Roles and Functions of Modern Investment Banks (2024)

Perhaps no other industry inspires as much awe, intrigue, controversy, and curiosity as the global investment banking industry. Investment banks have a storied history and today, they sit astride the fast-paced flow of global trade and capital.

This article provides a brief historical overview of investment banks, describes the different roles they play in the origination and distribution of securities, and examines the conflicts of interest that arise when these functions take place under one corporate roof.

An Early History

Adam Smith famously described capitalism as an invisible hand guiding the market in its allocation of goods and services. The financial engines of this hand during the 18th and 19th centuries were European merchant bankssuch as Hope & Co., Baring Brothers and Morgan Grenfell. For a time, the Netherlands—and later Great Britain—ruled the waves of global commerce in far-flung ports of call such as India and Hong Kong.

The merchant banking model then crossed the Atlantic and served as the inspiration for the financial firms founded by prominent families in what could perhaps be called the emerging market of the day—the United States. The structure and activities of early U.S. firms such as JP Morgan & Co.,Dillon Read, and Drexel & Co. reflected those of their European counterparts and included financing new business opportunities through raising and deploying investment capital.

Over time, two somewhat distinct models arose from this. The old merchant banking model was largely a private affair conducted among the privileged denizens of the clubby world of old European wealth. The merchant bank typically put up sizable amounts of its own (family-owned) capital along with that of other private interests that came into the deals as limited-liability partners.

The Rise of Investment Banks

Duringthe 19th century, a new model came into popular use, particularly in the United States. Firms seeking to raise capital would issue securities to third-party investors, who would then have the ability to trade these securities in the organized securities exchanges of major financial centers such as London and New York. The role of the financial firm was that of underwriter,representing the issuer to the investing public, obtaining interest from investors and facilitating the details of the issuance. Firms engaged in this business became known as investment banks.

Firms such as JP Morgan didn't limit themselves to investment banking, but established themselves in a variety of other financial businesses, including lending and deposit taking (i.e. commercial banking). The stock market crash of 1929 and ensuing Great Depression caused the U.S. government to reach the conclusion that financial markets needed to be more closely regulated to protect the financial interests of average Americans. This resulted in the separation of investment banking from commercial banking in the Glass-Steagall Act of 1933.

The firms on the investment banking side of this separation(Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston)went on to take a prominent role in the underwriting of corporate America during the postwar period, andthe largest gained fame as the so-called bulge bracket.

Merchant Banks and Private Equity Firms

The term merchant bankcame back into vogue in the late 1970s with the nascent private equity business of firms such as Kohlberg, Kravis & Roberts (KKR). Merchant banking in its modern context refers to using one's own equity (often accompanied by external debt financing) in a private transaction, as opposed to underwriting a share issue via publicly traded securities on an exchange, which is the classic function of an investment bank. Many of the large global firms today conduct both merchant banking (private equity) and investment banking.

The Regulatory Infrastructure

In the United States, investment banks operate according to legislation enacted at the time of Glass-Steagall. The Securities Act of 1933 became a blueprint for how investment banks underwrite securities in the public markets. The act established the practices of due diligence, issuing a preliminary and final prospectus, and pricing and syndicating a new issue.

The 1934 Securities Exchange Act addressed securities exchanges and broker-dealer organizations. The 1940 Investment Company Act and 1940 Investment Advisors Act established regulations for fiduciaries, such as mutual funds, private money managers and registered investment advisors. In Wall Street parlance, the investment banks represent the "sell side" (as they are mainly in the business of selling securities to investors), while mutual funds, money managers, portfolio managers, financial advisors, wealth advisors, and others make up the "buy side."

Anatomy of an Offering

A company selects an investment bank to be the lead manager of a securities offering; responsibilities include leading the due diligence and drafting the prospectus. The lead manager forms a team of third-party specialists, including legal counsel, accounting and tax specialists, financial partners, and others. In addition, the lead manager invites other banks into an underwriting syndicate as co-managers. The lead and co-managers will allot portions of the shares to be offered among themselves. Because their underwriting fees derive from how much of the issue they sell, the competition for the lead manager and senior allotment positions is quite intense.

