An investment bank, which includes the likes of Bank of America, JPMorgan Chase, and Goldman Sachs, finances or facilitates trades and investment on a large scale for institutional clients. But that is an overly simplistic view of how investment banks make money. There are, in fact, several facets to what they do.
Key Takeaways
- Investment banks provide a variety of financial services, including research, trading, underwriting, and advising on M&A deals.
- Proprietary trading is an effort to make profits by trading the firm's own capital.
- Investment banks earn commissions and fees on underwriting new issues of securities via bond offerings or stock IPOs.
- Investment banks often serve as asset managers for their clients as well.
Brokerage and Underwriting Services
Like traditional intermediaries, large investment banks connect buyers and sellers in different markets. For this service, they charge a commission on trades. The trades range from simple stock trades for smaller investors to large trading blocks for big financial institutions.
Investment banks also perform underwriting services when companies need to raise capital. For example, a bank might buy stock in an initial public offering (IPO), and then market the shares to investors. There is a risk that the bank will be unable to sell the shares for a higher price, so the investment bank might lose money on the IPO. To combat this risk, some investment banks charge a flat fee for the underwriting process.
Mergers and Acquisitions
Investment banks charge fees to act as advisors for spinoffs and mergers and acquisitions (M&A). In a spinoff, the target company sells a piece of its operation to improve efficiency or to inject cash flow. On the other hand, acquisitions occur whenever one company buys another company. Mergers take place when two companies combine to form one entity. These are often complicated deals and require a lot of legal and financial help, especially for companies unfamiliar with the process.
Creating Collateralized Products
Investment banks might take lots of smaller loans, such as mortgages, and then package those into one security. The concept is somewhat similar to a bond mutual fund, except the collateralized instrument is a collection of smaller debt obligations rather than corporate and government bonds. Investment banks must purchase the loans to package and sell them, so they try to profit by buying cheap and selling at higher prices on the market.
Proprietary Trading
With proprietary trading, the investment bank deploys its own capital into the financial markets. Traders that risk the firm's capital are typically compensated based on performance, with successful ones earning large bonuses and unsuccessful traders losing their jobs. Proprietary trading has been much less prevalent since new regulations were imposed after the 2007-2008 financial crisis.
Dark Pools
Suppose an institutional investor wants to sell millions of shares, a size that's large enough to impact markets right away. Other investors in the market might see the big order and this opens the opportunity for an aggressive trader with high-speed technology to front-run the sale in an attempt to profit from the coming move. Investment banks established dark pools to attract institutional sellers to secretive and anonymous markets to prevent front-running. The bank charges a fee for the service.
Swaps
Investment bankers sometimes make money with swaps. Swaps create profit opportunities through a complicated form of arbitrage, where the investment bank brokers a deal between two parties that are trading their respective cash flows. The most common swaps occur whenever two parties realize they might mutually benefit from a change in a benchmark, such as interest rates or exchange rates.
Market Making
Investment banks often have market making operations that are designed to generate revenue from providing liquidity in stocks or other markets. A market maker shows a quote (buy price and sale price) and earns a small difference between the two prices, also known as the bid-ask spread.
Investment Research
Major investment banks can also sell direct research to financial specialists. Money managers often purchase research from large institutions, such as JPMorgan Chase and Goldman Sachs, to make better investment decisions.
Asset Management
In other cases, investment banks directly serve as asset managers to large clients. The bank might have internal fund departments, including internal hedge funds, which often come with attractive fee structures. Asset management can be quite lucrative because the client portfolios are large.
Lastly, investment banks sometimes partner with or create venture capital or private equity funds to raise money and invest in private assets. The idea is to buy a promising target company, often with a lot of leverage, and then resell or take the company public after it becomes more valuable.
The Bottom Line
In a capitalist economy,investment bankersplay a role in helping their clients raise capital to finance various activities and grow their businesses. They are financial advisory intermediaries who help price capital and allocate it to various uses.
While this activity helps smooth the wheels of capitalism, the role of investment bankers has come under scrutiny becausethere is some criticism that they are paid too much in relation to the services they provide.
FAQs
Investment banks earn revenue through fees charged for their services. Typically, there are two types of fees they earn: Underwriting fees for arranging the sale of securities (debt or equity) on behalf of clients. Advisory fees for providing strategic guidance.
