What do investment banks actually do? – MoneyWeek Investment Tutorials

MoneyWeek’s Tim Bennett explains what investment banks actually do- and how they earn their huge profits.

This video is going to talk about investment banks they’ve been in the press a lot recently there’s talk about banking bonuses how big they should be how do they afford them so this time we’re going to take a look at what investment banks actually claim to do that justifies paying all that money to their star traders and so on ok so where do investment banks fit

In well these days it’s relatively uncommon to have an organization that is purely an investment bank there are some around but many are bolted on the side of retail banks so when you look at an organization such as barclays you’re actually looking at a global organization that comprises a number of different divisions so what you can do quite often is take a

Bank and in very simple terms split it down into two basic functions and there’s been a lot of talk in the media recently about where the bank should do both of these functions there’s retail banking and there’s investment banking now it is possible to get banks that just do do one or the other goldman sachs is largely an investment bank as is jp morgan but the

Likes of barclays hsbc actually do both they didn’t always but these days they do both so first of all before we look at this one what’s the difference well retail banking is the bread and butter of banking in many ways this is organizing mortgages and loans for retail investors businesses and the like and also organizing savings accounts for people with spare

Cash so on the one side retail banks take money in from investors who’ve got capital that they want to leave safely tucked away in a bank for a while and they also lend it out to people wanting loans and mortgages and ideally over here in simple terms you want to give away as a bank less to your savers than you grabbed from your borrowers that way you make profit

However that’s often seen as a little bit low risk little bit unsexy or bid it’s fairly safe solid cash flow generating business so investment banking is often perceived as the high-risk sexy bit of the industry and this is where the much higher margins are made there is much more money potentially in investment banking but there are risks associated with it so in

This video we’re going to steer away from retail banking and take a look at investment banking and we’re going to look at five basic bread-and-butter activities but many investment banks would claim sit at the heart of what they do and justify some of those big bonuses being paid at the moment whether or not they do justify the bonuses here’s another question for

Another video but nonetheless is these activities that tend to attract all the headlines so what are they let’s take a look at five so in investment banking and that’s where we’re going to focus right now we’ll leave retail banking to one side activity number one prop or proprietary trading prop or proprietary trading now just like i can take my own money out of

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My own bank account and gamble it on the horses spread betting that investing in shares property whatever i like investment banks can do the same they have their own funds they also raise money from investors of course but they have their own funds and those can be gambled often in spectacular amounts to make the bank money so banks employ teams of traders to bet

On currencies commodities bonds and so forth and if they get it right they make money like any good gambler would their aim is to employ the best gamblers in the market if you like and therefore outwit everybody else trying to do the same thing and that activity gambling the banks money in order to make money is known as proprietary trading second activity market

Making as a retail investor or as any investor if you want to go out and buy tesco shares for example you need a market and that market is provided by organizations such as the london stock exchange but a market needs buyers and sellers otherwise it doesn’t work so if i want to buy 10,000 tesco shares i need to be pretty sure that if i go to a market such as an

Exchange there’ll be someone willing to sell at least that many shares otherwise there’s no market um i might as well just hunt around for my own seller so market making is an important function of investment banks what investment banks often commit to do at the london stock exchange is trade regularly so that other people can – they literally make the market a

Bit like if i want to buy a second-hand car this morning i could run around trying to find an individual seller or i could approach a second-hand car dealer that is somebody who holds a stock of second-hand cars and is always willing to do a trade in them for my benefit as a customer or a punter of course they’re not a charity they try to make money out of it but

Market making a stock exchange is another important function of an investment bank it’s often not terribly profitable and it’s not to be confused with prop trading because they are subject to rules about the size of bid offer spreads and there’s also quite big competition so there might be a dozen banks all competing to make a market in a particular share a time

