The rise of investment banking was driven by economic shifts, such as the Industrial Revolution, which created massive businesses that needed large-scale financing for factories, railroads, and global trade. It was also shaped by financial crises, like the 1929 stock market crash, which exposed the dangers of unregulated speculation and led to major banking reforms. Additionally, investment banking emerged in response to the growing need for capital beyond what traditional banks could provide, as seen in the expansion of railroads in the 19th century, where businesses required far more funding than what commercial banks could offer through standard loans. For this matter, knowing the history of investment banking helps us grasp why investment banks are powerful, how their role has changed over time, and why regulation and innovation continue to reshape the industry today.
This guide gives a simple overview of the key moments that shaped the history of investment banking. From its early beginnings to the major events that changed the industry, you will see how investment banking grew into what it is today.
Early Financial Systems and the Birth of Merchant Banking
Before investment banks existed, the financial world was dominated by merchants, lenders, and informal banking families that facilitated trade. In medieval Europe, commerce was expanding, and a system was needed to finance long-distance trade, maritime expeditions, and growing industries. This is where the Bardi and Peruzzi banking families of Florence emerged as early financial powerhouses. These families, active in the 14th century, provided financing for maritime commerce, particularly to merchants traveling between Europe and the Middle East. However, they relied heavily on lending to monarchs, which ultimately led to their downfall when King Edward III of England defaulted on his debts, causing a massive financial collapse.
Despite these setbacks, the role of merchant bankers continued to grow. The Medici Bank, established in the 15th century by the powerful Medici family, revolutionized banking by introducing double-entry bookkeeping and letters of credit, making financial transactions more secure and efficient. The Medici were also deeply connected to the Popes, helping to finance the Catholic Church’s activities, including lavish construction projects and military campaigns.
But this expansion of banking faced a major obstacle—the Catholic Church’s ban on usury, which prohibited charging interest on loans. To bypass this restriction, early bankers disguised interest payments as foreign exchange fees or structured financial products like zero-coupon bonds, where a loan was issued at a discount and repaid at full value without explicitly charging interest. These innovations allowed banking to continue flourishing under religious constraints.
From Italy to Britain and The Evolution of Banking Practices
As banking spread beyond Italy, the bill of exchange became a crucial financial instrument in Britain, allowing merchants to settle debts without carrying large sums of gold or silver. British goldsmiths, initially responsible for storing precious metals, eventually began issuing banknotes and lending money, laying the groundwork for modern banking institutions.
By the late 18th century, Baring Brothers & Co., a British merchant bank, emerged as a major financial player. One of its most famous deals was financing the Louisiana Purchase in 1803, helping the United States acquire vast territory from France. This transaction demonstrated how merchant banks had evolved into global financial intermediaries, capable of facilitating deals between governments.
The Spread of Investment Banking to the United States
In the early 19th century, the U.S. banking system was still developing. The National Bank Act of 1863 played a crucial role in structuring the financial system, creating a national currency and allowing banks to operate under federal charters. However, traditional banks were limited in their ability to fund large infrastructure projects, leading to the rise of investment banking as a specialized industry. Firms like J.P. Morgan & Co. and Goldman Sachs emerged as key players, providing capital for railroads, steel mills, and industrial expansion.
During this time, investment banks acted as advisors, underwriters, and deal-makers, helping businesses raise capital through stock and bond offerings. They became particularly powerful during the Gilded Age, when massive industrial corporations needed financial backing for expansion.
The Early 20th Century, Speculation, Risk, and the 1929 Crash
By the early 20th century, aggressive lending and speculative investments became the norm. Investment banks, unregulated and highly profitable, took huge risks, promoting leveraged investments and overvalued stocks. The booming stock market of the 1920s created a financial bubble, fueled by excessive speculation and loose credit.
Then came October 1929—the stock market crash that triggered the Great Depression. Investment banks were at the heart of the collapse, having facilitated risky securities and excessive margin lending. The public lost faith in the banking system, and thousands of banks failed. In response, the Banking Act of 1933, including the Glass-Steagall Act, was introduced.
Glass-Steagall fundamentally reshaped investment banking by separating commercial banking from investment banking, prohibiting traditional banks from engaging in risky securities trading. This law impacted J.P. Morgan & Co., forcing it to split into two entities: J.P. Morgan Chase, which remained a commercial bank and Morgan Stanley, which became a pure investment bank.
For decades, Glass-Steagall provided stability, keeping investment banking confined to advisory services and capital markets while reducing excessive speculation.
The 1980s, Strange Mergers, Deregulation, and Growing Risks
By the 1980s, investment banks were once again at the center of financial innovation, but this time, in more aggressive ways. The rise of junk bonds, pioneered by Drexel Burnham Lambert, fueled a boom in leveraged buyouts (LBOs). This era also saw strange mergers between financial institutions(the Shearson/American Express's Acquisition of Lehman Brothers, (1984)) that blurred the lines between commercial and investment banking, setting the stage for future crises.
The Gramm-Leach-Bliley Act of 1999 repealed Glass-Steagall, allowing investment and commercial banks to merge again. This led to the creation of financial conglomerates like Citigroup and Bank of America, which now engaged in both traditional banking and high-risk investment activities. While this led to massive profits, it also created systemic risks that would eventually trigger a financial collapse.
The 2008 Financial Crisis and The Epic Collapse of Investment Banking
With investment banks now facing increasing competition from traditional banks, they had to take more risks to stay profitable. Mortgage-backed securities (MBS) became one of their biggest bets, as banks aggressively bundled risky subprime loans into complex financial products and sold them to investors. These products were highly profitable—until they weren’t.
When the housing market collapsed, so did the banks holding these toxic assets. The epic fall of Lehman Brothers in 2008 marked the largest bankruptcy in U.S. history. Bear Stearns, another major investment bank, collapsed and was hastily sold to J.P. Morgan Chase. Merrill Lynch, once a dominant force, was absorbed by Bank of America to prevent a total collapse. The crisis also affected AIG, the insurance giant that had sold vast amounts of credit default swaps (CDS) and was on the verge of failing.
The U.S. government responded with TARP (Troubled Asset Relief Program), a $700 billion bailout, to stabilize the financial system. New regulations, including the Dodd-Frank Act, were introduced to prevent another collapse, restricting proprietary trading and requiring greater oversight of complex financial instruments.
Investment Banking Today
Despite the crisis, investment banking survived and adapted. While bulge bracket firms like Goldman Sachs and Morgan Stanley remain dominant, boutique advisory firms have gained ground, focusing on M&A and restructuring without the risks of traditional trading. The rise of technology, AI-driven trading, and fintech has further transformed the industry, making investment banks more data-driven than ever.
But the history of investment banking reveals a fundamental truth; investment banks are crucial to global finance, yet their influence comes with risks. From the merchant bankers of Florence to the mega-deals of Wall Street, their role has remained the same—facilitating the flow of capital, structuring complex deals, and driving economic expansion. The challenge is ensuring that their power does not spiral into another financial catastrophe.