Role Of Investment Banking – A Detailed Guide With Examples
Before we start to know about the Role of investment banking, it highly important to know what is the origin of the investment bank. The origin of the ‘bank’ word is the Italian root. It means the table, but what is the connection of the table to the bank? In Italy, it is believed that two people sit around a table to make a deal in a business. Two people talk about buying and selling the commodity or services. Isn’t it a very interesting fact? Those two people invest their money into their business by making a transaction.
When discussing the role of Investment Banking, it is necessary to understand the intrinsic parts of Investment Banking Services. It essentially focuses on the creation of companies, government, and other entities and typically centers around three core functions: corporate finance, sales and trading, and transaction banking. Corporate finance lies at the core of investment banking. It is where banks focus on a customer building their business, like raising funds in a capital market and offering advice like strategic moves.
It helps in mergers and acquisitions, asset finance, and structured finance. The global market covers sales, trading, and structuring of a wide range of financial marketing products. Structuring and research provide analysis of markets, products, and training strategies of the clients.
Nowadays, trade happens quickly with the click of a button or even executed automatically with pre-programmable algorithms. If you could see yourself working with some of the world’s biggest businesses on high-profile deals and events of international importance, then investment banking is the best field.
History of Investment Banking
Investment banking came into the picture in the 19th century. In the USA, at that time, the government and big companies felt the urge to have huge financial support, which was not deliverable from the commercial banks. At that time, there was expansion of infrastructure throughout the country for road making, railway line extension, mining in several places, and also for heavy roads.
The commercial banks were incapable of providing financial support. The government understood the need for an organization that gives huge amounts of money in a short time. At that point in time, investment banks started its journey. What did an investment bank do that a commercial bank couldn’t do? The capacity of a risk-taking facility for a commercial bank is very limited. They didn’t take extra risks. A commercial bank accepts deposits from a customer and gives that money as a loan to companies. Therefore, there was a limitation on the loan amount in the future as deposits were not limitless.
But when we talk about governments or companies, in such cases, they require huge amounts of money. In that case, if two commercial banks were merged, then they also hadn’t the capacity to fund a government or a company. The middle road was to take money from the public, but it was not that easy to take money from the public. In that case, they need an investment bank. Investment banks served as a bridge between the issuers, those who wanted to issue the securities, and the investors who wanted to invest their money. In that place, you need to understand the importance of an investment bank.
If you think clearly, then you will know that the government doesn’t have the expertise to issue security bonds for money. They didn’t know the comfortable pricing for issuing the bonds as the price which was necessary for investors for the investment process. On the other side, investors will invest in a project if they think the money will be safe.
The investors were also not capable of negotiating the terms for a deal from a government. They need a middleman through whom they can represent their terms for negotiation. In that way, investment banks were filling the gap between the government and the issuers.
The first thing that an investment bank did was underwriting the securities. It means raising funds for corporate entities in the form of equity or debt. In this process, the capital flows from governments to issuer entities. James Rothschild is a well-known name in investment banking. In 1842, many countries raised money from debt, and they also defaulted the money with bonds. To be very specific, there were eight states in the USA that defaulted the money. For that reason, investors were at a huge loss.
At that time, Mr. James Rothschild was an investment banker. He forbade the investors from biding money to the defaulted states. In that effect, when those eight states came to raise money in the market, they couldn’t. At that time, MrRosthschild clearly stated that if those states did not clear the previous dues from the investors, then they couldn’t lend a dollar from the market.
So Rothschild was representing the investment bank at that time. In that way, the eight governments were bound to give less financial aid to the market to cover the losses. In that way, the investors develop a trust factor in investment bank so that the investment banks not only provide huge funds but also provides security for the money so that if any mishaps happen in the market, then they need to look out to someone for recovering the money. The industry of investment banking is based on reputation.
If a bank has a spoiled name, then it is very hard to be in an industry for doing business. A fun fact was that Mr Rothschild could afford a castle at that time when even lords or counts didn’t have that amount of money for such type of aristocracy. He was that rich man.
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Commercial Banks and Investment Banks
Whenever you are talking about a commercial bank, then you have to understand two things in mind. If a regulated entity (I mean any central authority controls the function like RBI) accepts deposits and gives loans to others, then it is a commercial bank.
Commercial banks facilitate their customers with multiple services like RTGS, NEFT, Bank guarantees or letters of credit, and more like ancillary services. Suppose they give loans at 12% interest and take deposits from people at 7% interest. The balancing amount is the commercial’s bank profit. But when we talk about investment banking, the game changes completely. In investment banking, there is a core division of IBD. It is a candidate’s dream to work in IBD. Then comes the equity capital market. It has to do two things within the capital market: it has something to do with equity. Then, investment banks do extensive searches. Then, it facilitates the client to raise debt. The next thing that an investment bank does is a proprietary trading test, and the last role is wealth management.
