Do you ever wonder how businesses raise capital, invest their money, and make strategic decisions? Merchant banks are the unsung heroes of the financial world. They’re connecting businesses in need of funding with investors looking to make a profit. But it’s not just about raising capital. Merchant banks provide a range of services to businesses and individuals, from investment banking to wealth management.
What is a Merchant Bank?
“A merchant bank is a financial institution that conducts underwriting, loan services, financial advising, and fundraising services to corporations, startups, and high net-worth individuals (HNIs) with a specialization in international trade.”
From the definition, it is evident that the merchant bank has little to do with the general public and you must be wondering why it is important for you to know about these institutions.
Well, even though Merchant banks typically go unnoticed by the general public, these financial institutions play a vital role in the financing of businesses and organizations that affect the lives of everyone participating in the national economy at any level.
Merchant banks specialize in providing financial services to businesses at every stage. Services like capital raising, mergers and acquisitions, and even risk management. They play a crucial role in the emphasis on financial stability and are prominent in promoting economic growth in general.
As merchant banks play an important part in handling and managing risks for other financially dominant organizations, they need to maintain financial stability and oversee any banking crisis. Also, contagion between banks, to prevent any financial harm or downfall. The financial statements and regulatory compliance of businesses are also a concern for merchant banks. They are responsible for creating and maintaining accurate financial statements, as well as ensuring compliance with current regulations. Reporting financial performance to business leaders and identifying issues and opportunities to maximize profit are also part of their responsibilities.
It is also worth noting that the financial crisis of 2007-2009 affected the banking sector significantly. The collapse of the real estate market in 2006 was a significant factor in the crisis. While merchant banks were not the direct cause of the crisis, they were impacted by it, with banks losing money on mortgage defaults and interbank lending freezing up. The crisis highlighted the importance of liquidity to the functioning of the financial markets and the banking sector.
Economic growth is primarily facilitated by merchant banks as they ensure providing capital to the right start-up or organization at the right time by evaluating the underlying fundamentals of the business, assessing the valuations, and structuring the finance flow in a manner that is particularly calibrated to the specific company. From the economic standpoint, this is such a crucial step in the success stories of all start-ups which improve the overall health of the national economy.
Understanding the role of Merchant Bank
Let’s imagine a scenario to help us understand the nature of the role of a merchant bank.
Company X, a fast-growing technology start-up, is interested in acquiring a smaller competitor, Company Y, in order to expand its market, share and increase its product offerings. Company X approaches a merchant bank to assist with the acquisition process.
The merchant bank begins by conducting due diligence on Company Y, including analyzing its financial statements, assessing its market position, and evaluating its potential for growth. Based on this analysis, the merchant bank advises Company X on the appropriate valuation for Company Y and helps to structure a deal that is attractive to both parties.
Next, the merchant bank helps to negotiate the terms of the acquisition, including the purchase price, payment structure, and any contingencies or warranties. The merchant bank also assists with drafting the necessary legal documents and ensuring that all regulatory requirements are met.
Once the deal is finalized, the merchant bank helps with the integration of the two companies, including managing the transition of employees and customers and identifying opportunities for cost savings and revenue growth. The merchant bank also provides ongoing financial and strategic advice to Company X as it continues to grow and expand its business.
The Calculative “Rule of 72”
Origin and Evolution of Merchant Bank
Step back in time for a moment and let’s explore the fascinating history of merchant banking! Did you know that this financial institution dates back to the 13th century when family-owned firms engaged in the sale and purchase of commodities also engaged in banking activity? These firms acted as bankers to the kings of European States, financed coastal trade, and even issued bills of exchange.
The concept of merchant banking originated in Italy, and the first-ever merchant banks were Riccardi of Luca, Medici, and Fugger, among others. These institutions’ primary purpose was to facilitate and/or finance the production and trade of commodities, hence the name. Initially, there was no distinction between the functions of commercial banking and merchant banking until 1932 when the term merchant banking came into existence.
