Believe it or not, even investment bankers find it difficult to describe what exactly investment banks do! This has to do with the sheer complexity and enormity of the financial transactions involved.
In simple words, an investment bank is an intermediary between organizations such as ABC Steel that need money and individuals and institutions that need to invest. Broadly speaking, an investment bank is an institution that:
- Helps organizations or governments to raise money by issuing and selling securities such as stocks and bonds
- Provides a range of advisory services on complex transactions such as mergers and acquisitions
- Offers a range of structured products and services to institutional and individual investors to help them manage their assets and wealth
Role of an Investment Bank
Investment banks could play different roles in a financial transaction. Some of the most common roles played by them are:
- Underwriter
- Principal Trader
- Broker or Agent
- Prime Broker
- Advisor
Underwriter
As an underwriter, an investment bank purchases all new securities of a company and resells them to the public. For example, ABC issues 20,000,000 shares for $10 each. An investment bank directly purchases all these shares from ABC and sells it to the public at a higher price, say $15 each. The investment bank also bears the cost of the sale.
Principal Trader
As a principal trader, an investment bank buys shares from other investment banks and investors and keeps them in its inventory. It may sell these shares at a higher price in the future. The term ‘principal trading’ simply means that the trader of securities is also its owner or principal.
For example, after ABC Steel’s shares are sold to the public, an investment bank may purchase some of these shares from the market. It may sell these shares later when the price rises.
Broker or Agent
As an agent or broker, an investment bank buys and sells securities on behalf of a company. The key here is that the investment bank does not own these securities. It only trades in them for a commission.
The important thing to remember here is that the brokerage or agency represents buyers or sellers who are the principals or owners of the securities.
Prime Broker
A prime broker offers a range of services to professional investors, including:
- Administrative and operational support for trading
- Lending of securities
- Management and safeguarding of securities
- Financing
Without a prime broker, it would be difficult for professional investors to trade with several different brokers and manage their cash and securities from one centralized account.
Advisor
Investment banks provide a range of advisory services on complex transactions such as mergers and acquisitions. They also advise companies on the different options to raise capital. They provide high net-worth individuals with customized wealth management services.
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