Merchant Banks (Investment Banks)

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A merchant bank, also known as an investment bank, helps people find money. Among its activities, there are accepting bills of exchange, corporate finance, securities trading, investment management, loan arrangements, foreign exchange, derivatives trading

Merchant banking can be summarized as “helping people to find money”. It can be defined as a financial institution that acts as an “agent” between corporations or governments that want to attract investment capital and investors who have money to buy securities.

We should note that commercial and investment banking do not exist in entirely separate compartments. There are activities which overlap and are carried out by both types of banks, for example, accepting and discounting bills of exchange, foreign exchange and some aspects of trade finance. Nevertheless, there are certain activities which would be regarded as clear ‘investment’ banking such as underwriting share issues. The range of activities of investment or merchant banks can be summarized as follows:

  • Accepting bills of exchange
  • Corporate finance
  • Securities trading
  • Investment management
  • Loan arrangement
  • Foreign exchange
  • Accepting bills of exchange

While bills of exchange can be, and are used, in connection with inland business, their main use is for import/export business. Nowadays, the whole procedure for trade finance is tied up by arrangements between the importer’s banks and the exporter’s bank. Usually, a letter of credit is involved. The market in bankers’ acceptances has reached a new level of sophistication. Major firms of good credit quality will ask their bank to accept a bill promising to pay a given sum at a future period of time. Bills of exchange are used extensively in the UK, quite widely in the continent of Europe and very little in the US. They are generally used for exports to the Near and Far East, the Indian continent, Australia and New Zealand.

  • Corporate Finance

Corporate Finance is likely to be a department of major importance for any investment bank. This department will manage:

    • ?    New issues - new issues of either shares or bonds will involve pricing the securities, selling them to investors, underwriting and general advice regarding the regulations that must be followed.
    • ?    Underwriting - is an undertaking to buy any securities that the investors cannot be persuaded to buy. Fees will be charges and the risk will be spread amongst other merchant banks and investment institutions. In the case of equities, the underwriters purchase the shares once it is clear that investors are not taking up their allocation. In the Eurobond market, on the other hand, the syndicate of underwriting banks buys the bonds from the issuer and then attempts to sell them to investors.  
    • ?    Rights issues – these also need to be priced and underwritten in case the market price falls below the offer price of the rights.
    • ?    Mergers and acquisitions – firms planning a takeover or merger will turn to investment banks for help and advice regarding price, timing, tactics, and so on. Equally, the subject of the takeover bid will turn to these bankers for help in fending off the predator.
    • ?    General advice – This is always needed by the treasury departments of major firms. They will meet their merchant bankers regularly to discuss the outlook for exchange rates, interest rates, risk management and generally to help them to clarify their policies.
    • ?    Research capability – This is clearly essential in the corporate finance department if the bank is to be able to give advice and play a major role in raising new capital
  • Securities Trading

In corporate finance we saw primary market activity: new issues and rights issues. Securities trading takes us into the secondary market dealing in the same equities and bonds. The trading will take place in one of the modern dealing rooms with computer terminals and communications giving up-to-the-minute prices and contact with other dealers and investors all over the world. The dealing will cover both domestic bonds and equities and international bonds and equities.

  • Investment Management

The investment funds which these managers are controlling may be the bank’s own funds or they may be, in effect, “looking after other people’s money”. These may be:

    • ?    High net worth individuals – apart from approaching a commercial bank to handle their investments (i.e. private banking), high net worth individuals may also approach an investment bank to handle their spare funds.  
    • ?    Corporate – they may either have good cash flow or wish to pay someone else to handle their investments or may build up a large ‘war chest’ ready for some takeover activity later and, temporarily, pay an investment bank to handle this.
    • ?    Pension funds – when economies have pension funds then they may feel that they lack the skill to manage the funds and pay others to do so. In these economies, pension funds will usually be the biggest clients of the investment management department.
    • ?    Mutual funds – they are collective investments in money market instruments, bonds or equities. The bank may run its own fund and advertise its attractions to small investors. In addition, it will manage mutual funds for others.

Typically, fund managers will charge a small percentage fee for handling the fund and the client will meet costs like brokers’ commission. Competition for the investment banks comes from firms of independent fund managers, who specialize totally in this business, or large pension funds who will look after the money of smaller funds as well as their own.

  • Loan arrangement

Where there are complex syndicated loans for special projects we may often find that the arranger is an investment bank. The bank is using its special skills to decide on the terms of the loan and the cheapest way to find the money. 

Outside of large, complex projects, investment bankers will help clients to raise finance for international trade. In this, there is an overlap with a major commercial bank activity. It may be a question of knowing sources of cheaper finance for exporter or importer or even acting as an agent or middleman – an export house or confirming house.

  • Foreign exchange

Typically we regard this as a commercial bank activity. However investment banks that are permitted commercial bank functions will run a foreign exchange trading desk for their clients and their own proprietary trading and it may be an important source of profit.

  • Miscellaneous activities

There are a range of miscellaneous activities which may be carried out by investment banks, possibly through separate legal subsidiaries. Commodity trading (including derivatives trading) for example, is quite common. Other activities include insurance broking, life assurance, leasing, factoring, property development and venture capital. Many of these miscellaneous activities overlap with those of commercial banks (for example leasing, factoring and venture capital).