Investment banking: linkages to the real economy and the financial system
By Kushal Balluck of the Bank’s Banking and Insurance Analysis Division
Most people are familiar with the main functions of retail or 'high street' banks, such as accepting savers’ deposits, making loans and providing payment services. In contrast, the functions of investment banks are typically less well understood. This article describes what investment banks do – as well as some of the risks that they can pose – assuming little prior knowledge. Along the way, it attempts to explain some of the terminology frequently used in relation to investment banking – from 'SPVs' and 'CDOs' to 'bid-offer spreads' and 'dark pools'. Two key functions of investment banks are:
- Capital market intermediation: Investment banks help large organisations such as companies and government agencies to raise finance through capital markets. When a company wishes to borrow money by issuing a bond, for instance, investment banks can help match the company with investors.
- Trading: Another key function of investment banks is to trade in a wide range of financial instruments – including shares, government and corporate bonds, foreign exchange and commodities such as oil or precious metals, and related derivative instruments. For the most part, they carry out trades on behalf of a range of clients in the financial sector, which are often described as ‘institutional investors’.
Investment banks also bring risks to the financial system, however. With the trading assets of the ten largest banks summing to more than £5 trillion, the sheer scale of these banks’ operations means that liquidity in financial markets can be vulnerable to the failure of a single firm. To give an idea of scale, the article includes an infographic that shows the global revenues of the various sub-divisions of the largest investment banks. In addition to size, the web of interconnections between investment banks and other financial institutions can act as a channel for the transmission of losses throughout the system, while the complexity of some of their activities also contributes significantly to risks in the global financial system.
Many of these risks crystallised during the recent global financial crisis when some of the largest global investment banks were taken over, bailed out using public funds or declared bankrupt after facing distress. And they remain relevant to financial stability in the United Kingdom, with all of the largest global investment banks having operations in London. A number of regulatory initiatives globally have been implemented since the onset of the global financial crisis to correct the fault lines that contributed to it and to build a safer, more resilient financial system to serve the real economy. The Bank of England has a key role to play in working with other regulatory bodies globally to fully implement these measures and ensure that investment banking activities are conducted in a way that is safe and sound.
A short video discuss some of the topics covered in this article.
