Banks and their environments.
Sten Jönsson
GRI
- reflections on a set of book reviews
Gothenburg University
Introduction
Part of our efforts to gain some knowledge of bank management against the background
of the recent financial crisis, which cannot be described other than as a gigantic
management failure 1, is to study the history of banks in their environment. The
knowledge we gain from such studies may have the form of book reviews and related
reflection as in this report.
- Book Review 1 (by Sten Jönsson)
Raymond de Roover, (1963), The Rise and Decline of The Medici Bank. Cambridge,
Mass.: Harvard University Press.
This book is a classic written by the Belgian de Roover, who worked as an accountant in
a bank and then in a shipping company before travelling to the USA to get an MBA at
Harvard in 1938. He received his PhD at the University of Chicago. He has published on
the history of banking, negotiable instruments, and accounting. Mrs Florence de Roover,
a renaissance scholar, introduced her husband to the Medici archives and helped him
with critical reviews.
The book is a classic in business history and is focused on and based in archival work.
The institutional background (e.g. usury, the money-changers guild, catasto (income
return for taxation)), the antecedents to the starting of the bank, the glorious days of
Medici under Cosimo’s directorship, and the organization of the bank (in many aspects
similar to Handelsbanken) are described. This first section is followed by a description
1
Markets do not fail, they emerge as large numbers of reasonable actors enter into exchange to improve
their lot. Markets do not do much – and they certainly do not know how to set the right price!
1
of the money market of the times (bills of exchange), the Medici as Merchants (alumn
and iron), and as industrialists (wool and silk), and as bankers to the Pope. Three
chapters are devoted to the different branches throughout Italy and Europe. A final
chapter tells the story of the decline of the Medici bank.
Institutional background
From the Crusades to the Great Discoveries Italy was the dominant economic power in
the western world. Merchants were the middlemen of spices from the Levant, silk, cloth,
wool. Banking prospered with trade since the transfer of payment for goods best was
accomplished through bills of exchange (transporting money over land or sea was
risky). In bank dense Florence and some other centres there even was a market for
those financial instruments. The Italians were good at organizing business in
partnerships (the Medici bank was organized as a holding company), they had double
entry book-keeping, and introduced what could be seen as insurance for marine
transports. They developed a body of mercantile law. The Florentine were global
businesses with as many as 90 employees in branches across Europe. The Medici bank is
remarkable because of its good archive; up to 1450 there are an unbroken series of
account books (confidential ledgers). After 1450 the material is largely business
correspondence. The Medicis are known for their role in Art and politics as well. As a
matter of fact it seems like their politics was the cause of the decline.
The institutional background to consider is the problem that the Church forbade the
taking of interest (usury). The banks solved this by focusing the business on Bills of
Exchange (sometimes “dry”, i.e., without any goods transaction behind it). Fees were
included and profit from differences in exchange prices of currencies (Florins were
higher valued in relation to the pound in Florence than it was in London). A permanent
problem throughout was the unbalanced trade (from Italy to Northern Europe, plus the
flow of payments to the Vatican).
As bankers Medici had to be members of the Money-changers Gild. De Roover notes that
the regulatory power of the Gild was rather limited and it did not interfere much in daily
business.
There was a direct tax in Florence based on individual tax returns (catasto), which
should not be expected to lead to overvaluation of assets.
2
The global firm of the 15th century.
The Medici bank, like many of its competitors, had branches in many centres of
commerce across Europa. From a modest beginning in Italy (branches in Florence,
Rome, Naples, Venice) in the early 1400s it expanded to 13 businesses in 1450
(branches in Ancona, Avignon, Basel, Bruges, London (subordinated to Bruges, Florence,
Geneva, Pisa, Rome, Venice, Woolshops 1 and 2, and a silkshop in Florence). The
executive managers of the different branches were usually co-owners, and their duties
were regulated in detail in management contracts for up to 5 years (which could be
terminated by the principals (maggiori) at any time). It was quite common that the
branch managers had a share in profits (and losses) that was larger than their
ownership share. A factor was a manager who was authorized to enter binding deals for
the firm. It was not the signature alone but the whole text of a Bill of Exchange that had
to be written in the factor’s hand to be valid. A factor could be promoted to partner
(invest his own money in the branch) and employees were groomed by being sent to
different branches to learn the business. Employment was closely monitored by the
principals and was largely based on family and trust. The legendary Cosimo was not
sentimental about dismissing non-performing managers, but his successors seem to
have been too tolerant for the good of the firm, which contributed to the fall of the bank.
In cities where Medici had no branch of their own they did business through
representatives or silent partnerships.
The Rome branch was somewhat different from the other branches in that it was run
without capital. This was a result of the flow of funds in this century, inward toward the
pope, and of the fact that members of the Vatican court deposited money with the bank
(against other remuneration than interest – usury).
The instrument on which most of the banking business was built was the bill of
exchange. The basic value of this financial instrument was that it was a much safer way
of transporting payments across Europe (land or sea). For this to function smoothly
there had to be a money market that could liquidate such instruments (and provide for
some trade credit). The power of the Italian banks in Europe came from this money
market effect – there were several dozens of banks in Florence at the time. The Hansa
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League had, according to de Roover, a much clumsier and slow way of dealing with
payments and could not compete in Western Europe (except perhaps in London).
Trade was the very reason for doing banking business. As mentioned Medici had two
wool shops and one silk shop during most of its lifetime. One could see that good
management made a difference by comparing the two wool shops in Florence. The best
wool was imported from Britain, which was difficult business since the King would
control the trade and collect custom fees (or borrow money on the promise for the
lender to collect fees during a certain period). The Medicis also had trade in materials
like alum, which was used to clean wool. However, contracts with the pope to secure
monopoly in (sometimes threatened by the Turks) did not work out so well. Political
games were frequent around trade. The most dramatic, and one reason for the decline of
the bank, was the ill-conceived strategies of its representative in Brügge, Portinari (who
had intrigued his way to the top there). The issue of appointing Portinari to manager in
Brügge came up in 1464, the year Cosimo died. The contract was written by Piero
(Cosimo’s elder son) in 1965. Both of them hesitated because they considered Pontiari
too reckless in business. Once installed he ventured into projects like buying the rights
to the toll on wool at Gravelines (bordering on the English enclave of Calais) hoping to
collect on all import to the Low Countries now that the Duke of Burgundy had banned all
English cloth from his dominions. Unfortunately he did not include English counter
measures in his calculations. Furthermore he persuaded the Medici to buy two
Burgundian galleys, surplus material from the Burgundian fleet now that the crusade
against the Turks did not materialise due to the death of the pope (Pius II). Those galleys
were costly and difficult to fill with cargo both ways as required for profitability. Brügge
and its relation to London was a constant problem to the maggiori.
The decline
During Cosimo’s reign the Medici policy was to avoid lending money to princes, or the
court (the state as it were) because princes often had no intention of repaying. Still
Cosimo was not foreign to use his financial resources politically. He avoided death by
bribes, but was expelled from Florence in 1433, when his enemy Rinaldo degli Albizzi
had him arrested and argued for execution – only to be called back a year later. Florence
was involved in complex and shifting alliances and wars at the time (Machiavelli, 2010).
4
When Cosimo died in 1464 the Medici bank was already past its prime. His older son
Piero had been trained in politics rather than banking. Machiavelli (2010) claims that
Piero caused discontent and many business failures by calling many outstanding loans.
De Roover (1963) says, true that Piero initiated an audit to see what state the business
was in and that audit revealed that the bank was in poor condition. He therefore took
steps to close down the Venice branch that was unprofitable, and he sent Tani to try to
solve the London problem by negotiating a deal with Edward IV. He also ordered the
Milan branch to reduce its loans to the Sforza court. Still de Roover maintains that it is
doubtful whether the retrenchment of the Medici bank was the cause of “the epidemic of
bankruptcies which broke out in Florence shortly after Cosimo’s death” (p. 359). It was
rather that many of the firms that went bankrupt had business with the Levant, which
was cut off with the war between Venice and the Sultan that lasted between 1463 and
1479.
There was more to come. Piero died already in 1469, and was succeeded by his sons
Lorenzo and Giuliano, aged 21 and 18, who necessarily became dependent of their
father’s advisors. Lorenzo soon developed into a gifted politician but was not interested
in banking. He relied completely on Francesco Sassetti, a long term employee, who
became the real manager at the headquarters. Due to Sassetti’s policy of allowing branch
managers too much room for extravagant manoeuvres the “maggiori” lost control of the
Medici group and mismanagement in some branches was allowed to go on for too long.
The Brügge branch and Portinari has been mentioned above (his brother Pigello was not
much better as manager in Milan as he got entangled in ever increasing loans to the
Sforza court). The other cause of decline was the Lyon debacle of Lionetto de’ Rossi.
Up to 1463 the leading fair for merchants had been Geneva, but that year the French
king Louis XI issued a decree that exempted all merchants that came to Lyon from toll.
Medici’s Geneva branch moved to Lyon in 1466 to be where the business was. The name
of the branch became Francesco Sassetti & Co (although the Medici provided 66 % of the
capital. At first the Lyons branch was successful, but soon the first branch manager was
expelled from France (for supporting enemies of the King). The second managers died
within a year, and the third manager, appointed in 1470) was the infamous Lionetto de’
Rossi, who had been a factor with the branch (first in Geneva and then in Lyon) since
1453. The first sign of problem appeared in 1976 where headquarters complained that
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the balance sheet submitted by Rossi was “too full of slow debtors and stocks of
merchandise”. An intervention from Leonardo made him promise to mend his ways, but
soon, by 1480, the balance sheet showed a loss and Medici’s agent in Montpellier
(Lorenzo Spinelli) was sent to investigate. Rossi did not like Spinelli’s spying on him. In
1482 Rossi sent two balance sheets, one to Sassetti and one to Lorenzo (this one with
lots of explaining text). Rossi claimed that business had picked up and the future looked
bright. He had managed to collect a lot of bad debts and build reserves. The letter to
Lorenzo contained a number of accusations against Sassetti. The real problem was that
Rossi had come into the habit of drawing on the Rome branch for payments but fail to
remit promptly. Rome complained but matters soured when that branch refused to
honour a draft by a French merchant on the Lyon branch. Another set of accounts sent in
1984 claimed that the Lyon branch was now free of bad debts and generated a profit.
Spinelli was sent to investigate again and found Rossi “out of his senses”. Lorenzo trying
to mediate called Rossi to Florence for a conference. Rossi took his time to set out on the
trip. When he arrived, months after being called, he was put in the debtors’ jail. An audit
of the books showed manipulation and a frightening loss. Spinelli was persuaded to take
over and clear things up, which were a formidable task since “the maggiori” were slow
to provide fresh capital at the same time as they insisted on reducing debt. Turnaround
by entrenchment is not an easy task. Sassetti, who had a (-n arrogant) son at the Lyon
branch promised to stay on as manager at headquarters until the mess was cleared up.
