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How does an Investment Bank differ from a Retail Bank?

Posted on Posted in Finance

 

A bank is a financial institution with the purpose of lending and borrowing money. Retail banks are banks with retail customers (most individuals and smaller institutions / businesses) where the customers typically deposit money (their savings, earnings, etc.) and where other retail customers would go to borrow money. These banks are better understood by most of us as we do have a savings account, and some of us do have loans with the banks too. Retails Banks are typically regulated by National Governments or their appointed agencies, and they are supported in their day-day operations and Cash management by a supervisory National Bank. The next thing to consider is that how do these retail banks make profits. These banks basically help bring together people who have money and people who need money, and they charge some commissions in between. Consider a simple example depicted below,

 

 

Person A has deposited $100 in a savings account with Retail Bank. Assume the bank pays him 5% interest per annum on this balance. If person B borrows $100 from the same Bank, the Bank may ask B for interest of 6% per annum on the loan. This way the bank earns 1% as its profit. One important point here is that while the Bank in this example acts as an intermediary in bringing together A and B, it also takes the risk between them. For example, if B does not pay its loan back, then the bank would have to pay $100 back to A by itself. Hence A never takes the risk of B’s default. Investment Banks also help bring together buyers and sellers. They issue certain financial instruments (shares and bonds) to help companies raise money, and these instruments could be traded in the market. The Investment Banks also deal with personal accounts of some very rich individuals and help invest their money into financial markets. Investment Banks are also regulated by a national regulatory authority and they are the heart of the Global Financial System. Most of the companies rely on Investment Banks to help manage their corporate activities on the financial structure. Investment Banks also help transfer of risk on behalf of their clients.

 

 

Comparing the loan example from Commercial bank, Investment Bank can help bring Customer A and B together (as shown above) but then it typically would let A face B in terms of risk and possibly future dealings. Hence the requirement for Investment Bank to have reserve cash is lower compared to a Commercial Bank. Furthermore customers of Investment Banks A and B are mostly larger companies, institutional investors, High Net Worth Individuals etc.

  

 

Investment banking is one of the most global industries and is continuously challenged to respond to new developments and innovation in the financial markets. They have globalized and innovated faster than the regulators could follow.  

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