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Role Of Investment Banking Explained in Detail below:
Role Of Investment Banking # 1 – Investment Banking Divison
Suppose there is an investment bank named Kontra. Another company named Infy comes to Kontra to acquire a company that performs duty on financial modeling. This is a part of horizontal integration because Infy is expanding its task to financial modeling, which is not its core field.
They wanted a mature setup of the financial company, which already plays into the market with a new setup. The first thing Kontra will do is to ask Infy what type of company they want, such as the profiling of the new company. Then Kontra starts their searching for targets. They come up with 8-10 options. Then Kontra starts their due diligence process of sorting the companies as if these are the viable options. It is the filtering process of eliminating the unfit options.
The next thing the Kontra will do is create the valuation of the remaining fit options. The reining options are charged by the budget range of the infy for further eliminating process. The next thing Kontra will be the option’s balance sheet for earning qualities, whether the balance sheet was telling the exact figures or not. The final options are measured on the legal aspects, basically whether they are following all the laws of the country. The second last step is negotiating the deals with the investment bank(kontra) for the infy. The final process for an investment bank is tax compliance of the new acquiring company.
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Role Of Investment banking # 2 -Equity Capital Market:
The capital market basically becomes a need that helps a corporation or a particular company in raising capital through equities. The different functions that will be done by these different companies in helping the other company to raise capital: the first is distribution and allocation of new issues. There will be companies will be helping a particular organization, especially merchant bankers, who will be helping the companies with the distribution and allocation of new shares.
Another important thing that the company, especially the merchant bankers, will be helping us with the IPO. so they will make sure that the company’s IPO is a smooth process that will also be taken care of by the bankers who will be collecting the money on behalf of the company .these are the different institutions which help the company to participate into equity capital market right from IPO to secondary market.
Third is your special warrants, another thing that the company’s organizations help in the easiest, so what is just like an option? In these warrants is something which gives the right but not an obligation to buy yourself. There are organizations that have the company with something called special warrants.
The private placement is where the selected group of investors are helped by the company to ensure that they are the only people to whom these assets are a lot. So that’s the special category that also ensures that the company doesn’t have to take risks to issue the shares or issue their stocks to the public. There’s a chance that it might be subscribed it might not be subscribed; hence, some of the companies would like to go for private placement. There are merchant bankers who help in the equity capital market. They help the companies with prices with the private placement. In addition to stocks, the capital market deals with derivative instruments also so derivative instruments. Basically, the ECM provides a mechanism for business today’s initial capital or additional capital through the issuance of stocks, so this ensures the company is being funded.
The operations keep on running, and the company is profitable, which will basically maximize the wealth for the investors themselves. Thus, there are various financial institutions that are responsible for underwriting the offerings, including the IPO when the company completes the process of going public. So, right from the idea that let’s go public to the money that has been received by the company to find this operation to grow to expand to maximize the wealth.
The entire equity capital market works in synergy to ensure that the company is achieving its motive. These companies will be there will be additional companies like bankers or investment bankers will be helping these companies to grow. It does not offer services to individuals. Its sole function is to ensure that the company is raising capital either through an IPO or through a private placement. In other ways, they ensure that the company gets its money either to start the operation or to expand its operation, so that’s the sole purpose of the entire equity capital market.
Role Of Investment Banking # 3 – Research:
This is a very in-depth department. There are two ways you can do research: you can do research for your clients, and you can do research for department divisions in investment banks. Suppose the view of Kontra Investment Bank on the coal industry.
They may publish a research paper or a white paper. So, that Kontra’s research team thinks in the next ten years, the coal industry will expand by a 2.5% growth rate in the dominant energy sector, so the market value of the coal mine will increase by 30% in ten years.
For that reason, the investment bank has the potential to acquire a coal company, or they need to consult with a coal company. So, a trading desk will rely on white papers when they want to invest in a big amount in the coal sector. Investment banks prepare the research report and circulate it through all their closed groups to entice their customer to a new trade in a specific field. This helps to save the brokerage fees after acquiring membership with a concerned authority. This is, hence one of the primary roles of investment banking.
Role Of Investment Banking # 5 – Wealth Management:
This is probably one primary role of investment banking. Let’s understand wealth management with the help of a story. Once, four bind men are called to describe an elephant. The first person touches its tail and says it is a rope. The second person touches its stomach and says it is a wall. The third person touches its tooth and says it is a spare.
The last person touches its trunk and says it is a snake. But at last, a man with eyes came and saw the elephant and claimed within a second that it was an elephant. The blind men weren’t telling the untrue facts, but they were telling what they had felt with their blindsided experiences.
Whereas it is very easy for a man with a clear vision of what an elephant looks like. It is a similar case with money, and if you go to a tax consultant, he will help you with saving the taxes. He is not much concerned with another part of your wealth. If you go to an accountant, he will tell you how to record the transactions of the businesses. Similarly, if you go to a financial manager or portfolio manager, they will tell you what the performance is on their end, but they can’t tell you how you can invest the money.