He visited the branch from May 1488 and found improvement and helped restore
confidence. His departure was delayed for different reasons. A new management
contract was set up in February 1489, but Sassetti died soon after his return to Florence,
in March 1490. Soon Lorenzo de Medici also died and the entire Lyon branch was
expelled from France as a result of new hostilities between the French king and
Florence. After the failure of the war efforts of the king Spinelli and staff returned to
Lyon but were unable to run a profitable business without capital.
The fate of the Lyon branch illustrates how accounting fraud undermines trust and how
difficult it is to re-establish trust by the new regime when there is insufficient capital
infusion.
Lorenzo devoted his energy to try to save the bank from 1478 until 1494 when the
Medici rule of Florence was overthrown and all property seized. Giovanni Tornabuoni
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and his son were charged with continuing to run the bank but without capital it soon
perished.
It should be mentioned, to illustrate business conditions of the time that the Pazzi bank,
probably the second largest bank in Florence, saw what trouble the Medici bank was in.
Was it heading toward bankruptcy or did it need a push? The Pazzi conspiracy was
based in the idea that by toppling the bank one could also remove the Medicis from
political power. There was an attempt to assassinate the two Medici brothers (Lorenzo
and Giuliano) in a church in April 1478. Giuliano was murdered but Lorenzo escaped
with his life…
What one can learn from Medici:
1. The Medici bank was run on trust with branches given much leeway during the
growth period under Cosimo. Still Cosimo was a strong willed and watchful “maggiore”.
He had a co-manager (Benci) who matched him in diligence. Lorenzo de Medici had a co-
manager too (Sassetti) but did not pay much attention to banking during the first decade
of his reign. A key to success for Cosimo seems to have been careful selection of trusted
branch managers and a watchful central eye on branch performance.
2. The lack of loyalty of some branch managers (Portinari and de’Rossi) resulted in
accounting fraud that was dealt with all too leniently; Lorenzo claiming that he “did not
understand these things” by a second-in-command principal.
3. Mismanagement, which included tying up capital in bad debts (sovereigns not
intending to pay but to borrow more against promises of future cash flows like toll
income) and merchandise, made the bank vulnerable to declines in business due to the
war between Venice and the Sultan.
4. Involvement in politics and establishing bonds with power centres are risk
generators.
Reflections concerning the roots of banking:
It seems to me, reflecting on the fate of the Medici bank and many other banks in
Florence, that banks prosper when they develop in some kind of symbiosis with some
other vital type of activity. In the Medici case it is trading that id the host activity. The
7
bank assumes risk against a fee and prospers as trade grows. The mechanism whereby
this happens is simple; the seller of goods to some distant buyer does not want to let go
of the goods until he has received payment while the seller mirrors this feeling in that he
does not want to pay until he has received the goods. The bank intercedes with a bill of
acceptance that provides payment in advance to the seller and sets transportation to the
buyer in movement. This will take some time – wool from England to Florence will take
90 days all in all – and during that time the bank’s money is tied up in the transaction. A
fee is in order. Furthermore there is a currency exchange gain to be made since the
English value their currency higher than the Florentines do (and vice versa). The bank
will do this risk taking well if it has well informed and connected representatives in both
destinations who know the character of the parties involved. As the volume of trade
grows the portfolio of accepted bills of exchange may grow. There will be enough capital
generated to set up business in other trade centres or contract agents to represent the
bank. The temptation to grow is there and the need for capital to cover irregularities in
the discipline of payment (credit losses) grows. As the volume gets big the number of
clients grows and soon a fair proportion of the clients are subject to similar risks. Like
when Venetian traders specializing in trade with Mesopotania find that the Sultan has
started a war with Venice and all trade is cut off from its sources. Their banks will fail. Or
when a bank, flattered and amazed by the splendour of the court, decides to grant too
big a loan to the sovereign – who does not really have any intention of repaying (not
now anyway, the loan is a matter of financing a war) – and finds repayment dependent
on the winds of politics.
Let us look upon the symbiosis between banking and economic growth.
Book review 2 (by Sten Jönsson)
Banking and economic development – Some lessons from history.
Edited by Rondo Cameron
Oxford University Press. New York 1972.
What was the role of banks in early industrial development in different countries with
their different settings? This is the theme of this volume of essays on some countries
8
that “failed” (Austria 1800 – 1914, Italy 1861 – 1914, Spain 1829 – 1874, Serbia 1878 –
1912) and some that were successful (Japan 1868 – 1930, Louisiana 1804 – 1861, The
USA 1863 – 1913).
A common theoretical frame for the essays, presented by the editor in the introductory
chapter, is the Gerschenkron hypothesis (1962). Gerschenkron saw industrialization as
a process that spread from England and any country’s backwardness in relation to
England varies directly with its distance to England. His hypothesis is that “Depending
on a given country’s degree of economic backwardness on the eve of industrialization,
the course and the character of the latter tended to vary in a number of important
respects.” (Gerschenkron, 1962, p.353). Six ways of deviation from the English pattern
depending on the degree of backwardness are mentioned:
1. The country experiences a discontinuous sudden spurt and high rate of growth in
manufacturing output.
2. Its emphasis is on large scale of both industrial plant and enterprise.
3. Its emphasis is on producers’ rather than consumers’ goods
4. It puts greater pressure upon levels of consumption
5. The more backward the country is …. “the greater…. [is] the part played by
special institutional factors designed to increase supply of capital to nascent
industries and, in addition, to provide them with less decentralized and better
informed entrepreneurial guidance.”(Gerschenkron, 1962, 353f)
6. It leaves a smaller role to agriculture.
Cameron points out that it is deviation 5 that is of special interest in this book.
The prototype, England, started out with relatively small enterprises that required little
capital or specialized entrepreneurship. Initial capital was provided by the
entrepreneur’s own savings (and those of friends, relatives, suppliers etc). Growth
stemmed from reinvested profits. No outside source of capital was needed.
But for Germany, that came later, technology and markets were more complex and size
mattered. Because of the larger investment required and since entrepreneurs and
“liquid capital” were less abundant banks became a prime source of entrepreneurship as
well as capital. It was investment banks that indicated growth paths and provided advice
for technological advance. The backbone of the German banking system came to be
“universal” banks with board membership and “cradle to grave” business relations. In
9
this perspective the two-level system with an inner executive and a more advisory board
(Aufsichtsrat) made sense.
Russia, to take Cameron’s last summary example, was even more backward than
Germany lacking also a proper banking system. Here the imperial government played a
major role in initiating large-scale, capital intensive industries in the late 1800s. These
industries could, in their first spurt of development nurture banks that could start to
play a role similar to their German colleagues in later stages.
This kind of reasoning by Gerschenkron was persuasive and was soon established as the
standard approach to economic development. But there were some problems; first
Gerschenkron seemed to have misunderstood the English banking system – it was
legislation that limited bank participation in industry investment by local banks. As for
Germany he was right in the description of the role of banks but wrong when It comes to
the lack of entrepreneurship. In fact many of the most notable industrial firms predate
the joint stock banks. And why did Germany succeed where Austria failed although they
had similar initial conditions?
True that the government in Russia took initiatives but it was in the form of public
relations campaigns to enlist support for industrialization. Railway construction was
important but it never exceeded 5 % of the government’s budget. The real agents of
industrialization were entrepreneurs, engineers and investors, many of them foreign.
Given these unique explanations for Germany and Russia it is difficult to see how a
standard model a la Gerschenkron’s thesis could be applied to all countries.
What we see in this book is an effort to expand and develop the Gerschenkron approach.
There are a number of cases to consider:
Austria 1800 – 1914
For Austria there is a period of several decades of industrial growth following the
Revolution of 1848, called the “Gründerzeit” followed by a crash in 1873 with a long
recovery period. From 1880 industrial output increased but growth was slow up to
1896 that saw an upswing that ended in the European depression of 1900. From 1903 to
the beginning of the First World War there was renewed growth. The Gerschenkronian
10
“spurt” that can be found for Austria is from 1896 onwards (sometimes called “the
second Gründerzeit”).
Before the 1848 revolution the banking industry was dominated by the National Bank
that served as central bank with monopoly of note issue. This bank served only the very
wealthy bank houses, which were involved mostly in government loans and loans to the
nobility. There was little traffic with industry. Still there was gradual development of
industry, with beginnings on the large estates where landowners would set up ventures
(textiles, mining, metallurgy), albeit on a small scale. These people also had access to
credit in later stages. However banks then tended to take an interest in only those firms
who had already established themselves. Up towards the crash in 1873 several banks
were turned into joint-stock companies and speculation flourished. The effect of the
crisis seems to have been that banks withdraw from involvement in industrial
development and focused on current business. One explanation for this withdrawal
(beside the crisis experience itself) was changes in tax legislation that discriminated
against the joint stock form of incorporation. One interesting aspect is that from the
1860s onward banks started to take over all of the output of given firms on a
commission basis and sold it through special bank sales bureaus (coal, sugar, petroleum,
lumber…). The ties developed with industry were almost only with well established
firms. The key-note was caution throughout the period. In the period banking in Prague
developed to make the city the prime competitor to Vienna in banking. Government
intervention (promoting industry) to keep up with Germany was frequent in the later
period.
Italy 1861 – 1914.
By the 1860s 2/3 of the arable land in Italy was low yielding (per acre as well as per
man hour) in comparison with other European countries. This generated only
subsistence surplus and the domestic market for manufactured goods was remained
small. Still Gerschenkron’s analysis indicated that the period 1898 – 1013 was the
period of Italy’s “big spurt”. This suggests that the capital distributing mechanism
became quite efficient during (or prior to) this period.
A basic requirement for industrial growth to take off is that the domestic market for
industrial goods grows and that the allocative efficiency of the financial system
improves. The banking system cannot create savings but the government can use a
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variety of policy instruments to further both aspects. After the unification of Italy was
completed in 1871 a small group of industrialists, financiers, and landowners dominated
the economy. There was no large middle class. There were new tariffs in 1878 and 1887,
in 1885 there was an act to promote Italian shipping, and in 1886 the government
started (together with Banca Generale and industrialists) the first modern steel mill.
In this time the system of banks developed to match needs; the savings banks were
restricted by their charters to cater for land credits, loans to municipalities. Although
they had some credit to local industry this part declined from 1870 to 1914.
In 1876 Parliament established the postal savings bank. These banks took savings
accounts and invested in government securities only. Since the state came to play an
increasing role in industrialization this was an important channel for funding industrial
investment. From 1864 onwards cooperative banks grew in numbers. Their business
was to fund small, local businesses (their members). By 1914 this category provided
about 1/3 of the industrial and commercial credits by banks.
It was the large scale commercial and investment banks (banche di credito ordinario)
that provided the funds for large firms. On average 40 % of their assets were committed
to industrial and commercial purposes. They also assisted firms by underwriting new
issues of securities, turning them into joint stock companies etc. Although there were
sever set-backs in the recessions of the 1870s, 1880s and 1890s this category recovered
and expanded its share. There were, of course risks related to investment in industry,
which banks vulnerable to recessions. The 1874-77 crisis meant that the number of
joint-stock companies declined by 20 %. The risks in industry were compensated by
speculation in real estate. Portfolio thinking.
The government policy initiated in 1886 but pursued more vigorously after 1894 aimed
to reduce risk in industrial investment. To that purpose Bank of Italy was established in
1894 as a lender of last resort. Before this financial panics were endemic in Italy.
