How Investment Banking Differs from Traditional Banking - dummies

How Investment Banking Differs from Traditional Banking

By Matt Krantz, Robert R. Johnson

The critical part of the investment banking process is in the way cash is funneled from the people who have it to the people who need it. After all, traditional banks do essentially the same thing investment banks do — get cash from people who have excess amounts into the hands of those who have productive uses for it.

Traditional banks take deposits from savers with excess cash and lend the money out to borrowers. The main types of traditional banks are commercial banks (which deal primarily with businesses) and retail banks (which deal mostly with individuals).

The difference between traditional banks and investment banks, though, is the way money is transferred between the people and institutions that need it and the ones who have it. Instead of collecting deposits from savers, as traditional banks do, investment bankers usually rely on selling financial instruments (such as stocks and bonds), in a process called underwriting.

By selling financial instruments to investors, the investment bankers raise the money that’s provided to the people, companies, and governments that have productive uses for it.

Because banks accept deposits from Main Street savers, those deposits are protected by the Federal Deposit Insurance Corporation (FDIC), which guarantees bank deposits. To protect itself, the FDIC along with the federal government puts very strict rules on banks to make sure they’re not being reckless.

On the other hand, investment banks, at least until the financial crisis of 2007, were free to take bigger chances with other people’s money. Investment banks could be more creative in inventing new financial tools, which sometimes don’t work out so well. The idea is that clients of investment banks are more sophisticated and know the risks better than the average person with a bank account.

The meaning of the term investment bank got even more unclear after the financial crisis that erupted in 2007. Due to a severe shock to the bond market, many of the dedicated investment banks went out of business, including venerable old-line firms such as Lehman Brothers and Bear Stearns, or were bought by banks.

Many of today’s largest investment banks are now units of banks or technically considered commercial or retail banks, although they still perform investment banking operations. Meanwhile, these banks will often say they perform investment banking functions. The term investment bank is somewhat of a misnomer, because the major financial institutions are now technically considered banks.

Now that you see that the chief role of investment banks is selling securities, the next question is: What types of securities do they sell? The primary forms of financial instruments sold by investment banks include the following:

  • Equity: If you’ve ever bought stock in a company, be it an individual firm like Microsoft or an index fund that invests in companies in the Standard & Poor’s (S&P) 500, you’ve been on the investor end of an equity deal. Investment bankers help companies raise money by selling ownership stakes, or equity, in the company to outside investors.

    After the securities are sold by the investment bank, the owners are free to buy or sell them on the stock market. Equity is first sold as part of an equity offering called an initial public offering (IPO).

  • Debt capital: Some investors have no interest in owning a piece of the company, but they’re more than willing to lend money to it, for a price. That’s the role of debt capital. Investment banks help companies borrow money by issuing bonds, or IOUs, that are sold to investors. The company must pay the prearranged rate of interest, but it doesn’t give up any ownership of the company.

    If a company falls onto hard times, though, the owners of the debt have a higher claim to assets than do the equity owners if a liquidation of the company is necessary.

  • Hybrid securities: Most of what investment banks sell can be classified as either debt or equity. But some securities take on traits of both, or are an interesting spin on both.

    One example is preferred shares, which give investors an income stream that’s higher than what’s paid on the regular equity. But preferred shares don’t come with as high a claim to assets as bonds, and this income stream can be suspended by the company if it chooses.