History of Finance - Laying the foundation for modern day banking

In 15th century Italy, the key financial service of providing credit moved out of the “ghetto” to become the legitimate preserve of banks. This transition was symbolized by the rise of the Medici family. With their rise, money lending ceased to be disreputable. It became glorious and a foundation of a new kind of power.

It was Giovanni di Bicci de’ Medici aim to make money lending legal that led to modern day banking. He was an Italian banker, a member of Medici family of Florence and the founder of Medici Bank. He is credited with devising an ingenious bit of creative accounting that helped him succeed and get the Medici off the hook of the anti-usury laws. The Medici was basically comprised of foreign exchange traders profiting from commercial bills for financing foreign trade. The church prohibited the collection of interests on loans, but there was nothing to prevent a trader from involving in transactions that involved multiple currencies. There was no interest and hence, no sin. There was simply a commission or deduction for the conversion of one currency into another. The commission varied depending on the time frame and amount that was loaned to the trader. In addition to this depositors, which included church dignitaries, great nobles, political figures, put their money into the Medici bank. Such deposits were not usually payable on demand but were either explicitly or implicitly time deposits on which interests, or rather “discrezione” were paid. The bankers argued that “discrezione” was a free gift, and not a contractual obligation. This was credit payment in simple words but with the interest payment discretely concealed. Now for the first time, money lending had evolved into banking. The key to the Medici bank success was diversification. Earlier, banks had been monolithic and very vulnerable to default by a single bad borrower. But the Medici bank was made up of multiple interlocking partnerships, each in some way independent from the rest. It was this decentralization that lead to their astonishing profits. Under Giovanni guidance, the Medici bank improved its network from Florence to Venice and also to Rome. The scale and diversity of the bank was the key to reducing the risks of money lending, and therefore the costs to the borrowers.

This was the main difference between a loan shark and a bank. While a loan shark is free to quote the interest rate based on his/her free will, the Medici bank worked towards a common aim of lowering the borrowing costs for traders. The rise of the banks had begun and it was now one of the most profitable and respectable business. In 150 years the Medici transformed themselves from backstreet money lenders to the most powerful financial force in Europe. Having once being damned, bankers were now close to divinity. The business model used by the Medici bank involved used scale and diversity to spread out risks. Also by focusing on currency trading rather than just lending they reduced their exposure to defaulters. However, they were not invulnerable and faced losses because of over generous debts and blue blooded defaulters. But more importantly the Medici left a permanent mark in the financial industry, giving rise to modern day banking. He gave the banking industry a logical business model to diversify risks and reduce interest rates, which govern our lives and our countries future in the most important ways.

The ascent of banks was followed by the ascent of the second pillar of the modern financial system, the bond market. Bonds provided the magical link between the world of high finance and the world of political power. Government normally spend a lot more than they collect in taxes and make up the difference by selling bonds that pay interest. But the magic with bonds is that if you want to get rid of them, the government doesn’t have to give you the cash back. You can simply go to a bond market to sell it. The birth of the bond market was the next big revolution in the history of finance. It paved a new way for the government to raise money. It funded the wars that plagued Italy 600 years ago, dictated the outcome of the Battle of Waterloo, decided the outcome of the civil war in United States, and in more recent history have made powerful nations such as Argentina come crashing down.

In the 14th and 15th century the medieval city states of Florence, Vienna and Tuscany were at war with each other. And these wars required financing and large volumes of money. Rather than requiring their citizens to fight, each city state hired military contractors or “condottieri” that raised and lead armies to another land and loot treasures. These condottieri required money in abundance and the armies were ready to fight for anyone who paid them. The costs of these incessant wars plunged Italy city states into crisis. Expenditures even in days of peace were more than double the money collected from taxation. Bonds were a way for a country or kingdom to turn its citizens to its biggest investors.

It looked like the problem of debt was solved but there was another that creeped in. How much money can be raised through bonds? The more number of bonds that were issued, the less valuable they would be to the investors. At the same time, it’s the bond market that sets interest rates for the economy as a whole. If the country has an effect to pay 50%, so do all the other borrowers. Thus bonds dictated the outcome of the country’s future deciding the fates of many other historic events. This proved to be an important milestone in the history of the financial world.

The next was the rise of the Stock market………………