them later to investors (individuals or other entities, like mutual funds, pension funds, and insurance companies), hopefully at a profit for the bank. The company gets the desired financing without the hassle and risk of marketing the securities in the market itself, and the investment bank can potentially make a large profit later by selling the securities. The investment bank can also lose money on underwriting securities if the securities later lose value or cannot be sold for whatever reason (which has been happening lately in the sub-prime securities markets). The rewards are huge but the risks are also great. As part of this process the investment bank employs Ph.D.s and other financial professionals to value the securities using highly mathematically sophisticated models to determine the price of the securities. This service is very important in connection with the valuation of new investment instruments such as derivatives (which get value on the basis of some associated security, property or right), and options pricing (an option is a separate right to buy/sell a security at a specified price, and this right is saleable and it is important to find the price for this right). The investment bank also has numerous professionals that track developments in individual industries (such as technology, energy, financials, manufacturing) and use that information in the valuation of new securities issues. Each industry is unique and it is the job of the investment banker to understand and study this information to aid in the bank's primary function of aiding companies in raising capital.
In addition to underwriting, investment banks often negotiate mergers and acquisition deals. A merger is where two or more companies decide they could compete more effectively in the market if they pooled resources and competencies and became one entity. It is important to know what the valuation of the companies is and how corporate control and ownership will proceed. Investment banks can help merger candidates negotiate deals and evaluate assets and liabilities to make the merger happen. Investment banks also assist companies that want to buy control of another company's stock (an acquisition). When the buying company wants to get controlling interest, they often have to offer extant shareholders a premium price (higher price) over the market price of their stock to get the shareholders to sell shares. The question then is how much to offer? The investment banker's expertise in valuing securities is essential here and the banker helps the company make its offer (called a 'tender offer') to the shareholders. The company doesn't want to pay too much but also wants to offer enough to ensure getting the acquisition done, and the investment banker works to make sure the purchase is done right.
Investment banks therefore provide very valuable services to securities market participants, making it easier for companies to raise needed money, merge with other firms or purchase controlling interests in other companies. The investment bank then helps investors find valuable investment opportunities for the right price.
Published on BankingQuestions.com 10/03/08
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