What is Merchant Banking? Nature, Functions, Types, Scope

  • Post last modified:20/11/2021
  • Reading time:10 mins read

What is Merchant Banker?

Merchant banker is defined as Any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager-consultant, advisor or rendering corporate advisory services in relation to such issue management

Nature of Merchant Banking

Merchant banking is skill-based activities and involves serving every financial need of every client. It requires a focused skill-base to provide for the requirements of the client. SEBI has made the quality of manpower one of the criteria for registration as a merchant banker.

These skills should not be concentrated in issue management and underwriting alone, which may have an adverse impact on business. Merchant bankers can turn to any of the activities mentioned above depending upon resources, such as capital, foreign tie-ups for overseas activities and skills.

The depth and sophistication in merchant banking business are improving since the avenues for participating in capital market activities have widened from issue management and underwriting to private placement, bought out deals (BODS), buy-back of shares, mergers and takeovers.

The services of merchant banks cover project counseling, pre-investment activities, feasibility studies, project reports, design of a capital structure, issue management, underwriting, loan syndication, mobilization of funds from Non-Resident Indians, foreign currency finance, mergers, amalgamation, takeover, venture capital, buyback and public deposits.

A Category-1 merchant banker can undertake issue management only. Separate registration is not necessary to carry on the activity as underwriter.


Categories of Merchant Bankers

Merchant Bankers fall under four categories:

  1. Category I
  2. Category II
  3. Category III
  4. Category IV
Categories of Merchant Bankers
Categories of Merchant Bankers

Category I

Merchant Bankers of this category can carry on any activity relating to issue management. The activities are as follows:

  • Preparation of Prospectus and other information relating to issue,
  • Determining the financial structure
  • Tie-up of financiers,
  • Final allotment of securities
  • Refund of subscribes etc.,

They could also act as Advisors, Consultants, Co-Managers, Underwriters or Portfolio Managers.

Category II

Merchant Bankers of this category can act as Advisors, Consultants, Co-Managers, Underwriters, and Portfolio Manager.

Category III

Merchant Bankers of this category can act as Underwriters, Advisors, and Consultants to an issue.

Category IV

Merchant Bankers of this category can act only as Advisors or consultants to an issue.

All the categories below Category – 1 were abolished by SEBI on 5th September 1997. Those operating below category-1 have to apply for Category-1 status.


Characteristics of Merchant Banking

  • High proportion of decision makers as a percentage of total staff
  • Quick decision process
  • High density of information
  • Intense contact with the environment
  • Loose organizational structure
  • Concentration of short and medium term engagements
  • Emphasis on fee and commission income
  • Innovative instead of repetitive operations
  • Sophisticated services on a national and international level
  • Low rate of profit distribution
  • High liquidity ratio

Types of Merchant Banking

  • Public Sector Merchant Banks
    • Commercial Banks (public)
    • National Financial Institutions
    • State Financial Institutions

  • Private Sector Merchant Banks
    • Foreign Banks
    • Indian Private Banks
    • Leasing Banks
    • Finance and investment companies

Scope for Merchant Banking in India

  1. Growth of New Issues Market
  2. Entry of Foreign Investors
  3. Changing Policy of Financial Institutions
  4. Development of Debt Market
  5. Corporate Restructuring
  6. Disinvestment
Scope for Merchant Banking in India
Scope for Merchant Banking in India

Growth of New Issues Market

The growth of new issue market is unprecedented since 1990-1991. Merchant banking can help with the further sophistication and penetration of the new issues market.

Entry of Foreign Investors

Foreign institutional investors were allowed to invest in the primary and secondary market in 1992 and also, Indian companies were allowed to directly tap foreign capital through euro issues.

Further, foreign direct investment by NRIs has risen considerably due to number of incentives offered to them. They need the services of merchant bankers to advise them for their investment in India. The increasing number of joint ventures abroad by Indian companies also requires expert services of merchant bankers.

Changing Policy of Financial Institutions

The policy of decentralization, increase in demand for technical and financial services and encouragement of small and medium industries, requires the services of merchant bankers.

Development of Debt Market

The development of the debt market will offer a tremendous opportunity to Merchant Bankers. Innovations in Financial Instruments: The Indian capital market has witnessed innovations in the introduction of financial instruments. This has further extended the role of merchant bankers as market makers for these instruments.

Corporate Restructuring

Due to liberalization and globalization, competition in the corporate sector is becoming intense. To survive and thrive, companies need new strategies, structures and methods of functioning. This has led to corporate restructuring including mergers, acquisitions, etc. These developments offer a good opportunity to merchant bankers to extend their area of operations.

Disinvestment

The government of India has raised Rs. 2000 crores through disinvestment of equity shares of selected public sector undertakings in 93-94. Merchant Bankers can help in the disinvestment process.


Functions of Merchant Bankers

Functions of merchant bankers are:

  1. Corporate Counseling
  2. Project Counseling
  3. Pre-Investment Studies
  4. Capital Restructuring Services
  5. Credit Syndication
  6. Issue Management and Underwriting
  7. Portfolio Management
  8. Working Capital Finance
  9. Acceptance Credit and Bills Discounting
  10. Merger and Acquisition
  11. Venture Capital Financing
  12. Lease Financing
  13. Foreign Currency Financing
  14. Brokering Fixed Deposits
  15. Mutual Funds

Corporate Counseling

A set of activities undertaken to ensure the efficient running of a corporate enterprise is known as corporate counseling. The merchant banker is guiding in the following activities:

  • Diversification based on the Government’s economic and licensing policies.

  • Appraisal of product lines, analyzing their growth and profitability and forecasting future trends.

