Investment Banking: Underwriting Explained - FINVOGUE

Investment Banking Underwriting

Banking Investment / February 5, 2020

Underwriting is frequently done in investment banking, insurance and commercial banking. Generally, underwriting means receiving payment for the willingness to cover a potential contingent risk. The term can be traced back to the Lloyd’s of London insurance market. Bankers were paid a fee, in this case an insurance premium, for literally writing their name under the risk they were willing to accept, as specified in the Lloyd’s document.

In investment banking, underwriting is the practice by which investment bankers represent corporate and government entities in the initial public offering of their securities. The investment bankers cover the risk of selling the securities to the public. What's the risk? Bankers guarantee to the issuers that the securities will be sold for no less than a minimum price set by the investment banker. If the investment bankers can’t find enough purchasers to buy the securities at the minimum price, the investment bankers must hold those securities on their books, or worse, sell them below the minimum price and suffer a loss. Conversely, if there is strong demand for the securities, the investment bankers make a profit by selling the securities above the minimum price they promised the issuer.

In the insurance industry, underwriting is the process of agreeing to bear the financial risk inherent in an insurance contract. The insurance underwriters assess the risk that is being insured, for instance, fire damage to a house. The underwriters receive the insurance premium from the homeowner and in return, the underwriters agree to provide compensation for damages that result from a fire.

In commercial banking, underwriting means assessing the credit worthiness of borrowers and agreeing to fund loans. The risk is that the borrower will default on the loan and thus fail to repay the amount borrowed. The fee for underwriting this risk is typically periodic interest charged to the borrower as long as there is a balance due on the loan.