How do investment bankers make a lot of money? ›
Investment banks earn revenue through fees charged for their services. Typically, there are two types of fees they earn: Underwriting fees for arranging the sale of securities (debt or equity) on behalf of clients. Advisory fees for providing strategic guidance.
How to answer why investment banking questions? ›
Common Answers for “Why Investment Banking”
- Learning experience.
- Fast-paced environment.
- Relevant internship / club experience / personal experience.
- Opportunity for lots of responsibility at a young age.
- Interface with executives from different companies.
- Exposure to different business models and industries.
They make money from what they call the spread, or the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make. They earn interest on the securities they hold.
How does an investment company make money? ›
Investment companies can be privately or publicly owned, and they engage in the management, sale, and marketing of investment products to the public. Investment companies make profits by buying and selling shares, property, bonds, cash, other funds and other assets.
Why are investment bankers so rich? ›
Investment bankers sometimes make money with swaps. Swaps create profit opportunities through a complicated form of arbitrage, where the investment bank brokers a deal between two parties that are trading their respective cash flows.
Why are investment bankers paid so well? ›
Investment banks often compete to attract and retain top talent, which drives up salaries. 2. High Levels of Responsibility: Investment bankers handle complex financial transactions, such as mergers and acquisitions, initial public offerings (IPOs), and large capital raising deals.
What is investment banking in simple terms? ›
Investment banking is essentially a financial service provided by a finance company or a banking division to help large multinational corporations in their investment plans. Along with large companies and organisations, this service also helps high net worth individuals and governments to raise or create capital.
How to answer why JP Morgan? ›
Reputation: JPMorgan Chase is a highly reputable and respected company in the financial industry. Working at such a well-established and successful organization would provide me with valuable experience and opportunities for growth.
What motivates you investment banking? ›
An example answer to the “Why Investment Banking?” question
Here is an example of how to answer the question concisely: I want to work in investment banking because it's the fastest way to learn financial modeling, valuation, Excel, and to understand the nature of large corporate transactions.
Banks make money by imposing service charges on their customers. These fees vary based on the products, ranging from account fees (monthly maintenance charges, minimum balance fees, overdraft fees, and non-sufficient funds [NSF] charges), safe deposit box fees, and late fees.
How do investment banks work? ›
An investment banker advises corporations, governments, or other entities on how to raise capital, as well as acquisitions, mergers, and sales of businesses. Investment banking is a type of banking involving organizing large financial transactions such as mergers or initial public offering (IPO) underwriting.
How much money do investment banks make? ›
How much do investment bankers make? As of October 2023, according to Glassdoor, the average annual investment banking salary in the U.S. is $131,021. In New York City, where the cost of living tends to be the highest in the country, the average salary is $316,432.
How do investment services make money? ›
They charge fees to you directly for managing your assets or providing financial planning, while also earning some commissions on the side. These commissions are usually in relation to securities or insurance sales.
What is the main purpose of an investment institution? ›
The main purpose of an investment institution is to manage financial assets on behalf of its clients or investors. What is an investment institution? An investment institution is a company or organization that manages money on behalf of other people.
How do investment funds earn money? ›
The fund may earn interest and dividend payments from its holdings. The fund may earn capital gains from selling assets held in the fund at a profit. The fund may appreciate, meaning each fund share will grow in value over time.
Do investment bankers make 500K a year? ›
Ways to make a lot of money in this world
Sure, anybody can make a good living being a doctor or a lawyer or an investment banker where you can make ~$200-500K per year a few years after you finish with your studies, but you hit a ceiling very quickly unless you start your own practice (aka start your own business).
Can you make 7 figures as an investment banker? ›
On average, a first-year investment banker makes a 5-digit salary, in the range of $70,000 – $90,000, while a 7-digit salary is considered above average and is difficult to achieve for most people in their careers.
Can you make a million a year as an investment banker? ›
Investment Banking Director Salary + Bonus: There's a bit of a bump over VP-level compensation, but not necessarily a dramatic one; the typical range for total compensation might be $800K to $1.2 million per year, with the majority in the bonus (as of 2022).
What is the highest paid investment banker? ›
1. Goldman Sachs is the highest paying bank overall - $398k in combined salaries and bonuses, on average. Goldman Sachs, which paid average salaries of $200k and average bonuses of $199k for 2023, was the highest paying bank we polled. It took top position by virtue a leap in bonus payments.
