Investment bank facts for kids

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The phrase Investment Bank refers to a business that helps other businesses (and also governments) borrow money from other people and businesses and/or allow businesses to partially or fully sell themselves to other people and businesses. Unlike a regular bank, they do not typically lend their own money or use their own money to purchase part or all of a business, but instead they help to match the business financing need to those other business and personal investors who are seeking to earn money by either lending to the business or owning part of the business.

In the mid twentieth century, certain investment banks started to also try and help their business clients to sell their business entirely to other businesses instead of to investors, as well as to help businesses decide what other business they should buy, in exchange for a fee based on the sale price of the business. This activity became known as Mergers and Acquisitions and today falls into the category of investment banking. In fact, there are many small investment banks that only offer this activity, and do not help businesses to borrow money or sell ownership in the business.

An investment bank most often helps businesses to borrow money using a form of a contract known as a bond, and to sell ownership in the company using a contract known as stock. Most countries have developed government rules that in exchange for requirements that the business operate in a certain manner and disclose their financial results in a certain manner, they are then allowed to borrow money using bonds and sell ownership using stock to the general public, and the general public is allowed to sell bonds and stock to other members of the public without being responsible for the operations and financial disclosures of the business. When a business operates under these rules it is known as a Publicly Traded Company. Those business owners who agree to follow the rules and regulations required to make their business a publicly traded company do so because they believe they can either borrow money more favorably or receive a higher price from the sale of part or all of their business because of the larger amount of individuals and/or businesses who can lend or purchase the business ownership when the business is publicly traded. This public trading system was originally started in the 1600's when a business was formed in Holland with the goal of building a fleet of ships to buy and sell spice from other countries for a profit. Since the cost to start this business was much more than any one individual was willing to risk, many individuals invested in the business using stock. Today however, except in the case of businesses that attempt to discover new medicines, most businesses that choose to sell stock are not brand new businesses but those that have been in business for a while, and where the owners either desire to sell ownership to receive money to be used in the business to further expand the business, or to receive money themselves as a profit to their original investment.

Some reasons that a business might choose to borrow money from investors instead of a bank may include the following:

  • The potential for lower interest rates
  • The potential for an interest rate that is fixed (cannot changed) for a longer time frame than what most banks would normally allow
  • Investors might be more willing to lend to a company more at risk at not being able to pay than what a bank would be willing to do

Some reasons that a business owner would agree to use an investment bank to sell part or all of their business to other investors include the following:

  • To earn a profit on the amount they initially invested in the business (because there might be a larger amount of buyers willing to buy businesses that are publicly traded, the price received for the business might be higher than if the owner sold the business to another individual)
  • To raise money that the business can use to further grow
  • To raise funds to pay back money that was borrowed for the business that the business owner might not be able to otherwise pay back

Investment Banks therefore work with two kinds of customers, one being the businesses/governments which desire to borrow funds or sell ownership, and the individuals and other businesses who want to earn a profit on their money by lending to or owning other businesses. As mentioned above, in a publicly traded company, people who have lent money in the form of bonds or purchased ownership in the form of stock can sell those stocks and bonds to other people. However, since at any given time only a relatively small amount of people/businesses might be looking to purchase stocks or bonds on any given day, in certain cases an Investment Bank might choose to purchase the stock or bonds from one individual with the intention of selling the stock and bond to another individual at a later date. The primary reason investment banks do this is to encourage people/businesses to continue to invest in stocks and bonds in the future by allowing them to realize one of the main benefits of doing so, namely that they can sell their stocks and bonds to others relatively quickly in order to receive some or all of their investment back. Without investment banks willing to buy stocks but especially bonds in this way, it might take a lot longer for someone to sell their stocks/bonds when they wish to (a difference between minutes and days or weeks for example). This activity of investment banks is called making a market. When an investment bank purchases a stock or bond from a customer, there is a risk that the stock/bond can lose value before they can sell it to another customer, and therefore banks use various strategies to try and protect themselves against this risk. Over time, banks began expanding how they invested their funds into stocks and bonds from just making a market, to trying new strategies unrelated to making a market in order to make a profit. This activity is known as proprietary trading. New rules passed since the 2008 subprime financial crisis however have limited proprietary trading an investment bank can do.

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