Must-know: Investment banks’ way of making money

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Must-know: An overview of the Banking sector (Part 8 of 14)

(Continued from Part 7)

Investment banks’ way of making money

Investment banks also provide financial intermediation by channeling money from net savers to net borrowers. However, the mode of channeling money is a lot different from other types of banks. Investment banks generally deal with corporations and governments. They help corporations and governments raise capital, both debt and equity, and provide advise for strategic decisions such as mergers and acquisitions and divestitures. They also manage assets and trade in equities, commodities, currencies, and their derivatives.

After the Glass-Steagall Act, many banks that had deep business linkages and strong trading and advisory desks chose to remain investment banks. Examples of such banks were Goldman Sachs (GS) and Lazard (LAZ). Morgan Stanley (MS) was spun-off from JP Morgan, which chose to focus on traditional banking.

In activities of equity, debt origination, underwriting, mergers and acquisitions, and asset management, investment banks earn revenue by charging an advisory fee. The fee is generally based on the total size of the transaction. Bigger and reputed investment banks, called bulge bracket firms, generally focus across areas and industries and fetch most of the large deals. There’s a set of small and specialized investment banks, called boutiques, that focus on only one activity or a few activities, like asset management, or on a particular industry, like technology, or a few industries where they provide all services. An example of such a boutique is Legg Mason (LM) which focuses on asset management. In trading, the investment banks earn revenue by having a team trade different securities on their own capital, prop book, as well as on behalf of clients. An exchange-traded fund (or ETF) like the Financial Select Sector SPDR FD (XLF) contains bulge bracket as well as boutiques.

The main expense for an investment bank is the salary and bonuses paid to employees. Investment banking is highly dependent on human capital because superior advisory and trading requires employees of high caliber. Other large expenses are on marketing and interest on short-term loans.

On the surface, investment banking looks like it’s a low-risk business based on advisory fees and trading. However, when we scratch the surface the risks associated with investment banking emerge. We’ll analyze this in the next section of the series.

Continue to Part 9

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