The evolution of financial systems - Open Knowledge …

1 The evolution of financial systemsIn preindustrial economies, finance was largelyconcerned with the development of a medium ofexchange. Barter was inefficient, transaction costswere high, and the lack of a medium of exchangelimited the extent of the market and the opportuni-ties for specialization. With the growth of nonlocaltrade, the development of payment media becamelinked to the financing of trade. Otherwise, apartfrom the financing of governments and seabornetrade, borrowing and lending were mostly infor-mal and on a small spread of urban society, and above all theadvent of large-scale industrialization in the sec-ond half of the nineteenth century, altered the rolethat finance had to play. Finance was now con-cerned with mobilizing resources for large infra-structure projects and for investments with heavycapital requirements that exceeded the capabilitiesof small family systems that emerged often suffered fromfraud and mismanagement.

2 They proved unstableand experienced frequent crises. Speculative ma-nias, fueled by financial institutions, causedmounting concern, and after the Great Depressionof the 1930s governments began to supervise theirfinancial systems more closely. But government in-tervention was by no means entirely successful. Itmade the financial system less flexible, and al-though it reduced fraud it did not eliminate , economic agents proved adept at get-ting around the regulations. In recent years thefocus has shifted back to deregulation, partly inresponse to financial innovation and partly to pro-mote competition and evolution of financial systems ought to castlight on two questions that are of interest to policy-makers in developing countries. What role shouldfinancial systems play in promoting industrializa-tion and development? And what role should gov-ernments play in creating such systems ?

3 Development of payment systemsThe search for an efficient medium of exchangegradually led to the monetization of preciousmetals. As a result the payment mechanism be-came simpler and safer. The new monies facilitatedtrade and provided a store of value and a unit ofaccount. Governments played an important part inthis change by owning and regulating mints andthus ensuring the quality and acceptability ofcoins. But they were also frequently responsiblefor debasing coins by lowering their weight oradulterating them with less precious metals, suchas payment was a big step forward. Gradu-ally, however, paper-based instruments, whichwere cheaper and more convenient, came to re-place coins and bullion. Payment orders, letters ofcredit, and negotiable bills of exchange evolved41with the expansion of nonlocal trade in were particularly useful in triangular trade,because only net settlements had to be made inspecie.

4 Commercial bills known as hundi weredeveloped in India. In Japan, the need for cashwas reduced by the use of bills and rice warehousewarrants and by the development of direct role of governments in creating paper-based credit instruments was limitedalthoughthey provided the legal framework that was neces-sary for their use. Governments played a greaterpart in the development of paper money. Theywere involved either directly (as in China) or indi-rectly (which was more common), through grant-ing the right to issue paper money to private bank-ers. China invented paper money in the ninthcentury. The ruler, acutely aware of the problemsof paper money, enforced acceptance with thethreat of death and by strictly limiting issuance(see Box ), although there were many later in-stances of overissue. Paper money was subse-Box Marco Polo discoverspaper money"In this city of Kanbalu [Beijingi is the mint of theGreat Khan, who may truly be said to possessthe secret of the alchemists, as he has the art ofproducing money.]

5 He causes the bark to bestripped mulberry-trees .. This ..ismade into paper, resembling, in substance, thatwhich is manufactured from cotton, but quiteblack. When ready for use, he has it cut intopieces of money of different sizes, nearly square,but somewhat longer than they are wide .. Thecoinage of this paper money is authenticated withas much form and ceremony as if it were actuallyof pure gold or silver; for to each note a number ofofficers, specially appointed, not only subscribetheir names, but affix their seals also.. The act ofcounterfeiting it is punished as a capital thus coined in large quantities, this papercurrency is circulated in every part of the GreatKhan's dominions; nor dares any person at theperil of his life, refuse to accept it in payment. Allhis subjects receive it without hesitation, because,wherever their business may call them, they candispose of it again in the purchase of merchandisethey may require; such as pearls, jewels, gold, orsilver.

