Concept & Evolution - Merchant Banking, Financial Markets and Institutions | Financial Markets and Institutions - B Com PDF Download

Origin of Merchant Banking:

The origin of merchant banking can be traced back to 13th century when a few family owned and managed firms engaged in sale and purchase of commodities were also found to be engaged in banking activity. These firms not only acted as bankers to the kings of European States, financed coastal trade but also borne exchange risk.

In order to earn profits, they invested their funds where they expected higher returns despite high degree of risk involved. They charged very high rates of interest for financing highly risky projects. In turn, they suffered heavy losses and had to close down. Some of them restarted the same activity after gaining financial strength. Thus merchant Banking survived and continued during the 13th century.

Later, merchant Bankers were known as “commission agents” who handled the coastal trade on commission basis and provided finance to the owners or supplier of goods. They made investments in goods manufactured by sellers and made huge profits. They also financed continental wars. The sole objective of these merchant bankers was profit maximisation by making investments in risky projects.

Then came the industrial revolution in England. The scope of international trade widened to include North America and other continents. Many people were attracted to take up merchant banking activities to transfer the machine made goods from European nations to other nations and colonies and bringing raw material from other nations and colonies to Europe and to finance such trade.

During the early nineteenth century, merchants indulged in overseas trade and earned good reputation. They accepted bills of the lesser reputed traders by guaranteeing the holder to receive full payment on due date. This practice of accepting bills has grown over the years with expansion in trade and has become part of the merchant banking activity.

Meaning of of Merchant Banking:

Dictionary meaning of merchant banking points at merchant bank as an organisation that underwrites securities for corporations advises such clients on mergers and is involved in the ownership of commercial ventures.

The term ‘merchant banking’ has been used differently in different parts of the world. While in UK, a merchant banking refers to the ‘accepting and issuing houses’, in USA it is known as ‘investment banking’.

The word merchant banking has been so widely used that sometimes, it is applied to banks who are not merchants, sometimes to merchants who are not banks and sometimes to those intermediaries who are neither merchants nor banks.

In UK, the term merchant banking originated from merchants in London who started financing of foreign trade through acceptance of bills. After sometimes, the merchants began to help governments of under­developed countries in raising long-term funds through floating of bonds in the London Money Market.

In 1914, these merchants formed an association which is now called ‘Merchant Banking and Securities House Association’.

The merchant banks then extended their activity to the domestic business of loan syndication both for short-term as well as long-term purposes.

Today, these banks provide a variety of services, such as issue management, portfolio management, asset management, underwriting of new issues, act as registrars, share transfer agents, trustees, and provide leasing, project consultation, advice on mergers and amalgamations, Euro credits, etc.

In USA, investment banking is concerned with ‘garnering savings and directing the flow of funds to business enterprises. ‘Investment bankers are primarily the intermediaries who provide specialised service in the marketing of securities. These banks do not invest their own funds in securities for a long-term.

They simply buy the securities in bulk with a purpose of selling the same shortly to the investors at large. They also provide other services involved in marketing of securities including underwriting of capital issues.

Thus, merchant banking can be defined as a non-banking financial activity resembling banking, originated, grown and sustained in Europe, got enriched under American influence and now being performed all over the world by both banking and non-banking institutions.

In India, merchant banking services were started only in 1967 by National Grindlays Bank followed by Citi Bank in 1970. The State Bank of India was the first Indian commercial bank having set up a separate merchant banking Division in 1972. Since then, a number of other banks, financial institutions and other organisations are also engaged in providing merchant banking services.

But merchant banks in India have been primarily operating as issue houses than full-fledged merchant banks as in other countries.

In view of the above, we can define merchant bank as an institution or an organisation which provides a number of services including management of securities issues, portfolio services, underwriting of capital issues, insurance, credit syndication, financial advices and project counseling, etc.

It would also be necessary to make a distinction between merchant banking and commercial banking for a better understanding of the nature of merchant-banking. The merchant banks mainly offer financial services for a fee, while commercial banks accept deposits and grant loans.

The merchants do not act as repositories for savings of the individuals. Even when merchant banks engage themselves in fund-based activities and act as commercial banks, they function only as whole-sale bankers for a few selected industrial houses and not as retail banks for the general public.

