College of Business and Economics

Merchant Banking and

Financial Services
CHAPTER I An Overview of Merchant Banking
Introduction- Definition of Merchant Banking- Role of Merchant Banker - Characteristics of Merchant Banker - Merchant Banking Functions

1.1 Introduction: In banking, a merchant bank is a traditional term for an investment bank. It can also be used to describe the private equity activities of banking. Banks were invented in the middle ages by Italian grain merchants. Merchant bankers were individuals or banking houses whose major objective was to provide capital for commodity traders, cargo owners, and buying, selling and shipping of goods. Merchant bankers carried out their leading operations from a bench, which in Italian term was known as banco. Later, the center of merchant banking operations was shifted from Italy to Amsterdam and thereafter to London. Modern Merchant Banking started in Italy during the 7th Century. The banking practices evolved from the financial structure of the Silk Route Trading that predates the Roman Empire. The basic financial structure was the advance payment for goods by Merchant Bank at a great discount to the delivery value of those goods. As the British Empire expanded in the 18th and 19th centuries, merchant bank prospered in London, for instance merchant banker funded Canadas Hudson Bay Company. Since the 18th century, the role of merchant bank has been considerably broadened to include a composite of modern days skills inherently entrepreneurial, managerial and financial. While in American Triangular Trade and Clipper Ships of the 19 th century should have created merchant banking centre in Boston and New York, unfortunately the American Global Trade was not a major catalyst for merchant banking growth. However, the Rockefellers and Back Bays wealth in Boston owe their fortunes to ancestors involved in merchant banking activities. The merchant Banking has been used differently in different parts of the world. In U.K. merchant bank refers to the accepting and issuing houses while in U.S.A. it is known as investment banking. The word merchant banking has been so widely used that it is sometimes applied to neither banks who are not merchants, sometimes to merchants,
Chapter I An overview of Merchant Banking

College of Business and Economics

Merchant Banking and

Financial Services
who are banks and sometimes to those intermediaries, who are neither merchants nor banks. 1.2 Definition of Merchant Banking: Financial markets include the capital market for long-term securities and the money market for short-term securities. Each of these markets involves a market for new issues, the primary market and a market for trading in existing securities, the secondary market. The primary market is the focus of these following paragraphs. Examples of primary market transactions include the private funding of a debt issue by a life insurance company for the construction of a new shopping mall, the issuance of treasury bills by the U.S. Treasury, a new municipal bond issue by the city of Philadelphia, and a new common stock issue by Ford Motor Company. The primary market comprises of Initial Public Offer and private placements. Initial Public Offering market is the market consisting of stocks of companies that are in the process of going public while a private placement is an enabling institution raises funds for a private or public entity seeking these funds. A privately placed security is one that is sold to fewer than 25 buyers.
Securities Securities
Investment Banking Houses

Business
Dollars

Savers
Dollars

Figure 1:1 CAPITAL TRANSFORMATION PROCESS

Direct transfers of funds from savers to businesses are possible and do occur on occasion, but it is generally more efficient for a business to enlist the services of an Investment Banking House. Merrill Lynch, Salomon Brothers, Dean Witter and Goldman Sachs are examples of financial service corporations which offer investment banking services. Such organizations (1) help corporations design securities with features that are currently attractive to investors, (2) buy these securities from the corporation and (3) resell them to savers. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a broker to help transfer capital from savers to businesses. Merchant banking has been a very lucrativeand riskyendeavor for the small number of bank holding companies and banks that have engaged in it under existing law. Recent legislation has expanded the merchant-banking activity that is permissible to commercial banks and is therefore likely to spur interest in this lucrative specialty on the part of a greater number of such institutions. Although for much of the past half-century commercial banks have been permitted (subject to certain restrictions) to engage in
Chapter I An overview of Merchant Banking

College of Business and Economics

Merchant Banking and

Financial Services
merchant-banking activities, the term merchant banking itself is undefined in U.S. banking and securities laws and its exact meaning is not always clearly understood. Merchant Banking as an institution or as an organization, which provides a number of services including management of securities issues, portfolio services, underwriting of capital issues, insurance, credit syndication, financial services, project counseling, etc., SEBI Act, 1992 Sec. 2(e) defines Merchant banker as any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager, consultant, adviser or rendering corporate advisory service in relation to such issue management. Merchant Banking is generally understood to mean negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies.

1.3 Role of Merchant Banker:

Merchant bank is the link between a company raising fund and the investors. It plays the role of a promoter, advisor, and an agent for corporate enterprises. It transfers ideas to ventures by providing a number of promotional services such as identification of projects, preparing reports, obtaining government approvals, raising fund for the projects. After project is promoted, a merchant banker acts as a corporate advisor and renders a number of services of the successful running of the enterprises. It is also expert on certain issues such as financial planning, tax planning, issue management, credit syndication, investment management and also renders useful advice to the investors. It acts as rehabilitator at the time of acquisition, merger, takeover, amalgamation. Many merchant bankers act as agents for their clients companies for maintaining registers of shareholders and bondholders and to act as transfer agents and paying agents for interest and dividend.

1.4 Characteristics of Merchant Bank:

Chapter I

An overview of Merchant Banking

College of Business and Economics

Merchant Banking and

Financial Services
A merchant Bank should contain the following characteristics 1. High proportion of decision makers as a percentage of total staff. 2. Quick decision process 3. High density of information 4. Intense contact with the environment 5. Loose organizational structure 6. Concentration of short and medium term engagements 7. Emphasis on fee and commission income 8. Innovative instead of repetitive operations 9. Sophisticated services on a national and international level 10. Low rate of profit distribution 11. High liquidity ratio

1.5 MERCHANT BANKING FUNCTIONS:

The Merchant Banking Function performed by a typical firm includes the following activities: advising, administration, underwriting and distribution.

Chapter I

An overview of Merchant Banking