Merchant Banking Services - Definition, Development, SEBI Regulations | MODULE D: FINANCIAL PRODUCTS AND SERVICES
Merchant Banking Services
Definition of Merchant Banking
Merchant Banking refers to a combination of banking and consultancy services. It involves providing capital to companies in the form of share ownership rather than loans, and offers advice on corporate matters such as mergers and acquisitions, underwriting, and fundraising. Merchant banks primarily cater to large enterprises and high net-worth individuals (HNIs).
Historical Background
Merchant banking originated in the 17th and 18th centuries in Europe, especially in London. Initially, merchant banks assisted in financing foreign trade by providing short-term loans and issuing letters of credit. Over time, they expanded their services to include management of public issues, portfolio management, and underwriting activities.
Development of Merchant Banking in India
Merchant banking in India began in the late 1960s, with Grindlays Bank (now part of Standard Chartered) being the first to establish merchant banking services in 1967. The market rapidly grew, with Indian banks like State Bank of India (SBI) and ICICI introducing similar services in the 1970s. Merchant banking became more structured with the establishment of guidelines by SEBI in the 1990s.
Merchant Banking Vs Commercial Banking
| Aspect | Merchant Banking | Commercial Banking |
|---|---|---|
| Primary Function | Advisory and capital raising | Deposits and loans |
| Client Base | Corporations, HNIs | Individuals, businesses |
| Risk Profile | Higher risk | Lower risk (secured loans) |
| Revenue Model | Fees and equity investments | Interest margin |
Licensing Requirements
As per SEBI regulations, any entity intending to conduct merchant banking activities must obtain a certificate of registration. The eligibility criteria include:
- Minimum net worth of ₹5 crores.
- Professional expertise and experience in financial services.
- No record of conviction for financial irregularities.
SEBI Regulations on Merchant Banking
SEBI (Merchant Bankers) Regulations, 1992, govern the registration, activities, and compliance of merchant bankers. The regulations ensure transparency, investor protection, and ethical conduct by merchant bankers.
Important Provisions:
- Classification of merchant bankers into categories based on permitted activities.
- Capital adequacy requirements.
- Obligations regarding due diligence in public issues.
- Code of Conduct adherence mandatory.
Activities of Merchant Banks
Key activities undertaken by merchant banks include:
- Issue Management – Pre and Post Issue obligations.
- Portfolio Management Services.
- Corporate Advisory Services – Mergers, Acquisitions, and Restructuring.
- Loan Syndication and Project Financing.
- Private Equity and Venture Capital Financing.
Key Policy Requirements as per SEBI Regulations
Some of the critical policy requirements are:
- Submission of Due Diligence Certificate with offer documents.
- Appointment of Compliance Officer.
- Mandatory disclosures in public offerings.
- Maintenance of books of accounts and audit reports.
Key Codes of Conduct as per SEBI Regulations
The Code of Conduct for merchant bankers ensures ethical functioning and includes:
- Honesty and Integrity in all dealings.
- Disclosure of all material facts.
- Maintaining confidentiality of client information.
- Avoidance of conflict of interest.
- Compliance with all applicable laws and regulations.
Advanced Mathematical Example: Fundraising Analysis
Consider a company planning to raise ₹200 crores through an Initial Public Offering (IPO). A merchant bank assists by underwriting the offer. Assume the following:
- Underwriting commission: 2% of total issue size.
- Expected subscription rate: 80%.
- Merchant bank has to subscribe the remaining unsold shares.
Step 1: Underwriting Commission Calculation
Underwriting Commission = 2% of ₹200 crores =
Commission = (2/100) × 200 = ₹4 crores
Step 2: Shortfall Subscription
Subscription Shortfall = 20% of ₹200 crores =
Shortfall = (20/100) × 200 = ₹40 crores
Step 3: Impact on Merchant Bank
The merchant bank must invest ₹40 crores to subscribe to the unsold portion. The net revenue can be computed as:
Net Revenue = Underwriting Commission - Opportunity Cost of Capital Invested
Advanced Equation
Assuming the opportunity cost of capital is 10% per annum, and the merchant bank expects to hold the shares for 1 year:
Opportunity Cost = 10% × ₹40 crores = ₹4 crores
Thus, Net Gain/Loss = ₹4 crores (commission) - ₹4 crores (opportunity cost) = ₹0
Interpretation: In this case, the merchant banker does not profit if the unsold shares are held without appreciation. Strategic planning is essential in underwriting agreements to maximize profitability.
Chapter List: MODULE D: FINANCIAL PRODUCTS AND SERVICES
- Overview of Financial Markets
- Money Markets and Capital Markets
- Fixed Income Markets - Debt / Bond Markets
- Forex Markets
- Interconnection of various markets/Market Dynamics
- Merchant Banking Services
- Derivatives Market including Credit Default Swaps
- Factoring, forfaiting & Trade Receivables Discounting System (TReDS)
- Venture capital
- Leasing and Hire Purchase
- Credit Rating agencies & their functions
- Mutual Funds
- Insurance Products
- Pension Funds (include APY, NPS)
- Guidelines on Para Banking & Financial Services provided by Banks
- Real Estate Investment Funds / Infrastructure Investment Fund (concept)
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