What Investment Banks Do: Advisory, Underwriting and Trading

An investment bank is a financial firm that helps companies, governments and institutional investors raise money, buy and sell businesses, and trade securities. What investment banks do falls into a handful of lines of work: advising on mergers and acquisitions, underwriting new stocks and bonds, making markets and executing trades for clients, and publishing research. Most are organized as broker-dealers registered with the SEC and subject to FINRA rules, and many sit inside larger bank holding companies. Anyone reading investment bank news, or the annual reports of the large firms, will meet these functions under different labels. This guide explains them in plain terms.

In brief

• Investment banks are intermediaries. They connect issuers who need capital with investors who have it, and they advise on transactions.
• The main revenue lines are advisory fees, underwriting fees, and trading and financing income, with asset management at some firms.
• The work is regulated: securities law governs offerings, FINRA rules govern conduct and compensation, and bank-affiliated firms face the Volcker rule.
• The term “bulge bracket” describes the largest global firms; smaller “boutiques” often specialize in advice.

The core idea: intermediation and advice

A company that wants to sell shares to the public, issue bonds, or acquire a competitor faces tasks it does not do often: valuing itself, finding buyers, preparing disclosure, negotiating terms, and meeting legal requirements. An investment bank does those tasks repeatedly and has relationships with institutional investors and counterparties. In return it earns fees, usually contingent on completion of the transaction.

The firm’s role is not the same as that of a commercial bank. A commercial bank takes deposits and makes loans. An investment bank generally does not take retail deposits; it advises, underwrites, trades and arranges financing. Large financial groups combine both kinds of activity under one holding company, which is why some of the best-known names in the news are corporate groups with a separate bank, broker-dealer and asset management units.

Advisory work: mergers, acquisitions and restructuring

Advisory, often called M&A, is the line that produces the most headlines. Typical assignments include:

• Sell-side advice. The bank helps a company or its owners find a buyer, prepares marketing materials, runs an auction or negotiation, and helps close.
• Buy-side advice. The bank helps an acquirer identify targets, value them, structure an offer and arrange financing.
• Defense. A target facing an unsolicited approach hires advisers to assess the offer and consider alternatives.
• Fairness opinions. A bank may give the board an opinion on whether the price is fair from a financial point of view. FINRA Rule 5150 sets disclosure and procedure requirements for members that issue them.
• Restructuring. Advisers help companies in financial distress renegotiate debt, sell assets or reorganize.
• Capital structure and strategic advice. This includes advice on dividends, buybacks, spin-offs and divestitures.

Advisory fees are commonly a combination of a retainer and a success fee tied to completion, though terms vary by deal. FINRA’s fairness opinion rule requires a member that knows its opinion will be given or described to public shareholders to disclose, among other things, whether it will receive compensation contingent on the transaction being completed. That requirement exists because contingent pay can create an incentive to favor closing.

Capital markets: raising money

The capital markets side helps issuers sell securities. It splits into two main products.

Equity capital markets (ECM) handle initial public offerings, follow-on offerings, convertible bonds and other equity-linked deals. Debt capital markets (DCM) handle investment-grade and high-yield bonds, and related loans and structured products often run alongside the leveraged finance group.

When a bank underwrites an offering, it plays several roles: advising on timing, size and price, preparing the prospectus with the issuer and its lawyers, marketing the securities to investors, and often committing to buy the securities from the issuer and resell them. The Securities Act defines an “underwriter” broadly as a person who has purchased from an issuer with a view to distribution, or offers or sells for an issuer in connection with a distribution, or participates in such an undertaking. The mechanics have their own guide on this site, under underwriting.

Two rules illustrate how this work is regulated:

• FINRA Rule 5110, the Corporate Financing Rule, provides that no member may participate in a public offering whose terms, including aggregate underwriting compensation, are unfair or unreasonable under the rule. A member acting as managing underwriter must notify other participating members if told by FINRA that terms are unfair and unreasonable and have not been modified.
• Regulation S-K Item 508 requires a registration statement for securities offered through underwriters to name the principal underwriters, state the amounts each will underwrite, identify any underwriter with a material relationship with the issuer, and describe the nature of the underwriters’ obligation to take the securities.

Sales and trading

The trading side executes and finances client orders. A sales team talks to institutional investors; traders quote prices and manage risk; and financing desks lend securities or cash.

In market-making, the bank stands ready to buy or sell a security from or to clients, earning the spread between its bid and offer, and holds inventory in the meantime. The Volcker rule, which the Federal Reserve Board describes as generally prohibiting banking entities from proprietary trading and from investing in or sponsoring hedge funds or private equity funds, shaped how bank-affiliated firms separate client-driven activity from trading for their own account. Five federal agencies, the Federal Reserve Board, CFTC, FDIC, OCC and SEC, developed the regulations.

