An investment bank is a special type of financial institution that helps companies raise capital by issuing stocks and bonds, among other tasks. Cultura Travel/Walter Zerla / The Image Bank / Getty Images

By Joshua Kennon

Updated April 27, 2016.

As the credit crisis unfolded, I've heard a lot of investors asking the question "What is an investment bank and how does it differ from a regular commercial bank?" Unless you work in finance, you may not have come across the term investment bank before the global meltdown began. That's understandable.

Now, let me break down the basic definition for you, give you a brief overview of what an investment bank does, and help you understand the reasons investment banks are so important to the economy. In the next few minutes, you're learn how investment banks make their money and why they helped cause one of the greatest financial meltdowns in history.

To put it simply, an investment bank is nothing like the corner institution you're used to dealing with to get a business loan or deposit your paycheck. Instead, an investment bank is a special type of financial institution that works primarily in high finance by helping company access the capital markets (stock market and bond market, for instance) to raise money for expansion or other needs.

If Coca-Cola Enterprises wanted to sell $10 billion worth of bonds to build new bottling plants in Asia, an investment bank would help it find buyers for the bonds and handle the paperwork, along with a team of lawyers and accountants.

Sometimes, investment banks come up with novel solutions to solve difficult problems. Several decades ago, holding company Berkshire Hathawayhad only a single class of stock. Due to the fact that its controlling shareholder, billionaire Warren Buffett, had refused to split the stock, the shares had grown from $8 to $35,400; far out of the reach of the typical investor. Money managers were creating mutual fund-like structures to buy these shares and then issuing shares in themselves, taking a fee, to make the firm accessible to ordinary families. Buffett didn't like these middlemen making wild promises about the potential returns he could generate when he had nothing to do with it, so to take away their business, he worked with his investment bank to create a dual class capital structure. In May of 1996, Berkshire Hathaway had an IPO for the Class B shares, which traded at 1/30th the value of the Class A shares (the old stock) but had only 1/200th the voting rights. The Class A stock could be converted into the Class B stock at any time but you couldn't convert the Class B stock into Class A stock. This allowed investors to effect what amounted to a do-it-yourself stock split, while making cheaper shares wildly available.

Later, when Berkshire Hathaway bought the railroad Burlington Northern Santa Fe, the board of directors split the Class B stock so that it now represents 1/1,500th of the Class A stock. This resulted in the company being added to the S&P 500.

None of it would have been possible had investment banks not been working their magic. Well-regulated, and prudently managed, they add a lot of value to civilization.

A typical investment bank will engage in some or all of the following activities:

Up until recent decades, investment banks in the United States were not allowed to be part of a larger commercial bank because the activities, although extremely profitable if managed well, posed far more risk than the traditional lending of money done by commercial banks. This was not the case in the rest of the world. Countries such as Switzerland, in fact, often boasted asset management accounts that allowed investors to manage their entire financial life from a single account that combined banking, brokerage, cash management, and credit needs.

Most of the problems you've read about as part of the credit crisis and massive bank failures were caused by the internal investment banks speculating heavily with leverage on collateralized debt obligations (CDOs). These losses had to be covered by the parent bank holding companies, causing huge write-downs and the need for dilutive equity issuances, in some cases nearly wiping out regular stockholders. A perfect example is the venerable Union Bank of Switzerland, or UBS, which reported losses in excess of 21 billion CHF (Swiss Francs), most of which originated in the investment bank. The legendary institution was forced to issue shares as well as mandatory convertible securities, diluting the existing stockholders, to replace the more than 60% of shareholder equity that was obliterated during the meltdown.

Investment banks are often divided into two camps: the buy side and the sell side. Many investment banks offer both buy side and sell side services. The sell side typically refers to selling shares of newly issued IPOs, placing new bond issues, engaging in market making services, or helping clients facilitate transactions. The buy side, in contrast, works with pension funds, mutual funds, hedge funds, and the investing public to help them maximize their returns when trading or investing in securities such as stocks and bonds.

Many investment banks are divided into three categories that deal with front office, middle office, or back office services.

Link:
What Is An Investment Bank - An Intro To Investment Banks