Chapter 2 - European Financial Markets in History

1. Chapter 2 - European Financial Markets in History

2. 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

3. The early beginnings 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 journeys • increasing 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 empires • division of labour in long-distance trade • emergence of dominant cities 10th century 12th century 15th century

4. The early beginnings The first financial centres: Italian cities Venice Genoa Florence

5. The early beginnings The first financial centres: Italian cities • 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.

6. The early beginnings The first financial centres: Italian cities • 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.

7. The early beginnings The first financial centres: Italian cities • 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.

8. The early beginnings The first financial centres: Italian cities 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).

9. The early beginnings The first financial intermediaries: • Pawnbrokers • Small 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. • Bankers • From 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.

10. 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

11. The early beginnings The first financial innovations: • Bank money based on fractional reserve • Bill of exchange • Limited-liability partnership • Coins • Cheques • Government bonds • Marine insurance

12. The early beginnings The first financial innovations: 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.

13. The early beginnings The first financial innovations: • Bill of exchange • The 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.

14. The early beginnings The first financial innovations: 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.

15. The early beginnings The first financial innovations: 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).

16. The early beginnings The first financial innovations: 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.

17. Interlude: the Champagne fairs Lagny Paris Provins Troyes Bar-sur-Aube

18. Interlude: the Champagne fairs 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.

19. Interlude: the Champagne fairs • 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.

20. Interlude: the Champagne fairs • 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.

21. The rise of merchant empires • ... and the threefold division of labour: Sedentary merchants specialising in the financing and organisation of trade Full-time agents resident in foreign places, selling and purchasing goods following the instructions sent by their principals Specialist carriers transporting the goods from principals to agents by land or by sea

22. The second succession of financial centres: the Low Countries Bruges Antwerp Amsterdam

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.”

28. 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.

29. 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.

30. 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.

31. 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.

32. 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).

33. 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.

34. 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.

35. 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.

36. 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.

37. Other European centres 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).

38. 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.

39. General observations In economic literature financial development is often regarded as a linear, stepwise process from simpler to more sophisticated forms. Two examples:

40. Financial relations 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.

41. 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.

42. 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.

43. 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.

44. 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.

45. Lessons from the history of financial centres in Europe? 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.

46. Lessons from the history of financial centres in Europe? 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.

47. Lessons from the history of financial centres in Europe? 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.

48. 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.

49. 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.

50. 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.