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The Allure of Investment Banking: Profitability and Prestige:
Investment Banking is one of the most profitable fields in the financial industry. In 2018, investment banks made over thirty-nine billion dollars in revenue in the US alone. If Investment Banking sounds like a foreign language to you, you’re not alone; this high-stakes industry continues to baffle even banking professionals with its complexity. Nonetheless, with salaries starting at a hundred and forty thousand dollars a year, it’s no surprise that so many people dream of becoming the next wolf of Wall Street. Others are just curious about how this glamorous industry works. Unfortunately, it’s not all yachts, nightclubs, and champagne; the job itself is extremely stressful, and some investment bankers work more than a hundred hours per week. After all, something had to trigger Patrick Bateman in American Psycho. So what is Investment Banking? Why is it so lucrative? And how do investment banks differ from commercial banks?
Origins of Investment Banking: From War Efforts to Financial Giants
Before we explain how investment banking works, let’s turn back the clock to see how it all began. From the early 19th century, commercial banks in the U.S. performed the functions we now associate with investment banks. But during the Civil War, this all changed. The tale of investment banking begins with Philadelphia financier Jay Cooke. In 1861, Cooke established the first-ever American investment bank to help fund the federal government’s war efforts. As such, the US government became one of investment banking’s first clients. Back then, the government had to issue bonds to raise enough money to support its rapidly growing economy and complete infrastructure projects like building the railways. Bonds are like IOUs between lenders and borrowers and are typically used to finance expensive projects. In many cases, investment banks would buy these bonds then sell them on to private investors for a profit. Today, investment banks practically do the same, just with different parties involved.
Mechanics of Investment Banking: Underwriting and Risk Management
The question is: where are those billions of dollars in revenue coming from? Well, the business model is actually pretty simple. Investment banks purchase assets that hold monetary value, otherwise known as securities, and then sell them on to third parties for a fee. This process is called underwriting. So why don’t clients and investors just save money and make the deal themselves? One of the biggest perks of making this kind of deal is that the middleman is responsible for distributing the securities. If they can’t find enough investors, they have to keep some securities themselves. When you think about it, investment bankers are basically risk-taking middlemen between clients and investors. Now, this isn’t exclusive to investment banks; commercial banks take on risks as well. But here’s where the difference lies. Commercial banks deal with individuals and small to mid-sized companies, giving out smaller sums of money, like individual mortgages and small business loans. They make their profits through the interest they charge. On the other hand, investment banks take much larger risks. They deal with huge companies and high-risk startups, acting as a bridge between companies and investors. In the process, they can earn a huge amount in fees.
The Subprime Mortgage Crisis: A Cautionary Tale
.ed US banks to give out more loans. In order to do this, the banks lowered their standards and started giving loans to pretty much anyone, regardless of whether they had a job or any money at all. These are known as subprime mortgages, but you may want to think of them as less than desirable loans. Of course, commercial banks couldn’t just give out loans endlessly. So to make room for new borrowers, they sold their old loans onto investment banks. Investment banks repackaged those subprime loans and sold them on to investors without disclosing how insecure those loans were. At the time, that didn’t seem to matter. It was one big party: borrowers were buying homes, investors were profiting, and banks kept on selling their loans so they could give out new ones. But after every massive party comes an equally massive hangover. After years of good times, interest rates started rising. Suddenly, subprime borrowers couldn’t afford to pay back their loans and started filing for bankruptcy, causing everyone involved to start panicking. In the space of a few months, the American economy had been crushed by the greatest banking collapse since the Great Depression. What happened was that investment bankers had created a massive bubble with their irresponsible trading, and when that bubble burst, everyone felt the effects.
Reassessing Investment Banking: Contributions and Criticisms
So at this point, you’re probably convinced that investment banks are evil and we’d be better off without them, right? Wrong. The 2008 subprime mortgage crisis is just one of many crises throughout banking history. The market has crashed before and will undoubtedly crash again. But it’s worth remembering that investment banking, for all its flaws, helped build America. The first railroads, mines, and IT companies would never have seen the light of day if it weren’t for the support of investment banks. And as we look towards an environmentally sustainable future, we’ll need investment banks to help us rebuild America too.
The Future Landscape of Investment Banking: Sustainability and Innovation
So what does the future hold for investment banking? Many have speculated that crowdfunding platforms like Kickstarter will take over as the preferred method for funding innovative projects. But that’s not going to happen. While crowdfunding certainly can help small projects get off the ground, it’s not reliable enough to support the renewable energy revolution the world so desperately needs. On the other hand, investment banks are already pouring billions of dollars into alternative energy projects. Of course, it’s not just renewable energy projects that stand to benefit. We can expect Investment Banking to play a role in every world-changing innovation in the near future. Companies will always need large investors, and investors will always be on the lookout for new opportunities. That’s why investment banking is here to stay.
You can also read the Unveiling the Origins of Central Banking blog and you can watch the videos on the above topics