Investment banking

Merchant banking and investment banking are often used as if they were the same thing. The workbook says there is a fine line between them, and then draws it.

Merchant banking is the narrow one. It is intermediation in the capital market — helping issuers raise capital by placing their securities with investors. It is a fee-based service. In India the merchant banker leading a public offer is called the Lead Manager.

Investment banking is the wide one. It covers all types of capital market activity, both fund-based and non-fund-based. So it includes merchant banking, and then adds stock trading, market making, underwriting, stock broking and asset management. On top of that come advisory services in project finance, business and financial advice, and mergers and acquisitions.

One more difference is the practical one. A pure merchant banker does not deal in securities in the secondary market. An investment banker does, and also risks its own capital to make money from trading.

The word is wide for a historical reason. American investment banks grew that way over the last century, and the term followed them.

The distinction the workbook draws (Chapter 2, section 2.1.1).

Where merchant banks also go. The workbook notes that modern merchant banks perform a variety of other activities: financing foreign trade, underwriting equity issues, portfolio management, foreign security and foreign loan business, and project appraisal. Not all merchant banks offer all these services.

Where the term comes from. Merchant banking originated in Italy, moved to France in the seventeenth and eighteenth centuries, and flourished in the United Kingdom in the late eighteenth and early nineteenth centuries as England became a rich trading nation. In the United States the same firms are called investment banks, and the workbook says American merchant banks have evolved into investment banks — taking on all the functions of a merchant bank and adding their own capital and proprietary trading. In the UK, merchant banks showed a short chain of command, sophistication in services and high liquidity, and were expected to focus on fee income rather than profits from investing funds.

The American regulatory arc, which explains the width of the term. The Glass-Steagall Act of 1933 differentiated the activities of commercial banks and investment banks and prevented depositories from underwriting. The Securities Exchange Act of 1934 sought to correct practices in securities trading and created the SEC. A relaxation of the Glass-Steagall rules in 1997 led to wider consolidation across investment and commercial banking. Glass-Steagall was repealed in 1999 and replaced by the liberal Financial Modernisation Act 1999. US investment banks then grew exponentially from 1990 to 2007, and after the global financial crisis of 2008 were brought under tight regulation again by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 — which, specific to investment banking, segregates banking from proprietary trading and asset management through the Volcker Rule.

In India. Foreign banks were the forerunners. Grindlays Bank began merchant banking operations in 1967 under a licence from the RBI, followed by Citibank in 1970; both syndicated loans and raised equity. The Banking Commission Report of 1972 asserted the need for merchant banking services in India to be provided by public sector banks and, based on the Glass-Steagall Act of 1933, recommended a separate structure to keep merchant banks apart from commercial banks and financial institutions. SBI set up its merchant banking division in 1972; ICICI was the first financial institution to set one up, in 1973; IFCI and IDBI followed, the latter in 1992. SBI Capital Markets was set up in 1986 and ICICI Securities was spun off as a subsidiary in 1995. The workbook says the bigger investment banks now spread core and non-core segments across several group entities, and names SBI, IDBI, ICICI, IL&FS and Kotak Mahindra as offering almost the entire gamut of investment banking services permitted in India.

Illustrative figures, applying the workbook's merchant banking versus investment banking split.

Vaitarna Financial Group has three registered entities. In one financial year they earn:

Only the Rs 148 crore is merchant banking. It is fee-based, it is intermediation between issuer and investor, and Vaitarna Capital signs the due diligence certificate on each offer document.

The whole Rs 794 crore is investment banking on the workbook's definition, because investment banking covers all capital market activity, fund-based and non-fund-based.

Merchant banking share = 148 ÷ 794 = 18.6% of group revenue.

Now read the two lines that are neither fee-based nor client-facing. The Rs 310 crore of asset management and the Rs 74 crore of proprietary trading are exactly the two activities the Volcker Rule segregates from banking in the United States. A pure merchant banker would earn neither.

And note what Vaitarna Capital Ltd itself may not do under Indian rules. A merchant banker must be a body corporate other than a non-banking financial company, and any fee-based, non-fund-based activity outside SEBI's purview has to run through a ring-fenced Strategic Business Unit. The American word is wider than the Indian licence, which is why the group needs three companies to do what one American name covers.

Chapter 2 (Introduction to the Merchant Banking) is 15% of the paper, and its first learning objective is the concept and evolution of merchant banking — with the merchant banking versus investment banking distinction set out as its own sub-section.

The reliable questions are comparison questions. Which term is wider (investment banking). Which of the following is not a merchant banking activity — the answer will be secondary market dealing, proprietary trading or asset management. What is the Indian name for the merchant banker leading a public offer (Lead Manager). The dates are also examinable one-liners: Glass-Steagall 1933, Securities Exchange Act 1934, relaxation 1997, repeal 1999, Dodd-Frank 2010, Grindlays 1967, Citibank 1970, Banking Commission Report 1972, ICICI 1973, SBI Capital Markets 1986, IDBI 1992, ICICI Securities 1995.

• Investment banking is the wider term. Merchant banking sits inside it, not the other way round.
• A pure merchant banker does not deal in the secondary market. That single line is the cleanest discriminator the workbook gives.
• An investment banker risks its own capital. Merchant banking is fee-based, so a question about proprietary trading is never about merchant banking.
• Merchant banking originated in Italy, then France, then flourished in the UK. It is not an American invention, although the investment bank label is.
• In the US, merchant banks evolved into investment banks. They were not displaced by a different kind of firm.
• 1997 was a relaxation; 1999 was the repeal. Two separate Glass-Steagall dates, in the same paragraph.
• India copied the separation, not the label. The Banking Commission Report of 1972 recommended a separate structure for merchant banks based on Glass-Steagall.
• 1972 is SBI's division and the Banking Commission Report; 1986 is SBI Capital Markets. Two different SBI dates.
• "Investment banker" is also used loosely for a merchant banker in India. AIBI is the Association of Investment Bankers of India and it is the industry body for merchant bankers. Read the context, not the word.