Spain 1829 - 1874
The development of the Spanish economy during this period can best be described as an
effort that failed rather than as stagnation. Spain landed further behind other European
countries than it was at the beginning. This is surprising first because of the promising
developments during the 18th century, and second because other Western European
countries did so much better. This while Spain was politically unified and independent.
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The comparative failure in industrialization was a domestic affair. The role of banking in
this period can be illustrated by the fact that up to 1843 there was only one joint-stock
bank (savings banks not included) in Spain (also allowed to issue notes), by 1866 there
were over 50 (21 of which could issue notes), and by 1874 there were 22 (of which one
could issue notes). This development is closely related to the failure of industrialization.
Three main policy mistakes by the government were responsible for this failure:
1. The government conducted a land-reform from 1836 to 1856, whereby it took land
that formerly belonged to the Church, nobility and villages and auctioned it off in
fairly small pieces. The compensation to the previous land owners was low, which
diluted funds that could have been invested in industry.
2. Despite the additions to the state budget that the land reform provided the state was
running a deficit (military expenditure), and the state borrowed from the banks. The
average lending to the government by the Bank of Spain (1852 – 1873) was 4 times
its lending to the private sector. The Caja de Depositos, a government agency, that
enjoyed the largest volume of deposits of all banks devoted its total resources to
provide funds to the government. Similar patterns for other banks.
3. Industrial enterprise was actively discouraged by a law passed in 1848, which
submitted all corporations to government approval with a lengthy administrative
procedure. This law was amended in the 1850s to promote railways, banking and
mining, but not manufacturing companies.
When investments in railways were selected as the solution this wave of investment
came in ahead of demand and draw a large amount of bank lending. Hirschman’s
reasoning about development through investment in excess capacity (Turnpike
Theorem?) does not seem to bear out in the Spanish case. The financial capacity of the
country was not large enough to provide financing for the industrial investment
required to take advantage of the transport capacity generated by the railways. Railway
companies remained low profit or loss operations, barely able to service their loans. The
international financial crisis of 1857 did not help. The conclusion of the chapter about
Spain of this period is that banks in the crucial period of 1856 – 65 followed the “line of
least resistance” abiding by the guidelines marked by the government
(investing/lending in government and railways) – flock mentality as it were.
Serbia 1878 - 1912
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During the period from being granted independence by the Berlin Congress in 1878 to
the beginning of the Balkan wars in 1912 Serbia had an opportunity to set industrial
development in motion on its own. Although time was short one must conclude that it
failed. By 1911 Serbia still had all the signs of underdevelopment. One important
structural change had occurred, though, the growth of a sizable financial framework. By
the end of 1911 the country had 176 commercial banks, including 4 foreign affiliates.
Industry prior to 1893 consisted of flour mills and other production related to
agriculture. Growth came in other private industry. The land locked Serbia was
dependent on Austria-Hungary for export and import. Livestock was an important
export leader. The problem was that a Tariff war, initiated by veterinary arguments to
put a brake on independence tendencies. This put traders in dire straits and they needed
to place their funds somewhere while waiting for things to improve. Meat packing
became a growth area.
The newly independent state had budget problems; a large part went to the military but
administration grew too. State industry was almost exclusively for military needs.
Infrastructure investments. The government professed to promote industry, but action
was limited to exemption from some taxes and import duties, but there was a constant
lack of credit facilities. A central bank (although private) was set up in 1884 but its first
issue of gold-backed 100 dinar notes failed. A later issue of 10 dinar notes was more
successful and the money supply grew. This encouraged the founding of a large number
of banks in 1884 – 1893 (there were many small savings banks at the time). The “tariff
war” contributed to the increased money supply as traders had little use for trading
credits. This was the opportunity to initiate industrial growth, but priorities were set on
other grounds. First banks waited for a speedy resumption of the export of livestock to
Austria-Hungary. In the meantime banks engaged in finding alternate routes for this
trade and even established commercial agencies for this purpose. Only quite late in the
period (1910-11) can we see direct bank investment in industrial ventures. The
“national” interests involved even prompted banks to use political interests to their own
advantage. The chapter points out that the ruling Radical Party sought to repair its lack
of influence with larger financial institutions. The political and other uncertainties made
foreign banks hesitate to engage in Serbia’s economic development. Then came the
Balkan Wars.
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Japan 1868 - 1930
Traditionally it has been claimed that the Japanese banking sector emulated and
functioned much like the German one – banks functioning as universal banks to groups
of companies often with owner interests. However this chapter gives a differentiated
view. There is an interesting time dimension here. The period indicated above starts
with the Meiji Restoration in 1868 when Japan opened up to modernization after having
been a closed, traditional society with old traditions (e.g., samurais) for centuries. The
end is when Japan entered into its fateful war efforts towards China and later in the
Second World War. The author of this chapter divides the period into 3 sub-periods; the
transition period 1868 – 1885, “the spurt” 1885 – 1905, and the initial modern economic
growth.
Transition
The Meiji government, striving toward modernization, had to take various measures to
obtain adequate revenues, establish a sound currency and a modern banking system.
Progress was slow. It took a crisis, the Matsukata deflation 1881 – 1885, to set the stage
for modern growth. Banks had stuck to traditional lending activities directed toward the
agriculture and commerce rather than bond issue and industrial ventures. The few
entrepreneurs had to finance projects, for instance in the textile sector, from savings,
relatives and surplus from other activities.
The spurt
The last 15 years of the 19th century and the period up to the Russian-Japanese war
1905 the economy had its first wave of industrial investment. Did banks, especially their
long term loans play a significant role here? The pattern is not homogeneous. The author
examines the 3 (out of the 5 big banks) largest banks when it comes to industrial
financing (Mitsui, Mitsubishi, Yasuda). These banks also came to be the core banks in the
3 largest “zaibatsu” (industrial groups). The analysis shows that bank strategies were
somewhat different, that short term credits dominated, and that long term credits
largely went to smaller companies with close links to the bank (the beginning of the
zaibatsus). One should also note that a large proportion of the banks resources were
used to buy government bonds.
Between the World Wars
15
It was during this period that the banking system came closer to look like the German
system. The transition was made possible because the zaibatsus had grown large
enough to be self-financing in the war boom and the banks themselves had become large
enough to embark on their own growth strategies (growing deposits, share issues,
mergers). There had been a series of bank runs in the 1920 and now the public
preferred to keep their savings in big banks. Loans went increasingly to non-zaibatsu
firms.
One of the bank runs mentioned above happened in 1927 due to an accumulation of
“earth quake bills” in many banks. These bills were notes that borrowers were unable to
pay after the earth quake of 1923, but which were guaranteed to other banks by the
Bank of Japan. These toxic assets accumulated in banks and decisions by government to
provide bail-out loans to banks with such bill came slow. This limited the space for the
Bank of Japan in their monetary policies and people worried about their deposits.
Another reason for savers to shift their deposits to bigger banks was the increasing
visibility of “organ banks” in this period. Such banks had come to be dominated by their
clients, became their financing organs, to the extent that they were forced to provide to
make unsound loans to their clients. The survival of such banks hinged on the success of
their one of few clients.
Further concentration was achieved as the Ministry of Finance from 1924 started to
persuade and assist small banks to merge. Also the larger banks were quite aggressive in
mergers and acquisitions.
This chapter illustrates the importance of the banking sector for the industrialization of
Japan by pointing out that the banks related to zaibatsus (commercial banks) grew in
terms of paid-in capital + deposits in relation to Japan’s GNP. This ratio grew from 44,2
% in 1911 to 80,9 % in 1926 (figures much higher than those of Western Europe and the
USA). This growth is partly due to the recession of the period, but still indicates how
banks assumed central positions in groups of companies. This is more like Germany, but
the prior period seems to have had more emphasis on banks investing in small and
medium sized growth firms (=taking on higher risks in industrial ventures). There
seems to have been a path of development with different roles for banks at different
stages.
16
Louisiana 1804 – 1861
Louisiana, purchased in 1803, is a counter-example in that we have a development of a
banking system based in agriculture rather than industrialization. At this time New
Orleans was already a trading city with 10000 inhabitants and accounted for 70 % of all
manufacturing in the state. Up to 1836 the state legislature chartered 20 banks all
located in New Orleans, but with branches in the sugar and cotton plantation areas. The
state promoted banking by issuing state bond on their behalf or by endorsing bank
bonds. By 1838 Louisiana had the second largest state debt in the USA, 95 % of it on
behalf of banks. This to the reaction against banks. There was a bank run in 1837 and
the panic lasted until 1842. There was a Louisiana Bank Act in 1842 that included
various bank reforms focused on cash reserves, and in 1845 there was a stop to the
chartering of new banks and to renewal of existing charters, later modified, This
restrictive policy did not bring about “sound money” and also did retard the economic
development of Louisiana. One significant effect was the shrinking of inter-regional
trade via New Orleans. The kind of specialization of banks (property banks that
provided mortgages to planters, improvement banks that financed canals, rivers and
transportation facilities, and the commercial banks focused of trade credits) served a
conserving purpose. By the beginning or the 1850s most of them had seized operations.
An amendment of the banking legislation to allowed banks to count state bonds as legal
reserves for bank notes. This gave room for development of “free banks”. Banks had
devoted a negligible part of their resources to manufacturing and this continued. These
free banks chose to engage in the promise of railroads, which still meant long term
commitment of resources against short term deposits, and made them vulnerable to
bank runs.
The bankers of Louisiana allocated their resources to the promotion of agriculture and
trade rather than to industrialization. They thereby served conservation, but within that
frame they allocated resources reasonably well.
The United States 1863 – 1913.
On the eve of the Civil War the United States Congress established in order for the
government to provide a uniform currency backed up by US government bonds. This
would prevent panics of the kind experienced over the recent decades to reoccur. This
was successful in the sense that panics where depositors wanted to turn their deposits
17
into specie. The panics after the war were about depositors turning their holdings into
currency (US dollars) because they worried about the status of their bank (panics in
1873, 1884, 1893, 1907). These panics, however, did not seem to have any significant
effects on the economic development of the country.
The bank reform did have effects on the banking system, though. The reform raised
barriers to entry, which had different effects geographically as well as the effect that the
new mobility of funds between banks came to favour industrial finance. The second
important effect was to tie the banking system (national banks were required to invest a
proportion of the funds in government bonds) closer to the financial policies of the
government.
The reform set minimum capital requirements high, which prevented entry, but also
stimulated “innovations” to circumvent the rules. It also prohibited mortgage loans of
national banks (but it did stimulate resumption of state banking in agricultural areas).
Before the Civil War country banks tended to deposit some of their funds in other banks
in trading towns up the stream of goods. This tendency was emphasised through the
bank reforms. In this way New York came to be a centre of concentration of bank funds.
This tendency also served a mobilization function with regard to industrial investment.
