Investment Banking

Historically, a “bank” has been a place where people could store money and know that it is safe. Centuries ago, when trade across cities and countries was difficult and dangerous, many merchants struggled with transferring money from one place to another, since the risk of highwaymen stealing their gold, currency, or gems was great. Banks developed and grew, especially in southern Europe, to deal with this problem.

Historically, a “bank” has been a place where people could store money and know that it is safe. Centuries ago, when trade across cities and countries was difficult and dangerous, many merchants struggled with transferring money from one place to another, since the risk of highwaymen stealing their gold, currency, or gems was great. Banks developed and grew, especially in southern Europe, to deal with this problem.

In those early banking days, the bank was just a safe place to keep money. However, the development of many banks meant that each bank began to compete with each other to get more business. Over time, banks began to offer more and more incentives to get merchants to store their wealth with them—including giving a rate of return to clients in exchange for letting banks store their money for them. This was the birth of the modern-day savings account.

Over time, the kinds of accounts banks offered to merchants got more complicated as the merchants began to develop increasingly complicated businesses that needed different kinds of banking services. Banks not only offered a place to store money, but also needed something called “credit”—that is, they would provide their clients with the capital (money) that they could then use to develop a business, and then their clients would give the money back after their business had begun to make money. These primitive commercial loans were extremely successful, and made many European economic projects possible.

From Credit to Equity

After a while, banks began to realize that they could do more than lend money to help customers start their businesses. Instead of lending money repaid with interest, they could offer to give clients funds in exchange for a percentage ownership in their clients’ businesses. Even better, the banks realized they could find people looking to invest in their clients’ businesses, and help pair up those investors with the businesses that were starting. In the Netherlands, this kind of pairing of investors with startups was what gave birth to the modern stock market, giving birth both to the concepts of equity shareholders and mutual funds.

The Dutch economy boomed, and neighbors such as the Germans and English followed their lead. Investment banks popped up all throughout Western Europe, but none would be as aggressive or as profitable as the investment banks in a small Dutch colony we now call Manhattan. The investment banks in the south of Manhattan allowed Americans and Europeans to invest in all kinds of American projects, from farm development in the Midwest, to cross-continental railroads to the pacific.

Although this innovation came with its problems—many early projects were not profitable, causing a lot of investors and investment banks to lose a lot of money—overall the ability to spread risk, invest in new ventures, and provide much-needed cash to profitable new projects meant investment banking would become a permanent part of the western economic landscape. The idea evolved and developed, until it became an important part of every major country on Earth.

Proprietary Trading, Market Making

As economies got more complicated, so did investment banking. The industry grew and became more complicated.  In 2008, in the aftermath of the financial crisis, the government decided many investment banks were “too big to fail” and needed massive bailouts. These bailouts were often misunderstood, and the reasons the banks were not be allowed to fail was unclear to many. Most experts agreed that investment banking had become a backbone of modern civilization.

How this portion of banking became so important, and so in need of help during a crisis, is a complex story that mostly relates to two things: proprietary trading and market making.

Proprietary trading, or “prop” trading, refers to banks using their own assets to make aggressive bets on the rise and fall in value of different kinds of assets. Just as large hedge funds are famous for making very aggressive bets based on complex calculations, investment banks began to use their own assets to bet on the future value of stocks, bonds, commodities, and other exotic financial instruments.

Those instruments came in all forms and they remain obscure to most. Derivatives like CDFs, options, warrants, MBSs, debt-backed securities, and reverse-repos are all examples of the highly complex financial instruments investment banks traded with each other and with clients.

Ideally, these instruments serve one purpose: to spread risk. By virtue of a connection to an index, asset, or underlying security, options, warrants, and debt-backed securities exist to allow people who invest in these financial instruments a way to buy insurance that protects those assets becoming worthless. In the same way, that you might buy car insurance to protect yourself if someone steals your car, investors would buy options to protect themselves from having their stock portfolios fall in value.

Failures and Bailouts

As with debts, equities, and other financial instruments, investment banks were in the business of creating and selling these exotic financial instruments to investors. This task is “market making” and is one of the most profitable parts of investment banking. It is also one of the riskiest. Because of that risk, when a major market crisis like the one in 2007 and 2008 happens, investment banks can suddenly owe billions, even trillions of dollars to clients all at once. If the banks do not have access to that cash, they can fail. This is what happened to Lehman Brothers in 2008, and was about to happen to almost all other investment banks at the same time—until the Federal government got involved with massive bailouts.

The Future of Investment Banking

Since then, investment banking has become a lot less glamorous. Investment bankers make less money, the government more closely regulates the industry and the risks banks can take are much lower. Some older investment bankers lament the “good old days” of huge bonuses and wild trading activity. Many are grateful the stress of those high-risk markets is gone. Others still worry that investment banking is as risky as it ever was, but insiders are not getting the big payouts they once received while still being exposed to job losses, prosecutions, and worse whenever the next big crisis unfolds.

Right or wrong, investment banking has reached a low point in its history. The banks themselves have consolidated, meaning there are a lot less of them. The services they offer are more controlled, less profitable and lower risk. The bankers themselves see tighter budgets, more competition, and tougher regulation.

Additionally, discussion in Europe and the United States about whether investment banks should be completely separated from banks other services has led many to wonder just what is in the future of the investment bank world.