Like commercial banks, investment banks are highly leveraged institutions that play an important role in both the primary and secondary markets. This includes investment banking activities.

  • Raising funds through public offering and private placement of securities.
  • Trading in securities.
  • Mergers, acquisitions and financial restructuring advice.
  • Merchant Banking.
  • Securities Finance and Prime Brokerage Services.

The first role is to assist in raising funds by corporations government agencies, state, local governments and foreign bodies sovereigns and corporations. Another role is to assist investors who wish to invest funds by acting as brokers or dealers in secondary market transactions.

Investment banking can be classified into two categories:

  1. Investment banking consists of affiliates of large financial services holding companies.
  2. Companies that are independent of a larger financial services holding company.

In investment banking, large investment banks are affiliated with large commercial bank holding companies. Examples of bank holding companies known as bank-affiliated investment banks are Bank of America Securities - a subsidiary of Bank of America, JPMorgan Securities - a subsidiary of JPMorgan Chase, as well as Goldman Sachs and Wachovia Securities - a subsidiary of Wells Fargo.

A second class of investment banks, referred to as independent investment banks, is a shrinking group. As of mid-2008, the group includes Greenhill, Co., Houlihan, Lockie Howard and Zukin.

Another way to classify investment banking firms is based on the type of activity, i.e., the lines of business in which they participate. Full service investment banks and boutique investment banks do. The former is active in a wide range of investment banking activities while the latter specializes in a limited number of activities.

Investment bankers perform one or more of the following three functions to assist organizations in raising funds in the public markets:

  • Advising the issuer of the terms and timing of the offer.
  • Underwriting.
  • Distributing numbers to people.

Investment bankers in their advisory role may need to design security structures that are more attractive to investors than the financial instruments currently available.

The underwriting function involves the manner in which an investment bank agrees to place a newly issued security in the market on behalf of the issuer. The fee earned by an investment banking firm from underwriting is the difference between the price paid to the issuer for the security and the price of re-offering the security to the public, called the reoffering price. This difference is called gross spread. There are two major types of underwriting arrangements:

1. Strong commitment

2. best effort.

In a firm commitment arrangement an investment bank buys a newly issued security from the issuer at a fixed price and then resells the security to the public at the offering price. In a best efforts underwriting arrangement the investment banking firm does not purchase a newly issued security from the issuer. Instead it agrees to use its expertise only to sell the security to people and earns a gross spread only on what it can sell.

Typically, firm commitment underwriting will involve multiple investment banks because of the capital commitment required and the potential loss of the firm's capital if the newly issued security cannot be sold to the public at a price higher than the purchase price. . This is done by forming a group of companies to underwrite the matter, referred to as the lead underwriter or the underwriting syndicate by the underwriter. The gross spread is then split between the lead underwriter and the other firms in the underwriting syndicate.

The distribution function is important to both issuers and investment banks. The entire securities issue must be sold to the public at the scheduled reoffering price to realize the total spread and may require a substantial marketing effort depending on the size of the issue. Members of the underwriting syndicate will sell the newly issued security to their investor customer base. Lead underwriters often put together sales groups to expand their base of potential investors. This group consists of the underwriting syndicate and other companies not in the syndicate whose gross spread is then divided among the lead underwriters, members of the underwriting syndicate and members of the selling group.

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