One should also note that from the Civil War up to 1893 the federal budget was in
surplus every year. This surplus was used to reduce debt that had accumulated during
the war. This transfer of public funds to private also contributed to a very favourable
climate for the post-war industrialization in the USA. As everywhere else railroad
building was a major target for investment and banks, sitting on the flow of funds, could
assist in the floatation of railway bonds. The engine effect of the banking system in
railroads was so strong that there was an overproduction
“In ordinary times, securities are offered to the end that railroads may be built. But in
1881 railroads were built to the end that securities may be offered.”
The in this way expanded capital market was large enough to absorb new security issues
now for the purpose of consolidation of industries by merger. In this way Bell, Standard
Oil, DuPont, General Electric and many other large corporations came into being. The
rest is history…
18
So what lessons are there to learn?
We note, obviously, that there are great differences in the precedents for further
development that the early banking system provides. National paths of development are
different. What could then be meant by the globalization of finance?
A basic function of banks is to serve as intermediary between savers and people who are
willing to borrow. This function is fulfilled differently in different contexts and with
varying results.
It seems to be crucial to what extent government policies are oriented toward economic
development or toward financing state expenditure for military or other expansion. Also
the ability of the banking system to mobilize large sums and feed a money market sets
the stage for different paths.
Agriculture, trade, railways, manufacturing industry – the balance between these
activities will be influenced by the structure of the banking sector even if the natural
endowment plays some role in early stages.
Banks come from different historical experiences and work in different contexts. Their
relation to their industrial context and to the “global” economy will differ. One might
wonder to what extent standardized global bank regulation has any chance of doing any
good (except for those countries who want to steer the world in their image.
Reflections on the change of banking over time.
It seems like the roots of banking is in trade but with industrialization the need to
channel deposits toward long term investment in industrial capacity and infrastructure
will grow. How do banks cope with this kind of changes in their environment? England
and the emergence of London as a global financial centre is interesting;
Book review 3 (by Sten Jönsson)
Erik Banks, (1999),The Rise and Fall of the Merchant Banks. London : Kogan Page
This book is about the rise of the modern British Financial era from medieval times to
the demise of the merchant banks at the turn of the century and the time of the writing
of this book. The approach is purely descriptive with references to historians, annual
reports and current press comments. The structure of the text for each period is to first
19
give an overview of the economic development, then of new features in the merchant
bank industry and finally give an account of the activities of the individual merchant
banks of London. The author was a senior risk advisor in a European bank at the time of
writing and has written several books about risk management in banks. One of his
books, written in 2004 (note), is called “The Failure of Wall Street – How and why Wall
Street fails – and what can be done about it”
The chapters deal with different periods of Britain’s modern financial era; the
emergence of the banks from 1800 – 1874, the Glory years before the wars, the
disruptions of the two wars, the changes after the Second World War and the
consolidation of the City in the 1980s, and finally the end of merchant banks during the
1990s.
Dawn
Banks starts from medieval times when, in the wake of William the Conqueror’s
occupation Jews established business in Cheapside (City). Since they were not allowed
to engage in trade or manufacture and had no legal status, they took up money changing,
providing Norman kings with funds for wars. Defaults on such loans were rather
common so high interest charges were required. This lead to conflict ending in expulsion
of Jews in 1290. The void was soon filled by the Lombards (Italians merchants and
bankers from Florence and other cities). The Lombards introduced their experience of
bills of exchange. By the 16th century the Italian banking houses declined and their
financial activities were taken up by merchants, brokers, scriveners and goldsmiths;
merchants trading and providing credit by bills of exchange, brokers lent money against
valuables placed in safekeeping, scriveners were clerical intermediaries who set up
contracts and provided advice, discounted payment orders and traded in gold,
goldsmiths established in jewellery and became important financiers taking deposits
and re-lending deposits. Goldsmiths’ deposit notes developed into a kind of bank notes.
The goldsmiths’ business was greatly promoted by the raid on the Royal Mint (a safe
deposit, people thought) by King Charles I in 1640 where he removed 200.000 pounds
in bullion.
From the middle of the 16th century joint stock companies appeared. They issued shares
to merchants and gentry against promises of participation in capital gains and
dividends. Such shares changed hands informally via brokers (who “transact business
20
for merchants”), and jobbers (who quote two-way prices for their own accounts of
stocks). The first recorded ‘stock jobbers’ appear in 1688. One place where these
middlemen met to conduct business was the Royal Exchange, but there were other
locales, not least Jonathon’s coffee house. Another coffee house was Lloyds, which
became a centre for exchange of shipping information and later (from 1771) developed
into an insurance business with members/underwriters retaining unlimited personal
responsibility for losses. Despite some progress London was still at the beginning of the
18th century a second rate financial centre after places like Amsterdam and Southern
Germany. But trade expanded, supported by a growing colonial empire and protected by
mercantilist policies (like The Navigation Act that prohibited export from the colonies of
enumerated products from the colonies except on British ships.) This policies were
however the seed of decline starting with the War of Independence in North America
and the revolutionary ideas from France. Britain came out winner of the Napoleonic
wars and as ruler of the seas. In this period the role of the Bank of England expanded
largely in connection with the management of the national debt that increased rapidly as
a consequence of wars. Amsterdam on the other side suffered numerous bankruptcies in
the crisis of 1763 (end of the Seven Years War). Then problems got worse through the
Anglo-Dutch war 1780-83, and finally the French invasion in 1795. With that the
financial, mercantile and naval power of Amsterdam was broken. London stepped in –
Paris had other business to attend to.
Merchants become bankers
Industry was growing steadily at the beginning of the 19th century, even if Britain was
involved in war. At the centre of this growth was cotton. Imports and exports dominated
the economy after the end of the Napoleonic wars. Soon the railway ere began. The first
railway project in Britain started in 1825, by 1835 there were 21 listed joint stock
companies trying to raise funds for railway networks. Britain and Europe at large were
plagued by large national war debts and there were financial crises. In 1825 there were
runs on country banks throughout the system with payment stoppages at many banks –
over 12 months 145 banks failed. In this situation Bank of England was successful in
calming the financial markets by discounting government bills and bills of exchange to
provide liquidity. Legislation strengthened the Bank of England in its role as central
21
bank. A further crisis in 1839, emanating from the USA, marked the turbulence of the
times.
It was in these tumultuous years at the beginning of the 19th century that merchant
banking emerged. Merchant families that had emigrated to England from Prussia,
France, Ireland, Russia, Italy and America formed the core. They started out from
expertise in trade and commerce, were small family-owned and managed houses with
limited capital. They provided an essential link between commercial centres of the
world. International trade was their business. Their reputation and connections with
agents made them suitable as intermediaries. Since they knew both parties in a
transaction they could accept bills of exchange issued by one party which guaranteed
payment to the other party. Merchant banks like Baring, Hambro, Brown, Kleinworth,
and Schroder ran very large acceptance books, while others like Rothschild and Peabody
and Benson were actively at trading bills at a discount in the market. Bills for payment in
London and the USA generated a market of currency exchange, and trusted clients could
be provided with letters of credit. Merchant banks had an advantage in judging
creditworthiness of clients. During this century foreigners also started to issue loans in
London (railways, sovereign debt), which needed underwriters to arrange things.
This book contains sections on how different merchant banks fared during the different
periods treated. For brevity we will focus on Baring adding short comments on other
banks when needed:
Baring
The Baring bank stems from Groningen where Peter Baring established a wool
importing house in the 15th century (Might have done business with the Medicis.). A
descendant immigrated to Exeter, a trans-shipment point for linen from Germany to the
West Indies and Mediterranean countries, from Bremen to start his own business in
1717. By the end of the Seven Years War (1763) two sons had established business in
London as agents for the Exeter branch. Gradually, and after several reconstitutions of
partnerships between members of the family, banking took on a more prominent place
in the business. Baring’s strength was its ability to develop and maintain relationships
with banking and merchant houses at key locations around the world. One such link was
that with Hope & Co in Holland. By 1803 Baring was appointed general agents for the US
Government, arranging payment of interest, purchasing armaments etc. By the turn of
22
the century the firm had gained considerably in stature. It took on a policy early on to
only act as the sole provider of credit to a given client. In 1803 Baring participated,
together with its partner Hope & Co in financing the Louisiana Purchase, its biggest
transaction up till then. The firm was also involved in arranging Spain’s payment of the
annual subsidy to napoleon under the Treaty of Spain (1803). It was Francis Baring,
who, during his 40 years’ rein had transformed Baring from a merchant house to a firsttier bank. As the bank increased its bank operations in the next few decades it often
competed with its rival N.M. Rotschild (Nathan Mayer Rotschild had moved from
Frankfurt to Manchester in 1798 to start business in the textile trade. He specialized in
“clandestine” trade during the Continental Blockade. An important step toward banking
was taken when Napoleon invaded Frankfurt and prince William (IX) was threatened
with seizure of his assets. He sent large sums of money to Rotschild for safe keeping. He
invested them wisely and became William’s banker and increased his capital.). Even if
Baring was larger than most houses in London it remained well behind Rotschild by the
mid 1820s. In order to implement its expansion plans for the US operations the firm
hired Thomas Ward to be its resident agent in 1830. He extended long term credits to
American merchants with business in the Far East and West Indies. A family member
(John) had moved to Boston in1826 to set up a partnership with Joshua Bates with focus
on the cotton trade. This partnership was soon absorbed by Baring and a new office had
been set up in Liverpool to engage further into the cotton trade.
The Hambroe family with roots in Hamburg and Copenhagen established themselves in
London during this time, in similar business but specializing in the Scandinavian
countries. Kleinwort came from Hamburg like Schroder. Warburg did not set up
business in London until in the 1930s but was already an agent for Rotschild in Germany
at this time.
From 1840 onwards free trade made great progress as trade restrictions (like the
Navigation Act and the Corn Laws) were dismantled. By 1880 Britain accounted for 50
% of the world’s shipping tonnage and British credit supported the growth in trade. The
empire generated revenue, e.g., in the form of “home charges” and interest payments
from India. Industry grew – by the middle of the century Britain produced 66 % of the
world’s coal, 50 % of its iron, 70 % of its steel and 50 % of its textile. Investment in
railways was a driver of the financial sector as was sovereign debt. London was the
23
undisputed centre. There were crises of course, many of them stemming from
speculative adventures (cotton, land speculation, railway securities bubble, states
overspending) in the USA. In May 1866 (Black Friday) the leading discount house
(discounting bills of exchange) called Overend Gurney collapsed. Bank of England
analysed the system effects and let it fall but provided credit to carry the financial sector
over. A major technological development in the form of the telegraph – the Atlantic cable
in operation from 1865 – changed the condition of international commerce drastically.
The American Civil War shifted business to the North. The merchant banks had to adapt.
While they could rely on their personal knowledge of clients’ creditworthiness before
the growing volume made this virtually impossible. Larger capital to carry risk was
required. There were mergers and acquisitions and joint stock banks kept growing.
Baring II
Still the traditional merchant bank Baring shifted more of its business toward the USA in
the period 1830 – 1860, among other business it became a major participant in Federal,
State and railway loans, but it also help issue loans for Russia, France and Brazil. It also
increased its portfolio of acceptances. Especially the financing of trade on the Far East
was lucrative. However the death or retirement of leaders of the bank exposed the bank
to considerable reductions of its capital as a consequence of withdrawal of funds.