But the history of merchant banking doesn’t end there!
Did you know that indigenous bankers in India used the Hundi as the primary instrument of credit before the arrival of western merchants in India? It wasn’t until 1813 that merchants from European countries began trading with India, and agency houses were set up by merchant bankers based in London. These agency houses raised deposits at cheaper rates of interest from their home and utilized them to advance loans in India.
Fast forward to the late 1800s, and we see the emergence of J.P. Morgan & Co. as the head of merchant banks, connected directly to London, the world’s financial center at that time. Today, merchant banks offer a range of services, including investment banking, portfolio management, and underwriting. They help clients raise funds, assist with mergers and acquisitions, and provide financial advisory services. Merchant banks also engage in legal formalities regarding investments to be approved and check the working capital requirements.
In India, merchant banking services were started in 1967 by National Grindlays Bank.
Now that we’ve taken a journey through time and learned about the evolution of merchant banking, it’s easy to see why these financial institutions have played such an important role in the growth and development of the global economy.
How does Merchant Bank help an Organization?
Investment Banking
Merchant banks offer investment banking services that can help businesses get off the ground and stay ahead of the competition. This includes underwriting new securities, assisting with initial public offerings (IPOs), and helping companies issue bonds and other debt securities.
Mergers and Acquisitions
Merchant banks can help businesses unlock their full potential by providing advisory services for mergers and acquisitions (M&A). These services include conducting due diligence, valuing companies, negotiating deal terms, and structuring transactions. It also assists with post-merger integration and restructuring.
Capital Raising
Merchant banks can help businesses raise capital to finance growth, expansion, or other activities. This includes providing equity capital to companies, as well as raising funds from debt markets. It also helps businesses with mezzanine financing, which is a hybrid form of financing that combines debt and equity.
Advisory
Merchant banks provide a range of advisory services to businesses and individuals. This includes strategic advisory services, such as helping businesses develop growth strategies and identifying potential acquisition targets. It also provides financial advisory services, such as assisting with the sale of businesses or the transfer of ownership.
Wealth Management
Merchant banks provide wealth management services to high-net-worth individuals and families. These services include investment management, tax planning, and estate planning. It also offers customized financial solutions, such as private equity investments and alternative investments.
Trade Finance and Working Capital Solutions
Merchant banks offer trade finance and working capital solutions to businesses. This includes providing letters of credit, factoring services, and other forms of trade finance. It also provides working capital solutions, such as accounts receivable financing and inventory financing.
The Working of Market-Linked Debentures
Differentiating Merchant Banks from Investment & Commercial Banks
| Merchant banks | Investment banks | Commercial banks | |
| Clientele | High-net-worth individuals, corporations, and start-ups | Large corporations and government entities. | The general public and small businesses |
| Services | Project financing, trade financing, leasing, underwriting, and merger and acquisition advisory. | Underwriting, private placement, initial public offering (IPO) management, debt and equity securities issuance, and financial restructuring. | Deposit accounts, loans, and credit cards, in addition to wealth management services |
| Capital | Merchant banks typically use their own capital to invest in their clients’ businesses. | Investment banks typically do not invest their own capital in transactions but rather act as intermediaries between clients and the capital markets. | Commercial banks also typically do not invest their own capital in transactions but instead, use the deposits of their customers to fund loans and other investments |
| Regulations | Securities and Exchange Board of India (SEBI) | SEBI and the Reserve Bank of India (RBI). | RBI |
| Risk | Lower financial risk compared to investment banks | High financial risk due to volatile market conditions | Lower financial risk compared to investment banks and merchant banks |
| Focus | International finance, trade finance, and corporate investment | Advisory services and help corporations raise capital through the issuance of securities
|
Broader customer base and focus on providing basic banking services |
| Revenue | The main revenue stream is through investment activities, such as investing in clients’ businesses and providing financing and advisory services.
