Merchant banking refers to a form of banking that both commercial and investment banks participate in. It involves trading unregistered securities including stock, bonds and private equity securities. Merchant banking serves large businesses, including international corporations, and some wealthy individuals. However, its role in the economy can affect consumers at all levels.
Some merchant banking activity involves buying debt, either from other banks or businesses. A bank that engages in merchant banking purchases debt securities, which represent outstanding debts to consumers such as home buyers, car buyers and small businesses. Merchant banking allows one institution to purchase the debt from the bank that issued the loan, allowing that bank to make new loans and letting the purchasing institution profit from the interest that the borrowers pay, or suffer losses if borrowers default.
Merchant banks also make loans directly to businesses and wealthy individuals. These are usually large, long-term loans that would be unavailable elsewhere. They feature complex terms and allow borrowers to fund major investments or expansion projects. For example, if a large business wishes to expand overseas, it may work with a merchant bank to fund the endeavour, paying back the money it borrows over a number of decades with new international revenue. Because of the risk involved in merchant bank loans, banks become heavily involved in the process.
Another major role of merchant banks is managing risk for customers. Merchant banks have access to many different markets, including securities markets and brokers that individuals and businesses would not otherwise have access to. The scale of their investment power allows merchant banks to distribute their investments widely, reducing the amount of risk that the investors they represent need to take on.
As a direct result of their investing to manage risk and create wealth for their customers, merchant banks drive markets. The money they invest in private equity securities, stocks and bonds alters the prices of these financial instruments and affects what other investors must pay for them. Likewise, when merchant banks experience crisis, as during the 2008-2009 recession, the falling value of their securities causes markets to fall.