Differences between Commercial Banking and Merchant Banking

Banks as we know them are a relatively modern institution. Historically, banks were established by wealthy families to fund trade and business growth, often using family money as a core for banking activities. Funds from other well-to-do investors were solicited for large projects. These bankers were directly involved in the movement of goods from place to place and often were traders as well as financiers.

The National Bank Act of 1863 established banks chartered at a national level and taxed the instruments issued by state banks to encourage them to become national banks. It also allowed the national banks to issue notes that carried a federal guarantee, insuring the users against the bank’s default. Demand deposit accounts, what we know today as checking accounts, appeared in the late nineteenth century.

It wasn’t until 1913 that the Federal Reserve Act brought the activities of all banks under federal regulation. In 1933, after the catastrophes of the depression, the Federal Deposit Insurance Corporation (FDIC) was formed to insure bank deposits up to $2,500 per account. That amount has increased over time and can be as much as one hundred times that number today.

Part of the Banking Act of 1933 prohibited a bank from accepting deposits and underwriting securities, thus legally segregating depository and investment banks. The repeal of that requirement in 1999 means that today’s banks can incorporate both elements. There are many in the financial community who believe that this relaxation of the regulations contributed to the recent financial woes in the United States.

Commercial banks are what the average person thinks of when he hears the word “bank.” These institutions offer checking and savings accounts, issue credit cards, offer mortgages and other loans to individuals and small businesses, and sell investments in the form of certificates of deposit and other securities. They are sometimes known as retail banks.

The distinction between merchant and investment banks is a little blurred. Generally, merchant or investment banks handle the financial needs of large companies. They provide capital for expansion or new projects. They are sometimes referred to as wholesale banks and they do not handle deposits. Some people further distinguish them by referring to a merchant bank as one that is sourcing capital with private dollars, sometimes funds from the bank itself, and an investment bank as one that is sourcing capital with public dollars, in other words, money raised through the sale of publicly-traded securities.

Investment banks may also assist customers with mergers and acquisitions and foreign exchange. To handle public securities, investment bankers must be licensed brokers and are subject to the regulations of the Securities and Exchange Commission.

The co-mingling of these two types of bank operations is still questionable. In the wake of the financial meltdown, analysts and regulators will be watching closely to see how the combination of commercial and merchant banking will perform.