Most banks offer different investment opportunities for their customers. Despite that there are traditional banks as well as investment banks. The term, investment banks, is heard quite often. In most of the cases it is overlooked and considered the same as a traditional bank. But that is not the case. This article explains how investment banks make money but before that one should know, the first and foremost thing i.e., to understand the difference between these kinds of banks.
What is a Traditional Bank?
Traditional banks are also known as retail banks. They take money from those customers which put their money in the bank to save it. Next, they give that money out to the borrowers in the form of loans, credit cards, or even mortgages. These banks make money by charging a higher interest rate from those who are borrowing the money as compared to providing the interest amount to those customers which are using the savings account.
What is an Investment Bank?
These banks do not earn their money through interest payments they receive from their clients. Their target customers are not regular customers. Instead, they target organizations, companies, fund collecting NGOs, and other fund offering government institutes. They offer their insight on stocks, and future financial market movement. For all these services they take a certain amount of fees or commission from their customer. This helps them earn large amounts of money.
Related Read: How Much Savings Should be Invested?
What Do Investment Banks Do?
We all know the hype around investment banks but nobody is ever clear about investment banks and what they actually do. By understanding what investment banks really do, we come to understand their role in the economy, society, and overall stock market.
Investment banks have a lot of functionalities in their day-to-day operations. But its main functionality is to assist businesses and individuals in making the right and beneficial choices for the future of their wealth. This wealth can be in the form of stocks, property, cash, and any form of inheritance. The government sectors of a country which handle various aspects of the country’s financial also work closely with investment banks. Investment banks both serve as advisors and implementers of your financial investments. They can invest money in various stock exchanges and get you a certain amount in return.
Skills in Investment Banking
Investment banking is not an easy job. It requires professional financial modeling skills along with valuation. Some of the skills which are required by the investment bankers are:
1) Financial modeling
2) Business valuation
3) Negotiation
4) Relationship management
5) Sales and business development
Ways on How Investment Banks Make Money
There are many services which are offered by investment banks to their clients. The services offered by investment banking plays an important role.
1. Merger and Acquisition Advisory Services
Merger and Acquisition (M&A) advisory is the process of finding, evaluating, and performing the process of acquisition of various organizations in the market. Since the client-base of a bank is very large, they use their research capabilities and find the relevant organizations to acquire them. They can represent both the seller or the buyer side of the deal making the process a lot easier for either of the parties.
All of the negotiation is done on behalf of the customers. Banks provide a proper plan for the acquisition once they identify the target organization to be acquired. Through their extensive experience and knowledge, this process can be executed in the most appropriate and legally secure manner. All the required contract and its details are sorted out by the investment bank. Financing can be provided as well. Investment banks ensure that they are a part of the implementation process until the end.
2. Advisory for Banking Clients
Investment banking offers many pieces of advice for their clients. It could either be for capital raising or M&A. Investment banks can have the government as their client. With the government they can raise money, buy or sell crown corporations, and trade securities as well.
Apart from working with different government organizations, investment banking helps out different corporations in the public and private sector. They help with raising capital. They provide extensive market research to their clients to ensure that they remain on top of the competitors and gain maximum profits. Any corporate financial advice needed by the clients is also provided by investment banks. If a client wants to acquire or sell units of their organization, investment banks help out with those as well.
There are some investor institutions which manage large sums of money for other people. Investment bankers help them out by providing research on different stocks and properties. They also provide trade securities. Initial public offering (IPO) or selling to a strategic buyer is also offered by the investment banks to when selling such institutions to a strategic buyer. Using investment banking expertise, such institutions can also acquire different organizations.
Why do We Need Investment Banking?
As discussed above, investment banking plays an important role in the financial industry. Whether we talk about investment banking in the light of financial advisory or merging and acquisition, investment banking plays a vital role in the world. The predictions of the stock market and the various financial advices are the core building structure for our banking and financial industry today. This is why investment banking is of utmost importance.
Underwriting Services
The process of raising capital through selling of stocks or bonds to different investors and interested parties. These services are performed on behalf of different organizations. Investment banks provide underwriting services to gain investor’s money for their clients by marketing the client businesses to the investors. The raised capital by investment banking can be in the form of equity or debt securities. An underwriter can make three different types of commitment with an organization.