Approaching the 1870s the bank reorganized, the number of partners doubled and a
merger with a Scottish bank was undertaken.
The Glory Years
Banks points out that the period between 1875 and 1913 is generally considered the
glory years of Britain. The entire world economy was built around Britain with the City
as its centre. Bagehot (1873, p.2) wrote: “Everyone is aware that England is the greatest
moneyed country in the world; everyone admits that it has much more immediately
disposable and ready cash than any other country.” London dwarfed New York and
other centres in terms of the volume of bank deposits. The volume evidenced the need
for joint stock companies in banking. The Big 5 emerged as the clearing banks by the
First World War. Merchant banks saw this development with suspicion. Foreign banks
in London granting trade credits to companies in their ‘home country’ expanded during
the late 1800s. It was now that the term “merchant bank” became widely used. And the
24
category expanded, while there were 39 such banks in the City by 1890 the number had
grown to 66 by 1897 even if they remained small. Baring had 71 employees by 1903.
Politics was important. Many partners of merchant banks were members of Parliament.
Baring III
During the latter half of the 19th century Baring concentrated its business on the
Americas and the Far East, but unlike other merchant banks it also made efforts to
finance domestic industry. Two issues brought the bank down; a syndicated loan to
Manchester Ship Canal was only subscribed to18 % leaving the banks to take up the
balance and tie up capital for a period. An ill-advised investment in share and
debentures of the Buenos Aires Water Supply and Drainage generated a liquidity
shortfall in 1890. Under the leadership of Bank of England governor Lidderdale a
successful rescue package was negotiated. In the aftermath Edward Baring, who had
lead the bank to the crisis was forced to resign, the bank was reconstructed as a limited
liability company with only two family members holding stock in the company (20 %).
The reconstruction allowed the baring family to repurchase voting share from new
shareholders – mostly banks that had contributed to the rescue package – and within 5
years they held all voting shares and were again in control. The first priority was to get
rid of the illiquid Argentinian assets and soon it was back to its traditional business;
acceptances, investments and new issues.
In the early 1900s Baring discussed a merger with JP Morgan but in the end Baring
decided to develop its own subsidiary in New York run by Hugo Baring. He started out
disastrously and was soon replaced, but in 1908 Baring decided to close down in New
York and work with Kidder Peabody instead. Still Baring had got through the 1890 crisis
and was again in business as the War approach, although a more conservative bank than
before. NM Rotschild had emerged as the top merchant bank with Barings setback.
The War period up to 1945
As tensions escalated in Europe financial markets suffered. Interest rates and volatility
increased, gold reserves flowed out of London. As the War started financial markets
came to a halt in London and Europe. The problem for the government was that the
large amount of outstanding acceptances to foreign clients who were unable to remit
payment. The Bank of England declared a moratorium on payment of bills and covered
large amounts of acceptances maintaining liquidity. The gold standard was suspended in
25
London and Europe, but this lead to liquidation of securities in New York and conversion
of the proceeds to gold. This threatened the US reserves and the New York Stock
Exchange closed. However, trading continued off-exchange, but as the exchange re-
opened several months later investors had started to look upon American securities as a
safe haven. In this way America became the recipient of large inflows of capital and its
gold reserves were no longer threatened. When the USA entered the war in 1917 it
could lend money to its allies.
At the end of the war England faced the problems of re-building its economy, stabilizing
its currency and holding the empire together, which required a mobilization of a large
amount of public and private capital. War reparation was a debated issue. The economy
contracted considerably, exports reached only 80 % of its pre-war levels. By 1918 2/3 of
the British economy was under direct or indirect control of the government. 90 % of all
imports were authorized under government directives. By the late 1920s imbalances
had grown out of control, culminating in the crash of the New York Stock Exchange in
1929. Total capitalization of securities decreased by some 30 % in ten days. Banks’ loans
to brokers for securities purchase could not be repaid. At the time of the crash 4 major
economies in Europe were in recession, which deepened and prolonged its effects. Soon
Austria reported difficulties to meet war reparation payments, was granted a small
international loan on condition that Austria leave the customs union with Germany.
Shortly thereafter Germany announced that it had insufficient funds to meet obligations.
There was a bank run in Austria that spread to neighbouring countries. Germany agreed
only to pay interest on outstanding trade credits in 1937 and 1938, while refusing
service on loans.
Merchant banking suffered during this period. Strict controls and state agencies building
their own capacity to purchase material reduced opportunities. Banks were managed for
survival with reduced staff. Even if trade rebound somewhat between the wars
providing some acceptance business it did not reach pre-war levels. Furthermore, the
number of clearing banks with deposits and large retail organization had solidified at
the “Big 5”, which set a completely new stage for banking business after 1945.
Baring IV
At the start of World War I “Baring’s operations had effectively come to a halt” (Banks, p.
250). Core operations were limited to arranging payments and maintaining
relationships. A new manager (Peabody, a Canadian) from the outside was recruited at
26
the end of World War I and served to the end of World War II. The acceptance business
was gradually rebuilt (tripled in 3 years), but Baring also focused on building a domestic
issue capability (which requires a reach out over the whole country). Corporate finance
and advisory work became new sources of revenue. International loans were much
reduced between the wars.
Post-war focus shift 1945 – 1979.
The war caused devastation for Britain as far as the basis for merchant banking goes.
Britain had lost half of its international trade, 2/3 of its overseas markets, and 1/3 of its
merchant fleet during the war. The position of the USA had grown proportionally
stronger. Coping with the large post-war debt burden was an important task for the
government. There was a strong need for restructuring industry. The traditional
industries (textile, coal, shipbuilding) were in decline, other industries were fragmented,
and e.g., there were 11 car manufacturers in Britain while there were 3 in the USA. The
Labour Government in power from the war until 1951, and again in the 1960s and
1970s, created a framework for solving these restructuring problems by state
ownership (National Coal Board, British Steel, British Gas etc.). The policy was
successful in the sense that unemployment was low (1-2 %) as well as inflation. In 1957
Britain declined to join the new EEC and banded together with other outsiders to form
EFTA. However the struggle to defend the sterling by raising the interest rate and
adding an import surcharge (in 1964) that had to be abandoned 18 months later as
violating the EFTA agreement but trade deficit and currency turmoil remained a
problem an exasperated by the 1973 oil crisis. Britain had for a long time been the
world’s largest overseas investors, but the wars had forced investors to liquidate
investments and the revenue from such activities was smaller. Industrial production
grew, though, and the management of pension funds had been de-regulated. This set a
new strategic field for merchant banks. And there was the US Regulation Q and Interest
Equalization Tax (IET). Regulation Q prohibited payment of interest on short term and
set an upper limit for interest on long term deposits. IET taxed US domestic investors
holding obligations of foreign issuers. This set the stage for the Euromarkets. The
Eurodollar deposit was an off-shore short term deposit paying a rate based on the
LIBOR. It originated in the Soviet Government worrying about the risk that its holdings
with American banks might be frozen or restricted (late 1940s). It re-deposited dollar
27
funds with the Soviet –controlled Banque Commercial pour l’Europe du Nord in Paris.
From this further dollar transactions could be undertaken outside the control of US
authorities. The Eurodollar was born and London was the entrepot at hand.
Baring V
Merchant banks had to respond to this changed circumstances after the Second World
War. There were about 40 of them in London. The strategic options ranged from growth
by acquisition to specialization to narrow niches. Baring’s choice was to expand its
domestic presence and seek a more diversified base of revenue. It made progress in line
with this (asset management, bond trading, M&A), but was considered a bit
conservative. Managers were recruited from the outside. Foreign new issues declined
during the 1950s but Baring took a leading role in bond issues for British corporations.
Baring set up an asset venture management team (Henderson Baring Asset
Management) that was very successful. In 1975 it won the mandate to assist in
managing a part of the vast petrodollar investments of Saudi Arabia. The other area was
M&A which offered opportunities to participate in the de-nationalization of industries
like British Steel. In 1960 the bank earned a reputation through its defence of Courtaulds
against a hostile bid from ICI. Its list of clients grew after this.
(Rotschild saw its capital decline after the war due to poor business conditions, but also
due to death duties as family members died. Measures were taken to protect the
company by setting up a holding company (Rotschild Continuation Holdings) and
convert it from a partnership to a private company. A similar development happened to
Kleinwort, burdened by a large portfolio of non-performing credits. Hambro became a
limited company too. All merchant banks started to hire professional managers from the
outside).
The City Consolidates its position. (1980 – 1989)
Global financial markets were under pressure in 1980 due to the American difficulties.
Chairman Volcker of the Federal Reserve had initiated monetary tightening to
counteract inflation (16 %), which in turn was due to the OPEC oil shock of 1979 (a
previous oil crisis in 1973 in relatively fresh memory). An unforeseen effect of this high
interest rate policy was the difficulties for less developed countries to service their much
increased debt. By 1984 35 such countries were unable to pay. Global banking
28
institutions faced large losses and began to reduce costs and rebuild reserves. The
British government had increased borrowing to fund its restructuring of industry. In this
situation de-regulation as the solution won adherents. The conservative government
started the stepwise process in 1980, but let it be accompanied by a strengthened
regulation (FSA, ISB) structure, from its previous “self-regulation” approach, to protect
investors, issuers, and intermediators from excesses of the free market.
On Monday 16 October 1987 the New York Stock Exchange crashed as a bubble burst.
Merchant banks made big losses mostly due to new equity issue underwriting
commitments.
During the 1980s British privatization of state-owned industries gradually gained
tempo, and was successful (accept during the 12 months following the Crash). The most
spectacular deregulation act, however, was “the Big Bang” – deregulation of the Stock
exchange – in 1986. The strategic field changed again.
(Under the previous regulations functions on the stock market were kept separate;
‘brokers’ (who matched sellers and buyers without owning any shares in between)
could not work as ‘jobbers’ (who bought and sold shares on their own book. These two
kinds of houses now became attractive acquisitions for merchant banks. Clearing banks
saw the Big Bang as an opportunity to enter the securities markets in a more forceful
way, and in effect became a new kind of merchant bank in the process.)
For merchant banks the Big Bang announced the need for a more serious strategic
planning approach rather than the previous ad hoc/grab opportunities policy. After
formulating their strategy the banks had to carry out their plans either by acquisitions of
firms or by hiring specialized staff to man new departments. “This contributed to the
creation of very high cost bases throughout the City, which became difficult to justify
when profit margins contracted or volatility generated losses.” (Banks, 1999. p. 416).
Baring VI
Baring entered the 1980s as a top-tier bank but with a somewhat conservative
reputation. Pioneering new activities was not in its taste. It was business as usual for the
first part of the decade, but by 1984 it bought a 30 % stage in a jobber (Wilson &
Watford), and later the same year it was eager to acquire the City’s top broker
(Cazenove) but negotiations failed and Baring chose to hire a 15-man team from another
broker. This team headed by Heath was specialized in the Asian equity markets. Since
29
Baring itself had started trading in Japanese Eurobonds that same year it seemed logical
to try to find more business there. Japanese Eurobonds with attached equity warrants
became increasingly popular generating handsome profit. From a balance sheet of 276
million GBP in 1977 it had grown to 2, 7 billion GBP at the end of the 1980s. Baring
Securities contributed 50 % of the profit and employed 1000 staff. But as the Japanese
market became more difficult in the early 1990s – decline in the Nikkei – a greater
amount of Baring’s warrant business became proprietary, rather than client, in nature….
