Why Do We Need Investment Banks? Utility, Importance, And More
Why do we need investment banks in today’s time? Investment banking refers to the advisory-based financial transactions conducted by financial services firms or business divisions on behalf of individuals, businesses, and governments. Traditionally associated with corporate finance, a bank of this type may assist customers in raising financial resources by underwriting or acting as their agent in the issuance of debt or equity securities. Investment banks may also assist firms with mergers and acquisitions (M&A) and provide auxiliary services such as market making, derivatives and equity securities trading, FICC (fixed income instruments, currencies, and commodities), and research (macroeconomic, credit, or equity research). Most investment banks include prime brokerage and asset management operations in addition to their investment research units. Let’s find out the importance of investment banks here in this article today.
The United States maintained a separation between investment banking and commercial banking from the introduction of the Glass-Steagall Act in 1933 until its repeal in 1999 by the Gramm-Leach-Bliley Act. Historically, other developed countries, including the G7, have not maintained such a division. The Volcker Rule, enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, establishes some institutional separation of investment banking services from commercial banking.
An investment bank can also be divided into private and public operations, separated by a screen to prevent information from passing. The bank’s private parts deal with private insider information that is not publicly published, and the public portions, such as stock research, deal with publicly disclosed information. In the United States, an adviser who provides investment banking services must be a licensed broker-dealer subject to Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) supervision.
Investment Banking: Organizational Structure
Investment Banking: Core Activities
Investment banking operations are classified as front-office, middle-office, and back-office. While major service investment banks provide all lines of business, both on the “sell side” and on the “buy side,” smaller sell-side investment businesses, such as boutique investment banks and small broker-dealers, specialize in investment banking and sales/trading/research, respectively.
Investment banks provide services to both firms that issue securities and investors that purchase securities. Investment bankers advise firms on when and how to sell their assets on the open market, which is critical to an investment bank’s reputation. As a result, investment bankers play a critical role in the issuance of new security offerings.
The front office is the component of a business that interacts with customers, such as the marketing, sales, and service departments. In certain businesses, the phrase has a more precise connotation.
The front office’s job is to directly contact consumers and is generally the first area that customers visit when they arrive at the firm. The front office may learn more about the consumer by asking them questions and assisting the customers.
Front-office personnel can also do minor activities such as email sorting and assisting with printing and typing. Front-office personnel must also be skilled in using technology, such as printers, fax machines, and phones. This is why training is required before employees begin working, even if the jobs are easy.
Front-office employees may be unmotivated since they do repetitious tasks. This is a critical problem since these employees will have the greatest contact with consumers, which may have an impact on the company’s profitability and efficiency. The personnel may be under a lot of stress since they are always dealing with difficult consumers. They may also receive a large number of complaints, making it difficult for front-office workers to maintain their excellent service.
A middle office is a group of people who work in a financial institution. The middle office is made up of risk managers and information technology managers who manage risk and maintain information resources.
In financial services and investment banking, the middle office serves several functions. It guarantees that financial transactions’ deals are handled, recorded, and fulfilled. Workers are in charge of overseeing worldwide agreements about corporate transactions, risk management, and profit and loss. They make certain that paperwork is finished per agreements. The middle office of information technology creates software to assist trading methods. It administers trading software platforms such as Reuters 3000 and Bloomberg. By monitoring and recording market and marketing information, the information technology middle office aids both the back and front offices.
Their employment often entails estimating revenues and losses using a computer information system. This division of the firm investigates transactions arranged by the front office. They look through the contract conditions, procedures, and how the back office will close it. The middle office keeps track of risk, profit, and loss. The middle office in some large corporations has legal help to certify the legitimacy of unique agreements.
