What do investment banks do?

By: Roger A Lee

Being the average American consumer and bank customer, I assumed that my local bank was a just a bank where you deposits money, wrote checks and got loans. I knew they also handled business accounts and mortgages and offered insurance. But as far as I knew that was all they did. I knew that they could handle wire transfers and international money needs, but I remember going into the bank when I was going to Europe on vacation to see if I could get foreign currency and I was told that I could but I had to request it a day ahead of time. This was a service to their depositors.

I assumed that Investment Banks were banks where investors, currency traders, companies doing buy outs or IPOs went for money to invest. I never thought that my same small bank, even though it was part of a national chain, was anything more than what I saw on the surface.

When the banking crisis started, I was amazed that my small local bank branch was closed and the deposits transferred to another bank. I read in the paper about all this mortgage stuff and credit swaps and investment vehicles and then I saw the word Investment Bank. Now I was curious and wanted to understand so I started to read and what I found out is.

Investment banks carry out two very different - and sometimes conflicting - functions in the financial markets.

Traditional "investment banking" refers to financial advisory work. Now I thought this was always done by a Stock Broker or an Investment Broker under the umbrella of stocks and bonds and not banking.

For example, a big corporation might ask for the bank's help if it wants to borrow money in the bond markets, or float itself on the stock market, or buy up another company.

In this capacity, the investment bank acts as an impartial adviser - like a solicitor or an accountant - using its expertise to help its client in return for a fee.

But investment banks also do something else quite different - they deal directly in financial markets for their own account and their own profit and losses.

An investment bank's "markets" division makes money by buying financial assets from one client, and then selling them to another - often with a hefty mark-up.

It is banks' capital markets whizz-kids who were behind the last decade's boom in "derivatives" - complex contracts that allow clients to speculate on financial markets.

For example, the investment bank may know a pension fund in New York who wants to buy California mortgage debt, while its California office may know a local home loans company or the bank itself sells mortgages it has issued.

The profits on these kinds of transactions were enormous during the boom years - and have become enormous again during the recovery.
These transactions are supposed to be risk-free for the investment banks - it is the buyer who should end up with all the risk.

But as the demise of Lehman Brothers and others demonstrated, the business can contain many hidden risks that only come to light during a financial crisis.

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Barry Norman is a contributor to and blogger at firstcredit.net. For over ten years FirstCredit.net has provided consumers free information helping them make sense of credit cards and the financial industry. Whether you are a longtime cardholder or looking for your first credit card, FirstCredit.net can help you make informed decisions.

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