(Hambro entered the 1980s a full service merchant bank. However it fails to reach a top
position in corporate finance. It purchased 30 of a broker and acquired a small American
investment bank, but as a consequence of the 1987 crash it narrowed its focus to
commercial banking, retail investment service, M&A, exiting the equity market and
government bonds. Rotschild retained a conservative business approach focusing on its
traditional strength; corporate finance, bullion dealing, export finance and new issues,
avoiding areas where they lacked expertise. Rotschild had difficulties with access to
capital since partners did not want to dilute their ownership interests. It grew into
dominance in international and domestic mergers and was successful in building the
asset management business. It purchased parts of a jobber and a broker to build a
securities service and set up office in financial centres around the world and stood
securely as a significant niche player at the end of the decade. Kleinwort gained
prominence over the 1980 demonstrating its capability to manage complex deals in
important privatizations and M&As. In October 1987 Kleinwort Benson issued new
stock – bad timing in relation to the Crash – but managed to secure 148 million GBP in
equity. The company still suffered from great variations in profit. Morgan Greenfell
started the decade by severing relations with its previous shareholder and partner JP
Morgan. In 1984 Deutsche Bank acquired a 5 % stage in Morgan Greenfell. Management
hesitated (due to limited capital) as to its approach to building a securities department
and by the time they made up their mind most top tier brokers and jobbers were already
spoken for. It bought minority shares in a broker and a jobber to take full control of
them after the Big Bang. Over the decade Morgan Greenfell won a top position in M&A,
but also a reputation for not abiding fully to the code of conduct in M&A. Its involvement
in the Guinness/Destillers takeover 1986/87, which turned into a scandal as various
30
senior managers of Guinness were arrested for improprieties, was a cause for several
clients to leave the bank.
The end game (1990 – 1999)
Britain entered the 1990s with a curious mixture of prosperity and crisis. Several
disturbances of markets happened in the early part of the decade (Irak’s invasion of
Kuwait 1990, the ERM currency crisis, sharp rise in interest rates in 1994 followed by
the crisis for the Mexican peso, and finally the failure of Baring in 1995. London City had
prospered in its off-shore investment business. Financial assets had grown dramatically,
not least by the new solutions in pension assets. Clearing banks continued to dominate
most aspects of borrowing and lending in the financial sector even if they did not
succeed fully in setting up merchant banking divisions, and they had to set aside
reserves for the risks in loans to less developed economies. The number of foreign banks
operating in London increased during the 1990s reaching 550 by the mid of the decade.
London City continued to dominate the international cross-border bank loans sector (18
% of the market compared to 14 % for Japan and 8 % for New York). Two major banks
collapsed in the 1990s; BCCI was closed own by the authorities because of reporting
irregularities and internal and external fraud, Baring will be discussed below.
An interesting aspect of the development was that the British clearing banks exited the
merchant banking sector during the 1990s. After trying to establish a viable presence in
the global market of merchant banking for 10 -20 years Barclays, National Westminster,
Lloyds TSB and Royal Bank of Scotland withdraw partly or entirely. Banks (1999, p
464ff) claims that it was the demands by shareholders for a competitive return on
investment that forced the decision. Banks could not justify the high expenses connected
with global competition in this field. The irregularities discovered in several banks
(Baring being the most spectacular) brought further demands for better internal control
systems, which would increase costs still more. Retail banking was simply more
profitable.
Merchant banks had to realize that aspirations to remain a top-tier global actor now
required vast financial resources (personal connections could no longer compensate),
world-wide distribution capability for securities, operating platforms, technology and
robust control systems. The strategic options were to merge with another actor to
31
become part of a financial conglomerate, to narrow business to a specialized field, or to
be satisfied with being a mid-range actor.
Baring VII
Baring entered the 1990 with 3 business divisions; Baring Brothers (merchant
banking/corporate finance), Baring Securities (securities sales and trading), Baring
Asset Management (investment managing). It now started to expand into new areas
(like asset swaps, asset repackaging, arbitrage, and derivatives trading) and new
markets (like Latin America and Far East). Baring Securities, so successful in Japanese
warrants began to decline in importance (losses in 1991 and -92). In 1993 Baring
restructured, integrating Baring Brothers and Baring Securities into Baring Investment
Bank. Heath the ‘creator’ of Baring Securities left the company. The challenge now was
to manage the different cultures within the company. In an effort to improve the
American presence Baring acquired 40 % of the US investment bank Dillon Reed in 1990
and a majority owning in 1997, and finally full ownership. Baring joined with Abbey
National – a building society that had converted to bank – to set up a joint venture
dedicated to derivatives trading. Abbey National brought a good credit rating to the
venture, which had some success for a while.
Baring’s Singapore office was the place where the notorious irregularities which in the
end led to the collapse of the entire bank. Leeson had been a trader there since 1992
used the weak control systems to establish very large positions in Nikkei index futures
and options, Japanese Government Bonds futures, and options and Euroyen futures.
Leeson’s job was to execute index arbitrage programmes (buying baskets of stocks that
comprised the index and selling the equivalent index futures. a rather boring job dealing
with negligible risk if done properly, one might think). The cheating was possible since
Leeson could cover up trading losses by booking them to an error account – a so called
88888 account. Leeson had effective control of back office functions, which was not in
line with accepted practice. It was the Kobe earthquake of January 1995 that exposed
Leeson. He had bet on the Nikkei remaining calm, but the earthquake caused the market
to fall and remain volatile for some time. Losses mounted and Leeson fled the company.
Baring had to call in Bank of England and other regulators to consider the consequences
of the situation. Other banks negotiated a rescue package of 500 million GBP, but soon
32
news came that losses would be larger than 650 the plan failed. A final offer involving
the Sultan of Brunei also fell through. There were too many open-ended contracts to
value the company. Baring started to unwind its positions and it turned out that the loss
in the end was 860 million GBP. Now the different parts of Baring could be valued and
after some turns the ING came out as the buyer of the whole operation for 1 GBP. The
‘post-mortem’ analysis of Baring was highly critical of merchant bank’s control
infrastructure, especially the control of posted margin calls – in January and February of
1995 Baring had paid 570 million GBP in margin calls; 25 % of it one week prior to the
collapse. ING integrated Baring with its own investment banking business, which was of
considerable size. By 1997 ING closed down large portions of its emerging markets
activities (where Baring had been strong). Although the Baring name continued to
appear in ING operations Britain’s oldest top-tier merchant bank had ceased to exist.
(Hambro, experiencing profitability problems in the early 1990s called in consultants
(fellow merchant bank Schroder) to suggest solutions. The recommendation was to sell
the bank. Although other merchant banks like Warburg, Kleinwort Benson, and Morgan
Greenfell were sold as whole units – with business intact – Hambro was dismantled and
sold in pieces (after 158 years).
Rotschild was one of the few merchant banks that remained independent during the
1990s. Even if business was slow in the beginning Rotschild managed to maintain a
revenue stream that was mainly fee-driven. By the middle of the decade about 20 %
came from privatizations, the bulk (50-70 %) from M&A. The bank joined ABN-Amro in
a joint venture (a replica of the very successful Smith New Court created after the Big
Bang in which Rotschild held 25 %, and which was sold to Merrill Lynch in 1995) of new
equity issue that could benefit from both ABN-Amros distribution capacity and
Rotschilds origination skills. After the Baring failure the bank reviewed its organization
and control and restructured on a global basis. The principal component was still the
family’s Swiss holding company Rotschild Continuation Holding. Rotschild had chosen a
niche strategy and was oriented toward corporate finance.)
The end
It was the European universal banks that emerged as the major purchasers of the British
merchant banks (UBS, Dresdner, Deutsche, ING). Banks (1999) claims that these banks
had an understanding of the specific culture of merchant banks (personal connections,
33
international deals, thinking in broader more long term categories). Interestingly these
banks were used to operate in much more regulated markets than the de-regulated
London City.
Banks (1999, 513ff.) recapitulation points to the fact that the premiere merchant banks
emerged from a gradual conversion of their mercantile business to banking between
1800 – 1839. The roots were mostly in Liverpool the most significant port for export
and import. All major houses were managed by a small family-based staff although the
addition of external partners or agents in important overseas locations became
increasingly common (p. 515). The pace in commerce increased with steamships,
railways and telegraph. Warehousing (in Liverpool and other places) was declining in
importance and buyer and seller could get in contact directly via telegraph. Financing
deals with reasonable risk presupposed a good knowledge of the business plus capital
and a good reputation. The period 1875 – 1913 was the pinnacle of British merchant
banking. A stable political environment, with a growing trade flow (not least to-and-fro
the colonies), railway investments in many countries, and an investing public in Britain.
The core business was still acceptances, advances, and loan issues (sovereign as well as
railway companies). Mergers and amalgamation of a fragmented industry generated
additional business. Family shareholdings and unlimited liability remained the norm.
But this made capital variable since death or retirement of partners and death duties cut
into equity.
The war period 1913 – 45 was very disruptive for these banks, which were so
dependent on international trade. Most merchant banks emerged from this period as
smaller and more conservative organizations.
The post-war period started with an inward focus on reconstruction. Remaining
regulation of most aspects of international business forced merchant banks to relate to
large industrial clients, nationalizations and privatizations provided opportunities to
build expertise in corporate finance.
Now London had lost out to New York as the global financial centre. The Eurodollar
market saved the day for a while, as did the large volume of privatization projects, but
the de-regulation of London (the Big Bang) put merchant banks (and other banks as
well) in situations where they faced difficult strategic problems; to go for full service
investment banking, specialize to certain niches, or accept a less prominent profile. In all
34
cases some acquisitions were required or new hiring of (teams of) expertise. This
increased cost levels and made merchant banks more defenceless toward variations in
profitability. One explanation to the conspicuous deficiencies in management and
control was that banks engaged in activities top management did not fully understand,
another that acquisitions generated internal differences in culture that could not be
handled in the rapid pace that was characteristic of the two decades prior to the 2008
crisis. This - the volatility in profitability was not liked by shareholders, which in turn
made it difficult to meet the capital requirements of a full service operation. The obvious
thing to do was to merge with a larger, global organization and hope for some room of
manoeuvring inside it. However the fragmentation of cultures, lacking control
instruments and the rapid pace instead opened up organizations for power games and
promotion of clever power gamers. The stage was set for the 2008 crisis with many
global banks being too big to fall (and too strong lobbyists to fall).
Book review 4 (by Sten Jönsson)
Lépinay, Vincent A., (2011), Codes of Finance – Engineering derivatives in a global bank.
Princeton: Princeton University Press.
