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

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

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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.

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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).
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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.

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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
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

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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.
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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.

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

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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.

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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
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
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The Low Countries

• Bruges
• The beginnings of the towns 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 Antwerps 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 Amsterdams 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 Europes 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 supplyd 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.

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.
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London
With the emergence of London as the centre of
international merchant banking after Amsterdams
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 Englands 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.

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London

• In the 19th century, Londons 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
Londons 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 Londons 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.

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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.
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 Politica
l and economic influences Examples are the
Spanish-Dutch conflict that put an end to
Antwerps 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.
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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 Londons 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.

51
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.

52
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 Lloyds Coffee
  House began to engage in the shipping business.
  Contrary to a widespread belief, Lloyds 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.

53
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.