How investment banks make their money

RBS chief executive Stephen Hester has finally agreed to knock back his £1m bonus. And not a moment too soon, some might say.

But as my colleague Merryn Somerset Webb regularly points out, the real problem with bonuses is that investment banks are able to make the enormous profits needed to pay them out in the first place.

So what do these businesses do? How do they make their super-profits? And will they continue to do so in the future?

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The first thing to note is that investment banks are very different to high street banks (or 'retail' banks). Retail banks typically take deposits from savers and lend them out to borrowers in the form of loans, mortgages and credit cards. They make most of their money by charging a higher rate of interest to borrowers than they pay to savers.

Investment banks, on the other hand, make their money by selling services to customers such as companies, governments and investment funds (fund managers and hedge funds). They are usually paid for these services through fees and commissions rather than interest payments.

What investment banks do

So what services do investment banks sell? There are four main types:

Advice

Corporate financiers and corporate brokers provide various types of advice to companies. They might advise a company on how to float on the stock exchange, or on how to pay less tax, or on potential merger targets, for example.

Financing

Investment bankers can also arrange financing for companies. Through their relationships with big investment funds, they can help obtain equity financing (by issuing shares) or debt financing (by issuing corporate bonds), as well as bank loans.

Trading

This is the much-criticised casino' bit of the investment bank. Historically, investment banks have employed large numbers of traders to trade everything from shares to currencies to derivatives. They can do this on the behalf of clients, or on their own behalf (known as proprietary, or prop' trading).

Research

Analysts spend their time researching companies and industries. The sales teams then sell this knowledge to fund managers and hedge funds.

Where does all the money come from?

All of these functions rely on each other at some point. For example, if you have a top-rated team of research analysts, backed by the ability to trade lots of different assets, then you'll be able to win business from the big investment funds.

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In turn, that attracts business from companies. Your high quality research means that you understand their business best. And your contacts with investors mean you know how best to raise money for them. If you can convince companies of these things, then you'll be in a better position to win very lucrative work from them selling new shares, advising on takeovers, or floating new businesses. This is the holy grail of cross-selling' services.

It's this sort of business that earns investment banks the fees that have historically enabled them to pay big bonuses. Without this kind of work, it's much harder for them to make huge profits as recent results from Goldman Sachs and Citi demonstrate.

And that's why the big banks such as Goldman, Morgan Stanley and JPMorgan tend to offer all these services to their clients, and try to do so on a global scale, so they can grab business from multi-nationals (after all, the bigger the business, the bigger the fees).

Do we need investment banks?

While investment banks have deservedly gained bad publicity for their reckless trading and financing activities, they do provide a useful role in that they help in the allocation of money from investors to companies in an economy, which hopefully ends up creating the wealth and jobs that we all depend on.

However, they are likely to get smaller, and to employ fewer people. Governments and regulators are pushing banks to hold more money to protect against losses, and to stop trading on their own accounts. On top of that, credit is tighter.

This almost certainly means that the days of investment banks being able to make huge profits by trading with large amounts of borrowed money against the backdrop of a very forgiving bull market are over. That also means that rewards for employees will shrink, along with profits for shareholders.

The end result is that we are likely to see smaller investment banks, focusing on advisory roles, and employing a lot fewer staff on lower salaries and bonuses. Few outside the investment banking industry will be sad about that.