Investment bankers are financial middlemen in the security offering process. They purchase securities from companies and governments and resell them to the general public. Thus, investment bankers bring together suppliers and users of long-term funds in a capital market and thereby play a key role in the security offering process. It is to be noted that investment bankers are neither investors nor bankers. They do not invest their own funds permanently nor accept and guard the savings of others, as commercial banks do.
Functions of Investment Bankers
The traditional function of the investor bankers has been to act as the middlemen in channeling individuals’ savings and funds into the purchase of business securities. But, nowadays, they also provide advice and help in the distribution of securities. Thus, investment bankers perform four basic functions: (1) underwriting, (2) distribution, (3) advising, and (4) making the market.
When underwriting a security issue, an investment banker guarantees the issuer that it will receive a specific amount from the issue. In this process, an investment banker buys the security at a lower price and then sells them at a higher price i.e. offer price to the public. In this sense, underwriting is the insurance function of bearing the risks of adverse price fluctuation during the period of distribution. Investment bankers take this risk for a specific amount of underwriting spread or commission. If an investment banker can not sell securities at a specified price, the underwriter, not the company, suffers the loss. Underwriter’s gain or loss is computed using Equation.
Gain or loss to underwriter = Gross proceed – Proceed to the company – Underwriter’s expenses
Where Gross Proceed = Price to public x Number of shares to be issued
Once the investment banker owns new securities, it must get them into the hands of the ultimate investors. Hence, the second function of the investment banker is marketing new issues of securities. The investment banker is a specialist with a staff and organization to distribute securities. So, they perform physical distribution functions more efficiently and more economically than an individual company.
The investment banker, through experience, becomes an expert in the issuance and marketing of new securities. Business firms may take valuable advice and counsel from investment bankers. Thus, investment bankers perform an advisory function by analyzing the firm’s financial needs and recommending appropriate means of financing.
4. Making a Market
In the case of a company going public for the first time, the investment banker may be obliged to maintain a market for the shares after the issue. The investment banker generally agrees to “make a market” in the stock and to keep it reasonably liquid. In making a market, the underwriter maintains an inventory in the stocks, quotes bids and asked prices, and stands ready to buy and sell it at those prices. Thus, investment banker also helps to maintain an active secondary market in the stock of a small and newly established company.