Chapter 2 - European Financial Markets in History

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Chapter 2 - European Financial Markets in

History

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This Lecture

The early beginnings

Financial centres and peripheries

Financial innovations

From pawn brokers to ABS

From cowrie shells to electronic money

Scale economies and lock-in

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The first financial activities: following trade

• First limited to the local town or village

to walking distances

to major trading routes

to business with personally known people

• With increasing long-distance journeysincreasing welfare

growing court life and urbanity

pilgrimages and crusades

rising awareness of other regions

emerging crafts, rising purchasing power

emerging preferences for luxury goods

• With the rise of merchant empiresdivision of labour in long-distance trade

emergence of dominant cities

10th century

12th century

15th century

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The first financial centres: Italian cities

Venice

Genoa

Florence

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Venice benefitted from

– the special relationship with Byzantium

– its role as early colonial power (Crete, Corfu, Cyprus, Alexandria)

– access to products of the Levant and Asia

– military and technological superiority

– relationship to the Islamic world and its already flourishing money economy.

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Genoa– established the first regular maritime trade with Flanders in 1277.

– The first references to banking in Europe in the Middle Ages are found in Genoese records of the 12th and 13th centuries.

– The king of Spain, "lord of precious metals" (Braudel) was among Genoese bankers' clients who changed the irregular sources of Spanish revenues from taxes and silver imports from the New World into regular streams of income.

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Florence

– From the 12th century onwards Florence was the origin of the great banking families, such as the Peruzzi, Bardi, Acciaiuoli, and later the Medici,

– which were all characterised by having large capital stocks

– and wide networks of subsidiaries and relations in western Europe, north Africa and the Levant.

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The Peruzzi

In 1335, the Peruzzi company had at least 15 branches in western Europe, north Africa and the Levant.

It had an estimated staff of about 90 factors or employees.

Its capital was about 90 000 florins, ...

which was a considerable wealth taking into account that, for example, before 1500 the value of a palace like that of the Medici in Florence was estimated to be 5 000 florins (De Roover).

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The first financial intermediaries:

• PawnbrokersSmall lenders who lent money at high interest rates holding some of the borrower's personal belongings as collateral.

Regarded as no better than prostitutes - sinners but necessary to society (Kindleberger)

• Money changers At first only exchanged currencies with no element of credit involved;

played an important role in trading centres given the great variety of coins in the Middle Ages.

• BankersFrom the twelfth and thirteenth centuries onwards local transfer banks began to take deposits and make payments on behalf of depositors.

In addition, since there were competing currencies, and gold and silver coins circulating simultaneously, they accepted deposits repayable in different kinds of money.

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Money changers

Money changers are still found today in big cities all over the world but also in remote and poorly developed rural areas or war-torn regions where banks do not exist or do not function well.

Jodhpur, Sardar Market, India

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The first financial innovations:

• Bank money based on fractional reserve

• Bill of exchange

• Limited-liability partnership

• Coins

• Cheques

• Government bonds

• Marine insurance

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Bank money based on fractional reserve

When money changers began taking deposits and making payments on behalf of depositors transfering deposits from one trader to another it was no longer necessary to transport coins.

However bankers always held a certain amount of cash in case depositors ask their money back. Over time, they found out that it was not necessary to hold cash covering the total value of deposits and they kept only a fraction of that amount at hand investing the rest in trading activities or lending it at interest to third parties.

In other words, they began operating on a fractional reserve basis.



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Bill of exchangeThe bill of exchange was a contract defining an agreement between two people, the deliverer and the trader.

The deliverer agreed to advance a sum of money to the trader,

and, in return, received from him a “letter missive”, the bill of exchange, payable

• at a distant place and

• in another currency.

Usually, the implementation of the contract required two other parties to be involved acting as agents: the payor and the payee.

Under the prohibition of usury bills of exchange were long used as credit in disguise.



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Limited-liability partnership

Long-distance trade increased the demand for financial products which allowed to raise funds, defer payments and share or transfer risks.

Since the 10th century Italian cities knew the one-venture contratto di commenda (in Venice known as collegantia, in Genoa as societas maris):

A merchant received a sum of money from someone at the beginning of a voyage and, on his return, the gains and losses he made were divided between the two parties according to the share of capital each of them had provided.

The commenda was in use until the 15th century when long-distant trade had become routine and old-style merchants were replaced by businessmen operating through agents.