When a company issues publicly traded securities for the first time through an initial public offering (IPO), the lead manager appoints a research analyst to write a research report and begin ongoing coverage of the company. The report will contain an economic analysis of the business and its prospects given the market for its products and services, competition, and other factors. Once the analyst initiates coverage, they will make ongoing recommendations to the bank's clients to buy, hold or sell shares based on the perceived fair value relative to the current share price.

Distribution and Underwriting

Distribution begins with the book-building process. The underwriting syndicate builds a book of interest during the offering period, usually accompanied by a road show, in which the issuer's senior management and syndicate team members meet with potential investors (mostly institutional investors such as pension funds, endowments and insurance companies). Potential investors receive a red herring, a preliminary prospectus that contains all materially significant information about the issuer but omits the final issuing price and number of shares.

At the end of the road show, the lead manager sets the final offering price based on the prevailing demand. Underwriters seek to have the offering oversubscribed (create more demand than available shares). If they succeed, they will exercise anoverallotment option, called a greenshoe, which is named after the Green Shoe Manufacturing Company, the first issuer of such an option. This permits the underwriters to increase the number of new shares issued by up to 15% (from the number stated in the prospectus) without going through any additional registration. The new issue market is called the primary market.

The Securities and Exchange Commission (SEC) registers the securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading.

Conflicts of Interest

Investment banking is fraught with potential conflicts of interest. This problem has intensified through the consolidation that has swept through the financial services industry, to the point where a handful of large concerns—the fabled bulge bracket banks—account for a disproportionate share of business on both the buy and sell side.

The potential conflict arising from this is simple to understand. Buy-side agents—investment advisors and money managers—have a fiduciary obligation to act solely in the best interests of their investing clients, without regard for their own economic incentives to recommend one product or strategy versus another. Investment bankers on the sell side seek to maximize the results to their clients, the issuers. When a firm in which the main line of business is sell sideacquires a buy-side asset manager,these incentives can be at odds.

Unfortunately for investors, the economics of the business are such that a disproportionate amount of an investment bank's profits derive from its underwriting and trading businesses. The competition for mandates is intense, and the pressure is high on all participants—the bankers, research analysts, traders and salespeople—to deliver results.

One example in particular is research. The research analyst is supposed to reach independent conclusions irrespective of the investment bankers' interests. Regulations mandate that banks enforce a separation between research and banking. In reality, however, many firms have tied research analysts' compensation to investment banking profitability. Scrutiny following the collapse of the dotcom bubble in 2000 has led to some attempts to reform some of these flawed practices.

Compensation for Careers in Investment Banking

A discussion on investment banking wouldn't be complete without addressing the enormous sums of moneyinvestment bankers are paid. Essentially, a bank's main income-producing assets walk out of the office building every evening. Deals are completed and money is made based solely on the relationships, experience and clever thinking of the professionals who work there.

As such, an investment bank has little to do with the profits it earns except to pay the folks who produced them. It is not unusual for 50% or more of top-line revenues to go into the salaries and bonuses ofan investment bank's employees. Most of this goes to the principal architects of the deals, but italso goes to the associates and analysts who toil over discounted cash flow spreadsheets and comparables models until the early hours of themorning.

The catch is most of this compensation is paid as bonuses. Fixed salaries are by no means modest, but the big seven-figure payoffs come through bonusdistributions. The risk for an investment banker is that such payouts can quickly vanish if market conditions turn down or the firm has a bad year.

Investment bankers spend an inordinate amount of time trying to figure out new ways to make moneyin good times and bad. Business areas like mergers and acquisitions(M&A), restructuring, private equity and structured finance, most of which were not part of an investment bank's repertoire prior to the mid to late 1970s, provide evidence of this profession's ability to continually find new ways to make money in all phases of the economic cycle.

The Bottom Line

For all the mystery surrounding investment banks, the role they have played throughout the evolution of modern capitalism is fairly straightforward. These institutions provide the financial means to enable Adam Smith's invisible hand to function.

Investment banks have flourished in a variety of economies, from the merchant traders of 18th-century London and Amsterdam to the behemoths of today, whose influence spans the globe. As long as there is a market economy, there are likely to be investment bankers coming up with new ways to make money through enabling flow of capital.