How Investment Banks Really Make Money: A Detailed Breakdown (2024)

The operations of investment banks can be very confusing and misunderstood to outsiders. In part, this is because the industry is rife with overly complex terminology and jargon.

However, in this article, I will describe in simple terms exactly how investment banks’ business models work and how they make money.

Let’s jump in!

The role of investment banks

First, let’s cover the basics.

Investment banks play a crucial role in raising capital for corporations and governments.

They help their clients on various financial matters such as mergers and acquisitions, initial public offerings (IPOs), debt issuances, and restructuring.

These are critical services for the functioning of businesses and the global economy.

Primary revenue streams of investment banks

Investment banks earn revenue through fees charged for their services.

Typically, there are two types of fees they earn:

  • Underwriting fees for arranging the sale of securities (debt or equity) on behalf of clients
  • Advisory fees for providing strategic guidance

They also often make performance-based bonuses based on the success of the deals they complete.

Below is a breakdown of each revenue stream for investment banks:

Debt underwriting

Business clients often need loans to expand, grow, or operate their business.

Investment banks help with this by providing “debt underwriting” services.

This means the bank will make a loan to the company, and later it will resell pieces that loan to other investors.

While they do not typically hold onto the loan ultimately, they are compensated for arranging and structuring the transaction.

Also, they are compensated for taking risk by holding the loan for the period after the deal closes and before the bank can resell the loan to others (usually earning 2% to 3% on each sale).

This is risky since the bank will incur a large loss if the debt’s value declines while it is held on balance sheet.

Equity underwritings (aka IPOs)

Investment banks also assist privately held businesses in becoming public.

This means they provide “equity underwriting.” In other words, they assume the risk by purchasing the shares themselves before they are resold to other equity investors on the public market.

Investment banks impose a high fee based on the amount of the offering (usually 2-8% of the total deal). They earn millions of dollars in commissions as a result. They are also paid for setting an appropriate price and assembling a solid network of enthusiastic investors about the company’s long-term prospects.

Equity underwriting and IPO business tends to be dominated by a small number of large investment banks, who receive most of the underwriting profits.

M&A advisory fees

Many businesses grow by acquiring other businesses. This is called a “merger” or an “acquisition.”

Businesses frequently consult investment bankers on these transactions, because they are very high stakes and usually quite expensive. It never hurts to have a second set of eyes on a big decision!

Investment banks have whole teams devoted to the consulting on such transactions (called the “M&A group”).

They offer clients advice on the right price to pay, how best to approach the target, how to conduct finance analysis, etc.

Investment banks sometimes demand a hefty consultation fee, which fluctuates depending on how many hours of work the investment banker has to put in since the advice is given by some of the most experienced investment bankers.

In contrast to other revenue sources, this doesn’t involve the bank taking on any risk or making a commitment to their balance sheet; instead, they only offer to advise and are compensated handsomely (e.g., 1-2% of deal value). Although there may occasionally be a retainer element, this is mostly a success fee.

Banks can also get “debt underwriting” business by advising on M&A deals, if the transaction requires additional financing.

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Interest income from lending

Above I described how investment banks make money by underwriting and arranging debt deals.

Well, banks also make some money (though a small amount) by holding onto a small percentage of the debt they issue for clients. When they hold onto debt, they earn interest on the debt as it is paid by the borrower.

Typically, the debt held by investment banks falls into two buckets:

  • Revolving” credit facility – think of it like a “credit card for companies”. It allows companies to access cash on demand if it is needed. Banks not only earn interest on the borrowings, but they also charge fees for any unused amount as well
  • “Hung” underwritten debt deals – Whatever piece of an underwritten debt contract they cannot sell on favorable terms is kept on the balance sheet, and the bank will get interest revenue from it.

Trading & market-making

Many investment banks have sizable sales and trading departments in charge of purchasing, briefly holding, and then selling stocks and bonds to provide liquidity to clients.

Investment banks frequently operate market-making activities to generate money by facilitating liquidity in the stock market or other marketplaces.

A market maker displays a quote (purchase price and sell price) and receives a modest commission, known as the bid-ask spread from the difference between the two prices.

In most markets, these commissions have gotten smaller and smaller over the years as markets have gone electronic and information asymmetries have disappeared.

Securitization

Investment banks also make money by packaging and reselling shares in assets (called “securitization”).

For instance, banks might purchase a pool of assets (say a group of corporate loans) pools from commercial banks.

They take these loans and create a new security from the whole with different tranches to make the securities more appealing to various investors. In this business, banks will typically make a small underwriting fee as a percentage of each deal.

Proprietary Trading

Sometimes investment banks invest their own money in the financial markets through proprietary trading.

In trading, the bank makes money on the performance of the trades.

Since new laws were enacted in the wake of the 2007–2008 financial crisis, proprietary trading has become significantly less common.

Asset management

Strictly speaking, asset management fees are OUTSIDE of the investment bank, but many large investment banks (e.g. JP Morgan, Goldman Sachs) have asset management arms, so I’m including it here.

Typically, asset management fees are earned by advising large clients on how to invest their money. Traditionally, the fees earned by banks are calculated as a percentage of the amount of money invested.

