by Felix Martin
This was the system of which the paper-pushing Italian was a part—and it was every bit as mysterious and confusing to the uninitiated as the global financial markets of today. In place of the vigorous and venial atmosphere of the fairs of yesteryear—the ambience of a gigantically exaggerated local market day, complete with fireworks and bonfires, gambling and girls, tumblers, tightrope walkers, and tooth-pullers—there were merely the etiolated shades of the merchant bankers with their ink-stained fingers and incomprehensible account books. Nothing real changed hands except bundles of bills. Commerce had become a branch of mathematics. The standard textbook on the subject, published in Venice in 1494 by the Franciscan friar Luca Pacioli, was called De Arithmetica—“On Arithmetic.” Most observers found the activities of its practitioners “a difficult cabbala to understand”: the fact that it led so mysteriously but inexorably to enrichment without apparent exertion was baffling.5 Five hundred years later, the reaction of one fictional everyman to the most recent financial revolution was uncannily similar:
Her English husband Ossie, now he’s rich-for-life but he works in money, in pure money. His job has nothing to do with anything except money, the stuff itself. No fucking around with stocks, shares, commodities, futures. Just money. Sitting in his spectral towers on Sixth Avenue and Cheapside, blond Ossie uses money to buy and sell money. Equipped with only a telephone, he buys money with money, sells money with money. He works in the cracks and vents of currencies, buying and selling on the margin, riding the daily tides of exchange. For these services he is rewarded with money. Lots of it.6
The merchant banker, for whom commerce had become a branch of mathematics, depicted in a sixteenth-century German print.
(illustration credit 6.1)
As the scandal of 1555 demonstrated, bafflement could easily turn to resentment. However difficult to understand in its details, the system of credit regulated by the fairs and their participants was commonly understood to be the pinnacle of the new system of monetised exchange that was increasingly governing even the humblest farmer’s life. But such a general understanding only went so far. Numerous questions remained to nag the suspicious mind. What exactly did the merchants do with their bills of exchange, and why did it give them such enormous influence over the lives of people who never set eyes on their exclusive conclaves? How and why did it make them so rich? And how did the emergence of these powerful and unaccountable parliaments of merchants relate to the established political powers of the day—the sovereign, the nobility, and the church? It took better informed and more financially literate observers to solve such riddles.
These were few and far between; but they did exist. Claude de Rubys—a retired crown official who wrote a history of the Lyons fair in 1604—observed that the most remarkable feature of the great fair at Lyons was the way in which it enabled such a huge volume of trade to be settled without the use of cash. It was not unusual, he wrote, to see “a million pounds paid in a morning, without a single sou changing hands.”7 In other words, tens of millions of pounds’ worth of business was being done, with the sovereign’s money almost nowhere to be seen. The great merchant houses of Europe had rediscovered the art of banking—how to produce and manage private money on an industrial scale.
THE SECRETS OF THE PYRAMID
The new medieval mercantile classes faced in essence the very same problem that their modern counterparts faced in the disintegrating Soviet Union, in Argentina after its crisis, or in Greece today: how to operate a monetary economy when the sovereign’s interests diverged from their own. They too yearned for a Utopia in which there would always be just enough money to satisfy the needs of trade, and in which the sovereign would not take advantage of his seigniorage prerogatives to extract unwarranted revenue. They had tried persuasion, in the guise of Oresme’s ingenious arguments, but that had not worked.8 The alternative, as in the latter-day cases of the Monetary Maquis, was rebellion.
The obvious means of escape was via the creation and clearing of private networks of mutual credit. Wherever merchants had dealings, it was natural for them to accumulate credit and debit balances against their clients and suppliers—and as far as possible to offset them and carry forward the residuals on an ongoing basis, rather than to settle every invoice back and forth using the sovereign’s coin. As we saw, though, the problem with such mutual credit networks is that natural limits to commercial and personal familiarity and the fragility of confidence impose constraints on scale. They cannot function as mechanisms to organise a whole economy: in the real world, only the money of the sovereign enjoys sufficient currency for that. This was the unfortunate problem that had confronted the sponsors of Nicolas Oresme. They might not have liked the way the sovereign managed his money—but the only alternative was hardly up to supporting the growth of the new commercial economy.