1. Firm Commitment
When the underwriter makes a firm commitment with the client, the underwriter bears full responsibility for the share. It doesn’t matter whether the stock or the share is fully sold or not. The underwriter has to bear the financial cost in all situations. The entire issue needs to be sold. In this commitment the underwriter purchases the complete issue at a price.
2. Best Efforts
In this kind of commitment, the underwriter does not define an amount or limit to the selling of the stock or share. As the name implies, they give their best effort in order to sell the maximum amount and gain benefit for the client. But no hard and fast implications along with liabilities exist for the underwriter if they are not able to sell the share or stock completely. This is the most common form of underwriting commitment made by investment banks.
3. All or none
If an underwriter fails to sell all of their shares at the decided offering price, the deal is not valid and there is no profit for the underwriter in it.
Who Do Investment Bankers Deal With?
This is also a very common question that comes into mind when talking about investment bankers. It is important to remember that investment bankers deal with several different kinds of people. They have to deal with small and large business owners, people with money (investors), other banks, and financial angels. They also have to work with various NGOs and other non-profit organizations to raise capital for them.
Where Do Investment Banks Put their Money Into?
Every time you run into a friend who ended up becoming an investment banker, you will notice he or she has only become richer with the passage of time. The overall success rate of investment banking is quite high. This is why you must wonder where do investment banks put their money into for such a high return. Well, the answer to that is simple!
Investment banks serve as the middlemen for businesses and the investors or people with the money. Once a business owner gets the approval from the investor i.e., that they are genuinely interested in investing their business, investment banks draw out the financial plan for the complete transaction. Depending upon the type of investment the revenue stream can be in various forms. For example, it can be commissions based, dividends and interest based, or even investments and trade model.
Also Read: How to Sell a Business Idea to A Big Company?
How Much Money do Investment Banks Make?
This is the most crucial and popular question when in it comes to investment banking. Obviously, the way investment banks pay and provide for their employees, is a good indicator that they make good money.
Depending upon the type of the investment deal that the bank is handling, the amount of money raised by the investment bank can vary greatly. Usually, the bankers close the deals of millions and billions of dollars on a regular basis. This means if the employees get even 1% of the total share, they are rewarded in ridiculously large amounts. The investment banks make money by keeping a percentage value of the total deal. They charge this fee to ensure that the whole process ends smoothly.
Crowdfunding vs Investment Banking
The difference between these two terms can be a little ambiguous. But, here is an easy understanding and distinguish between both of these terms.
1. Crowdfunding
It is a method that is used to collect large sums from money from a group of people. Most of the time, crowdfunding is done for a cause and people pool in large sums of money in order to execute that cause in a successful and smooth way. Crowdfunding can be loan-based or just charity based. In the former, you have to pay back the money to the group of investors bit by bit. There is also some interest rate involved as well. But in the latter case, people do not demand you to pay back the money in any way or form.
2. Investment Banking
While there is no doubt that investment banking requires a few hurdles to be crossed, but it is a good way to raise capital for any business. Most of the times, the interest rate associated with the amount provided with the investment banking is higher. But, the major benefit of working with investment banks is that it allows you to build great contacts with the right brokers over a period of time. If you are looking for legal financial advice, you do not have to look for an external investment advisory service. The bank would provide the services to you on its own.
Also Read: How to Invest in a Small Business?
Benefits of Investment Banking
Keeping in view of the above discussion, here are some of the advantages that are associated with investment banking:
- You know the right places to make your investments at all times. You can also rest assured that you money is in the right place.
- Gain the expertise of an individual who has a thorough grasp on the middle market.
- Enhance the credibility of your company when working with any investor or business by hiring the services of investment banking.
Conclusion
The answer to how investment banks make money is quite complicated. There are several different factors involved that play a role in the money-making process of said banks. But it is important to remember that investment banks are different from traditional banks in many ways. There are many different ways from which they can extract revenue as have been discussed above. They charge high amounts of fees for their services. They also buy and sell different stocks and keep a large amount of money for themselves. This is one of the major sources where investment banks make their money.
The services that investment banks offer may seem straightforward but they are quite complicated and require a lot of research and evaluation work. Bank of America, Citi, Deutsche Bank, and other similar banks are the number one investment banks.