Hiring an Investment Bank II: A Brief History
This blog is part of the “Hiring an Investment Bank” blog series. For more, visit the first installment of the series here.
As we look at the process of and considerations for hiring an investment bank, it is interesting to understand the origins of these institutions.
The emergence of investment banks in the United States of America occurred in the late 1800s when the state-chartered commercial banks of the time lacked the ability to fund a rapidly expanding American economy that was increasingly dependent on capital intensive industries like oil, mining, steel and railroads. However, the story of these institutions began well before that.
The Italian cities of Florence, Genoa, Venice, and Siena were home to the first investment banks in the 1400s and later expanded to Amsterdam and London in the 1600s. The family owned enterprises were primarily engaged in merchant banking, which entailed the trading of commodities such as spices, cotton, silk, metals, grains and so on. Typically, they used their own capital.
Their role was to facilitate and finance the production and transportation of commodities domestically and overseas. They would commonly lend money to farmers and transportation merchants for a share of profits (equity) or provide financing for interest (credit) using crop yields as collateral. That model evolved to the service of managing transactions for those parties buying and selling commodities. That included holding interest-bearing deposits and issuing bills of exchange. This change represented a fundamental shift for the Merchant Banks as they no longer needed to use their personal funds to participate in commercial activities.
As trade continued to grow, so did the notoriety and status of the bankers. They took on customers of prominence such as monarchs, the papacy, nobles and received interest and fees as consideration for their services. They routinely financed their client’s infrastructure projects, armies, travel carriages, and expansion abroad (colonization). This led to the rise of prominent banking families of that era such as the Fuggers, Schroders, and Berenberg’s of Germany, Medici of Florence, and in the United Kingdom, Kleinwort’s, Barings, Warburg’s, Hambros, and Rothschilds.
Expansion from Merchant Banking Roots
From the 1700s to the 1800s, Monarchs started to slowly lose relevance and the newly empowered governments were viewed as credible and stable by investors and citizens alike. They needed large scale financing for things such as development projects, expensive military engagements in Europe, and the Revolutionary War (1775-1785) in the United States. Tax revenues lacked the sufficiency to cover costs arising from events of that nature and the building of infrastructure. This began the evolution that led to the investment banks as they function in modern times. With the increase in government credibility, investment banks began engaging in the underwriting of government bonds to investors, which entailed the evaluation of risk, the negotiation of terms and pricing, issuance (sale) of the bonds to the underwriters, and the reselling of the bonds to investors. Government finance became a dominant part of what investment banks did at the time as investors viewed the bonds as a safe and reliable way to make returns. This demand continued to increase as the Mexican War and the Civil War occurred in the early to mid-1800s.
After the Civil War, there was an economic boom that saw an expansion of railroads and heavy industry in mining, machine tool building, and steel making. Commercial banks did not have enough resources to meet the funding demands, so people turned to the investment banks who sold securities (equity and debt capital) on behalf of the private entities. Investment banks purchased stocks and bonds from issuers (corporations and other entities) and resold them to individual or institutional investors.
In the 1850s, there was a large immigrant wave from Germany, London and France that coincided with the post-civil war boom. Goldman Sachs, Kuhn Loeb, Seligman and Speyer, Salomon brothers, Lehman brothers, Morgan and Lazard Freres all arrived from Europe with very little means. They would all venture into investment banking and help in the development of a secondary market (the beginnings of the modern stock market) to increase the investor base by giving common people access to the capital markets and simultaneously creating liquidity for private enterprise, municipalities, and governments. This led to the creation of Universal Banks which were a combination of investment and commercial banking. This came under scrutiny from regulators and laws were crafted to mitigate the conflict of interest that would arise from such an arrangement.
In conclusion, investment banks grew from merchant banking that supported trade in commodities to serving as intermediaries between those seeking capital for growth and development and those searching for good investment opportunities. In modern times, they offer four main services, capital markets (raising debt and equity capital), advisory (mergers, acquisitions and restructuring), trading and brokerage (trading publicly listed securities and bonds) and asset management (expertise in managing investments).
The Rise and Fall of the Merchant Banks, (Erik Banks)
How important Historically were Financial Systems for Growth in the U.K., U.S, Germany, and Japan?’ (Allen Franklin et al.)
Investment Banking in America: A History, (Vincent P. Carosso)
Encyclopedia of World Trade since 1450, (Hickson and Turner)
A Brief History of Investment Banking from Medieval Times to the Present, (Caroline Fohlin)
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