Banking is something that almost anyone can do. But the highest levels of banking and banking investors are a highly exclusive group. Choosing the right bank to work with can make a huge difference in your life and your business. But that means that you need to know what the differences are between investment banking and commercial banking. Knowing how they can affect you, both as a business owner and as a potential investor is important.
This guide will take a closer look at the roles and differences between these types of banks. This article will tackle investing tips and risk management tips to improve your investment success.
What is investment banking?
Investment banking is something a lot of people have heard of, but many people don’t really understand. Even after the popularization of movies like “The Big Short,” the world of investment banking is still obscure for some. At the simplest level, investment banks help connect potential investors with the businesses they might want to invest in.
Their clients tend to be large corporations, governments, and people with a lot of money to invest. They both help those investors access capital markets and advise on the kinds of investments they might want to make.
Investment banks also often have hedge funds and other kinds of large funds that are personally managed by bankers. Index funds have a wide selection of investments meant to perform on track with the index they are invested in. Investment banks also issue securities and shorts and can be direct finance providers for the largest business ventures.
What is commercial banking?
Commercial banking is probably a lot closer to what you think a bank is. These are the banks that are directly involved in giving loans. They provide direct funding for projects, and helping you perform basic banking tasks like opening an account and making payments. These are also the banks that you can physically visit to discuss account options or secure a small business loan.
Commercial banks do a lot of the everyday work of banking. Investment banks wouldn’t work without commercial banking services available to their customers. These two systems are very intertwined. Commercial banks do the everyday routine tasks, while investment banks are generally more exclusive.
What are the most important differences between investment and commercial banking?
The core difference between these two types of banks is how they approach transactions. Commercial banks provide liquidity that allows people to make purchases and spend money the way they want to. This can be anything from a small loan to help them get through a couple of expensive months to long-term business loans and mortgages. These banks make money by charging interest on loans and through other fees and costs associated with their products.
Investment banks don’t try to provide liquidity. Instead, they offer products that take advantage of liquidity and make their money off of service fees for their products and services. They also tend to be investors. Some of their money also comes from taking advantage of their own products and services. Investment banks can also make money by offering insurance services to investors. They do this by providing some protection against losses when market conditions change.
Investment comparison: Should you invest in investment or commercial banking?
Investing in both commercial and investment banks can offer benefits, and both types of banks can be an important part of any healthy investment portfolio. At the same time, investing in varying kinds of banks appeals to different investors. Like everything involved in the investment market, there are risk profiles associated with these types of banks and the potential to profit. Here are the key things to consider when deciding which type of bank you want to invest in.
What is the purpose of investing in commercial or investment banking?
Anytime you make an investment, the goal is to benefit in the future. This is usually done by getting more money out of the investment than you spent. But the core difference is how quickly you can expect to receive that benefit, along with how much money you anticipate making.
Safe investments with lower risk tend to be more consistent but less profitable than higher-risk investments. High-risk investments have the potential to pay bigger dividends. However, they have a much greater risk of not returning anything for the initial investment.
With that in mind, commercial banking investments tend to be very safe and consistent but have smaller returns. Investing in an investment bank can offer huge returns over time. But that also comes with the risk that the investment bank won’t do well in the long term and that the returns on your investment are likely to be less consistent than lower-risk alternatives. Commercial banks can be a safer backbone to your investment portfolio. Investment banks can offer bigger returns but aren’t as consistent and can be risky long-term.
What kind of activity are you investing in?
Knowing what kinds of activities you’re invested in is an important part of being a conscientious investor. It’s also part of being a strategic and effective investor. When you invest in a commercial bank, you provide capital for them to continue generating liquidity in the economy.
Your investment helps provide the money they need to make loans. It also allows them to make their own investments, and engage in loan management and loss reduction. Your money is then used by other people in the economy, and you receive a portion of the interest from their loans as dividends on your investment.
Key risk management and investment regulations
As with any kind of investment, it’s important to think about risk management options when you are investing in banks. One of the most common misconceptions about investing in banks is the idea that your investment is inherently safer because banks are safer. The truth is that while banks are often long-running institutions, they can encounter serious problems that endanger your investments. Both the 2008 financial crash and the more recent collapse of Silicon Valley Bank are examples of the risk of investing in banks, particularly investment banks.
Risk management
Risk management in this kind of investing requires a diverse portfolio. Having a combination of investment and commercial banks in your portfolio and other investments can also help with risk mitigation.
You also need to be aware that many banks have both commercial and investment banking arms. Those arms can impact performance on the other side of the business as well. For example, investing in Citigroup Global Markets and in Citibank is not as diverse as choosing commercial and investment banks that are not directly connected.