In most organizations, the back office is where work that supports the front office is done. The front office is the company’s “face,” and it includes all of the company’s resources that are utilized to make sales and communicate with customers and clients. The back office includes all of the company’s resources that are dedicated to creating a product or service, such as data entry, payroll, bookkeeping, and all other work that is not visible to customers, such as administration or logistics. Back-office employment includes responsibilities that impact the expenses side of a company’s income statement, whereas front-office work encompasses roles that affect the income side of the company’s income statement.
Although back-office operations are rarely visible, they are a significant contributor to a company’s success. Accounting, planning, inventory management, supply-chain management, human resources, and logistics are examples of such functions. Back offices are frequently placed in locations other than the corporate headquarters. Many are in places or countries with lower rent and labour expenses. Some business parks provide rear offices to tenants whose front offices are located in more costly areas. Back-office operations can be outsourced to consultants and contractors throughout the world.
The human resources department, office managers, and customer service agents make up the back office, which provides support, administrative, and payment services. Generally, the back and middle offices are responsible for non-revenue-producing functions such as risk management and transaction execution.
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Corporate finance is the branch of investment banking that assists customers in raising funds in capital markets and providing advice on mergers and acquisitions (M&A); transactions in which capital is obtained for the business include those mentioned separately. This activity may include, for example, soliciting investors to subscribe to a securities issue, collaborating with bidders, or negotiating with a merger target. To advertise the bank to a potential M&A customer, a pitch book containing financial facts is created; if the presentation is successful, the bank arranges the deal for the client.
Investment banking (IBD) is organized into industry and product coverage groups. Healthcare, public finance (governments), FIG (financial institutions group), industrials, TMT (technology, media, and telecommunications), P&E (power & energy), consumer/retail, food & beverage, corporate defence, and governance industry coverage groups each focus on a specific industry and maintain relationships with corporations within that industry to bring in business for the bank. Product coverage groups for financial goods include mergers and acquisitions, leveraged financing, public finance, asset finance and leasing, structured finance, restructuring, equity, and debt issuance.
Sales & Trading
The term sales refer to the investment bank’s sales force, whose major responsibility is to contact institutional and high-net-worth investors to recommend trading ideas (on a caveat emptor basis) and accept orders. The orders of their clients are subsequently communicated to the relevant trading rooms, which can price and execute transactions or develop new products to meet a specific requirement. Sales negotiate deals that are suited to the demands of their business customers, which means that their conditions are frequently particular. They may deal with a wide range of asset kinds while focusing on their customer connection. In contrast, agreements negotiated by market-makers normally have predefined conditions; in market-making, traders will purchase and sell financial items to make money on each trade.
Structuring has been a relatively recent industry as derivatives have come into play, with highly technical and numerate staff focusing on constructing complicated structured products which often give significantly better margins and returns than underlying cash instruments, so-called “yield enhancement”. In 2010, investment banks came under fire for offering sophisticated derivatives contracts to local governments in Europe and the United States.
The securities research section evaluates firms and provides assessments on their future, frequently with “buy,” “hold,” or “sell” ratings. Sell-side analysts at investment banks often cover a wide range of businesses. Buy-side research will be available through their sponsored funds or proprietary trading desks. Research also encompasses credit risk, fixed income, macroeconomics, and quantitative analysis, all of which are utilized internally and externally to advise customers; alongside “Equity”, they may be independent “groups”. Typically, the research group(s) provide critical consulting and strategy services.
With MiFID II forcing sell-side research teams in banks to charge for research, the research business model is becoming more revenue-generating. External rankings of academics are becoming more relevant, and banks have begun the process of monetizing research papers, client contact times, client meetings, and so on.
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Importance of Investment Banks: Services they Offer
An investment bank and a bank’s investment banking division (IBD) might be confused at times. Full-service investment banks provide a variety of services such as underwriting, mergers and acquisitions, sales and trading, equities research, asset management, commercial banking, and retail banking. An investment banking business offers underwriting and M&A advising services.
Importance of Investment Banks #1 – Underwriting:
Capital-raising and underwriting organizations connect investors and firms looking to raise capital or go public through the IPO process. The major market is served by this function.
