1.1 The History of Finance

Financial services have historically always played an important role in the economy of every society. Banks mobilise funds from investors and apply them to investments in trade and business. Although the actual origin of banking is difficult to determine, the history of banking is long and varied, and the financial system as we know it now is generally ascribed to the Florentine bankers of the fourteenth to seventeenth centuries ad.¹ The word “bank”, for example, is derived from the Italian word banco (for the merchant's bench). Interestingly enough, the word “bank” also assists in tracing the origins of “bankruptcy”, which relates to the breaking of a merchant's bench in medieval Italy as a signal of failure. Whether it be safe keeping, money changing, investing funds on behalf of others or making other capital goods such as land available at a charge, financial services have been around in some form for a long time. Even pre-dating the invention of money, safekeeping of valuables was long a task ascribed to religious temples. Deposits would initially have consisted of grain, but also other valuable goods such as cattle and agricultural implements, followed by precious metals such as gold. The latter would typically have been stored in a form that was easy to transport such as plates or bars. There were good reasons to store valuables in temples: the continuous stream of visitors would make it difficult for any thief to go about his business unnoticed, in addition to which they tended to be well built, making them secure. Perhaps even more importantly, ­temples were sacred places that were deemed to provide additional protection against potential thieves.

Evidence exists of priests in Babylon lending money to merchants as early as the eighteenth century bc, and the Code of Hammurabi,² believed to have been written around 1760 bc, includes laws governing banking operations in ancient Mesopotamia. Although not the first known law, it is the best-preserved one. Table 1.1 provides some examples of the laws in the code that are related to financial services.

In addition, any compensation for loss of articles in safekeeping and the amount of rent to be paid for having the usufruct³ of land and different species of livestock was clearly defined.

In the Roman Empire, money lenders would conduct their transactions from benches in the middle of enclosed courtyards rather than setting up shops. The ancient Roman money lenders merely converted any currency into the currency of Rome, which was the only legal tender in the city, and are not known to have provided any further financial services.

At the time of the ancient Greeks, bankers not only converted currency but also invested in projects and other businesses. Banking was no longer restricted to temples, and other entities such as money changers also conducted financial transactions including loans, deposits, exchange of currency and validation of coins. Trade finance, in the form of letters of credit, flourished. Money lenders in one city would, against a fee, write a credit note that could be cashed elsewhere in the country, which meant that no coins needed to be carried around on their journey, nor did guards have to be hired to protect it. Interestingly enough, most of the early bankers in Greece were foreign residents, and there is little known about the individual bankers themselves, although records have been found relating to Pasion (c.430–370 bc), originally a Phoenician slave, who rose to be one of the wealthiest citizens in Athens and owned one of the most successful private banks in Athens.⁴

Credit-based banking spread in the Mediterranean world from the fourth century bc. In Egypt grain has long been one of the most used forms of money, in addition to precious metals. State granaries functioned as banks, and when Egypt briefly fell under Greek rule, the government granaries were transformed into a network of grain banks with a centralised head office function in Alexandria. Payments could be effected by transfers between accounts without any physical money changing hands.

The Romans then perfected the administrative aspect of banking and introduced enhanced regulations of financial institutions, in the wider sense of the word. The practice of charging and paying interest developed further and became more competitive. However, as a direct result of the Romans' preference for cash, the development of the banking system itself was limited. Additional restrictions were introduced on the banking system by theologians and philosophers, mainly due to the fact that the charging and paying of interest was deemed to be immoral. With the fall of the Roman Empire, banking declined significantly in western Europe and did not feature again until the time of the Crusades from the late eleventh century ad.

The Crusades, in combination with the expansion of European trade and commerce, led to an increase in the demand for financial services. As a result of people travelling to a variety of different countries, there was a significant demand for money-changing services. Any service that would make it possible to transfer large sums of money without the complications of having to carry chests full of gold around and requirements for elaborate precautions against theft was particularly in demand. Crusades were expensive and the participants often had to borrow money, which was regularly done by mortgaging land and buildings. The terms were, however, far more favourable to the lender than to the borrower, as a result of which the demand for mortgages deteriorated over time.