The merchant banks are also different from the dealers, traders and brokers of securities. The merchant banks mainly deal in new issues while the dealers, traders and brokers deal mainly in secondary market.

Evolution of Merchant Banking:

‘Hundi’ was the main instrument of credit used by indigenous bankers before the coming of western merchants in India. It was in 1813, when merchants came from European countries to trade with India. Agency houses were set up by merchant bankers based at London.

These agency houses raised deposits at cheaper rates of interest viz. 4% to 5% from their home and made advances to native merchants at 10% to 12% and in addition they charged high commissions on every kind of service provided to the clients.

Easy availability of money at the spot from the agency houses had completely eliminated the role of acceptance house or the merchant banking in India. It was only with the entrance of East India Company that restrictions were put on operation of agency houses.

During 19th century, foreign merchant bankers operated in India through ‘East India House’. East India House members moved into real estate business viz. tea and rubber plantation, cotton mills etc. They faced tough competition from Persian finance houses who were willing to grant credit to the trade with India.

It was in 1860 when the merchant’s interest in joint stock banking started growing and with their own investments they floated joint stock banks. Some new banks were founded which included Orient Bank in 1845, Chartered Bank of India and Asia in 1853, Chartered Merchantile Bank of India, London & China in 1857 and so on.

These banks financed the trade transactions. The control and management of these banks lied with managing agents.

The managing agency system enabled a single firm to look after a number of firms in complementary industries. With the result, the banking industry flourished in India on the support of London based merchant bankers and the merchants who had full control on the Board. Telegraphic transfers improved banking links and the business.

The managing agents acted as merchants banks and performed functions of promoting financing and marketing of securities. They developed strong roots in depth of India’s economic, commercial and industrial structure. They served the industry, trade and commerce as the merchant bankers were doing in UK and European countries or the investment bankers were doing in USA.

Managing agents acquired large share of investible capital initially and later on dispose off the shares once the company gets established. In other words, Managing Agency Houses acted as issue house for securities. It was found that 600 industrial establishments were managed under the managing agency system in 1951.

Few Indian managing agency houses were also established in the pre-World War II who started as family business later on, converted into partnership and public limited companies.

Examples of prominent managing agency houses included:

1. Tatas,

2. Birlas,

3. Dalmias,

4. Singhanias,

5. Thapars,

6. Narangs etc.

These managing houses had necessary skills and expertise which helped in the development of projects. Functions performed include:

(i) Investing funds as venture capital in promoting the enterprise.

(ii) Assist the enterprises in procuring finance by guaranteeing the bank loans and advances.

(iii) Raising public deposits.

(iv) Enter into negotiation with foreign capitalists.

Thus, they acted as intermediaries of investment by holding the shares of new companies, motivating people to invest and keep deposits for investment.

In Post-World War II, Amendments in the Companies Act, 1956 led to the streamlining of the procedure for capital issues and facilitated the growth of capital market in India.

In order to speed up the pace of economic development, efforts were made to channelise the household savings into investment in industry and trade. Significant amendments were made in Companies Act, Capital Issues (Control) Act, Banking Companies Act to regulate the growth of business enterprises.

In 1948, Industrial Finance Corporation of India (IFCI) was set up to provide long and medium term finance to industrial enterprises and underwrite new securities. At state level, State Financial Corporations were also established in 1951 to provide financial assistance to industry.

In 1955, the Industrial Credit and Investment Corporation of India (ICICI) were set up to provide developmental finance to industrial concerns. ICICI makes investment in equity by way of direct subscription and also underwrites shares and debentures.

Many more financial and investment institutions emerged at national and state levels e.g. LIC, RCI (Refinance Corporation for Industry), Industrial Development Bank of India (IDBI), Unit Trust of India (UTI), State Industrial Development Corporation (SIDC) etc. over the years.

The basic objectives of setting up all these institutions was to boost industrial sector, improve capital market, make finance easily available and support the investment climate in the country. These institutions also underwrite the capital issues besides lending support of broking houses.

The need for merchant banking services was widely felt. It was during this period that National & Grindlays Bank (now Grindlays Bank) took a lead by taking up merchant banking activities and announced inauguration of its “Merchant Banking Division” in January, 1969.