Merchant Banking

What is a Merchant Bank?

A merchant bank is a bank involved in trade finance. They began when merchants started helping to finance the transactions of fellow merchants. In Great Britain, this occured in the late 18th century when the expansion of British interests abroad saw Britain develop into a powerful trading nation. Over the years merchant banks refined the services they offered and branched out into new areas. Their main functions included:

Accepting Commercial Bills

In the days of sailing ships, long-distance trade was fraught with risks. For example, a merchant in Exeter supplying wool to a customer in New York would have to wait months before they saw payment for the wool - and the customer often sent their payment months before the goods arrived. Each party did not know for sure that the other would honour their side of the deal. This problem led to the rise of 'Accepting Houses' (or Merchant Banks, as they came to be called). This new type of bank allowed merchants in different countries to transact sales through them. 

Accepting Houses had trusted agents around the world. They issued Letters of Credit, a type of ‘Bill of Exchange’. This was an IOU where the buyer agreed to pay the seller the value of the goods at a future date, usually within three months. This agreement was endorsed or guaranteed by the Accepting House. For example if someone in New York wanted to buy some British wool the Accepting House would confirm that the shipment was of the correct amount and quality agreed and that it was ready for dispatch. For a fee the Accepting House would then issue a Letter of Credit to the seller. The Accepting House would then organise the sale of the wool to the buyer through its New York agent and the seller would deposit the money with the agent in New York.

After the due date the seller of the wool could take their Letter of Credit to the Accepting House to be paid. By this time the goods should have been delivered and the Accepting House should have received payment from their agent in New York. Alternatively, the holder of the Letter of Credit could sell it on at a discount before the due date – quite often back to the Accepting House, who would either take the full value of the sale themselves at the due time or sell on the Letter of Credit to a third party. The Letter of Credit thus became a tradeable commodity in its own right.

Acceptance credits were a risky business. A lot could go wrong. Accepting firms had to be trusted by the merchants involved in a deal as well as any third party that might purchase the Letter of Credit. Integrity and creditworthiness were vital. Without a good reputation a house was nothing. Letters of Credit still exist today and this activity has become known as the provision of ‘commercial credits’. In personal finance credit cards operate on exactly the same principle.

Barings started accepting bills in 1768. In the early years this part of their business was not always profitable. By 1781 they had learned their trade and improved their assessment of risk. Their Acceptances credit business grew from £42,000 in 1776 to £121,000 in 1799 and in the same period commission doubled. Trade finance would continue to be an important part of the business into the 20th century. See a bill of exchange in the sources.

Government and Corporate Loans

In the late 18th and 19th centuries governments often needed to raise money to finance their armies or to support large projects such as building railways or other enterprises. When governments needed money they turned to merchant banks who could either loan them the money or help them raise funds by selling bonds.

When selling bonds a merchant banker had to judge the price of the issue correctly. If they got their figures right then they had a chance to make a profit. However, if the stock price was too high, or they misjudged the public mood, the banker could find themselves left with a lot of unsellable bonds. This was a high profit high risk business. There was also the possibility that a foreign power would default on their loan payments. In the early 19th century some governments, particularly in South America, were very unstable.

In order to encourage bond issues, merchant banks became involved in buying and selling bonds, either on behalf of clients or on their own account. In this way they created the bond market, now the largest global financial market. Although the first loans were for governments, large companies soon followed. In this capacity the merchant banks played a vital part in the expansion of commerce and industry and helped spur on the Industrial Revolution.

Barings made their first loan to the British Government in 1770s to help them finance the cost of the British war effort in North America. Later on they arranged loans to help finance the British in their war against the French which ran from 1793 to 1815. During the 19th century they also acted as agents for the Portuguese, French, Chilean, Argentine, United States, Canadian and Russian governments. Other overseas clients ranged from the Canadian Pacific Railway Co to the Buenos Aires Water Supply & Drainage Co Ltd. See a loan agreement in the sources.

General financial services to the British and other governments

Merchant banks also provided financial advice and services for governments. For example they were well placed to provide general financial advice and to purchase gold and other commodities. They could make diplomatic payments between governments and could also liquidate assets when cash was required. The provision of these services was low risk and could be very lucrative.

Barings had worked closely with the British Government on various occasions. In 1845-7 they brought huge quantities of corn to stave off famine in Ireland. During the Second World War Barings was used by the British government to liquidate assets in the USA and around the world in order to finance the war effort. 

Corporate Finance
 
In 1844 a new Parliamentary Act enabled joint stock companies to be formed without a Royal charter. This was followed in 1856 by an Act that allowed limited liability. The aim behind both Acts was to place business and the economy on a surer foundation and to increase public confidence in business. The Acts laid the ground work for private companies to float on the stock market. Merchant banks become involved with this process in the latter part of the 19th century. Merchant banks were also sometimes called upon to provide advice to large companies about their finance and organisation and to assist when a company wanted to buy another company or part of it.

Barings corporate finance work began with the flotation of Arthur Guinness Sons & Co Ltd in 1886. Other clients included Whitbread’s, Combs & Co., Vickers and the London Omnibus Co Ltd. This sort of client became more important in the 20th century. Barings played an important part in financing, and advising on, the rebuilding and reorganising of British industry in the post-war period in the 20th century.

Fund Management and Private Banking

In the 20th century Merchant bankers became involved in new areas of work. Some developed strong fund management arms and became involved in managing pension funds for institutions. Others began to handle the private financial affairs of wealthy individuals, advising them on a whole range of financial issues including how to invest their assets. This latter activity is known as private banking or private wealth management.

Barings were among the first firms to realise the potential of asset management and set up an Investment Department in 1955. Clients included corporate clients, sovereign connections, pension funds and charitable institutions. From the 1970s this business become more international with offices in the Far East, North America and Europe.

Equity Brokering

In the 1980s, after "Big Bang", international brokering of equities as well as proprietry trading emerged as another major area of business for Merchant Banks. Banks bought up many of the brokerage companies that had been members of the stock exchange.

Barings became involved in equity brokering in 1986.

What happened to Merchant Banks?

A few merchant banks still exist. However for the majority the increasing costs of operations and computer systems saw smaller merchant banks merged into large international investment banks. These large international organizations dominated the financial world of the late 20th century.

In 1995 Barings became insolvent as a result of unauthorised trading by one of its employees, Nick Lesson. Its business was acquired by ING of the Netherlands. Baring Brothers Ltd, Baring Brothers International Ltd and ING Baring Securities Ltd were initially the three major operating companies. In 2004 ING Group finalised the sale of Baring Asset Management to MassMutual Financial Group and Northern Trust Corp.