Importance of Investment Banks #2 – Mergers and Acquisitions (M&A):
Advisory positions for both business buyers and sellers, overseeing the M&A process from start to end.
Importance of Investment Banks #3- Sales and trading:
It entails bringing together buyers and sellers of securities in the secondary market. Investment banking sales and trading departments function as agents for customers and can also trade the firm’s funds.
Importance of Investment Banks #4 – Equity Research:
The equity study group’s research, or “coverage,” of securities assists investors in making investment decisions and facilitates stock trading.
Importance of Investment Banks #5 – Asset Management:
It is the management of investments for a diverse group of investors, including institutions and individuals, across a variety of investing strategies.
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Investment Banking Underwriting Services
Underwriting is the process of obtaining cash by selling stocks or bonds to investors on behalf of businesses or other organizations (e.g., an initial public offering IPO). Businesses require money to run and develop, and bankers assist them in obtaining that money by promoting the firm to investors.
Underwriting is Classified into Three Types:
Firm Commitment –
The underwriter promises to purchase the whole issue and bear full financial responsibility for any unsold shares.
Best Efforts –
The underwriter pledges to sell as much of the issue as feasible at the agreed-upon offering price but has the option to return any unsold shares to the issuer without financial repercussions.
If the entire issue cannot be sold at the offering price, the transaction is cancelled, and the issuing business receives no compensation.
After the bank begins promoting the offering, the following book-building processes are done to price and close the transaction.
Investment Banking: Mergers and Acquisitions Advisory Services
Mergers and acquisitions (M&A) advising is the process of assisting firms and institutions in locating, evaluating, and completing company acquisitions. This is an important function of e-banking. Banks utilize their broad networks and contacts to identify opportunities and bargain on behalf of their clients. Bankers advise on both sides of mergers and acquisitions, representing either the “buy-side” or “sell-side” of the transaction.
The 10 Steps for the Mergers and Acquisitions Procedure Are Outlined Below:
- Acquisition Strategy
- Acquisition Criteria
- Target Identification
- Acquisition Planning,
- Valuation & Evaluation
- Due Diligence
- Purchase & Sales Contract
Investment Banking Customers
Investment bankers assist a wide spectrum of customers with capital raising and mergers and acquisitions. These customers may be found all around the world.
Investment banks cooperate with governments to raise funds, trade securities and purchase or sell crown businesses.
Corporations Bankers assist both private and public firms in going public (IPO), raising extra cash, growing their operations, making acquisitions, selling company segments, and providing research and general corporate finance assistance.
Banks collaborate with institutional investors that manage other people’s money to assist them trade securities and doing research. They also assist private equity firms in acquiring portfolio companies and exiting those positions by selling to a strategic bidder or through an IPO.
Investment Banking Skills
An investment banking job necessitates a significant amount of financial modeling and appraisal. Analysts and Associates at banks spend a lot of time in Excel, constructing financial models and utilizing various valuation methodologies to advise their customers and finalize agreements, whether for underwriting or M&A activity.
Investment Banking Needs the Following Abilities:
Financial Modeling –
It involves a variety of actions such as developing 3-statement models, discounted cash flow (DCF) models, LBO models, and other sorts of financial models.
Business Valuation –
It entails employing a variety of valuation techniques, including similar business research, precedent transactions, and DCF analysis.
Presentations and Pitchbooks –
Created pitchbooks and PowerPoint presentations from scratch to pitch ideas to prospective clients and earn new business.
Preparing Papers –
It is a confidential information memorandum (CIM), investment teaser, term sheet, confidentiality agreement, constructing a data room, and much more.
Relationship Management –
It entails working with current clients to effectively seal a sale and ensuring that clients are satisfied with the service delivered.
Sales and Business Development –
It entails visiting prospective clients regularly to propose ideas, give assistance with their job, and provide value-added advice to acquire new business.
