Merchant Banks: Their Structure and Function

Checklist Description
This checklist describes merchant banks, what they do, and who can make use of their services.

Definition
Merchant banks, also known as investment banks, offer various services in international finance and long-
term loans for wealthy individuals, multinational corporations, and governments.
An investment bank is split into the so-called front, middle, and back office functions. The front office deals
with investment banking and management, sales and trading, structured products, private equity investment,
research, and strategy. The middle office deals with risk management, finance, and compliance. The back
office deals with transactions, operations, and technology.
The main function of a merchant bank is to buy and sell financial products. They manage risk through
proprietary trading, carried out by special traders who do not interface with clients. The trader manages the
risk for the principal after they buy or sell a product to a client but does not hedge their total exposure. Banks
also try to maximize the profitability of certain risk on their balance sheets.
Merchant banks manage debt and equity offerings. They assist companies in raising funds from the market.
This can include designing instruments, pricing issues, registering offer documents, underwriting support,
issue marketing, allotment and refund, and stock exchange listing. They also help in distributing securities
such as equity shares, mutual fund products, debt instruments, insurance products, and fixed deposits
among others. Merchant banks use a mix of institutional networks—mutual funds, foreign institutional
investors, pension funds, private equity funds, and financial institutions—and retail networks, depending on
how they interact with specific clients.
Merchant banks offer corporate advisery services to clients for their financial problems. Advice may be
sought in such areas as determining the right debt-to-equity ratio, the gearing ratio, and the appropriate
capital structure. Other areas of advice may be in areas of refinancing and seeking sources of cheaper
funds, risk management, and hedging strategies. Further areas for advice are rehabilitation and turnaround
management. Merchant bankers may design a revival package in conjunction with other financial institutions.
Merchant bankers assist clients with project advice, helping them from the project concept stage, through
feasibility studies to examine a project’s viability, to the preparation of documents such as a detailed project
report.
Merchant banks arrange loan syndication for their clients. This begins with an analysis of the client’s cash
flow patterns, helping to determine the terms for borrowing. The merchant bank then prepares a detailed
loan memorandum to be circulated to the banks and financial institutions that are to join the syndicate.
Finally, the terms of lending are negotiated for the final allocation.
Merchant banks provide venture capital and mezzanine financing (a hybrid of debt and equity financing that
is typically used to finance the expansion of existing companies). In this way they can help companies to
finance new and innovative ventures.
Following the global financial crisis of 2008, which saw the collapse of several prominent investment banks
in Europe and the United States in September of that year, the viability of using a business model that is
based heavily on banks purchasing each others’ debts has been severely questioned. Certainly in the United
States, the view is that this business model is no longer sustainable and is unlikely to continue in the same
form in the future. It remains to be seen how merchant banks will restructure in the aftermath of the financial
turbulence of 2008.

Advantages
• Merchant banks perform functions that cannot be carried out by businesses on their own.
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 • Merchant banks have access to traders, financial institutions, and markets that companies or
individuals could not possibly reach.
• By using their skills and contacts, merchant banks can get the best possible deals for their clients.

Disadvantages
• Merchant banks are really only for large corporate customers, or extremely wealthy smaller businesses
owned by individual clients.
• Not all deals carried out by merchant banks meet with unqualified success.
• There is always risk attached to the kinds of deal that merchant banks undertake.

Action Checklist
• Shop around for a merchant bank.
• Understand what the bank is offering and make clear exactly what you expect it to do.
• Make sure that the results are fully monitored and reported back to you.

Dos and Dont’s

Do
• Use a merchant bank with good standing and history.
• Use a merchant bank with a firm financial footing—especially in times of uncertainty about financial
institutions.

Don’t
• Don’t use a merchant bank if you are a small business.
• Don’t use the first merchant bank you find.
• Don’t go in blindly without understanding the risks involved.

More Info
Books:
• Chapman, Stanley. The Rise of Merchant Banking. Economic History Series. London: Routledge,
2005.
• Young, George Kennedy. Merchant Banking: Practice and Prospects. 2nd ed. London: Weidenfeld &
Nicholson, 1971.

See Also
Best Practice
• Mergers and Acquisitions: Today’s Catalyst Is Working Capital
Checklists
• Acquiring a Company
Industry Profile
• Banking and Financial Services

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