These people are so blind-sighted with their vision that they can’t help you with how you can maximize your wealth. In this case, the wealth management comes in. It is an advisory service for enhancing the financial situation of the client, focusing on individuality rather than corporate. Wealth management is looking at the lifestyle maintenance of the clients. It also wants to make sure the client gets life enhancement. It also helps the client with family continuity, philanthropy, and risk management.
When we are talking about lifestyle maintenance, it deals with savings and budgeting. Lifestyle enhancement refers to buying some assets like a home, car, jewelry, planning retirement, or a world tour. Family continuity refers to generational wealth transfer, children’s education, and marriages.
With wealth management, if you want to donate some amount of your wealth to create a trust, you can do that. Risk management refers to buying insurance and investment allocation for portfolio balancing. When a person is looking at your wealth from a holistic point of view as a person who is helping you with the entire financial goal by not only looking at your balance sheet or taxes, that is the purpose of wealth management. The current wealth management industry is more than 1.25 trillion dollars. It is expected to grow by more than 3.45 trillion dollars by 2030. It has a CAGR of more than 10% per annum.
● What do investment bankers do?
When we are looking at the role of investment banking, we have to take a deep dive into what investment bankers do. Your job description will significantly vary depending on the specific area of employment. The capital markets division helps companies raise funding by selling equity or debt to the public.
In the case of equity, we speak about equity capital markets (ECMs), and when an investment bank helps a company sell the debt to the public, we talk about debt capital markets (DCM). The focus of advisory is M&A deals and debt restructuring. M&A stands for Mergers and Acquisitions—when companies wish to merge or acquire each other. Investment bankers assist in this process.
Sometimes, they’re even the engineers behind the deal, advising clients on which companies would make good acquisition targets. Besides M&A, investment banks’ other advisory services are related to corporate distress. A restructuring process is when a firm cannot service its existing debt and is in danger of going bankrupt. Trading and brokerage is an investment banking business line that involves purchasing and selling securities by using the bank’s money or conducting it on behalf of clients.
And lastly, the fourth investment banking area includes asset management—helping clients with investment management and strategic advice. The aim is to support clients in achieving their financial goals. Let’s pick one of the areas—for example, M&A—and describe what an M&A investment banker does on the job. An M&A investment banker would be expected to analyze companies, understand their financials, research potential M&A opportunities in a given sector, and create pitchbooks, which are then presented to clients.
They will spend significant time in Excel working on Multiples and DCF valuation models, which are then discussed with clients, who are advised whether a particular M&A deal makes sense from a financial perspective. When a deal does make sense, clients will engage in an M&A process, which is relatively technical and complex. This is when investment bankers coordinate different workstreams and help their clients execute the deal. Investment bankers don’t simply work on spreadsheets and value companies; they also build relationships with diverse stakeholders and manage different activities in the M&A process.
This is a demanding job that assists individuals to grow professionally quickly. Investment bankers’ income grows at a breakneck pace when they reach the associate and VP levels. In seven or eight years in the field, one can become a VP and earn around $350 thousand dollars annually. In general, the compensation in this field is much higher than the one finance graduates can expect for other finance roles.
Still, significant dedication in time and willingness to perform is also required. Let’s address the elephant in the room and discuss how to become an investment banker. The skills you need to get hired are multidisciplinary—encompassing technical, practical, and soft skills. You’ll need to be proficient in Microsoft Excel and PowerPoint. Much of your work will involve creating valuation models, working with financial figures, and analyzing performance—all done in Excel.
The other tool you’ll need the most is PowerPoint—creating documents for clients and company presentations. It’s also how you present your progress when working on M&A deals. You must be proficient (and quick) in Excel and PowerPoint. Sometimes, you’ll need to learn how to use a Bloomberg terminal or extract data from such providers as Thomson Reuters.
You pick up these technical skills on the job because learning these tools at home is challenging. To build good DCF models, you’ll need solid financial modeling skills and a good understanding of foundational corporate finance. Moreover, you need to create stunning slides.
This sounds superficial, but it’s an essential requirement. Regarding soft skills, investment bankers must be prepared. Work is frequently client-facing and requires an excellent ability to build personal relationships, communicate well, and navigate through complexity. Moreover, the dynamic nature of M&A processes, IPOs, and financial markets requires investment bankers to operate under time pressure.
FAQs on the Role Of Investment Banking
1. Are investment banking interviews hard?
No Interview is hard if you prepare for it in the right way. Investment banking interviews are lengthy and detailed to follow, but it is not hard at all.
2. Are investment banking fees tax deductible?
Yes, the fee is always tax deductible for everybody.
3. Are investment banking bonuses taxed?
Every income is taxed if it crosses a certain limit. Yes, the bonuses you earn from investment banking are liable for tax if it is according to the law of the land.
Concluding Thoughts on the Role of Investment Banking
The roles of investment banking are very limited as a business entity. In this article, I covered the major role of an investment bank. You can give your valuable view after reading this article also as a comment.