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Banking on Failure: Merchant Banking

WORLDWORKS by Joe Pimbleyby Joe Pimbley, Columnist & Featured Contributor

[message type=”custom” width=”100%” start_color=”#F0F0F0 ” end_color=”#F0F0F0 ” border=”#BBBBBB” color=”#333333″]Editor’s Note: This is the next in a new Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt. [/message]

Bank Lending

[su_dropcap style=”flat”]T[/su_dropcap]HERE’S AN OLD AND TIRED JOKE to describe the happy life of a successful banker. It goes like this: “Bankers follow the 3-6-3 rule. What’s that? The banker borrows money at 3%, lends money at 6%, and makes it to the golf course at 3 pm.” It’s not funny, but nobody forgets it. Call it the equivalent of “Hello, World” for computer programmers.

Banking on FailureThe point is that lending is a core element of the banking business. Banks borrow funds through the customer deposits they receive and by issuing bonds, selling commercial paper, and other means. The two core competencies of banking are credit underwriting (which is the assessment of “credit risk,” “loan risk,” or “default risk”) and the ability to convince the bank’s depositors and other lenders that the bank itself is creditworthy (i.e., has very low credit risk).

The scope of bank lending extends to virtually all types of borrowers. Loans to homeowners to purchase houses are residential mortgage loans. Loans to businesses to buy property are commercial real estate loans. Banks make loans to companies of all sizes. Banks lend to investors, investment companies, mutual funds, and insurance companies. In the segment known as “consumer loans,” banks lend to individuals to purchase cars, boats, motorcycles, et cetera.

A significant lending program for banks is credit cards. When a consumer uses his credit card to buy $100 of goods from Wal-Mart (Wal-Mart Stores, Inc.), he is borrowing this $100 from the bank that issued the credit card. Note that we’d used the debit card earlier as an example of the function of the payment system since the consumer who uses a debit card is paying his own money. With a credit card transaction, the cardholder is a borrower.

For a good mental picture of a bank, think of the balance sheet. Every company, whether it’s a bank or something completely different, has a balance sheet. For a bank specifically, though, the assets (on the left-hand side of the balance sheet) are loans the bank has made to other borrowers (such as homeowners, large and small businesses, credit card holders, et cetera). The liabilities (on the right-hand side of the balance sheet) include funds the bank has borrowed and the bank’s equity. See figure 3-1.

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Figure 3‑1

Earlier we described bank depositors as investors in the bank. These depositors are debt investors rather than equity investors, but they are investors nonetheless. If it were not for the typical government insurance of bank deposits, then one could say the fate of the depositors’ return of principal depends on how well the bank’s assets perform. Again, the bank assets are the loans the bank makes to other borrowers. Unlike the “payment processing” and “deposit taking” functions of the bank, lending entails undeniable risk of loss. When a bank makes loans, it is likely that some fraction of the borrowers will not repay the loans.

Merchant Banking

The term “merchant banking” has varying meanings in different countries and through history within the same country. Let us just apply the general and somewhat vague description as “financial activity and support for private business and trade.” It’s instructive and interesting to describe one specific example of merchant banking from history that continues in different form today.

Consider the situation of merchants such as dry-goods wholesalers in the U.S. and U.K. in the nineteenth century. Merchants acted as intermediaries in buying inventory – often from a distant supplier – and selling this inventory locally either with or without additional processing or manufacture. Such merchants had timing mismatch in their payments. That is, they needed to make payments for inventory before receiving payment from their customers. This dilemma persists today and is a normal condition of the business world.

When a merchant sold a product to a customer, he would give the customer an invoice that obligated the customer to pay the merchant in a specific timeframe such as thirty days. The merchant retained a document (a “bill”) signed by the customer as evidence of the payment obligation. This merchant’s bill was not cash, but it had value since it entitled the bearer to receive a future payment from the customer.

Nineteenth-century bankers called on merchants to ask if they had customer bills to sell them. In buying bills, the bankers were converting the bills to cash for the merchants. For the bankers, such purchases were effectively short-term loans to the customers. Once the banker owned the bill, the customer made his payment within thirty days to the banker.

For a purchase obligation of $1,000, the banker would pay an amount less than this $1,000 for the bill. This difference, the “discount,” represented the profit to the banker for customers that paid their bills promptly. A reasonable discount for a thirty-day payment period would be 1% since earning this 1% over a month is roughly equivalent to a 12% annual return. Hence, the banker would “discount the bill” by paying $990 to the merchant for a $1,000, 30-day payment obligation. Note that the banker might refuse to buy the bill of a customer he considered to be less likely than others to make payment.

As we noted, the banker’s purchase of a bill was equivalent to lending to the customer to enable the purchase of merchandise with thirty-day payment period. Instead of paying the $990 for the $1,000 bill to the merchant, the banker might rather lend the $990 to the merchant. It would then remain the merchant’s responsibility to collect the $1,000 from the customer within thirty days and pass this payment to the banker as repayment of the loan from banker to merchant. Whether the purchase of a bill (first case) or the loan against the bill (second case), the flow of payments and assistance to the merchant are similar. A crucial difference is the party that bears the risk of loss if the customer fails to pay his $1,000 obligation (i.e., the banker in the first case and the merchant in the second case).

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Figure 3‑2(a) Banker buys a bill at a discount

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Figure 3-2(b) Banker lends to the merchant

Three helpful and well written references to describe this historical practice are Lombard Street – a Description of the Money Market (Walter Bagehot, a Public Domain book published circa 1870), Money and Power: How Goldman Sachs Came to Rule the World (William Cohan, Random House, 2011), and Money, Gold, and History (Lewis Lehrman, The Lehrman Institute, 2013). Note, however, that the transactions of figure 3-2(a) are entirely analogous to popular use of credit cards in today’s world. Thus, credit cards are the modern “discounting of bills” – though we’d add that credit cards represent unsecured lending while the historical references to bill discounting don’t make clear whether the borrower pledges collateral for the lender’s claim.

The final excerpt for Chapter 3 will discuss “Foreign Exchange,” “Trading and Market Making” and “Investment Banking”

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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