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Government bonds

In Genoa and Venice the first government bonds were issued before 1200. Citizens lend money to the communes in exchange for “shares of stock” paying regular interest. Most of them were “forced loans” with the amounts lent calculated by the communes on the basis of the citizens’ wealth. Citizens finding themselves short of cash could waive their credit to the commune to a third party - usually for a smaller amount than the sum originally lent.

In Florence, which fought expensive wars employing companies of mercenaries and artillery, public debt rose from around 50 000 gold florins in 1300 to about 450 000 in 1338 and 600 000 in 1343.

In Genoa, public debt titles were known as luoghi and traded by citizens and foreigners just like present-day securities (Cipolla).

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Marine insurance

Increasing uncertainties as the result of rising international warfare and violence throughout the Mediterranean world and western Europe and the spread of brigandage on land routes and piracy on the seas raised the demand for insurance.

In Italy, prototypes of marine insurance date back to the 13th century.

Genoa became the centre of marine insurance - a position the city maintained up to the 17th century when it was replaced by London.



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Interlude: the Champagne fairs

Paris

Lagny

Provins Troyes

Bar-sur-Aube

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In the 13th century the Champagne fairs in the European

heartland became important centres of financial activities

where merchants from Italian cities and the industrially

developing textile region of Flanders met.

The individual fairs established a continuous cycle throughout

the year.

It started with the fair of St Ayoul at harvest time in September

at Provins and continued with Troyes in November, followed

by Lagny and Bar-sur-Aube.

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The reasons for the dominant role of the fairs were:

• the counts of Champagne who were politically independent offered competitive terms to traders. They, in turn, benefitted from tolls on goods in transit and rents on halls, stables and houses, from charging license fees for economic entreprises and for seals and registering.

• The counts offered protection to the merchants from the day they set out to the fairs even negotiating with the dukes of Burgundy and the counts of Flanders to ensure the safety of their travel.

• They established a local system of justice at the fairs appointing guards to officially enforce contracts, collect fines and punish cheating.

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The role of the fairs declined mainly for three reasons:

• In 1285, the region came under the jurisdiction of the King of France and the towns lost their special status.

• When the Atlantic sea route opened Italian merchants could reach Flanders without passing through France.

• With increasing division of labour Italian companies began to establish permanent agencies in major European cities.

However, while the volume of trade at the fairs was shrinking the financial business continued until 1310/1320 - for the first time in Europe on a regular basis independent of the trade of goods.


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The rise of merchant empires

... and the threefold division of labour:

Sedentary merchants

specialising in the financing and organisation of trade

Specialist carriers

transporting the goods from principals to agents by land or

by sea

Full-time agents

resident in foreign places, selling and purchasing goods following the instructions sent

by their principals

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The second succession of financial centres: the Low Countries

Bruges

Antwerp

Amsterdam

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The Low Countries

Bruges

• The beginnings of the town’s international role date back to 957 when the counts of Flanders allowed the city to establish an annual trade fair.

• Bruges’ true rise started in 1134 when a storm changed the cost line opening a deep channel, the Zwin, which allowed the navigation of big commercial ships.

• Using Damme, and from 1290 onwards Sluis, as outports Bruges became the main trading port at the North Sea coast.

• In 1252, the town established relations with the Hanseatic League.

• Between the 13th and 15th centuries Bruges became one of the richest cities in the world.

• At its height, 16 nations were represented there, half of them from Italy.

• Economic recession and political unrest brought an end to Bruges’ predominance.

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The Low Countries

Antwerp

• In 1488, Emperor Maximilian ordered foreign merchants to shift their offices from Bruges to Antwerp.

• Antwerp was the first European town to grant almost total liberties to both domestic and foreign merchants.

• In 1518, the Antwerp exchange was founded which was open to merchants from all nations.

• In the 1570s and 1580s, the Spanish-Dutch conflict, the closure of the river Scheldt and the isolation of the town by Spanish troops put an

end to Antwerp’s supremacy.

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The Low Countries

Antwerp

One reason for the existence of fairs in the Middle Ages

had been the temporary lifting of trade restrictions.

In Antwerp, under far-reaching liberalisation almost

uninterrupted market trade became possible.

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The Low Countries

Amsterdam

• The last city in the succession of financial centres in Europe whose ambitions were not supported by a modern united state whose efforts were directed at becoming a trade and financial empire (Braudel).