There are a few academic studies of the inside of these new kinds of global banks where
top management did not seem to understand all aspects of the risks generated by
models in interaction and large volumes in weak markets. Mackenzie (e.g. 2009) has
done some interesting anthropological studies in the financial sector, but we have not
seen any management studies yet. Inside views, based on interviews, written by
experienced journalists (e.g. Sorkin 2009) have value of course, but they do not usually
deal with the managerial problems faced in the finance sector. Lépnay, although a fairly
inexperienced field worker – his book is based on work for his master thesis – gives an
insight into the processes which top management are supposed to master.
Lépinay’s book is about an anonymous bank called “the General Bank” 2 that sells CGP
(capital guarantee products) to HNWIs (high network individuals) or UHNWIs (ultra
2
But he informs us that the General Bank had its own rouge trader in 2008, Kevin Voldevieille, and
thereby helps the curious to identify it.
35
high net worth individuals). This means that it is in the business of structured finance
and negotiable financial instruments are instruments with a secondary market. In this
case the product is negotiable between the bank and the owner but no other party is
involved. The client pays the bank to manage their capital for 3 – 15 years. At the end of
the period the bank will pay back 100 % of the nominal amount plus return based on a
formula based on the quarterly gains of the portfolio composed of an equally weighted
basket of 3 indices (S&P, Nikkei, DJ Eurostoxx) and payable at maturity. Lépinay
discusses how this product differs favourably from ordinary hedge fund management
(which is based on the performance of a secret investment recipe) in that it is
completely transparent and the client can follow the ups and downs of the indices. It is a
story about derivation, how contracts are “engineered” on the basis of some underlying
asset (in this case a virtual basket of shares composing the 3 indices that determine the
amount to be paid at maturity) and traded with prices dependent upon the ups and
downs of the underlying asset. Furthermore the contracts give the client the right to redesign the product once it has been issued. This increases the complexity of the
operation since several professions become intimately involved in the process. The
General Bank has received price as the best derivation house in France. The capacity to
design and price these unique products is the strength of the General Bank. It requires
‘quants’ of different kinds and traders that can hedge the different contracts with one
eye at the simulation model’s expected prices (“the pricer”) and another at current
tendencies in the relevant markets. A problem with these products is that they are
related to 3 different markets in different time zones. Alan, an anonymous trader
presented in chapter 1 has to hand over the care of his large portfolio to a colleague in
New York at the end of his working day, who in turn hands it over to the colleague in
Tokyo, etc.
Some comments about the complex business of derivation design claim that derivatives
are parasitic, others that they help markets function better, but it is a fact that the
volume of structured financial products took off with the recognition of the Black –
Scholes (1973) formula for the valuation of options. Never mind that the maths behind
the formula was borrowed from the technique used to calculate the movement of
molecules in gases (Brownian motion). (That is why the formula presupposes Random
36
Walk movement of prices – no flock mentality among traders or following the moves by
Long Term Capital Management hedge fund!)
“- finance as a pure promise, disembodied and detached from the rest of the economy.”
(Lépinay, 2011, p. xvii).
In chapter 2 the organization, personnel categories and their communication codes are
presented.
The ‘front office’ holds traders and sales people as well as financial engineers. Clients
can initiate a deal by starting a conversation with the sales people. The sales people
want to close as many deals as possible. The quants put the emerging product into the
formal language of mathematics and model how prices might develop for the product.
The traders buy and sell underlying assets to make sure that the bank can honour the
contractual payment at maturity.
The ‘middle office’ stand between the front and back offices. It checks information
flowing back and forth between the two. If, in a specific bank, the transactions are so
straight forward that they can go directly to the back office the middle office is
redundant. Its task may be described as ‘maintaining deals’.
The ‘back office’ records transactions and deals with a focus on data accuracy and due
dates. When the deal is closed the client speaks with the front office, but when the
contract is signed the back office takes over the client relation. This may cause tension
between the two at times.
Lépinay (2011, p. 13) illustrates the language problem by way of the description of the
product used by the different professions involved:
- The financial engineers (‘quants’) call it “a zero-coupon and a call option”
- The back-officers call it “a contract and 32 fixing dates”
- The traders call it “the indices’ futures hedging scheme”
- The clients call it “aggressive insurance”
As volume increases and more and more unique contracts are generated the
possibilities for misunderstanding multiply. Most banks use accounting as a common
language – how much money the bank is making on a given product. But there are many
private codes in use as well, riskiness has to be described, new innovative products
37
cannot readily be described in the old codes (It is like an X but with a Y). A further
complication is that client relations are long and ‘sticky’.
Lépinay now discusses the product (CGP) from the perspective of the different
participating professions against a kind of “common language” called ‘thinking
financially’. The ‘quant’ has two approaches to engineering a product; (1) they may pick
up an idea from an academic or professional journal, analyse it, and build a model that
makes use of the new insight. That model is added to the set of other models in the
arsenal. (2) Quants have to be like ‘sponges’ sucking up information by conversations
with the other actors in the trading room, at the coffee machine, with lunch partners,
and in the spaces between the desks. What is going on out there? Any ideas for new
products? It is a matter of combining mathematical and financial intuition. The former is
a matter of having “quite a few mathematical rules in one’s head” (p. 40). The latter is
“which product I will use so as to be able to calibrate this probability [that a certain
event will occur], that is, when I will hedge, what I will do to hold my price and to put in
place a portfolio that I will manage in such a way as not to lose money.”(p. 40). Financial
modelling sits uncomfortably between a quickly growing ecology of products, and on the
other side, families of mathematical and physical formalisms that address more stable
entities. A pricing model for a unique CGP will be entered into a machine (‘the pricer’) to
give current prices of the product (there is no market where the product is valued).
The trader will have to look at the pricer and the “real” market indices at the same time
while executing hedging strategies, but things are more complicated than that. Every
trader will manage a portfolio of about 500 products (each built on a large number of
underlying securities in 3 different exchanges). To hedge each one individually would
generate far too high transaction costs. Hedging takes place on the aggregate level. So
the output of the “pricer” provides input to a risk-analysis program. For the output from
that analysis hedging thresholds are determined. The trader will have to choose to
conduct a series of transactions among those recommended by the risk analysis (firstorder and second-order risks (correlations between variations)). Furthermore
simulations may be used to ‘test the waters’, whether a mood is building in the market
(Knorr Cetina, 2002). Traders also do not mind losing money on a small order to elicit
data from the market. Lépinay (p 79) points out that it is not always an advantage to be
the first mover in this game.
38
Selling customized financial products with long duration requires secrecy since
derivatives are involved. This has an effect on the organization, among other things the
design of the trading room itself. Obviously there are access controls and authorizations
to pass before you enter, but once in you discover that traders are clustered in various
ways (e.g by product or by profession, or geographical area of your exchange) with two
rows of screens in front of each trader. Traders slide between positions on their chairs
that are carefully marked and guarded. There is a quasi-market in the room kept in
motion by the remuneration system, which allocates bonuses – often many times the
base salary – in a somewhat arbitrary manner. This makes the room the object of
manipulation since trade information (signals from the market) assumes value.
Collaboration and opportunism travel hand in hand. You have to position yourself in the
room to be “in the know”. Still people move around (not only in the room) and pick up
risk information that is in great demand by modellers and others. The quant will go over
to the risk department and present valuation models, hedging models and risk analysis
models used at the desk now and then, which is what regulators expect of good risk
surveillance capability. Sometimes, the auditor will come over to the quant to ask: what
is the best way to assess the risks of the new product he has just presented? Sometimes
leaks of information are required. A bank cannot hope to orchestrate the establishment
of a market for a product on its own, so it will disseminate models that will channel
conversations and create counterparts. The conclusion: the trading floor/room is a
market too.
Traders’ (work) life centres around portfolios of c.a 500 contracts, new ones coming in
and others were ending continuously. It is the back office’s job to keep track of all this
and much more, e.g., a contract goes through several stages before it is legally binding.
Since the products are customized to fit the customers’ need they will be “exotic” and,
consequently difficult to describe properly (modelled). The back office has its own
system of recordkeeping and need to categorise products for their needs. (note: the
trader who knows the system of the back office can see to it that his/her product ends
up in a good bonus category). A new in house software to integrate front and back office
recordkeeping, named TRADE was installed, but in the end human coordination was
required since mistakes will happen. The contingencies observed by Lépinay illustrate
39
how conversations benefit from a shared knowledge of the organization when
reconciling information kept in these systems.
The sales people, who meet clients, discuss their “needs”, and design a portfolio
insurance together with the financial engineers, need to be taught to ‘thing financially’.
This was done in a course where a professor of financial mathematics (two chairs, a
university and a business school) came in once a week The principles of exotic finance
was taught in a fairly non-technical way (p.166). It was not marketing that was taught,
rather the logic of clients’ preferences. The matter of pricing the products never came
up. Focus was on how product worked – their economic rationales. Products were
anchored in clients’ needs as the instructor used hypothetical situations to illustrate
(“fabricating scenarios” took up much of the teaching). Still participants complained that
they were “losing touch with the economy” (p. 166). When such touch was lost also by
the instructor (he could not construct a situation where the product could be used as a
hedging tool) he would retreat to the speculative aspects (digitals) and celebrate
financial creativity. It seemed to work best when products were classified and presented
in groups (managing interest rate risk etc.).
Custom-tailoring products were the name of the game. A story that Lépnay heard many
time recounted how a hotel owner in ski resort, who wanted to hedge against the
currency fluctuations stemming from having customers from various countries, came
away with a weather derivative protecting his revenues from the effects of bad weather.
In chapter 6 Lépinay starts out by showing that the total assets of the bank’s balance
sheet in year 2000 is about 1/10 of its off-balance sheet item “Forward financial
instrument commitments (note 17)”. Later he discusses the effects of Basel regulation
on value at risk (VaR) as the basis for capital reserves. When the Basel Committee
opened the door to customized (1995) the bank applied for permission to apply a
customized version of VaR. This aroused regulator curiosity in the organization of the
bank. Combining the unique products with standardized measures was no easy task and
the cost was less space for manoeuvre for front office operators. Still the bank was run
like a portfolio of relatively autonomous businesses, which is a mixed blessing. You may
get sold off. The success of the exotic desk made other teams look less attractive.
Lépinay tells the story of how the ‘emerging markets’ room disappeared. But he also
40
points out the increased pressure of regulators (the State) and investors and how it gave
rise to the instalment of the TRADE system mentioned above to protect the bank from
intrusions from the outside by integrating it better. There was resistance to TRADE
among desks, and it was not universally adopted, but it managed to tie the exotic desk
very tightly to the bank.
The final chapter questions the value creation through derivation by illustrating
different aspects of it. He points out that it is in situations of great uncertainty that
calculations are the richest, the most complex, and the most sophisticated (p. 226).
Financial derivatives thrive on spatial discontinuities (p. 228). Derivatives’ value
creation is parasitic – and proud of it.
What can we learn from Lépinay’s book?
Lepinay himself points out that his ambition has been to show the elusiveness of
derivation. We can see how calculative practices thrive in absence of market prices and
how the risk of disconnection from real economic processes, and from the gaze of
regulators and owners, is ever present. It is an illuminating ethnography of the modern
phenomenon of derivation. But the text often suffers from the author’s sometimes too
flowery language.
