Just as economies of scale and specialization create profit opportunities for financial intermediaries, so too do these economies create niches for firms that perform specialized services for businesses. We said before that firms raise much of their capital by selling securities such as stocks and bonds to the public. Because these firms do not do so frequently, however, investment banking firms that specialize in such activities are able to offer their services at a cost below that of running an in-house security issuance division. Investment bankers such as Merrill Lynch, Salomon Smith Barney, or Goldman, Sachs advise the issuing firm on the prices it can charge for the securities issued, market conditions, appropriate interest rates, and so forth. Ultimately, the investment banking firm han- dles the marketing of the security issue to the public.
Investment bankers can provide more than just expertise to security issuers. Because investment bankers are constantly in the market, assisting one firm or another to issue securities, the public knows that it is in the banker’s interest to protect and maintain its reputation for honesty. The investment banker will suffer along with investors if it turns out that securities it has underwritten have been marketed to the public with overly optimistic or exaggerated claims, for the public will not be so trusting the next time that investment banker participates in a security sale. The investment banker’s effectiveness and ability to command future business thus depends on the reputation it has established over time. Obviously, the economic incentives to maintain a trustworthy reputation are not nearly as strong for firms that plan to go to the securities markets only once or very infrequently. Therefore, investment bankers can provide a certification role—a “seal of approval”—to security issuers. Their investment in reputation is another type of scale economy that arises from frequent participation in the capital markets.