• Among Amsterdam’s advantages were the port and its superiority in shipbuilding, its geographic position and its liberal

government in contrast to that of Antwerp in the conservative Spanish Netherlands.

• The Amsterdam Bourse became Europe’s leading securities market.

• European merchants concentrated their transactions in one or more specified towns known as staples and Amsterdam became the biggest staple in the western world.

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The Low Countries

Amsterdam

In 1728, Daniel Defoe described the Dutch as “the

Carryers of the World, the middle Persons in Trade,

the Factors and Brokers of Europe: ... they buy to sell

again, take in to send out: and the Greatest Part of

their vast Commerce consists in being supply’d from

all Parts of the World, that they may supply all the

World again.”

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The Low Countries

The second wave of financial innovations:

• Bruges became known as the first place to establish brokers, called

“makelaer” or “couretier”, as intermediaries.

• In Antwerp, the bond or debenture was invented: assets and liabilities

were settled by an issuer who committed himself to pay an agreed sum at

maturity to the owner of a paper that could be sold by the borrower in

the meantime.

• Another Flemish invention was the rentes, an alternative to loans to

governments which were strongly controversial in usury debates.

• Amsterdam largely contributed to stock trading becoming widely

accepted.

• Forward transactions as a specific form became a common tool of

exchange trading.

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Coin-weight box

Since coins’ intrinsic value, i.e. that of their weight in precious metal, played an important role in medieval trade money changers travelled with balance and weights, which they kept in a specially designed box.

The example on the left side is from Antwerp from 1730 and is stamped inside the lid with a printed vignette consisting of instructive texts and illustrations.

Source: http://www.nbb.be/Sg/En/Contact/33_19e.htm.

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London

With the emergence of London as the centre of

international merchant banking after Amsterdam’s decline

in the 17th and 18th centuries a new era began.

The City of London maintained its predominance until the

First World War,

temporarily lost it to New York,

and regained it in the 1960s with the rise of the

Euromarkets.

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London

There are several key developments favouring the rise of the City:

• the Navigation Act of 1651 which favoured English shipping and trade;

• the establishment of English colonies;

• the effects of the French Wars of 1793-1815 on Amsterdam;

• the migration of many Dutch commercial and banking families that stayed in London when peace returned to the low countries;

• the presence of Jewish financiers after 1066, who became the main providers of loans until the middle of the 13th century;

• the settlement of Italian and Hanseatic merchants.

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London

In the late 15th century, Italian merchants handled about a quarter of England’s overseas trade;

they dominated its banking system in using financial techniques and capital not available to native merchants and

introduced almost all institutions and instruments an organised financial market at that time required (Ingersoll).

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London

Up to the 18th century, England had neither an efficient banking system nor a well-functioning capital market.

Before the 1880s, there were two almost separate financial sectors:

the City with its highly sophisticated system of mainly foreign banks and insurance, shipping and commodity markets;

and the rather backward country banking sector.

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London

In the late 17th and 18th centuries, there were some radical changes:

• The first true English banking houses were founded around 1700 and increasingly replaced foreign institutions in international financial activities;

• the Bank of England was established in 1694 becoming the only central bank in the world producing a paper currency with a fixed and guaranteed gold value;

• since the late 17th century it became possible to buy insurance against all kinds of calamities from individual

brokers and underwriters.

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London

In the 19th century, London’s international role strengthened:

• It became common for European merchant banks to open offices in London; American banks followed;

• the Barings and the Rothshilds became the most powerful financiers in the City;

• London became the centre of international lending - mostly government and railway issues, but also mining, industry and public works, in America, Australia, Canada, India and New Zealand - with a large proportion of the money originating overseas and much of the businesses handled by London offices of American and German finance houses.

• Internationalisation was fostered by technology: The first submarine cable linking London to Paris was established in 1851, to New York

in 1866 and to Melbourne in 1872.

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Other European centres

London’s main rival in the 19th century was Paris.

Between 1850 and 1870 Paris was the first place in Europe for foreign exchange and historians emphasise its dealings with Russia and Italy.

In Germany, up to the second half of the 19th century Frankfurt was the most important financial centre

owing a great deal of its success to names as Bethmann and Rothschild. It became strong in bond trading, but lost its position to Berlin with the boom in railway stocks and the crisis of 1848, only to take the lead again after 1945.