As their operations increased in size and complexity, the great merchant houses of Europe realised that there was, however, an intermediate option. What they rediscovered was the possibility of a hierarchical organisation of credit. A local tradesman’s promise to pay might not be worth much beyond his small circle of suppliers and clients. But the promise of one of the international merchant houses, with their much larger volume of trade, their great stocks of reserves, and their long histories of success, was a different matter. If a great merchant substituted his word for that of a local tradesman, an IOU that might previously have circulated at most within the local economy could be transformed into one that could circulate anywhere where the great merchant’s prestige was acknowledged. A pyramid of credit could be constructed, with the obligations of local tradesmen as the base, larger wholesalers in the middle, and the most exclusive, well-known, and tight-knit circle of international merchants at the top. The international merchant house could interpose itself, in other words, between local merchants and their ultimate counterparties—and in doing so, transform inert, bilateral promises to pay into liquid liabilities that could easily be assigned from creditor to creditor and so circulate as money wherever the great house’s credit was current. The private trade credit of even the humblest local merchant, in other words, could break its parochial bounds and, endorsed by a cosmopolitan mercantile name, become good to settle payments on the other side of Europe, where its original issuer and his business were entirely unknown.
It was here—in the creation of a private payments system—that the invention of modern banking originated. Such a humble birth may sound disappointing. Today, the banking sector’s unglamorous routine of providing payment services takes a distant second place in the popular imagination to the exciting businesses of lending and trading. But their ability to finance and settle payments is the more fundamental activity. This is banks’ specifically monetary role, and what makes them special. A bank is in essence an institution which writes IOUs on the one hand—these are its deposits, its bonds, its notes; generically, its liabilities—and accumulates IOUs on the other—its loans and its securities portfolio; generically, its assets. Every business has some promises to pay outstanding to suppliers, and owns some promises to pay from customers. But for most businesses, these financial assets and liabilities—the firm’s accounts receivable and payable, as they are called in the book-keepers’ jargon—are dwarfed by the value of the business’ real assets: its plant, its premises, its inventory, and so on. In a bank, it is the other way round. The mysterious Italian at the fair of Lyons is entirely representative. A bank’s real assets are always negligible. The balance sheets of modern banks are vast: in 2007 the balance sheet of a single British bank, the Royal Bank of Scotland, was larger than the GDP of the entire U.K. No manufacturing business could ever accumulate assets of this magnitude. The reason that a bank can do so is that almost all its assets are nothing but promises to pay, and almost all its liabilities likewise.
As we have seen, any IOU has two fundamental characteristics: its creditworthiness—how likely it is that it will be paid when it comes due—and its liquidity—how quickly it c
an be realised, either by sale to a third party or simply by coming due if no sale is sought. The risks associated with any promise to pay depend upon these two characteristics. Accepting a promise to pay in a year’s time entails more risk than accepting a promise to pay tomorrow: a lot more can go wrong in year than in twenty-four hours. This is the dimension of liquidity risk—so called because unless it can be sold in the meantime, a private promise to pay only becomes liquid at the moment it is settled in sovereign money. Then there is the possibility that the IOU’s issuer will not be able to pay at all, regardless of the time frame. Accepting a promise to pay from a NINJA—the banking industry acronym for someone with No Income and No Job or Assets—is more risky than accepting a promise to pay from Warren Buffett. This is the dimension of credit risk.