It entails being a key player in the negotiation strategies used by buyers and sellers in a transaction and assisting clients in maximizing value generation.
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Why Investment Banking?
You will almost certainly be asked this question in an investment banking interview. Why should you work in investment banking after graduating from university?
The goal is to rapidly establish that you’re clever, that you understand what the work includes, and that even knowing everything necessary, you still want to do it!
At the end of the day, investment banks seek Analysts/Associates who are: smart enough to perform an outstanding job; capable of working long hours; and unwilling to resign.
Importance of Investment Banks: Positive Reasons
Work on Valuation and Financial Modeling
Investment banking allows you to become an expert at developing huge, complicated financial models from the start of your career. While bankers aren’t always terrific investors, they do spend a lot of time on valuation work, which might be a wonderful way to get started.
High-profile Transaction Exposure
Most of what bankers work on is kept under wraps until it’s officially publicized, and when it is, it’s frequently on the front page of the business section. If you say anything to that effect, it will likely massage the interviewer’s ego while also expressing a really convincing reason to work in the business.
A Difficult Challenge with a High Learning Curve
If you can point out that IB needs exceptionally long hours and that you’re truly inspired by the task, you’ll go a long way toward making yourself an enticing job prospect. Drawing analogies to your personal life, such as competing as an exceptional athlete, or musician, or in any highly difficult event, might be beneficial (like climbing Mount Everest).
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Why Investment Banking: Negative Reasons
It’s All About Money
Even if money is most certainly a big motivator for you, saying you’re inspired by how much money bankers earn is not a smart idea. It might be true, but most people find it offensive, so avoid mentioning it.
Using it as a Platform
This may also be true, but you should avoid expressing anything about wanting to work in private equity or hedge funds in the future and believing that IB is a fantastic route to get there. When a firm hires you, they hope you will stay with them.
Want to know more about investment banks and job roles in them? Book a call with our career expert for guidance on a career in financial modeling and valuation.
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Frequently Asked Questions on the importance of investment banks
Q1. What is the relationship between investment banks and private equity and venture capital firms?
Private equity and venture capital businesses are not the same as investment banks. Investment banks operate as go-betweens for publicly traded corporations and other investors, whereas venture capital firms invest their own money in privately owned businesses.
Q2. How do investment banks profit?
Investment banks often generate money by linking buyers and sellers in various markets. They often charge fees on trades that are proportional to the size and prestige of the bank. Banks will sometimes give underwriting services for a charge as well.
Q3. How do investment banks compete against one another?
In general, investment banks compete in the same way that many service businesses do:
- Trying to attract new customers.
- Encourage clients to select their services over those of rival investment banks.
- Recruiting top talent
They often use the non-price competition approach, which involves using their reputation and knowledge to guarantee the finest service possible.
Conclusion on the importance of investment banks
Investment banks’ names, such as Goldman Sachs and Morgan Stanley, crop up regularly in conversations about the financial market, indicating their prominence in the financial world. Investment banks, in general, assist clients with big and sophisticated financial transactions. This involves underwriting new debt and equity securities, assisting with securities sales, and assisting with mergers and acquisitions, reorganizations, and broker transactions. Investment banks may assist other organizations in raising funds by underwriting initial public offers (IPOs) and preparing the necessary papers for a firm to go public.
The long-term revenue and costs that investment banks accrue benefit them. They are also known as a distinct field that provides financial assistance, as well as various professionals and consumers who have shown an interest in purchasing. For a long time, the banks listed above have engaged in this behavior. The investment banking technique keeps up with the present state of their own countries’ economic worries, similar to recent times that have been operating on current advancements.
Many individual investment banks, as well as the investment banking sector as a whole, have come under fire for several reasons, including potential conflicts of interest, excessively huge compensation packages, cartel-like or oligopolistic behavior, taking both sides in deals, and more. The secrecy of investment banking has also been criticized.