Commercial Banking vs. Investment Banking

While regulation has changed the businesses in which commercial and investment banks may now participate, the core aspects of these different businesses remain intact. In other words, the difference between how a typical investment bank and a typical commercial operate bank can be simplified: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank does not. We'll begin examining what this means by taking a look at what commercial banks do.

Commercial banks

A commercial bank may legally take deposits for checking and savings accounts from consumers. The federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC), on amounts up to $100,000. To get FDIC guarantees, commercial banks must follow a myriad of regulations.

The typical commercial banking process is fairly straightforward. You deposit money into your bank, and the bank loans that money to consumers and companies in need of capital (cash). You borrow to buy a house, finance a car, or finance an addition to your home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the dry cleaner on the corner to a multinational conglomerate. The commercial bank generates a profit by paying depositors a lower interest rate than the bank charges on loans.

Private contracts

Importantly, loans from commercial banks are structured as private legally binding contracts between two parties - the bank and you (or the bank and a company). Banks work with their clients to individually determine the terms of the loans, including the time to maturity and the interest rate charged. Your individual credit history (or credit risk profile) determines the amount you can borrow and how much interest you are charged. Perhaps your company needs to borrow $200,000 over 15 years to finance the purchase of equipment, or maybe your firm needs $30,000 over five years to finance the purchase of a truck. Maybe for the first loan, you and the bank will agree that you pay an interest rate of 7.5 percent; perhaps for the truck loan, the interest rate will be 11 percent. The rates are determined through a negotiation between the bank and the company.

Let's take another minute to understand how a bank makes its money. On most loans, commercial banks in the U.S. earn interest anywhere from 5 to 14 percent. Ask yourself how much your bank pays you on your deposits - the money that it uses to make loans. You probably earn a paltry 1 percent on a checking account, if anything, and maybe 2 to 3 percent on a savings account. Commercial banks thus make money by taking advantage of the large spread between their cost of funds (1 percent, for example) and their return on funds loaned (ranging from 5 to 14 percent).

Investment banks

An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds.

Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds). Because commercial banks already have funds available from their depositors and an investment bank typically does not, an I-bank must spend considerable time finding investors in order to obtain capital for its client. (Note that as investment banks are increasingly seeking to become "one-stop" financing sources, many I-banks have set aside billions of dollars of their own capital that they can use to loan to clients directly.)

Private Debt vs. Bonds - An Example

Let's look at an example to illustrate the difference between private debt and bonds. Suppose Acme Cleaning Company needs capital, and estimates its need to be $200 million. Acme could obtain a commercial bank loan from Bank of New York for the entire $200 million, and pay interest on that loan just like you would pay on a $2,000 personal finance loan from Bank of New York. Alternately, it could sell bonds publicly using an investment bank such as Merrill Lynch. The $200 million bond issue raised by Merrill would be broken into many smaller bonds and then sold to the public. (For example, the issue could be broken into 200,000 bonds, each worth $1,000.) Once sold, the company receives its $200 million (less Merrill's fees) and investors receive bonds worth a total of the same amount.

Over time, the investors in the bond offering receive coupon payments (the interest), and ultimately the principal (the original $1,000) at the end of the life of the loan, when Acme Corp buys back the bonds (retires the bonds). Thus, we see that in a bond offering, while the money is still loaned to Acme, it is actually loaned by numerous investors, rather than from a single bank.

Because the investment bank involved in the offering does not own the bonds but merely placed them with investors at the outset, it earns no interest - the bondholders earn this interest in the form of regular coupon payments. The investment bank makes money by charging the client (in this case, Acme) a small percentage of the transaction upon its completion. Investment banks call this upfront fee the "underwriting discount." In contrast, a commercial bank making a loan actually receives the interest and simultaneously owns the debt.

Later, we will cover the steps involved in underwriting a public bond deal. Legally, most bonds must first be approved by the Securities and Exchange Commission (SEC). (The SEC is a government entity that regulates the sale of all public securities.) The investment bankers guide the company through the SEC approval process, and then market the offering utilizing a written prospectus, its sales force and a roadshow to find investors.

The question of equity

Investment banks underwrite stock offerings just as they do bond offerings. In the stock offering process, a company sells a portion of the equity (or ownership) of itself to the investing public. The very first time a company chooses to sell equity, this offering of equity is transacted through a process called an initial public offering of stock (commonly known as an IPO). Through the IPO process, stock in a company is created and sold to the public. After the deal, stock sold in the U.S. is traded on a stock exchange such as the New York Stock Exchange (NYSE) or the Nasdaq. We will cover the equity offering process in greater detail in Chapter 6. The equity underwriting process is another major way in which investment banking differs from commercial banking.

Commercial banks (even before Glass-Steagall repeal) were able to legally underwrite debt, and some of the largest commercial banks have developed substantial expertise in underwriting public bond deals. So, not only do these banks make loans utilizing their deposits, they also underwrite bonds through a corporate finance department. When it comes to underwriting bond offerings, commercial banks have long competed for this business directly with investment banks. However, as a practical matter, only the biggest tier of commercial banks are able to do so, because the size of most public bond issues is large and Wall Street competition for such deals is quite fierce.