The development of international trade led directly to the requirement for a foreign exchange type contract, the first of which was recorded in 1156 in Genoa.⁵ The use of these types of contracts expanded significantly, not only because of the requirements following the development of international trade, but also since profits from time differences in a foreign exchange contract were not covered by canon laws against usury.

Financial contracts of this time were largely governed by Christian beliefs, which prohibited interest on the basis that it would be a sin to pay back more or less than what was borrowed. In addition, justness of price and fairness were important underlying guiding principles that applied to society as a whole and included financial services. The evolution from an interest-free to an interest-based banking system did, of course, not happen overnight, but was based on a number of factors such as the change from agrarian to commercial economies, the move towards pricing on the basis of supply and demand, decentralisation of the Church, and the recognition of money as a factor of production.⁶

During the Middle Ages, until the thirteenth century, the Church was the largest single entity possessing significant wealth and was an important lender. However, the impact of the Church declined, and as commerce flourished and generated more wealth than could be reinvested in commerce alone, it was the merchants who lent the money to finance individual and government consumption.⁷ Initially only lending their own money, some of the merchants became merchant bankers lending both their own capital as well as capital deposited with them by others.

While in most of Europe the Christian prohibition of usury was still in place, charging interest was, however, legalised in Valencia in 1217 and Florence in 1403. The legalisation of interest in Florence was more significant for the development of the banking industry as we know it now since the Florentine bankers, who already had a presence in a number of ­European countries, started to offer loans and deposits on an interest basis.

In the UK, London was the main centre of trade and hence the majority of financial transactions were executed there, mainly from the many coffee houses in the City. In 1565, the Royal Exchange was established in London to act as a centre of commerce, and some of the banking business moved there too. However, during the seventeenth century stockbrokers were expelled due to their rather rowdy behaviour, and the buying and selling of stocks was again confined to the coffee houses.

In the early part of the seventeenth century Amsterdam started to grow into a major trade hub, which in turn resulted in it becoming the financial centre of the world. It managed to maintain this position until the Industrial Revolution in the late eighteenth and early nineteenth centuries, and was home to the first ever recorded economic bubble, due to tulip mania. The tulip was first brought to Holland in 1593 from the Ottoman Empire, and became so popular that in 1623 a single tulip bulb could fetch as much as 1,000 florins, which was equivalent to 6.7 times the average annual income. By 1636 the price had risen to unsustainable heights, and the bubble burst in 1637 as a result of an absence of buyers and abundance of sellers. Tulip mania⁸ was only the first economic bubble of its kind. Inflated asset prices have since given rise to a multitude of busts and booms, the most recent ones being the dot.com boom and the subprime mortgage crisis.

The Industrial Revolution put America and the UK firmly on the map of international finance. With this shift of emphasis, the banks in these countries gradually gained importance over time. London and New York became the major financial hubs, later on joined by Hong Kong, Tokyo and Singapore. The main financial centre in the Middle East has long been Lebanon, until the war broke out in 1972 and the banks started to move to Bahrain and later Dubai. Increasing internationalisation in trade, commerce and manufacturing applies to banks as well and was often achieved by a combination of the establishment of new branches and acquisitions. In addition, banks started to offer financial services across the whole spectrum, from retail to wholesale, with the side effect that the once numerous small banks have now mainly merged into a few large conglomerates offering increasingly complex financial solutions. Few relatively small banks remain.

The events of 2007 and 2008, beginning with the subprime crisis, which was largely considered to be an American problem, led to unprecedented liquidity problems and resulted in the bankruptcy of Lehman Brothers⁹ and the forced sale of others such as Bear Sterns in March 2008 and Merrill Lynch in September 2008.