The whole business of banking resolves into the management of these two types of risk, as they apply both to a bank’s assets and to its liabilities. Banks transform uncreditworthy and illiquid claims on the assets and income of borrowers into less risky and more liquid claims—claims which are so much less risky and so much more liquid that they are widely accepted in settlement of debts. They achieve this miraculous transformation through their management of the credit and liquidity risks of the loans they make to governments, companies, and individuals, on one side, and of the credit and liquidity risks of the obligations they owe to their depositors and bondholders on the other.9
The management of credit risk—working out which borrowers are NINJAs and which are Warren Buffetts, devising the best combination of borrowers in the overall portfolio, and monitoring borrowers over the lifetime of their loans—is the most obvious part of what banks do. But it is not the most important part.10 Strip a bank’s balance sheet back to its bare bones, and the simplest form of banking, the form practised by the most risk-averse of banks, is the short-term financing of trade. In this kind of banking, credit risk is minimal: loans are usually extended simply to cover the purchase and transport of goods for which a sale has already been agreed, and the goods themselves are often used as collateral. With sufficient insurance, the bank might even eliminate the credit risk altogether. The risk it can never get rid of, however, is liquidity risk. Even in the short-term financing of trade, when the loan is only for the days or weeks it takes to bring the goods from the producer to market, the banker is making a commitment for a definite length of time. And on the other side of its balance sheet it has its own liabilities—its deposits, bills, and bonds—which are coming due. When the higher complications of credit risk are absent, the essence of the banker’s art comes into focus. It is nothing more than ensuring the synchronisation, in the aggregate, of incoming and outgoing payments due on his assets and liabilities—which are themselves, of course, the aggregated liabilities and assets of all his borrowers and creditors. This was the art that the great international merchants of the Middle Ages had rediscovered.11
Within domestic economies, the effects of this rediscovery began to be felt as early as the twelfth century. By the end of that century, in the Italian maritime city state of Genoa, merchants had founded local banks that both kept accounts for clients and maintained accounts with one another, so that payments could be made across the system, from the client of one bank to the client of another.12 By the fourteenth century, payment via such bank transfers was the preferred method of making any sizeable payment in Florence; and there were as many as eighty banks offering the service.13 To the extent that the account-holders were required to present themselves at their bank to approve payments—as was the case, for example, in Venice—the system remained limited by a degree of inconvenient centralisation. But by the mid-fourteenth century, payment by cheques and other written IOUs was becoming common in the city states of Tuscany, in Genoa, and in Barcelona. Such written instruments could circulate amongst the merchant community without notarisation at the bank, before being presented for redemption. Thus they facilitated fully decentralised clearing, just as the sovereign’s coinage did. The first example that survives—a cheque drawn by the aristocratic Tornaquinci family of Florence on their bankers the Castellani—dates from 1368, less than a decade after Oresme addressed his Treatise to the Dauphin Charles.14 Even as Oresme was pleading for more equitable management of the sovereign’s money, the new mercantile class was devising ways to escape its tyranny altogether.
Operating as it did within the jurisdiction of a given sovereign, the business of domestic banking was subject to the close attention of the political authorities, however. The resuscitation of a profession which specialised exclusively in financial transactions revived ancient suspicions. The medieval schoolmen, starting with St. Thomas Aquinas, devoted the majority of their writings on money to parsing Aristotle’s condemnation of lending at interest as unnatural. Even Oresme, the champion of the new monetary rentiers, was quick to criticise the “money-changers, bankers or dealers in bullion” who “augment their own wealth by unworthy business … a disgraceful trade.”15 Then there were the ominous lessons of the potential macroeconomic risks associated with large-scale banking contained in ancient texts like Tacitus’ account of the Tiberian financial crisis. Above all, there was the sovereigns’ interest in ensuring the continuing priority of their money, and hence their seigniorage. As a result, the new invention of banking was subjected to draconian regulation. When in 1321 the authorities in Venice discovered that merchants were practising fractional reserve banking—holding only a small proportion of their assets in coin of the state—they passed a law specifying that banks must be able to meet all requests for withdrawals in coin within three days.16 In the same year the Catalonian authorities revised their 1300 order that failed bankers be forced to live on bread and water alone until all their clients were reimbursed. Henceforth, any banker who failed to meet his clients’ demands was to be publicly denounced—and then summarily beheaded in front of his bank. It was no idle threat, as the hapless Barcelona banker Francesch Castello discovered in 1360.17 Under such uncompromising regulatory regimes, domestic banking really was a risky business.
