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The high street banks are household names. Although most people have heard of the term ‘merchant bank’, few can name specific institutions such as Morgan Grenfell or S. G. Warburg. In general, the merchant banks have a bad image and are associated with asset stripping and hard-hearted capitalism in many minds. However, they also offer for some the suggestion of adventure and romance in the financial system.

It is very difficult to define exactly what a merchant bank is: one of the main guides to the business says that merchant bankers are now ‘seldom merchants and by no means always bankers’. The other name by which merchant banks have been known is that of accepting houses, referring to their habit of accepting bills of exchange as a means of financing companies’ trading activities. But that term is far too narrow as a definition of their activities.
The Growth of Merchant Banking

Before the development of a world wide banking system, much international trade depended on trust – trust that goods would be delivered and that they would be paid for. It was much easier for overseas clients to trust merchants with whom they had traded before or those with whom their friends had traded. Thus, the larger and well-established merchants found it easier to trade than their smaller and less familiar competitors.

The smaller firms needed some way both of assuring their clients that they were trustworthy, and of raising money to cover the interval between the time goods were delivered and the time they were paid for. The normal method for raising finance in this period was for the exporter to draw up a bill of exchange, whose value was a large proportion of the value of the goods being sold. The exporter could then sell the bill to a local banker at a discount and receive a substantial proportion of the money in advance. The extent of the bank’s discount would represent two elements, a charge equivalent to interest on what was effectively a loan and a charge reflecting the risk of non-payment.

Small exporters found the banks would often charge a very large discount to advance money on their bills, if they agreed to do so at all. So the smaller merchants began to ask their larger brethren to guarantee (or accept) their bulls. In the event that the small merchant failed to pay up, the large merchant would be liable. In return for the service, the large merchants charged an acceptance commission, based on a percentage of the size of the bill.

Eventually, some of these large merchants found that they could earn more money from their finance activities than from their trading and became full-time merchant banks or accepting houses. For a long time, their business was centred around the financing of trade but gradually, as they developed a reputation for financial acumen, they increased the corporate finance side of their activities.