Investment Banking

Investment Banking Explained

7 min read

From JP Morgan Chase to Morgan Stanley, Investment banking is one of the most profitable fields in the investment industry. For example, did you know that in 2021 alone, the revenues of JPMorgan amounted to approximately 11.57 billion U.S. dollars? What does that have to do with investment banking?

Investment banking is also known as corporate finance. In simple terms, it’s part of an investment bank that advises companies and governments on how to raise money, merge or take over companies, and restructure their business to be effective and efficient.

If investment banking sounds like a foreign language to you’re not alone. This high-stakes industry continues to baffle even banking professionals with its complexity.

Nonetheless, with salaries starting at $140,000 a year, it’s no surprise that so many people dream of becoming the next Wolf of Wall Street. Others are curious about how this glamorous industry works.

Unfortunately, it’s not all yachts, nightclubs, and champagne. The job is highly stressful, and some investment bankers work more than 100 hours per week.

5 Divisions of Investment Banking

There are five areas within the investment banking division. They are as follows:

  1. Merger and Acquisitions (M&A)
  2. Equity Capital Markets (ECM)
  3. Debt Capital Markets (DCM)
  4. Leveraged Finance
  5. Restructuring

When a big company takes over a small company, we call this a merger and acquisition. Investment banks help facilitate this process as much money is involved in many cases. Next, you’ve got equity capital markets (ECM) and debt capital markets (DCM). In comparison, M&A focuses on advising businesses on mergers and acquisitions.

ECM focuses on raising capital through equity, while D.C. focuses on raising money through debt. So, for example, let’s say Facebook wants to raise funds through equity. To do so, they need to sell shares to the public.

Investment banking allows you and me to buy these Facebook shares publicly. That means we get a piece of Facebook based on the cash we give them. As a compromise, Facebook offers a part of their company: raising money directly.

Raising Money Through Debt

On the flip side, the capital markets are raising money through debt. Think of a mortgage or loan you take from the bank. You go into debt while the bank makes money from your interest payments. Similarly, a loan is taken out in the DCM market, but the clients are massive corporations where the interest payments are in the millions.

Then we’ve got leverage finance, kind of like DCM but riskier. But, again, when we think of debt capital markets, we think about safe loans and government bonds—or using equity and cash to purchase assets. But, leverage finance uses an above-normal debt to finance the purchase of investment assets.

Last, we’ve got restructuring; this is where investment bankers scrutinize and analyze the structure of a business. Part of this process involves looking at the debt-to-equity ratio. Questions such as: How much debt does a business have, how much equity does a business have, it is structured most efficiently for the company to run in the best interest of shareholders so on, and so forth.

Bankers in the restructuring team look at all this and try to structure the best structure for the company.

The Rise Of Investment Banking

So what is investment baking? Why is it so lucrative? And how do investment banks differ from commercial banks? Before we explain how investment banking works let’s turn back the clock to see how it all began.

From the early 19 century, U.S. commercial banks did the same things we now associate with investment banks. However, during the Civil War, this all changed.

The tale of investment banking begins with Philadelphia financier J Cook. To help fund the federal government’s war efforts, Cook established the first-ever American investment bank in 1861. As such, the United States government became one of investment banking’s first clients.

Back then, the government issued bonds to raise enough money to support its rapidly growing economy and complete infrastructure projects like buildings and highways. IOUs were issued between lenders and borrowers to finance these expensive projects. Investment banks would buy these bonds and sell them to private investors for a profit. Today, investment banks do the same thing with different parties involved.

How Do Investment Banks Make Their Money?

The question is, where are those billions of dollars in revenue coming from? Well, the business model is actually pretty simple.

Investment banks purchase assets with monetary value, or securities, and then sell them to third parties for a fee.

This process is called underwriting. So when you think about it, investment bankers are just the middleman between clients and investors.

This is not exclusive to investment banks; commercial banks take on risk, but the difference lies here. Commercial banks deal with individuals and small to medium-sized companies, giving out smaller sums like individual mortgages and small business loans.

They make their profits through the interest they charge. So look at your annual mortgage statement and see how much you’re paying in interest; ensure you have a barf bag close.

Investment Banks Assume Larger Risks

On the other hand, investment banks take much larger risks. They deal with huge companies and startups, acting as a bridge between companies and investors. In the process, they can earn a considerable amount in fees.

A Dark Cloud

All of this sounds great, in theory. But these banks don’t have an excellent reputation.

We all lived through one of the worst financial disasters in history, the subprime mortgage crisis of 2008.

Here’s what happened.

In 2001, the federal reserve increased bank liquidity by lowering the federal funds rate. In turn, this enabled U.S. banks to give more loans. However, to do this, the banks lowered their standards and started giving loans to anyone regardless of whether they had a job or any money.

These are subprime mortgages, but you may want to consider them less than desirable loans. Then, of course, commercial banks could give out loans and sleep.

So, to make room for borrowers, they sold their loans to investment banks. Investment banks then packaged them into subprime loans and sold them to investors without disclosing how insecure these loans were.

At the time, that didn’t seem to matter. It was a big party. Unemployed people were buying huge homes, investors profited, and banks kept on selling their loans so they could give up new ones.

But as you know, after every massive party comes the equally enormous hangover. After years of good times, the interest rates started to rise. Suddenly, subprime borrowers couldn’t afford to pay back their loans and began to file for bankruptcy. Have you heard of the term jingle keys? The jingle was jingling nationwide, causing everyone involved to start panicking.

In just a few short months, the American economy experienced the biggest crash since the great depression.

What Caused The Subprime Mortgage Crisis?

What happened was that investment bankers created a massive bubble with their irresponsible trading. And when that bubble burst, everyone was affected.

How Investment Banking Helped To Build America

2008 was a prime crap mortgage crisis. It’s just one of the many crises throughout banking history. The market has crashed before and undoubtedly will crash again. But it’s worth remembering that investment banking, for all its flaws, helped build America.

The first railroad lines and I.T. companies would never have seen the light of day if it weren’t for the support from investment banks. And as we look toward the future, we will need investment banks to help us rebuild.

We can expect investment banking to play a role in every world-changing innovation in the future. Companies will always need large investors, and their investors will always look for new opportunities. That’s why investment banking is here to stay.

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