  • Diagnosing sick units, assessing revival prospects for rehabilitation by way of modernization and diversification, suggesting suitable strategy for improving their production technology and financial structure.

  • Arranging funds for rehabilitation through banks/financial institutions.

  • Monitoring of rehabilitation schemes.

  • Assisting takeover of sick units

Project Counseling

Project counseling is the feasibility study of the project with reference to various aspects such as financial, economical, commercial technical, etc; It includes the following activities:

  • Review of project idea, conducting feasibility study and providing advice for implementation.

  • Providing assistance in the preparation of project reports, conducting market surveys and obtaining government consents (approvals/licenses/permissions/grants) for implementation of the project.

  • Providing guidance in making investment in Indian projects in India and abroad.

  • Arranging and negotiating foreign collaborations, amalgamations, mergers, and takeovers.

Pre-Investment Studies

It is a detailed feasibility study to evaluate alternative avenues of capital investment in terms of growth and profit prospects. Activities related to pre-investment studies are:

  • Analyzing environment and regulatory factors.

  • Identification of raw material sources

  • Estimation of demand

  • Estimation of financial requirements

Capital Restructuring Services

Capital restructuring aims to reduce the cost of capital and maximize the shareholder’s wealth. Merchant bankers provide the following services related to capital restructuring:

  • Determination of optimum capital structure conforming to legal requirements.
  • Getting consent of controller of Capital issues for capitalization of reserves by way of issuing bonus shares.

Credit Syndication

Credit syndication refers to activities connected with credit procurement and project financing, aimed at raising Indian and foreign currency loans from banks and financial institutions, are collectively known as ‘credit syndication’. The activities are:

  • Estimating the total cost of the project and drawing up a financing plan for the total project cost.

  • Preparing loan application for financial assistance from term lenders/financial institutions/banks, and monitoring their progress, including pre-sanction negotiations.

  • Selecting institutions and banks for participation for financing.

Issue Management and Underwriting

Issue management and underwriting is concerned with the activities of management of the public issues of corporate securities, viz. equity shares, preference shares, and debentures of bonds to procure money from the capital market.

Portfolio Management

Portfolio management is making investment decisions in marketable securities for maximizing returns with minimum risk.

The services are:

  • Providing advice on selection of investments.

  • Carrying out a critical evaluation of investment portfolio.

  • Collecting and remitting interest and dividend on investment.

  • Undertaking investment in securities.

  • Safe custody of securities in India and overseas.

  • Undertaking review of Provident fund investment, Trust investment, etc.

Working Capital Finance

Working Capital finance is the fund required to meet the day-to-day expenses of an enterprise. The related activities are:

  • Assessment of working capital requirements.
  • Facilitating sanction of credit facilities speedy disbursements.

Acceptance Credit and Bills Discounting

Acceptance credit and bill discounting’ means activities relating to acceptance and discounting of bills of exchange and advancement of loans on the strength of such instruments.

Merger and Acquisition

The merchant banker arranges for negotiating acquisitions and mergers by offering expert valuation regarding the quantum and the nature of considerations, and other related matters. The activities relating to merger and acquisition are:

  • Conducting SWOT analysis in order to help formulate guidelines and directions for future growth.
  • Conducting studies for locating overseas markets, foreign collaborations and prospective joint venture associates.
  • Obtaining approvals from shareholders and other stakeholders
  • Monitoring the implementation of merger and amalgamation schemes.

Venture Capital Financing

Venture capital is the seed capital in the form of equity financing for high-risk and high-reward projects.

Lease Financing

Leasing is one of the fund-based financial services of merchant bankers. Leasing means letting out assets on lease’ for use by the lessee for a particular period of time. Merchant banker provides the following services:

  • Providing advice on the viability of leasing
  • Providing advice on the choice of a favorable rental structure.

Foreign Currency Financing

Foreign currency finance is the fund provided for foreign trade transactions in the form of export-import trade finance, euro currency loans. The role of merchant bankers in this regard is:

  • Assisting the study of turnkey project and construction of contract projects.

  • Liaison with RBI, EXIM, ECGC and other institutions.

  • Providing assistance in opening and operating banks accounts abroad.

  • Assisting in obtaining export credit facilities and letter or credit.

  • Providing guidance on forward cover for exchange risk.

  • Arranging foreign currency guarantees.

  • Arranging various types of foreign currency loans such as Eurocurrency Loans, Syndication of Euro loans, Bank guarantees etc.

Brokering Fixed Deposits

The merchant bankers render the following services:

  • Working out the quantum of procurement of fund in the form of deposits from the public.

  • Drafting of advertisement for inviting deposits and filing a copy of it with the registrar of Companies for registration.

  • Arranging payment of interest amounts.

  • Advising on the terms and conditions of fixed deposits the company.

Mutual Funds

Mutual funds are institutions that mobilize the savings of innumerable investors for the purpose of channeling them into productive investments in a wide variety of corporate and other securities.

Investment of the fund is in a diversified portfolio of shares and debentures belonging to well-managed and growing companies.

FAQ

Is it mandatory for a merchant banker to register with the SEBI?

Yes. Without holding a certificate of registration granted by the Securities and Exchange Board of India, no person can act as a merchant banker.

Who is eligible to obtain registration as a merchant banker?

Only a body corporate other than a non-banking financial company shall be eligible to get registration as merchant banker.

What is the capital requirement for carrying on activity as merchant banker?

The capital requirement depends upon the category. The minimum net worth requirement for acting as merchant banker is given below:
Category I – Rs. 5 crores • Category II – Rs, 50 lakhs • Category III – Rs. 20 lakhs • Category IV – Nil

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