The stock exchange and that competition can narrow spreads right down nonetheless quite an important function and quite a few banks likely seem to be acting as market makers it’s a kind of prestigious good pr thing to do number three m&a or m&a advisory mergers and acquisitions the people actually doing the deals merging with each other or buying each

Other are usually companies so you might find that in the airline industry you have one company merging with another or taking over another for example the banks make a decent fee out of advising those companies so a predator as they’re known might want to buy a target it might approach a goldman sachs for example and say wright would need some advice we need some

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Advice on the timing when should we go for the deal when it’s move ice on how to structure it is it going to be cash deal are we going to try and by using something else we need some help with the regulator’s one of the documents we need to get sorted out we need some help screening the target due diligence as it’s called making sure we know what we’re buying and

So on we also need some help publicizing it so all of those jobs you can pass a lot to an investment bank and they generally take a cut of the size of the deal if you like so the bigger the deal the more the bank will earn they also do something else which is similar in a way but i’m going to call corporate events in particular new issues another reason the bank

Might be approached by a company as it needs to raise funds now it could be raising funds to fund the takeover of another company but it might not be a company such as tesco or marks and spencers might simply need to raise more capital so they might decide to issue shares or bonds depending on what they want to issue debt or equity and again a bank can help and

The bank can help in a number of ways with say a share issue number one when should the company looking to raise the funds do it there are good times they’re a bad time spends on the market depends on which investors the bank can find to buy these shares number two how do i market and publicize this new issue who are we going to sell these shares to on behalf of

Tesco so the bank might do a little roadshow go around approaching institutions such as pension funds likely investors on behalf of the company trying to sell the shares and that takes a bit of time it might prepare prospectuses to market the whole thing it might then advise on the price it might even get involved in underwriting it’s all very well for a company to

Say we want to raise x many million pounds and we want to do it within a month but what if no one wants to buy the shares bit of a problem if you’re an airline and you’ve committed to buy a certain number of aircraft you’ve got to have the funds ready so an investment bank might take a hefty fee for committing to buy shares that other investors don’t want in a new

Issue and quite often the fee is a percentage of the amount raised so you can imagine where hundreds of millions of pounds are involved that fee gets big pretty quickly so these two things often an advisory role but the underwriting element brings some risks the investment bank hence in theory the big fees that they charge and then another big area is structuring

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Products again it’s a sort of advisory role up here you get clients of the investment bank institutional or even retail represented by for example another bank coming on and saying we need a product we want to sell something to the public or to institutions that does a particular job and they’ll bring in an investment bank to help them design it so for example you

May have come across those products that money week we’re not desperately keen on them called structured products that say things like as an investor give us your money for two years in a worst-case scenario you get your money back in two years time in a best-case you get your money back and 80% of the rise in the footsie 100 over the next two years as an investor

You might think that’s good so the worst thing is i get my money back in two years and i might get my money back plus 8% the rise in the now the bank that sells you that is sending you a structured product they’ve had to put together two or three different securities to make that work and that’s something that investment banks get involved in – and just in case

You’re thinking what is wrong with that product have a think about it if i say to you in a worst-case scenario you’ll get your money back in two years time that’s not great because over the next two years you could be earning interest on your cash for simply putting in a bang account so just getting it back in two years time isn’t fabulous and if you think the

Book is going to rise over the next two years why on earth would you only want 80 percent the gain in the foot see when you might as well take one hundred percent anyway structure products have their fans money week we’re often not amongst them but nonetheless investment banks are quite good at designing those products whether ultimately the target is the retail

Market or the the sort of institutional market that involves pension funds and life insurance companies so lots of different activities does it all justify the big bonuses frankly very good question which i won’t attempt to address here but nonetheless investment banks would say these are risky activities that should command big fees to the people directly involved

In them and although investment banks do other things and you won’t always find all of them agreeing on the terminology i’ve used here these are five of the biggest and most common ways but a lot of them try to make money

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What do investment banks actually do? – MoneyWeek Investment Tutorials By MoneyWeek