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Meyer Amschel Rothschild (1744-1812) established the famous Rothschild dynasty in Frankfurt in 1766. He was followed by his eldest son Amschel Meyer Rothschild (1773- 1855); his other sons established banks in London, Paris, Vienna and Naples.

The parent house in Frankfurt ceased to exist in 1901; Banque Rothschild in Paris was nationalised in 1982. Rothschild banks still exist in London (N.M.Rothschild & Sons Ltd. with branches and subsidiaries in 40 countries) and Zurich (Rothschild Bank AG).

Other European centres

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The 20th century

With declining influence of the United Kingdom in the global economy and the economic and political rise of the USA London’s role as an international financial centre was weakened.

New York took the lead and maintained this position up to the stock market crash of 1929 and the following worldwide economic crisis when London temporarily regained its supremacy.

World War II brought another setback for London and New York again took the lead.

With the emergence of the Euromarkets in the 1960s the City of London became the lasting unrivalled Number One among a growing number of competitors in Europe and worldwide.

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General observations

In economic literature financial development is often regarded as a linear, stepwise process from simpler to more sophisticated forms.

Two examples:

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Financial relations

derivatives, ABS,

synthetic products

stock exchanges

bond markets

commercial banks

loans from friends and family

pawn brokers, money lenders

In history, financial relations often started with informal borrowing and lending arrangements with friends and family, followed by professional pawn brokers and money lenders and then developed into a system dominated by banks with bond and stock markets playing an ever growing role with more sophisticated financial products such as derivatives and asset-backed securities (ABS) emerging still later on.

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Development of money

In the history of money developments started with individual barter and then proceeded from crops and cattle to cowrie shells. The next steps were metal coins, followed by paper currency and, most recently, electronic money.

electronic money

paper currency

metal coins

cowrie shells

barter

cattle and crops

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A linear, stepwise process?

Development of finance:

• History shows that in western Europe financial products of varying complexity often emerged in parallel in reaction to the needs of trade and finance.

• On the other hand, even highly advanced economies long made without a fully developed financial system as the German example demonstrates.

• History also shows that the process from lower to higher sophistication is not irreversible. Examples are some of the new EU member countries.

Poland and Hungary had already well-developed stock markets at the end of the 19th century.

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A linear, stepwise process?

Development of money:

Again, the process is not irreversible.

One example from outside Europe is Japan, where mintage of coins started in the

8th century only to be abandoned again in 958 when the government forbade all

circulation of coins after 250 years of mixed success and the country returned to rice and fabrics

as mediums of exchange.

This situation lasted until in the 12th and 13th centuries merchants and smugglers

introduced foreign coins which soon became widely used and remained the main pillars

of the Japanese currency system for the next 500 years.

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Lessons from the history of financial centres in Europe?

• Long-distance trade first created the backbone along which money and credit travelled across Europe.

• The high risks involved established the need for inventing cashless means of payment, capital pooling and

insurance.

Further sources of inspiration for financial innovations were

• frequent failures as the result of excessive loans to finance wars and other rulers’ ambitions;

• speculative bubbles in financial and commodity markets;

• the prohibition of usury and other restrictions.

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The rise and decline of European financial centres was influenced by many factors:

Political and economic influences

Examples are the Spanish-Dutch conflict that put an end to Antwerp’s supremacy, or the decline of Amsterdam during the French wars.

Institutional influences

These may help explain the rise and fall of German centres in the 18th and 19th centuries which were rooted in two different developments: in the general market activities of trade fairs in towns like Nuremberg

and Augsburg, and in the guilds and merchant cooperatives found in Frankfurt, Cologne, Hamburg, Berlin and elsewhere.

Natural disasters and other “historic accidents”

One example is the storm that in Bruges in the early 12th century opened a deep channel allowing the navigation of big commercial ships which contributed to making the town the biggest trading port on the North Sea coast for many years.

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Scale economies, path dependence and lock-in

Scale economies

Broadly defined, scale economies are benefits arising from a

production of more, rather than less, allowing maintenance of a low

share of fixed costs per unit.

For example, if inventing or adapting a new product or production technique requires

significant setup costs, larger firms would, on this ground, perform better than smaller ones.

Scale economies may also arise from agglomeration effects and a concentration of activities

in one place.

A concentration of financial institutions in one location leads to improved information flows,

greater liquidity and higher efficiency in organised markets, and a centralisation of support

services, that all contribute to reduce costs.

