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14 FDIC Banking Rev. 29 (2001)
Merchant Banking: Past and Present

handle is hein.journals/fdicbnkrv14 and id is 31 raw text is: 

by  Valentine V. Craig*

         erchant banking has been  a very lucrative-
         and risky-endeavor  for the small number of
         bank  holding  companies   and  banks  that
have engaged  in it under existing law. Recent legisla-
tion has expanded the merchant-banking  activity that
is permissible to commercial banks  and is therefore
likely to spur interest in this lucrative specialty on the
part of a greater number of such institutions. Although
for much  of the past half-century commercial banks
have been permitted (subject to certain restrictions) to
engage  in merchant-banking activities, the term mer-
chant banking itself is undefined in U.S. banking and
securities laws and its exact meaning is not always
clearly understood.
   This article begins by defining merchant banking
and  provides a short history of it. The article then
looks at the  private equity market  in the  United
States, examining that market in terms  of its evolu-
tion, typical uses of funds, and forms taken by the
investments.  (In examining  the private equity mar-
ket, one needs to be aware that the private equity mar-
ket is, in fact, private. Data are limited and could be
subject to error.) Discussed next is commercial bank
involvement  in merchant  banking:  the structure of
commercial  bank  involvement, the evolution of that
involvement, and  the recent track record. The major
provisions of the Gramm-Leach-Bliley   Act of 1999,
legislation which authorizes financial holding compa-
nies to engage in merchant banking, is looked at next.
The  final section focuses on the relationship among
merchant  banking, risk, and the regulators.

   Although not defined in U.S. federal banking and
securities laws, the term merchant banking is general-
ly understood to mean negotiated private equity invest-
ment  by financial  institutions in the unregistered
securities of either privately or publicly held companies.
Both investment  banks and commercial banks  engage
in merchant banking, and the type of security in which
they most  commonly  invest is common  stock. They
also invest in securities with an equity participation
feature; these may be convertible preferred stock or
subordinated debt  with conversion privileges or war-
rants. Other investment bank services-raising capital
from outside sources, advising on mergers and acquisi-
tions, and providing bridge loans while bond financing
is being raised in a leveraged buyout (LBO)-are also
typically offered by financial institutions engaged in
merchant  banking.
   Merchant  banks first arose in the Italian states in
the Middle  Ages,1 when   Italian merchant houses-
generally small, family-owned import-export and com-
modity  trading businesses-began  to use their excess
capital to finance foreign trade in return for a share of
the profits. This trade generally consisted of lengthy

* Valentine V. Craig is a Chartered Financial Analyst in the FDIC's
Division of Research and Statistics. The author gratefully acknowl-
edges the comments of the FDIC's Legal Division in preparing this
Much  of the history of merchant banking is derived from Banks (1999).


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