If you've been following my mini-series on investment banking, you now know what true investment banking is, and how far the investment banks have gone down the asset-management rabbit hole. Now we come to the third primary activity of the major investment banks: capital markets and proprietary trading.

As you can easily gather, there are at least two major activities under this heading. In reality, this final grouping often acts as the "other" category for the i-banks, and depending on the specific firm, there can be other sources of revenue in here as well. For the purposes of this review, though, I'll focus on the two areas mentioned above.

Capital markets
We all know there's plenty of money out there -- but how does one get to it? The capital markets division of an investment bank acts as a middleman, linking those who need capital with those looking for a home for their capital. To make this magic happen, capital markets specialists work with salespeople and traders to get in contact with potential buyers, set a price that will make both buyers and sellers happy, and execute the transaction.

For clients raising money, investment banks do this through both debt and equity. In the initial public offering (IPO) process, for example, the bank's capital markets, sales, and trading staff will coordinate with major institutional investors, like mutual funds and hedge funds, to find buyers for the newly issued public shares. The money that the bank collects in the sale of the equity shares then goes back to the issuing company.

In addition to helping clients raise money, investment banks also help facilitate trading in a wide variety of financial instruments. In some cases, this means helping a large institutional investor unload (or buy) a big block of a particular publicly traded stock. In other situations, though, the bank may roll up its sleeves and help structure a financial instrument, in addition to connecting buyers and sellers.

Cashing in
Whichever major firm you consider -- be it Lehman Brothers (NYSE:LEH), Morgan Stanley (NYSE:MS), or Bear Stearns (NYSE:BSC) -- it's going to have some incarnation of these incredibly lucrative capital markets, sales, and trading activities. The firms profit from these activities through fees and securities discounts.

Fees are pretty straightforward. When the bank provides its services to a client, it collects a fee on that service -- either a predetermined lump sum, or an amount based on some measure of the size of the transaction.

Securities discounts often come into play when the banks are helping clients raise money. If you take a look at the IPO prospectus for VMware (NYSE:VMW), for example, you'll notice a line on the very first page that says "underwriting discount." The underwriting discount is the difference between the price at which the bank buys the new shares from VMware, and the price for which it sells them to the institutional buyers. In the case of VMware, the discount was $1.595 per share, amounting to $52.6 million for the whole deal.

Whether they collect a lump sum or fee, banks want to see high volume, whether in trading activity, structuring activities, or new issues. Volume tends to be at its highest when business confidence is high and the economy is doing well. In other words, as with the other investment banking businesses, this activity tends to follow the markets in cyclical patterns.

Proprietary trading
This is my favorite investment banking business line, but it's also the most opaque and mysterious. Basically, investment banks take the very best and brightest people that they can find, and lock them in a room where nobody can find them. Then they give these brainiacs the firm's own capital, to put to work in whatever investment opportunities the brain trust find.

OK, they don't actually lock them in a room, but the banks don't make it easy for the outside world to gain access to their prop traders. They've got good reason for secrecy -- these internal traders and investors make an incredible amount of money for the firms.

As long as the firms can continue to find exceedingly smart people to run these desks, they will continue to be a great profit center. With the popularity of hedge funds and private equity funds, though, and the willingness of institutional investors to give money directly to a savvy manager, it's getting tougher for even the likes of Goldman Sachs (NYSE:GS) to hang onto the best and brightest.

A very interesting recent article (subscription required) in The Wall Street Journal chronicled the career and performance of Mark McGoldrick, who ran Goldman's proprietary "special situations" desk. In exchange for reportedly producing a good chunk of Goldman's profit, McGoldrick was handsomely compensated. He wasn't, however, paid quite as well as he would've been if he had been at a hedge fund. As a result, he left Goldman to seek greener pastures (literally and figuratively).

Should this become a recurring theme for Goldman, JPMorgan Chase  (NYSE:JPM), Merrill Lynch (NYSE:MER) or any of the other big boys, paying up for talent could be a potential solution. But no one likes to cut into profitability.

The i-bank wrap
The investment banking business has seen incredible evolution and growth over the past decade, as firms have combined, new business lines have been created, and greater risk appetite has been added. The banks continue to be fluid and adaptable, though, and more change and evolution should be expected. As market cycles peak and wane, newer and growing opportunities will take center stage, while those that don't make as much sense any more will be phased out.

As I discussed recently, I think i-banks might see their profits start to fall in the coming quarters. However, those slumping profits could eventually provide ideal investment opportunities, since best-of-breed banks like Goldman Sachs should deliver very good long-term results for their investors.

More financial Foolishness:

JPMorgan Chase is a Motley Fool Income Investor pick. Dividend lovers who enjoy market-beating returns can try out the service free for 30 days.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out Matt's CAPS portfolio here, or visit his blog. You can always bank on the Fool's disclosure policy.