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Scale economies, path dependence and lock-in

Scale economies are special sources of rigidities in an economy giving

rise to path-dependence and lock-in.

Path-dependence broadly means that history matters. The current international status of a financial place is depending on the advantages – and

disadvantages – it has acquired in the past and the way in which those have influenced financial

firms' location decisions.

Lock-in stands for an inflexibility resulting from this process. Even if offering high incentives for financial institutions to change location, due to long-

established bonds and customs newly emerging competitors will find it hard to succeed in

challenging the status of the Number One.

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Scale economies and lock-in explain some advantages underpinning London’s status both in Europe and worldwide.

Others are

• the existence of high quality professional and supporting services

These include accounting, actuarial and legal services, IT and the whole range of services which in the economic literature is known as producer services.

• an efficient infrastructure

This includes office accomodation and telecommunications.

• the use of the English language.

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The influence of electronic trading and the internet?

The need for financial institutions and activities to “cluster” in centres declined, but history also showed that relations between information technology and financial location are complex:

• Unlike many other sectors, in international finance IT is not a new phenomenon.

Since the invention of the telegraph in the early 19th century, financial services have always been bridging

distances using every available new medium and technology for speeding up communication and trade.

• Many financial activities continue to require proximity.

One aspect here is risk considerations and the experience that electronic surveillance is no substitute for human management. Others are the role of trust building that is crucial to many financial transactions and the need to become familiar with a special context before making financial decisions. Further arguments for an ongoing centralisation are innovation and networking and the desire to benefit from the constant presence, exchange and communication with others.

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Note that

Before 1200 Genoa and Venice both introduced the instrument

of public debt to finance infrastructure and military projects.

In the 12th century it took 30 to 40 days for wool from

Southampton to reach Porto Pisano on a Florentine galley; the

distance between Venice and Alexandria was covered in

three weeks in favourable weather - and in three months

under less favourable conditions.

In the early 14th century it took 21 days to transport coins

collected in Rouen to the Papal court at Avignon but only eight

days for a courier to deliver a bill.

Bills of exchange were traded on the fairs of Italy and the

Champagne as early as in the 12th century.

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Note that

In Italy, prototypes of marine insurance date back to the 13th

century.

The first European cities minting their own coins were Florence

(the Fiorino) and Genoa (the Genovino) in 1252.

Bank money based on fractional reserve dates back to the 14th

century with cash reserves (with central banks non-existent and surpluses

invested in rather illiquid assets) making up to 30 percent of

deposits.

By 1350, in most banking centres “manual” or “merchants’

exchange” - the exchange of coins against each other - was

replaced by deposit banking.

In the 14th century, there was a daily courier service between

Bruges and Venice overland.

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Note that

Among Bruges’ wealthiest residents was the van der Beurs

family, inn- keepers who allegedly gave their name to the later

bourse.

The first known share worldwide dates from 1602. It was issued

by the Dutch East India Company (Vereenigte Oost-Indische Compagnie,

or VOC).

In the late 17th century Edward Lloyd’s Coffee House began to

engage in the shipping business. Contrary to a widespread belief, Lloyd’s

Coffee House itself, although a central institution in London, had

never been an insurance company. Its function was comparable to that

of an exchange: to be a forum for maritime insurance business where

special “rules of conduct” prevailed.

It was only in 1863 that M.M. Warburg, formed in 1798 in

Hamburg, changed its name from money changer to banker.

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Key Words Bank - rooted in the benches or “bancos” Italian merchants established at European

trade fairs in the middle ages.

Bourse - An organised market or exchange located in a building or regular meeting

place for trading financial products such as securities and foreign exchange.

Contratto di commenda - developed in Italian cities from the tenth century onwards,

forerunner of the joint-stock companies, a form of limited-liability partnership to

share economic risk enabling people to use their savings to invest in long-distant trade.

Usury - an ecclesiastical doctrine, developed in Europe from the ninth century

onwards, which condemned loans at interest.

Rentes - a financial product first appearing in Flemish towns in the 1270s developed

from an older medieval contract, the census, of probably feudal origins. Initially, the

census was a means by which the a landowner or peasant could acquire some capital

while the investor received a guaranteed annual income, either perpetual, or at least

for a lifetime without expecting repayment. Rentes represented the purchase of a future

stream of income. The modern English term coming closest is annuity.

Chapter 2 - European Financial Markets in History

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