Chapter 7. Investment Banks

Most people are familiar with the activities of commercial banks because of the role they play in every day life. Commercial banks take deposits in the form of certificates of deposits, passbook savings accounts, and money market accounts. They use this money to provide loans. You have your checking account at a commercial bank. These borrowing and lending activities are much different from the primary activities of investment banks.

The primary role of investment banks is to help companies raise capital by issuing securities. Company managers are experts in the business activities of their particular industry. They know how to build, market, sell, and service their products. These managers are not experts in obtaining the capital they may need to develop new products or expand operations. Should the company sell more stock or conduct a bond issue? What about more complex securities like preferred stock or convertible shares? Financial engineering over the past decade has created some very complicated securities. Should a firm sell the securities to public investors or to deep-pocket private investors like state pension funds? Indeed, even the process of registering new securities with the SEC is complicated. Investment banks specialize in steering firms through this maze of questions and helping them obtain the needed capital with the best security issue.

Both commercial and investment banks find capital for those who need it. Commercial banks are mostly compensated by the difference in interest rates that they receive from lending and paying depositors. Long after money initially changes hands, these banks continue to service both the depositors and lenders. Alternatively, investment banks are compensated by a fee that is charged to the company for selling the new securities. After the firm gets the capital and the investors get their security, the investment bank no longer is involved. That is, investment banks put together deals and then move on. They are an important and integral part of the corporate system.