Investment Bank

An investment bank is a financial institution that provides services related to the raising of capital and to the provision of financial advice, including underwriting securities, advising on mergers and acquisitions, and trading financial instruments.

Activities

The activities of an investment bank are commonly divided into advisory and underwriting activities, which constitute investment banking in the narrow sense, and trading and market-making activities, which constitute the securities business.

Advisory services include advice on mergers and acquisitions, on restructuring, and on the raising of capital. Underwriting involves the purchase of securities from an issuer and their resale to investors, with the bank bearing the risk that the securities cannot be sold at the expected price.

Trading involves the purchase and sale of securities and of derivatives, both on behalf of clients and on the bank's own account. Market making involves quoting prices at which the bank is willing to buy and sell, providing liquidity to the market.

Organisation

Investment banks are organised into divisions that correspond to their activities, including investment banking, sales and trading, and research. The divisions serve different clients, including corporations, governments, and institutional investors.

The organisational structure of investment banks has changed over time. The separation between commercial and investment banking, which was a feature of the regulatory framework in some countries, has been relaxed, leading to the emergence of large universal banks that combine both activities.

The compensation of employees in investment banks is heavily tied to performance, through bonuses and equity awards. The structure of compensation affects the behaviour of employees and has been a subject of debate in the context of risk-taking and of the financial crisis.

Role in the Economy

Investment banks channel funds from savers to firms and governments, and they provide the expertise required for complex financial transactions. They play a central role in the primary market, where new securities are issued, and in the secondary market, where they are traded.

Investment banks also provide advice that shapes the structure of corporate transactions, including mergers and acquisitions. Their advice affects the allocation of corporate control and the value of the firms involved.

The role of investment banks has been criticised in the context of conflicts of interest, of excessive risk-taking, and of the conduct of the financial crisis. The reform of the sector has focused on the structure of the industry, on the regulation of capital and liquidity, and on the alignment of incentives.

Regulation

The regulation of investment banks focuses on the capital and liquidity that they must hold, on the conduct of their business, and on the transparency of their operations. The framework has been strengthened since the financial crisis, with higher capital requirements and with restrictions on proprietary trading.

The regulation also addresses the risks that investment banks pose to the wider financial system, through their interconnectedness and through their role in the markets. The designation of some institutions as systemically important reflects the recognition of these risks.

The reform of the sector remains a subject of debate, with questions about the appropriate balance between regulation and market discipline and about the structure of the industry.

The Financial Crisis and Its Aftermath

Investment banks were at the centre of the financial crisis, and the failure of one of the largest institutions in 2008 marked a turning point in the crisis. The failure reflected the exposure of the institution to mortgage-related securities and the fragility of its funding structure.

The crisis revealed weaknesses in the business model of investment banks, including the reliance on short-term wholesale funding and the high degree of leverage. The crisis also revealed weaknesses in the regulatory framework, which had not kept pace with the evolution of the industry.

The aftermath of the crisis saw the reform of the sector, including the strengthening of capital and liquidity requirements, the introduction of restrictions on proprietary trading, and the reform of compensation. The structure of the industry has also changed, with the consolidation of some institutions and the emergence of new entrants.

Proprietary Trading and the Volcker Rule

Proprietary trading is the trading of securities and of other instruments by a bank on its own account, as distinct from trading on behalf of clients. The activity was a source of profit for investment banks, and it was also a source of risk.

The Volcker rule, introduced in the United States after the crisis, restricts banks from engaging in proprietary trading and from owning or sponsoring hedge funds and private equity funds. The rule is intended to reduce the risk that banks take and to protect the deposit insurance fund.

The implementation of the rule has been complex, and it has involved the definition of what constitutes proprietary trading and the establishment of compliance programmes. The rule has been a subject of debate, with some arguing that it reduces risk and others arguing that it reduces liquidity and imposes unnecessary costs.

The Future of Investment Banking

The future of investment banking is shaped by several forces, including the regulatory framework, the evolution of technology, and the changing demands of clients. The regulatory framework constrains the activities that the banks can undertake and raises the cost of capital.

Technology is changing the nature of the business, through the growth of electronic trading and of automated advice. The changes affect the structure of the industry and the skills that are required.

The demands of clients are also changing, with the growth of emerging markets and the increasing importance of institutional investors. The banks that can adapt to these changes and that can manage the regulatory and the technological challenges will be well positioned.

Summary

Investment banks provide advisory, underwriting, and trading services, and their role in the economy and their regulation have been reshaped by the financial crisis. The reform of the sector and the evolution of the industry are central to the analysis of finance.

See also

• Banking
• Financial Asset
• Capital Market