How Do Investment Banks Make Money?

Unlike commercial banks, investment banks don't make most of their money from taking in deposits and loaning money out. In this clip, Michael Douglass and Matt Frankel discuss how these institutions make their money, using major players like Goldman Sachs (GS 0.61%) and Morgan Stanley (MS 0.63%) as examples.

A full transcript follows the video.

This video was recorded on Dec. 11, 2017.

Michael Douglass: The first question I think anyone is going to ask is, what is an investment bank, and why is it different from a more traditional bank? Matt?

Matt Frankel: Traditional banks, if you heard our episode last week, we went into a nice discussion of this, as Michael said. Traditional banks generally make most of their money from lending out money. They take in deposits at a lower cost, lend money out at a higher cost, and profit from the spread between the two. Investment banks, I would actually call them a little bit more fee oriented. They tend to be a little light on loans. Investment banking includes things like M&A, advisory equity underwriting. Investment banks are the ones that bring IPOs to Market. Wealth management, especially for high net worth clients. Goldman and Morgan Stanley are both in the trillions of wealth management assets. Trading, and investment banks make investments themselves, that's a big part of their business models. But it's a lot of more fee-based types of financial activities than traditional banks.

Douglass: Yes. So, when thinking about the first part of the banking framework that we've been talking about, which is what does the bank do, as you noted, one of the first things that immediately jumps out, loans are not a high percentage of assets. For Goldman Sachs, it's about 7%. For Morgan Stanley, it's about 12%. And so, just with that, you can tell, this is a very different breed of bank from what we were talking about last week. Another point that I'll throw out there is, on the deposit side, so, this is a liability, deposits make up a relatively small percentage of the liabilities as well, about 16% for Goldman and 20% for Morgan Stanley. One of the things that that means, you can immediately know, that if a bank doesn't have a lot of its liabilities in deposits, it's going to have to get that money some other way, usually either by issuing debt or by issuing stock.

Frankel: Yeah. You can see the difference in the numbers of between deposits and other liabilities on their balance sheets. Goldman, for example, has only about 16% of its liabilities coming in the form of deposit; it's 20% for Morgan Stanley. And both have substantially more in unsecured long-term debt. Goldman, 25% comes from long-term debt, and actually about the same for Morgan Stanley. So these are more debt-reliant businesses than deposit-relying businesses, which is one reason why they're not quite as efficient as commercial banks, which we'll get to in a little bit. When you issue debt, it generally comes at a higher rate than you have to pay for deposits just from mom-and-pop consumers.

Douglass: One of the other things that'll really highlight this to you is when you're looking at the income statement and you look at revenue. For a traditional bank, net interest income, which comes from loans, is usually going to be a higher percentage. For Goldman Sachs, it's only about 10% of total net revenues. And Morgan Stanley actually lost a little bit on net interest income last quarter. Instead, what you see is, for Goldman, over 20% in investment banking, market making, and about 20% in M&A. On Morgan Stanley's side, there's a lot in investment banking and trading. This is where they make their money. It's the bread and butter, and it's very different from traditional banks.