3. Reflections
This essay has been written by a member of a team of researchers who have conducted
interviews in various Scandinavian banks over the last 3-4 years. Other approaches,
including ethnography, have been applied as well. The inspiration to try to read
historical text on the nature of banking comes from the discovery of the elusiveness of
banks as to their “real” nature as organizations. A few themes emerge from the current
reading;
-
banks thrive in symbiosis with their environments. This calls for a specific look
-
there are some core functions that seem to define a bank (in the traditional
-
into the boundaries of banks
sense)
disconnect processes seem to be latently present and need to be counteracted by
bank managers.
41
1. Banks in symbiosis
I think ‘symbiosis’ is an adequate description of the relation of successful banks with
their environment. In the old days (Medici) the relation centred on trade – the buyer
does not want to pay until the goods have arrived while the seller wants payment before
the goods is shipped. Financing the gap between seller and buyer expectations and
providing for safe transfer of payments makes the bank party to the trade. The success
of the merchant is the business of the banker. Benefits are mutual. Relations build on
justified trust. The merchant banks of London were part and parcel of the emergence of
London as a financial centre. Banks played different roles in different countries as
modern times broke through in the 19th century. Also in private banking operations in
post-big bang Paris advising clients with large sums of money to invest is a matter of
maintaining a dialogue over time.
Banks do well when they refer to some other business of which they have good
knowledge (like the North-American cotton trade). Then they can be able to provide
judgement that weighs all the evidence and separate good deals from the bad ones. This
is risk management, as opposed to risk calculations. By having detailed and complex
information bank representatives can take action to avert emerging risks before they
explode in credit losses and other extraordinary costs.
True that very important technological innovations de-regulation, wars and other events
changed the environment of the banks. The old basis for excellence of the merchant
banks, personal relations and a good reputation was not enough. But this means that the
environment changed and banks have to find their symbiotic relations elsewhere.
Focusing on corporate clients (M&A, privatizations, buyouts) after the very strict
regulations of wartime were relaxed (and New York had taken over world domination of
finance) was a strategic move that required other knowledge bases but still could do
with personal relations. Selling financial products en masse to clients of all kinds
gradually turned the business of banks to self-referencing and to a conception of banks
as “betting houses”. We are many who have bought a structured product that would pay
handsomely if the Euro gained in value against the dollar (or vice versa) The bank’s
customer advisor (sales person) could show convincing analysis by experts that the
Euro was advancing. Simple to benefit from that by buying a structured product – and
there is virtually no risk. The reference is no longer the banks knowledge about trade,
42
but the expertise in risk modelling of the “quants” and the mass distribution of products
by global banks (too big to fail).
Banks failed in the good old days too! Not least in Florence. We can see through history
that banks easily end up in trouble when they liaise too closely with sovereigns. It was
when the Medici branches got involved too much with financing princes and their wars
that would find themselves tied up with large sums and for longer time (if they did not
end up on the losing side). Baring, Rotschild and others, were very active in helping
states with the floatation of loans in the 19th century but that did not (usually) mean that
capital was tied up for long since there was a growing market for financial papers, not
least government bonds. On the other hand banks did not want to have much to do with
companies with limited liability in those days – to much irresponsibility in joint stock
companies. The driver toward conservatism in banking was the unlimited responsibility
of partners. The limited size of the bank made it possible for partners to watch out for
and manage risk. With the size and complexity of global banks today one “rouge trader”
can go very far astray before he (no she yet as we know of?) is discovered, as many
examples have shown.
2. The risk of disconnect
A rouge trader in Singapore or the recklessness of a Pontiari in Brügge seems to stem
from symbiosis going awry. Too close involvement with environment phenomena, be it
the court of an extravagant prince or the game spirit of finance. Focus of the
representative of the bank shifts to own (potential) benefits rather than the good of the
company. Pontiari and other representatives of Medici were charmed by the possibility
of improving their standing at the court by fixing finance from Florence and thought
they were smart enough to see the expected benefits of their action (which headquarters
did not). The controlling influence of duties toward the organization is muffled/severed
by the glorious presence in in a charming environment. Duties and prudence are
forgotten. Virtues, if ever present, have been pushed aside; the excitement
(expectations) of the present game takes over. The actor disconnects. When the actor
disconnects the organization may be cut off from vital parts of its environment. Similar
effects may arise if the organization is compartmentalized and cooperation between
43
departments discouraged by profit centre thinking or individually determined
incentives.
The opportunities and reasons for disconnect have multiplied in modern organization
practices as applied to banks. This happened as a consequence of de-regulation. Onestop-banking and the widespread use of the internet and related technologies
forced/encouraged banks to acquire complementing competences, e.g., brokers and
jobbers in London, or to build from scratch by hiring individuals or teams with the
longed for expertise. Most banks and especially the global banks entered the new
century with fragmented organizations and overwhelming business opportunities in the
wake of states encouraging citizens to become investors. The consolidation of the
finance business by M&A forced margins in traditional services down. To survive and
stand up to competition from abroad bank had to increase volumes and find new
business opportunities. Creativity bloomed, while time did not allow the building of
matching control systems. Top management in banks became disconnected from
operations they did not understand. When the crisis struck in 2008 top management
and regulators alike did not have the tools to intervene in time to avert a major crisis.
The bail-out solutions chosen (TARP etc.) have created still bigger banks in the USA,
which are clearly too big to fail and prone to new disconnect situations.
The remedy is to strengthen the unity of banks around key societal functions that banks
serve in society. The tools to build links that will maintain control and responsibility in
banks need to be built from a different ontology (assumption about what the system we
are analysing consists of).
The dominating ontology in today’s financial world is agency theory, which builds on
very simple assumptions about the nature of man. Humans are rational utility
maximizers, who follow rules and are fully informed. Since they are only interested in
their own utility the only problem top management has is to design the right incentive
system. If the right incentives are sent into this black box, the right action will come out
of it. Incentives first and action as a consequence:
A Assumptions
about
Assumptions
Human
About
human
Nature
Nature
1. The right incentives
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2. The right action
Figure 1 Agency theory ontology
The assumptions about human nature are (by definition) stable since they form the
premises for calculation (of risks among other things in models).
An alternative view would be to look upon humans as individuals, who want to build an
identity and improve themselves, i.e., as a human project. To become a person, a
responsible member of an organization or society the first thing is to find out who you
are. This cannot be done by introspection (Hannah Arendt (1958) tells us) so the only
way is to act and see how other react. This requires courage since there is always the
risk that the others might signal that you are an incompetent. Hesitating before acting
the individual might consider giving up his identity project and become part of the
crowd (mob), which, among other things, entails irresponsibility. Another strategy
would be to try to control the reactions of others if successful this strategy will provide
the individual with a distorted view of himself (Hitler and Stalin are famous examples –
there are a few others in the world). We must gather the courage to act while facing the
risk of disapproval. When we meet approval from the environment our human project is
under way we can build on experience and develop into fully fledged members of the
organization or society – a responsible person.
2. Approval
A Human
Project
1. Action
Designed
Environment
‘mission’ etc
Figure 2 A stewardship theory ontology
In this case the initiative rests with the individual, who has to act on the environment in
order to get a response; hopefully an approval but possibly a rebuke. The individual
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De
developing his/her person will learn from experience. Top management may have some
influence on this development by designing “the mirror” in which the individual finds
his feedback. The design of that “mirror” will be Janus-faced, catering to the need of the
individual as well as the need of the organization. Two projects will be in motion at the
same time individual development and organizational development. The key issue is
communication. Learning from the experience of others is made possible by narratives
(Cooren, 2000). Narratives that survive and may serve as exemplars have a specific form
that makes them translatable into specific environments.
This ontology, the human as a development project, striving toward betterment does not
preclude striving for personal utility (money), but it ensures attention to the
surrounding world and thus to duties and responsibilities. It is dynamic because it is
interactive, and it is likely to build stewardship if top management signals responsibility.
3.
The core activity of banks
As mentioned above banks will operate in symbiosis with selected parts of the
environment. Specific trust relationships are central. Two ‘functions’ have been pointed
out; trade credits that bridge the gap between buyer and seller, and safe keeping of
deposits from clients. This later function implicates an ability to evaluate placement of
funds in the meantime in evaluated projects that promise growth. Skilful investment of
deposits in projects makes banks dependent on the success of credit clients in their
projects, which in turn allows deposit clients to receive interest. The innovations of the
world have mostly been financed by credits (McCloskey, 2010). Therefore banks, in their
credit evaluation, are in a constant development of their role in society. They are
dependent on the success of their clients and clients are dependent upon the success of
their bank. The core competence that determines how well banks fulfil their social
function obviously, then, is picking the winners, i.e., applying judgement in balancing
prospective gains from the investment project under consideration against the risk of
failure. This kind of risk-taking is managerial in the sense that it judges unique projects
one by one on their own merits. There is no basis for probability calculations. One could
look upon these ‘functions’ as related to industrial capitalism.
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A fairly recent ‘social’ function of banks that emerged with “securitization” is market
making. The case reported by Lépinay above deals with a (part of a) bank with such
activities. Market making means to see to it that there is a liquid market for investors in
a certain kind of financial instrument for them to be able to get in or out of the market
without undue delay. That function requires the bank to have a cadre of buyers and
sellers at hand to keep the market ‘alive’, and, in the beginning, to have a sales
organization for new issues that can distribute large volumes of a product. In a sense
this function starts from personalized relations to investors (usually representatives of
institutional investors) with the intention to set the stage for anonymous mass
distribution of “products”.
All these ontological reflections need to be developed in separate papers.
Further readings:
Arendt, Hannah (1958) The Human Condition. New York:Doubleday
Bagehot, W., (1873), Lombard Street. New York: Scribner Armstrong.
Banks, Erik (2004), The Failure of Wall Street – How and why Wall Street fails – and what
can be done about it. London: Macmillan.
Black, F., and Scholes, M. (1973), The Pricing of options and corporate liabilities. Journal
of Political Economy. Vol. 81, no 3, pp 637 – 54.
Cooren, Francois, (2000), The Organizing Property of Communication. Amsterdam:
Benjamins
Gerschenkron, Alexander, (1962), Economic Backwardness in Historical Perspective: A
Book of Essays. Cambridge, Mass. : Belknap Press
Hirschman, A.O. (1958), Strategy for Economic Development New Haven: Yale
University Press
Knorr Cetina, Karin, (2002, Inhabiting Technology: Features of a Global Lifeform.
Current Sociology, vol. 50, no 3, pp 389 – 405.
Machiavelli, Niccolo (2010), Florentinsk Historia (övers. Paul Enoksson). Stockholm:
Atlantis
MacKenzie, Donald, (2009), Material Markets – How Economic Agents are constructed.
Oxford: Oxford University Press
McCloskey, Deirdre, (2010), Bourgeois Dignity. Chicago: Chicago University Press
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Parks, Tim, (2005), Medici Money. Banking, Metaphysics and Art in 15th Century Florence.
London: Profile Books
Schumpeter, J.A., (1933), The Theory of Economic Development. Cambridge Mass.:
(kompletteras…)
Sorkin, Andrew Ross, (2009), Too Big to Fail – Inside the battle to save Wall Street. New
York: Penguin.
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