Conditions were altogether more propitious in the parallel world of international banking. To begin with, international trade was the most dynamic part of the medieval economy: the aristocracy benefited first from the monetisation of feudal relations, and it was their taste for foreign luxuries that drove high-value commerce. What’s more, the great merchant house, with its resident agent in the foreign jurisdiction, its extensive operations in both countries, and its new expertise in banking, could supply the local merchant both with credit and with foreign exchange services. But most important of all, there was, by definition, no sovereign authority to regulate commerce between countries, and no sovereign money with which to transact. So it was here, in the international sphere, that banking’s potential to accelerate the commercial revolution was first fully realised. The central innovation was the perfection, by the mid-sixteenth century, of the system of “exchange by bills”: a procedure for financing international trade using monetary credit issued by the clique of pan-European merchant bankers, denominated in their own abstract unit of account, recorded in bills of exchange, and cleared at the quarterly fair of Lyons.
The system was simple.18 An Italian merchant wishing to import goods from a supplier in the Low Countries could purchase a credit note known as a bill of exchange from one of the great Florentine merchant houses. He might pay for this note either in the local sovereign money or on credit. By buying such a bill of exchange, the Italian merchant achieved two things. First, he accessed the miracle of banking: he transformed an IOU backed by only his own puny word for one issued by a larger, more creditworthy house, which would be accepted across Europe. He transformed his private credit into money. His second achievement was to exchange a credit for a certain amount of Florentine money into one for a certain amount of the money of the Low Countries where he was making his purchase. The bill of exchange itself was denominated in a private monetary unit created specially for the purpose by the ne
twork of exchange-bankers: the écu de marc. There were no sovereign coins denominated in this écu de marc. It was a private monetary standard of the exchange-bankers alone, created so that they could haggle with one another over the value of the various sovereign moneys of the continent. Somewhat bizarrely to modern eyes, the foreign exchange transaction included in the bill of exchange therefore involved two exchange rates—one between Florentine money and the écu de marc, the other between the écu de marc and the money of the Low Countries.
The end result was to overcome a previously insurmountable series of obstacles. The exchange-banker would accept the importer’s credit in payment, knowing him and his business well from the local market. Meanwhile, the supplier in the Low Countries would accept the exchange-banker’s credit as payment, knowing that it would be good in its turn to settle either a bill for imports or for some local transaction—and satisfied that he was being paid in the local money. Of course, the banker ran the risk that the exchange rates of the two sovereign moneys against the imaginary écu de marc might change in between his issuing the bill of exchange and its being cashed in the Low Countries, but he made sure that his fees and commissions made this a risk worth taking.19
As they continually wrote and accepted bills of exchange to finance trade between the great European cities, the exchange-bankers would accumulate credit and debit balances. The circle of exchange-bankers was a close-knit one, and willingness to allow outstanding balances to build up was therefore high. Nevertheless, to ensure a clear picture of who owed what to whom, it was necessary to have periodic offsets. These could be done bilaterally on an ad hoc basis; but the regular fairs provided a natural opportunity for a more generalised clearing—and this is precisely what they gradually became. Every quarter, the clique of great merchant houses would meet at the central fair of Lyons in order to square their books. On the first two days of the fair there was a frenzy of buying and selling, of writing new bills or cancelling old ones, at the end of which all delegates’ books were closed for the quarter and the resulting balances between the houses were verified. The third day—the “Day of Exchange”—was the heart of proceedings. The exclusive cadre of exchange-bankers would convene alone to agree on the conto: the schedule of exchange rates between the écu de marc and the various sovereign moneys of Europe. This schedule was the pivot of the entire financial system, since it was at these exchange rates that any outstanding balances had to be settled on the final day of the fair—the “Day of Payments”—either by agreement to carry over balances to the next settlement date, or by payment in cash.20