Earns fees through underwriting and managing IPOs, mergers and acquisitions, and other investment banking services. |
Generates revenue mainly through investment banking activities, such as underwriting and managing IPOs, mergers and acquisitions, and other corporate finance services.
May also earn revenue through trading activities, including securities trading and derivatives trading. |
Generates revenue through traditional banking activities such as deposit-taking, lending, and interest on loans.
May also generate revenue through fees charged for services such as ATM usage, account maintenance, and wire transfers. |
Key Development that has shaped the Growth of Merchant Banking in India
Setting up of Banks Subsidiaries
Many commercial banks in India started offering merchant banking services by setting up distinct divisions for the same. The State Bank of India became the first commercial bank to set up a merchant banking division in 1972, followed by ICICI and several others. This move marked a significant shift in the Indian banking landscape and gave impetus to the growth of merchant banking in the country.
Re-organisation of Private Firms
With the rise of merchant banking in India, many private firms started re-organizing their structures to take advantage of the services offered by merchant bankers. This move helped private firms raise capital through the issuance of securities, restructuring of debt, and taking advantage of various government schemes.
Establishment of the Securities and Exchange Board of India (SEBI)
SEBI was established in 1988 to regulate the securities market in India. The formation of SEBI provided a regulatory framework for merchant banking activities in the country. It helped in improving transparency in the securities market, reducing the risk of fraudulent transactions, and ensuring fair practices.
Discount and Finance House of India (DFHI)
DFHI was set up in 1988 to provide short-term money market instruments. The establishment of DFHI helped in improving liquidity in the money market and provided an avenue for merchant banks to access funds. This move brought much-needed stability to the Indian money market and helped in reducing the cost of borrowing.
Credit Rating Information Services of India Ltd. (CRISIL)
CRISIL was established in 1987 as India’s first credit rating agency. The establishment of CRISIL helped in improving transparency in the debt market and provided valuable information to merchant bankers to make informed investment decisions. It helped in reducing the cost of borrowing for firms and ensured that investors made informed investment decisions.
Stock-Holding Corporation of India Ltd. (SHC)
SHC was set up in 1986 to provide custodial and depository services to investors in the Indian capital markets. The establishment of SHC helped in improving the settlement process and reduced the risk of fraudulent transactions in the market. It helped in bringing transparency to the Indian capital markets and ensured that investors’ interests were protected.
Emphasis on Digitalization
The rise of digitalization has transformed the merchant banking landscape in India. The value of digital payments is expected to grow three-fold by 2026, and the adoption of digital payments has made merchant banking services more accessible and cost-effective. This has brought a lot of convenience to customers and has helped in reducing the cost of transactions.
The Final View
In essence, merchant banks are the catalysts of economic development and stability. Catering from corporations to HNIs with advisory solutions having expertise in international trade makes them stand out from commercial banks. Originating as bankers to the European king to its evolution from the concept of “Hundi” in India, Merchant Banks have made their stance in offering vivid solutions that can help the corporations grow.
The Essence of Volatility
FAQs about Merchant Bank
1. What is merchant banking?
A merchant bank is a financial institution that conducts underwriting, loan services, financial advising, and fundraising services to corporations, startups, and high net-worth individuals (HNIs) with a specialization in international trade.
2. Difference between Merchant Banks and Investment Banks
Merchant Banks are sought to help HNIs, Corporations, and Startups whereas Investment Banks are into helping Large Corporations and Government Entities.
3. What are the functions of merchant banking?
It includes investment banking, mergers & acquisitions, capital raising, advisory, wealth management, trade finance & working capital solutions.
4. Is a merchant bank a type of bank?
Merchant banking deals with small businesses, but its functions are comparable to those of a typical savings bank. Getting funding for a small business through an IPO (initial public offering) is usually challenging. These banks offer them corporate credit products, equity financing, and bridge financing, among other financial services.
