Two Grand Traditions in Financial History

By Joakim Book

Before New York acquired its status as the financial center of the world, the honor of that title was reserved for London and, before then, Amsterdam for roughly a century each. The financial markets, instruments, and practices that evolved there are rightly considered to have been the foundation for modern financial capitalism.

Well-developed financial markets, the basis of their trading being regular commercial transactions, have naturally followed in the wake of thriving merchant societies, such as the city-states of 15th-century northern Italy. Scholars of financial history often trace the European arc of financial deepening along the so-called Lotharingian axis, from the early public banks of Genoa, of Venice, of Florence, via Bruges and Antwerp to Amsterdam — and finally to London during the latter half of the 18th century. The sophistication and quality of financial institutions deepened at every step.

But in one sense the routes to financial supremacy taken by Continental centers such as Genoa or Amsterdam were remarkably different from that of London, and actually capture two different traditions in financial history. In jargon, we refer them as “bank-centered” and “market-centered” routes to financial development. The differences between them can help us better understand the challenges of our current financial markets, particularly so regarding credit intermediation in the crypto world.

Banks and financial markets provide crucial services to an economy; they both provide outlets for cash-rich savers lacking promising investment projects to come together with cash-strapped borrowers that do have such investment plans. By both moving funds from where they are to where they are needed, loans provided by a bank or bonds issued on a stock exchange seem to amount to the same thing: placing funds in the hands of entrepreneurs.

On this topic, there’s currently a rift opening up among financial historians where earlier generations emphasized — almost to the exclusion of all else — banks as engines for industrialization. Much more research is currently targeting stock markets and, most noticeably, peer-to-peer lending in countries like France and Sweden that may have gone unconsidered among earlier financial historians. The prerequisite of economic growth, according to much of the earlier literature, was well-functioning banking institutions that could spur industrialization.

And they weren’t entirely wrong to do so. Elaborate models suggested as much, and most economists have accepted this “banks first” argument. Joseph Schumpeter’s notable book Theory of Economic Development is essentially a long celebration of that position. The two growth models known to every student of economic history — Rostow’s stages of economic development and Gerschenkron’s catch-up thesis — both involve banks powering industrialization. Ross Levine, whose article “Financial Development and Economic Growth” is one of the 100 most cited economics papers ever, summarized the argument in the following terms:

Starting as early as Bagehot (1873), economists have argued that better banks — banks that are better at identifying creditworthy firms, mobilizing savings, pooling risks, and facilitating transactions — accelerate economic growth.

And the argument makes a lot of sense. Banks enjoy economies of scale in channeling funds between lenders and borrowers; they have access to non-public information about their clients, allowing them to better monitor loan performance. Those characteristics allow banks to partially overcome asymmetric-information problems innate to all credit intermediation and make them better placed to lend to businesses and individuals than publicly traded securities on a stock market.

Indeed, the banks-first argument also seemed to conform well to historical experience. Scotland’s remarkable catch-up to England in the late 1700s and early 1800s clearly owed much to its thriving banking sector; the German growth miracle in the late 1800s and the Japanese growth miracle in the 1900s are both credited to extensive banking institutions directing lots of funds to growing industries.

Of course, the argument never sat well with England — the first industrializing country — whose banks, it seems, played almost no role in financing the Industrial Revolution (recent research, however, also appears to be overturning that long-held conviction).

Bank-centered Amsterdam vs market-centered London

To some extent the following division, like all sweeping tales of history, is a simplification. But broadly speaking we might consign Amsterdam to the Continental tradition of bank-centered finance, and London firmly to market-centered finance. So, what did that actually mean?

Far from intermediating funds solely through banks, Amsterdam did have an active financial market — consisting mostly of municipal bonds, Dutch East India shares, and derivatives based on them. But its prime financial innovation came through its exchange bank — the Wisselbank — which bore a close resemblance to Genoa’s Banco di San Giorgio and Venice’s Banco di Rialto.

Prior to the Wisselbank’s establishment in 1609 by the City of Amsterdam, the monetary setting facing merchants must have seemed rather chaotic; thousands of different coins circulated and were legally recognized by the cities and regions in the Low Countries. The bank’s purpose was to offer settlement of all bullion in one withdrawable coin.

What happened over time was that deposits were subject to both a withdrawal fee and varying state-defined “ordinance values,” which meant that “the Bank now had a distinct unit of account that came to be called the bank guilder,” separate from the currency traded outside the bank. Instead of depositing and withdrawing funds for use in trade, merchants quickly learned to simply transfer the funds on the bank’s ledger between them — and thereby avoid the fee and the markdown of current money (the “agio”). In this way the Wisselbank, rather than a bank intermediating funds between savers and borrowers, became a highly sophisticated and centralized payment system for the 17th- and 18th-century Dutch economy. Rather than intermediating funds itself, it provided the payment platform for other agents to do that — the similarity to Bitcoin is striking.

The English case is somewhat different. The scriveners and goldsmith bankers of 17th-century London did provide some measure of intermediation and the chartering of the Bank of England in 1694 did establish a bank that offered more widely circulating banknotes. However, as the bank’s paying-for-privilege schemes were principally concerned with financing the government, the real action took place in the emerging London stock market.

The Crown, often in pursuit of wars or lavish lifestyles, would borrow, tax, and demand merchant advances without much structure. Raising funds for the government, both before and after 1688 with its changes to British government, was subject to extreme public-finance experiments — of which the Bank of England was not even the largest. Various lotteries, tontines, annuities, and of course the renewal of charters for the so-called Three Sisters (East India Company, Bank of England, South Sea Company) all provided plenty of financial instruments that could be traded in Exchange Alley, the companies’ various offices, or the Royal Exchange. Ranald Michie, the main historian of the London securities markets, repeatedly emphasized the importance of active markets for most of these instruments.

Remarkably, the market for the Three Sisters’ stock, various kinds of government debt and annuities, and the many privately issued short-term bills of exchange (essentially securitized trade credit) was so liquid that even Dutch merchants and lenders began using English securities “for laying off the risks of short-term commercial loans, a basis that their own capital market failed to provide,” financial historian Larry Neal argued.

After the mid-1700s consolidation of government debt into one single security — the consolidated 3 percent annuity, or “consol” — the thriving of abundant discount houses and stock market traders ensured active trading for most financial securities, earning London its designation as a market-centered financial system.

For bank-centered Amsterdam, financial intermediation took place inside the bank, a process the Wisselbank’s existence greatly facilitated. For market-centered London, as the Bank of England primarily advanced funds for the government in exchange for legal privileges, the Three Sisters’ stocks themselves and other financial assets such as the bill of exchange and the consols became vehicles for moving funds, collateralizing loans, and carrying out payments.

In contrast to Amsterdam, the distinctly English way of financial intermediation thus took place outside the bank, with the use of the general stock market.

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Joakim Book

Joakim Book holds a masters degree from the University of Oxford and was a visiting scholar at the American Institute for Economic Research in the fall of 2018.