Investing 101: Inside an Investment Bank

Updated: Jun 21, 2020

Nearly all investment banks divide their operations into several areas – the front office, middle office, and back office. These three integral parts to an investment bank are often bandied about in conversations, with few truly knowing exactly what goes on in each division. So, to uncover the truth, read on!

The Front Office:

If you, or someone you know, mentions that they want to go into investment banking when they’re older, they most likely are referring to the front office, because of the assumption that there’s a lot of money to be made in the business, and that it’s all fun and games like films portray it to be. (Think Wolf of Wall Street)! And, while the first assumption may not be so far from the truth, it isn’t always a party in the office. The front office is the only part of an investment bank that sells investments, and it’s also that part that searches for potential clients to strike deals with.

Another function of the front office is to facilitate mergers and acquisitions (M&A’s). Companies that are looking for a quick way to boost their growth may consider buying another company. They may also feel threatened by a rival, so decide to merge with them, to share the profits. For example, imagine that Domino’s Pizza created an amazing vegan pizza, and it sold lots and lots of them. However, along comes Papa John’s, who have an even tastier recipe. Domino’s might decide to buy Papa John’s, or merge and work together with Papa John’s, so that Domino’s doesn’t lose any customers to its rival, and thus lose out on potential profits. This example is very far-fetched, and generally speaking, the buyer (in this case, Domino’s), would have to be a lot larger than the company it is acquiring (in this case, Papa John’s). However, hopefully it helps you to understand how M&A’s work and why a company would be interested in doing one. From the front office, investment banks can open the door to an M&A by pairing up buyers and sellers – it is their role to match a company that wants to acquire another one, with one that wants to sell.

The front office is, as is usually depicted in films, the part of the investment bank where trading happens. Trading occurs as investors are constantly dealing shares of securities (explained in the previous article here) to take advantage of any good deals or securities that are underpriced. This trading style, that uses the bank’s, rather than the client’s money, is referred to as proprietary trading, and can be extremely profitable.

This is where you usually see men shouting numbers into their phone, computer, or at each other on the trading floor in the films. What they are doing is constantly monitoring company share prices. They try to buy them for a low price, and then sell them for a high price. This process is known as capital gains.

Finally, in the front office are research analysts. Their job is to conduct extensive research into specific companies, and produce recommendations and reports, so that the investment bank knows whether to buy or sell more of a position in a company.

So, that concludes our section on the front office. What have we learnt so far? Well, the front office:

  1. Isn’t necessarily as glamorous as portrayed in Hollywood blockbusters

  2. Is where the real money is made

  3. Is extremely hectic, with lots of functions

  4. Requires employers to work in a fast-paced environment, generally with great communication and analytical skills

The Middle Office:

The middle office of an investment bank tends to stay out of the limelight. It is the part of the bank that manages risk and calculates profits and losses. It is also generally where the IT services can be found. However, above all, the middle office draws on resources from both the front and back offices.

Managing Risk

  1. The middle office doesn’t normally directly produce revenue or income, as the front office does. However, it manages the risk of investment decisions, and also makes sure that transactions are correctly executed, precisely following each rule.

  2. To help with this work, some companies have specialised legal support teams that form part of the middle office, because they have to ensure that all necessary documents have been signed, and all deals and transactions made by the front office have been paid for and documented. It is an extremely technical job!

IT Services

  1. The IT services within the company are responsible for making sure that all software used by the firm is up and running constantly, without fail. If important software went down for even a second, it could have really significant consequences for the company, so this role carries a lot of responsibility!

  2. The IT employees manage software systems that are used globally such as the Bloomberg Terminal, to make sure that it is running smoothly. However, they may also design their own software, to help the investment bank implement their trading techniques.

So, the middle office is pretty cool, and to recap, it does the following:

  1. The middle office includes risk management, transaction processing, compliance, and IT services.

  2. The middle office grew out of the increasing complexity of modern financial transactions.

  3. The middle office tracks and processes all of the deals made by the front office.

  4. It may not be captured by the spotlight as much as the front office, but its role is fundamental to the functioning of the company.

The Back Office

The back office in an investment bank refers to all the operations that are conducted behind the scenes, and behind the glitz and the glamour of the front office. Back office staff tend to work in settlements, making sure that payments are processed. Human resources is also a vital part of the back office, where employees ensure that bankers are paid their salary. They also making hiring/firing decisions!

The back office also includes technological support, just like the middle office, to confirm that all central software systems are running smoothly. In fact, there’s so much crossover between the middle and back offices that Goldman Sachs has decided to group them together under the name “The Federation.”

Compliance is a key factor behind the success of the back office. Compliance divisions within an investment institution ensure that every trader, employee, conversation, and deal, is fair, and follows every rule and regulation, as denoted by the Financial Conduct Authority. They make sure that employees are not trading forbidden securities on their own personal accounts, that every move and every single happening follows the correct legal process, or that there is no insider trading going on.

Insider trading is as follows:

Let’s say that I am working in the front office of JP Morgan. My friend who works at Apple has told me that they are about to unveil a brand new type of smartphone, that will shock the world and be extremely popular. However, Apple has not yet announced this to the public, and so I am at an advantage. I therefore decide to buy some shares in Apple, as I predict that the share price will rise in the coming weeks significantly when the public finds out that they are going to release a new smartphone. This is illegal insider trading, and it would be the job of a compliance division in the back office of a bank to flag up this trade and take further action against me.)

So, what can be taken away from this article. I would say that, if anything, you should try and remember these key points:

  1. Dividing an investment bank into three sections (front, middle and back offices) is a dated concept. However, in many places, it is still used to distinguish the different roles within the company.

  2. The front office is generally more often in the spotlight, and is where most people believe the exciting stuff happens. However, this is not always the case.

  3. The middle and back offices play very similar, yet equally important roles.

  4. Each section is imperative to the functioning of the company, and so even if many believe back office jobs to be tedious or monotonous, they still carry a significant amount of responsibility.

  5. Front office jobs may earn a larger salary, but they require great communication and interpersonal skills, and can often necessitate longer working hours.

Which part of an investment bank interests you most? Let me know in the comments section below!

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Thanks for reading!

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