The operations of investment banks can be very confusing and misunderstood to outsiders. In part, this is because the industry is rife with overly complex terminology and jargon.
However, in this article, I will describe in simple terms exactly how investment banks’ business models work and how they make money.
Let’s jump in!
The role of investment banks
First, let’s cover the basics.
Investment banks play a crucial role in raising capital for corporations and governments.
They help their clients on various financial matters such as mergers and acquisitions, initial public offerings (IPOs), debt issuances, and restructuring.
These are critical services for the functioning of businesses and the global economy.
Primary revenue streams of investment banks
Investment banks earn revenue through fees charged for their services.
Typically, there are two types of fees they earn:
- Underwriting fees for arranging the sale of securities (debt or equity) on behalf of clients
- Advisory fees for providing strategic guidance
They also often make performance-based bonuses based on the success of the deals they complete.
Below is a breakdown of each revenue stream for investment banks:
Business clients often need loans to expand, grow, or operate their business.
Investment banks help with this by providing “debt underwriting” services.
This means the bank will make a loan to the company, and later it will resell pieces that loan to other investors.
While they do not typically hold onto the loan ultimately, they are compensated for arranging and structuring the transaction.
Also, they are compensated for taking risk by holding the loan for the period after the deal closes and before the bank can resell the loan to others (usually earning 2% to 3% on each sale).
This is risky since the bank will incur a large loss if the debt’s value declines while it is held on balance sheet.
Equity underwritings (aka IPOs)
Investment banks also assist privately held businesses in becoming public.
This means they provide “equity underwriting.” In other words, they assume the risk by purchasing the shares themselves before they are resold to other equity investors on the public market.
Investment banks impose a high fee based on the amount of the offering (usually 2-8% of the total deal). They earn millions of dollars in commissions as a result. They are also paid for setting an appropriate price and assembling a solid network of enthusiastic investors about the company’s long-term prospects.
Equity underwriting and IPO business tends to be dominated by a small number of large investment banks, who receive most of the underwriting profits.
M&A advisory fees
Many businesses grow by acquiring other businesses. This is called a “merger” or an “acquisition.”
Businesses frequently consult investment bankers on these transactions, because they are very high stakes and usually quite expensive. It never hurts to have a second set of eyes on a big decision!
Investment banks have whole teams devoted to the consulting on such transactions (called the “M&A group”).
They offer clients advice on the right price to pay, how best to approach the target, how to conduct finance analysis, etc.
Investment banks sometimes demand a hefty consultation fee, which fluctuates depending on how many hours of work the investment banker has to put in since the advice is given by some of the most experienced investment bankers.
In contrast to other revenue sources, this doesn’t involve the bank taking on any risk or making a commitment to their balance sheet; instead, they only offer to advise and are compensated handsomely (e.g., 1-2% of deal value). Although there may occasionally be a retainer element, this is mostly a success fee.
Banks can also get “debt underwriting” business by advising on M&A deals, if the transaction requires additional financing.
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Interest income from lending
Above I described how investment banks make money by underwriting and arranging debt deals.
Well, banks also make some money (though a small amount) by holding onto a small percentage of the debt they issue for clients. When they hold onto debt, they earn interest on the debt as it is paid by the borrower.
Typically, the debt held by investment banks falls into two buckets:
- Revolving” credit facility – think of it like a “credit card for companies”. It allows companies to access cash on demand if it is needed. Banks not only earn interest on the borrowings, but they also charge fees for any unused amount as well
- “Hung” underwritten debt deals – Whatever piece of an underwritten debt contract they cannot sell on favorable terms is kept on the balance sheet, and the bank will get interest revenue from it.
Trading & market-making
Many investment banks have sizable sales and trading departments in charge of purchasing, briefly holding, and then selling stocks and bonds to provide liquidity to clients.
Investment banks frequently operate market-making activities to generate money by facilitating liquidity in the stock market or other marketplaces.
A market maker displays a quote (purchase price and sell price) and receives a modest commission, known as the bid-ask spread from the difference between the two prices.
In most markets, these commissions have gotten smaller and smaller over the years as markets have gone electronic and information asymmetries have disappeared.
Investment banks also make money by packaging and reselling shares in assets (called “securitization”).
For instance, banks might purchase a pool of assets (say a group of corporate loans) pools from commercial banks.
They take these loans and create a new security from the whole with different tranches to make the securities more appealing to various investors. In this business, banks will typically make a small underwriting fee as a percentage of each deal.
Sometimes investment banks invest their own money in the financial markets through proprietary trading.
In trading, the bank makes money on the performance of the trades.
Since new laws were enacted in the wake of the 2007–2008 financial crisis, proprietary trading has become significantly less common.
Strictly speaking, asset management fees are OUTSIDE of the investment bank, but many large investment banks (e.g. JP Morgan, Goldman Sachs) have asset management arms, so I’m including it here.
Typically, asset management fees are earned by advising large clients on how to invest their money. Traditionally, the fees earned by banks are calculated as a percentage of the amount of money invested.
How investment bankers make money
Above we’ve covered how investment banks make money.
However, we should also clarify how investment BANKERS make money.
Overall, investment banking is a lucrative field that requires a deep understanding of finance, strong analytical skills, and excellent interpersonal abilities. “Why investment banking” is not a hard question for many for this reason.
Investment bankers make money through the fees charged to their clients. As discussed above, this includes underwriting fees for arranging the sale of securities and advisory fees for providing strategic guidance.
Investment bankers also can earn performance-based bonuses, based on the actual success or quality of the transaction they completed.
Investment bankers compensation typically has the following components:
- Cash bonus
- Equity bonus
Read the rest of the investment banking primer to know more about investment banking.