Investment regulations
Lastly, investing in banks is often more highly regulated. You have more limited options compared with making other kinds of investments. That happens because of how important banks are in the financial world. This is also because their investors often have access to information that other kinds of investors do not.
All of this means that you need to make sure you understand the regulations surrounding your potential investment before you invest. This is important so you can accurately assess how risky the investment is. You also need to assess how much making that investment will limit your other investment opportunities in the future.
The behavior of investment and commercial banks is also highly regulated. This is important for investors to understand because a bank that violates the regulations around banking can be fined and punished in ways that affect your earning potential as an investor.
What are the benefits of investing in both investment and commercial banking?
Many investors specialize in a specific kind of business they invest in heavily and make other kinds of investments mostly out of a desire to diversify without fully understanding why investing in different kinds of businesses can be valuable. When you specialize, you’re able to learn more about the business, trends, and competition in that specific market. But when it comes to banking, it’s even more important to be diverse because all banks are heavily interconnected, especially the big-name banks that you’re most likely to invest in.
Choosing to invest in both investment and commercial banks is a good option because it offers balance in your portfolio. Investment banks tend to reap bigger rewards than their commercial siblings but with big ups and downs. Having investments in a couple of commercial banks at the same time gives you some consistency without as much risk. You don’t want to invest exclusively in commercial banks because they have a lower earning potential, especially in the short term. You don’t want to invest just in investment banks because those banks are much more volatile. And a high-earning year followed by three low-earning or no-earning years doesn’t work out over time. By having both kinds of investments in your portfolio, you can better adjust to economic shifts and how the markets are moving.
Having both kinds of investments in your portfolio also gives you more information, both as an investor and a business owner, to understand the market and what is happening in the financial world. You can learn a lot about what is happening in the financial world just based on the reports you get from different kinds of businesses when you invest.
Challenges and risks involved when investing in both sectors
Investing is always a risky option. This is not because you aren’t going to benefit or you’re making a gamble. It’s because of the nature of the economy. Not every investment is going to be a good one or can be a good one. For the economy to function, some investments are going to fail.
One of the challenges when it comes to investing in investment banks is that you’re betting on the investment bank’s skills. You’re also betting that their services offer sufficient value to their customers.
When investing in commercial banks, not only are you trusting that the bank has a good sense of who they loan to. You’re also trusting the use of tools like credit scores and hoping that there aren’t larger systemic issues that can affect the bank as they did in 2008. Even when your bank is doing everything right, they aren’t immune to the ups and downs of the economy as a whole.
You also need to understand the risk of financial scandal and censure. Wells Fargo is a good example of this since their high-pressure sales tactics lead to widespread fraud and other problems with the bank. When a bank behaves badly or becomes too profit-motivated, it runs the risk of increased oversight and fines. Unfortunately, banks often pass on the costs of these failures to their investors, which can lead to poor performance even when things are otherwise going well for the bank.
Tips for investing in both sectors successfully
Here are a few tips to help you learn how to be a more effective bank investor.
Understand nonperforming loan ratios (NPL)
When it comes to commercial banks, in particular, you want to know what their NPL ratio is compared with performing loans. Nonperforming loans are loans that are at least 90 days overdue and are approaching default. They aren’t performing because the bank isn’t getting their expected interest from the loan. Ideally, banks should have an NPL ratio under 2%; higher than that can indicate a bank with a high level of exposure.
Check the price-to-earnings (P/E) ratio
This is an important ratio for how a given stock’s price will translate to earnings for the investor. The better the P/E ratio, the more you’re likely to earn from that stock, but it can also lead to inflated prices since a good P/E makes that bank’s stock much more desirable.
Keep an eye on fintech
A lot of bank investors these days invest in banks in part because they are attracted to the more traditional financial models that banks represent. However, fintech, or financial technologies, are a potential risk to the old business models. There are a few reasons for this. Fintech solutions like peer-to-peer lending and cheaper brokers are more accessible to consumers and may eventually crowd out traditional banking alternatives.
That said, the potential risk of fintech advancements is pretty controversial. Many people argue that the old standards have survived as long as they have because of their significant long-term benefits. At the same time, you don’t want to be caught unprepared if fintech solutions do eventually supersede traditional banking. So it’s a good idea to keep an eye on these developments and even to invest in some as a way to ensure your portfolio is robust and resilient to changing markets.
Wrap-up: Bank investing
Investing in banks is a safe and reliable long-term investment strategy, especially when you choose a range of banks and different types of banks. However, like all investing, it’s important to do your research first and make sure you understand the risks. You need to increase your knowledge of the market to match the money you’ve tied up in investments, especially if you want to build a large investment portfolio over time or are considering investing a larger sum of money.