Trading revenue tends to move with market volatility and client volumes. That differs from advisory and underwriting revenue, which depends on deal activity.

Research

Many large firms publish research on companies, sectors and markets. Research helps institutional clients and, in some cases, supports the firm’s trading and underwriting franchise. Because analysts’ views can affect the price of securities that the firm’s bankers are helping to sell, conduct rules limit what analysts can do. FINRA Rule 2241 governs research analysts and research reports, covering policies to manage conflicts, such as separating analysts from investment banking pressure, and required disclosures in reports. Readers of a research note will often find a disclosure section about the firm’s relationship with the company covered.

Asset and wealth management

Several groups own investment banks alongside asset managers and wealth advisers. These businesses manage portfolios for institutions and individuals and earn fees based on assets. They are separate in function from the deal-making side, although they appear in the same corporate reports. Rules for investment advisers differ from those for broker-dealers.

Who works in a bank, and how a deal team looks

A typical advisory or capital markets team is organized in layers:

• Coverage bankers hold the relationship with a client or industry.
• Product specialists in M&A, ECM, DCM or leveraged finance bring technical expertise.
• Analysts and associates build the models, documents and presentations.
• Syndicate and sales place the securities with investors.
• Legal and compliance check disclosure, conflicts and regulatory requirements.
• Control functions such as credit and risk assess exposures when a bank commits capital.

A senior banker usually pitches the idea, a team executes, and the compliance function clears information barriers so that confidential deal information does not leak to trading or research.

A worked illustration

Consider a hypothetical mid-sized manufacturer that wants to sell a division. It hires a bank as sell-side adviser. The bank values the division, prepares a confidential information memorandum, contacts potential buyers under non-disclosure agreements, runs a process to receive bids, advises on the winner, and supports negotiation of the purchase agreement. The manufacturer’s board, advised by counsel, then decides whether to approve. If the buyer needs financing, its own bank may arrange loans or a bond offering, which brings the capital markets desk into the picture. If the sale is large enough to need a shareholder vote and the board wants an independent view on price, a bank may provide a fairness opinion, with disclosure about its fees and any other relationships.

At no point in this illustration is any single firm guaranteeing the result. The bank’s incentive is to complete a transaction on acceptable terms, and the regulatory framework exists in part to make conflicts visible.

Conflicts of interest

Because one firm may advise, underwrite, trade and lend, conflicts are built into the model. Common examples:

• advising a company while the firm’s trading desk trades its stock;
• advising a seller while a sister unit finances the buyer;
• earning success fees that depend on a deal closing;
• an analyst covering a company that is an investment banking client.

Responses include information barriers between units, disclosure to clients, committee review of opinions and approvals, and the conduct rules described above. Boards and investors are expected to read the disclosure.

Common misconceptions

“Investment banks hold your savings.” Retail deposits are held by commercial banks. An investment bank’s balance sheet funds trading and underwriting commitments.

“Banks guarantee that a deal will price or close.” Many offerings are firmly committed by underwriters, but market conditions and conditions in the agreements can still change the outcome. An adviser does not guarantee completion.

“All the big names do the same thing.” Strengths differ by product, region and sector, which is one reason league tables rank firms differently by category.

“Investment banking and investing are the same.” Investment banks advise and arrange. Funds and individuals invest.

Where to learn more

The SEC, FINRA and the Federal Reserve publish the primary materials. FINRA’s rulebook covers conduct and compensation. The eCFR contains the SEC’s disclosure rules. Company filings, including annual reports and 8-Ks, describe how each firm reports its segments and risks.

FAQ

Are investment banks and commercial banks the same?

No. Commercial banks take deposits and lend. Investment banks advise on transactions, underwrite securities and trade. Some financial groups own both, under different legal entities with different regulators.

How do investment banks make money?

Mainly through fees for advice and underwriting, income from trading and financing, and, at some firms, fees from managing assets. Mix varies by firm and by year.

What is a bulge bracket bank?

The term refers to the largest global investment banks with broad product coverage. There is no official definition or list, and the label is informal. Smaller advisory firms are often called boutiques or middle-market banks.

Who regulates investment banks?

The SEC regulates securities offerings and broker-dealers, and FINRA is the self-regulatory organization for broker-dealers. Bank holding companies are supervised by the Federal Reserve, and bank-affiliated entities are also subject to other banking regulators. The CFTC covers derivatives activities.

Why do banks disclose conflicts in fairness opinions and research?

Because the firm may be paid based on completion or may have other relationships with the parties. Rules such as FINRA 5150 and 2241 require disclosure so that boards and investors can weigh the advice.