Investment Banking

Investment banking is a form of banking related to arrangement and service of large complex financial transactions, similar to a merger or underwriting of an initial public offering (IPO). Raising money for companies by these banks can be done in different ways, such as underwriting the issuance of new securities for corporations, municipalities and other institutions. Investment banking helps to manage an initial public offering (IPO) of entities and advise corporations regarding the processes of merger or reorganization. Investment bankers are always up-to-date with the current investment climate and allow their clients to freely navigate the financial world.

What is Investment Banking

Investment banks act as guarantors of new debt as well as equity securities for many corporations’ types, assist in the sale of securities and streamline mergers and acquisitions, restructuring processes, organizational changes and brokerage transactions. In addition, issuers receive recommendations from these banks concerning stock’s offering and placement. Most commonly, investment banking systems are subsidiaries of larger credit institutions, such as Goldman Sachs, Morgan Stanley, JPMorgan Chase and others.

Financial transactions recognized as large and complex are carried out with the participation of investment banks. Investment banker’s clients can benefit from the valuable advice on the company’s value and the best options for optimizing processes and structuring the transactions, since investment banks always tailor their instructions to the current market conditions.

In order for the company to go public, it may be necessary to issue securities as a way to raise funds for different clients’ groups and prepare the documentation for the Securities and Exchange Commission (SEC), which is also a part of the responsibilities of investment banks.

Regulation of Investment Banking 

The stock market crash of 1929 was followed by a series of bank failures, leading to the passage of the Glass-Steagall Act in 1933, which aimed to separate two types of activities: commercial and investment banking. That combination could exacerbate the stock market crash of 1929, being quite risky. 

At the moment of the stock market crash, investors started withdrawing their money from the banks. However, not all credit institutions were able to meet these requirements, as they also invested their clients' funds in the stock market. With adoption of the Glass-Steagall Act, financial institutions could no longer put private investors’ money at risk, engaging their funds into speculative positions and transactions, for example, into investing in stock markets.

The Glass-Steagall Act was repealed by Congress in 1999 since its stipulations were deemed too harsh by certain representatives of the financial sector. Gradually, the separation between banks’ types went away, and financial institutions began to combine again commercial operations and investing banking.

More about Investment Banking

In the very process of issuing securities, investment banks act as intermediaries between companies and investors. In order to get the maximum profit while complying with all regulatory requirements, investment banking serves as an indispensable tool in the pricing of financial instruments.

When a company goes through a procedure of an initial public offering (IPO), it is quite common for an investment bank to purchase all or most of the shares directly from the company itself. The sale of company’s shares conducting the IPO will also be carried out by the investment bank, which is its representative or trustee. In fact, the company enters into a kind of IPO contract with the investment bank, which greatly simplifies the existence of the company itself.

Despite a significant degree of risk, the investment bank can also make tangible profits, since the sale of shares occurs at a markup in relation to their initial price. However, if the company's shares were overvalued by the investment bank, the money on the transaction could be lost due to the fact that their sale will be carried out at a price lower than the original purchase price.

Investment Banking example

Assume that Alex Co., a children's clothing and toy chain, decides to go public and to use investment banking services for it. They opted for JK, one of the investment banks, to accompany their transaction.

Under the terms of the deal, JK acquires 150,000 shares of Alex Co for the initial public offering of the company at the price of $25 per share. This price was determined by the bank's financial experts as a result of thorough analysis.

JK pays Alex Co. $3.75 million for the shares, which number is 150,000, and, upon filing the relevant documents, begins to sell shares with the price of $27 per share. However, JK is forced to cut the price to $24 per share as it cannot sell more than 20% of the shares at $27. Thus, the investment bank sells the remaining part in Alex Co at a price of $24 each.

JK has made $3.69 million for the IPO with Alex Co. [(30,000 x $27) + (120,000 x $24) = $810,000 + $2,880,000 = $3,690,000]. JK has lost $60,000 on this deal since it overvalued Alex Co.

Competition for IPO projects is quite common between financial institutions that are in the investment banking system, which in many cases leads to a decrease in the net profit of an investment bank.

However, it is worth noting that there are also advantages. For example, underwriting of securities will be carried out not by one, but by several investment banks. And the fact that the investment bank earns less profit also means that the degree of risk will also be less.