How investment bankers make money

Above we’ve covered how investment banks make money.

However, we should also clarify how investment BANKERS make money.

Overall, investment banking is a lucrative field that requires a deep understanding of finance, strong analytical skills, and excellent interpersonal abilities. “Why investment banking” is not a hard question for many for this reason.

Investment bankers make money through the fees charged to their clients. As discussed above, this includes underwriting fees for arranging the sale of securities and advisory fees for providing strategic guidance.

Investment bankers also can earn performance-based bonuses, based on the actual success or quality of the transaction they completed.

Investment bankers compensation typically has the following components:

  • Salary
  • Cash bonus
  • Equity bonus

Next steps

Read the rest of the investment banking primer to know more about investment banking.

How Investment Banks Really Make Money: A Detailed Breakdown (2024)

FAQs

How Investment Banks Really Make Money: A Detailed Breakdown? ›

Proprietary trading is an effort to make profits by trading the firm's own capital. Investment banks earn commissions and fees on underwriting new issues of securities via bond offerings or stock IPOs. Investment banks often serve as asset managers for their clients as well.

How does investment banking make money? ›

Investment banks earn revenue through fees charged for their services. Typically, there are two types of fees they earn: Underwriting fees for arranging the sale of securities (debt or equity) on behalf of clients. Advisory fees for providing strategic guidance.

How do banks make money in detail? ›

They earn interest on the securities they hold. They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).

How are investment banks broken down? ›

An investment bank is comprised of three main areas: investment banking division (IBD), sales and trading (S&T), and Asset Management.

Why are investment bankers so rich? ›

As long as investment banks remain gatekeepers to the market for companies (and capital markets), they will be able to extract high fees, and use those high fees to pay high salaries and bonuses.

Why does IB pay so much? ›

Investment bankers are compensated for the high levels of responsibility they carry and the potential impact their work can have on the financial markets. 3.

Do investment bankers actually make a lot of money? ›

Can you become a millionaire as an investment banker? It is possible to become a millionaire as an investment banker, but it is not easy. Investment bankers typically earn salaries in the $200,000 to $700,000 range, with bonuses that can bring their total income up to several million dollars per year.

How do banks get so rich? ›

Commercial banks make money by providing and earning interest from loans [...]. Customer deposits provide banks with the capital to make these loans. Traditionally, money earned in the form of interest from loans often accounts for up to 65% of a banks' revenue model.

What type of investments do banks use to make a profit? ›

Final answer: Banks use opening checking accounts, buying stocks and bonds, and issuing loans to make a profit.

What is a predatory financial service? ›

Predatory lending is any lending practice that imposes unfair and abusive loan terms on borrowers, including high-interest rates, high fees, and terms that strip the borrower of equity. Predatory lenders often use aggressive sales tactics and deception to get borrowers to take out loans they can't afford.

What is investment banking in a nutshell? ›

Summary. Investment banks play a key role in helping companies and government entities obtain capital financing. As financial advisors to their clients, they help to price capital, allocate resources, and manage investments.

How do investment banks lose money? ›

For example, a bank might buy stock in an initial public offering (IPO), and then market the shares to investors. There is a risk that the bank will be unable to sell the shares for a higher price, so the investment bank might lose money on the IPO.

What are the cons of investment banks? ›

The Cons of Working with an Investment Banker
  • Requires a fee, typically comprising an upfront retainer and a more substantial success fee once the deal closes.
  • Increases your emotional commitment to go through with a sale, since you will have paid and engaged a professional to handle it.

Can investment bankers make 500K? ›

Sure, anybody can make a good living being a doctor or a lawyer or an investment banker where you can make ~$200-500K per year a few years after you finish with your studies, but you hit a ceiling very quickly unless you start your own practice (aka start your own business).

Do lawyers or investment bankers earn more? ›

Compensation at investment banks hasn't changed much since the 2008 financial crisis, with managing directors still earning an average $1.9 million a year, amid mounting regulatory pressure. Equity partners at top law firms, meanwhile, can make from $3 million to more than $15 million annually.

Can you be a millionaire as an investment banker? ›

It is fairly common for front-office investment bankers to be earning over US$1m after 8 years in the industry. But it caps out at around US$20m, which is how much a top-performing investment banking CEO gets.

Is investment banking really worth it? ›

Investment bankers are typically the highest-paid workers in the finance industry—high salaries are most prevalent even among younger employees. The starting salary for the typical investment banker exceeds that of most other finance positions, but working in this field has its challenges.

How do investment companies make their money? ›

1. Fees, Fees, Fees: Investment companies often charge fees for managing your investments. These can be upfront fees (like load fees) or ongoing management fees. These small percentages might seem insignificant, but they add up, especially when they manage massive portfolios.

How does Goldman Sachs make money? ›

Goldman Sachs engages in a variety of market-making, proprietary trading and arbitrage activities in equity securities and equity-related products (such as convertible securities and equity derivative instruments) on a global basis.

Do investment bankers use their own money? ›

Investment bankers don't use their own money for their professional transactions. Instead, they act as advisors to clients on how to best invest the clients' capital. Those working at private equity firms, however, typically use their own private capital.

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