Question

Outline the main roles played by investment banks. Explain how their activities may complement traditional commercial banking

Answer 1

One of an investment bank's primary roles is to act as a kind of broker between companies and investors via initial public offerings (IPOs). Investment banks offer underwriting services for new stock issues when a corporation wants to go public or needs capital for equity. Underwriting basically involves buying an agreed number of new stock shares from the investment bank, which it then resells through a stock exchange. Part of the job of the investment bank is to analyze the company and assess a reasonable price for selling stock shares. IPOs generally involve more than one investment bank, especially for larger companies. This spreads the risk of underwriting across multiple banks, reducing any single bank's exposure and requiring a relatively lower financial commitment to the IPO. Investment banks also act as corporate bond underwriters.

Investment bankers are acting for their clients in several different advisory capacities. In addition to handling IPOs, investment banks offer advice to corporations to take over the public company or raise capital by alternative means. Investment banks regularly advise their customers on all financing aspects. Mergers and acquisitions are a major role for investment bankers. As with IPOs, an investment bank's ability to determine the cost of a potential transaction and arrive at a fair price is one of the key areas of expertise. In fact, an investment bank will help arrange and promote the transaction to ensure that the sale goes as smoothly as possible.

Federal authorities such as the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) are strongly controlling commercial banks. The federal government insures commercial banks to retain customer account safety and provide a certain level of security. Investment banks differ because the Securities and Exchange Commission (SEC) is much more loosely regulating them. The Commission offers less security for consumers and requires large amounts of operational flexibility for investment banks.Together with the specific business model, the relative weakness in government regulation gives investment banks a higher tolerance for and risk exposure. There is a much lower risk limit for commercial banks. Commercial banks have an implicit obligation to act in the best interests of their clients. Higher levels of government control also decrease their level of risk tolerance on commercial banks.

There are some advantages for banks that combine investment and business services functions. For example, a combined bank can use investment capabilities to help a company sell an IPO and then use its business division to offer the new business a generous line of credit. It allows the company to fund rapid growth and thus increase its stock price. In addition, a combined bank gains the benefits of increased trading, resulting in commission revenue.