6 With it, in short, every article may be pro-cured."Marco PoloThe Travels of Marco Polo, Book II, Chapter 24(Komroff 1926, pp. 156-57)42quently introduced in Japan. In Europe, banknotes (representing promises to pay on demand)were issued in the seventeenth century by gold-smiths, notaries, and merchants, who graduallydeveloped into bankers. Banks created by specialcharter, such as the Bank of England, also issuednotes. In the colonies of North America, a chronicshortage of bullion led to the issue of land-backedcertificates, which circulated as paper overissue of bank notes often underminedthe credibility of paper money and led to financialcrises and the suspension of the notes' convertibil-ity into bullion. This happened in the AmericanCarolinas and France in the eighteenth century,and in several European and Latin American coun-tries in the nineteenth century. Attempts in thenineteenth century to regulate the supply of gold-backed bank notes in England stimulated the useof checks drawn on bank deposits to make pay-ments and thus promoted the spread of a moreefficient and versatile instrument of payment.

7 Thegrowing use of bank notes issued by differentbankers led to the creation of clearing facilities,which were later extended to cover the clearing central banks evolved to cope with the recur-ring financial crises of the latter part of the nine-teenth century, they came to monopolize the noteissue. This led to the eventual adoption of fiatmoneythat is, paper (and later credit) money notbacked by bullion. Fiat money solved the problemof loss of confidence in bank notes issued by indi-vidual banks, but not the problem of overissue ofpaper money by the central bank. Many countriesin Asia, Europe, and Latin America suffered epi-sodes of hyperinflation after governments hadused the central bank's printing presses to financetheir twentieth century has seen further innova-tion in payment instruments, including plasticcards and electronic transfers. These were devel-oped primarily to improve the efficiency of pay-ments rather than to promote expansion of most countries, central banks now play an im-portant role in the payment system: they provideclearing and settlement facilities to banks and toother institutions that offer payment of trade financeIn preindustrial economies, governments bor-rowed to pay for wars, and seaborne trade wasfinanced, as it had been since classical times, by so-called bottomry loans (a combination of loan andBox Trade financing in Renaissance ItalyThe businessmen and bankers of northern Italy's Re-naissance city-statesparticularly Genoa, Florence,and Venicedeveloped many of the fundamental prac-tices of modern finance.)

8 Their innovations includeddouble-entry bookkeeping and the provision of creditthrough discounted promissory notes. One of theirmost important innovations, however, was that a Florentine textile manufacturer re-ceived a potentially profitable order from Barcelonaand had the means to fill it. Two things might keep himfrom accepting the business. First, the importer mightnot pay until he received the goodsperhaps not evenuntil he had sold them. Meanwhile, the exporterwould have to pay for materials, labor, storage, andshipment. Second, having produced and shipped hisgoods, the exporter would have to bear the risk that theimporter might simply fail to pay. And there was nocourt to which the exporter could take the banksthat is, banks which specialize infinancing commercecame into being to solve suchproblems. By providing short-term finance (workingcapital), commercial banks enabled such merchants topay for materials and labor in advance.

9 They solved thesecond problem by having trusted agents in major cit-ies. For a fee, the bank could pay the exporter as soonas the shipment embarked. The importer would thenpay the bank's agentadding a feewhen the ship-ment arrived. For an additional fee the same bankmight even insure the time, the Italian banks developed this vitaltrade-financing function. The leading Florentine bank-ing family, the Medici, acquired agents or correspon-dents in Europe's trading cities and made itself indis-pensable in the continent's commerce. Probably in thethirteenth or fourteenth century, the bankers inventeda variation that limited the degree to which their owncapital was tied up over the course of the was the "acceptance," or "four-name paper."The Barcelona agent (name 1) would sign a document"accepting" the liability of the importer (name 2) to theexporter (name 3), and the document would be con-veyed to the banker in Florence (name 4).

10 The bankerwould disburse (after subtracting a discount) to the ex-porter against this acceptance. The banker could thensell the acceptance at a discount in the Florentine finan-cial market and thus replace most or all of the cash thebank had disbursed. After some weeks the importerwould pay the agent, the agent would pay the bank,and the bank would repurchase the acceptance, con-cluding the contract, which was repayable upon thesafe completion of the voyage). Otherwise, bor-rowing and lending were mostly on a small scaleand were limited to trade credit, short-term loansto farmers, and loans for nonbusiness financial system comprised money changersand moneylenders and a few private bankers whodealt mostly with wealthy individuals, acceptingdeposits for safekeeping and providing loans. Inaddition, tax farmers helped to administer the taxsystem by collecting and transferring taxes, andvarious religious establishments offered their ser-vices as expansion of commerce was driven by thespread of trade fairs from medieval times and byadvances in maritime technology in the fifteenthcentury.