EC120 week 10, topic 9, slide 1

Innovations and Crises in Finance

Topics:• Monetary Standards and Systems• Varieties of Financial Instruments and their Purposes• Banks: their evolving role• Financing Trade• Long-term Finance• Financial Crises and Economic Fluctuations• Finance and capital: evolution of the banking system• Finance and capital: expansion of long-term capital markets

Monetary systems and standards

• What is `money’? • Coinage of precious metals, antiquity onwards• Governments have always intervened

– Temptation to debase the currency• Multiple monies

– Different states (typically) have different currencies

EC120 week 10, topic 9, slide 2

Financial Instruments and their purposes

Apart from money:• Debt contracts

– Long-term debt, e.g. mortgages, or bonds– Short-term debt, e.g. Bills of Exchange, or bank loans

• Equity, conferring ownership, e.g. shares in a partnership, or in a corporation

Important distinctions:• Marketable: may the instrument

be traded among holders?• Liability: equity often imposes

unlimited liability

EC120 week 10, topic 9, slide 3

The Role of Banks• Banks link money and credit• How? Through borrowing and lending• Borrowing (banks’ liabilities)?

– Owners equity, debt, deposits, “money”• Do banks “create” money?

– Some, not all, banks issued notes• Lend to firms, individuals, governments

– Key role: to finance trade

EC120 week 10, topic 9, slide 5

Financing Trade• Credit becomes vital to support trade expansion

– Long-distance trade → time in transit– Work in progress → time to produce

• Specialist institutions evolve to lend to buyer or seller, or both– “Banks” obtain funds, from partners or borrowing– And lend, at interest, to those who can provide collateral

• Bill of Exchange − a trade contract, facilitating trade credit– Banks made loans by “discounting”, i.e. buying, Bills of

Exchange• Banks also arranged settlement of debts

– Especially important for widely separated borrowers and lenders

EC120 week 10, topic 9, slide 6

Bills of Exchange

• The Bill of Exchange – an instrument for short term credit

• `bill’ = contract between `buyer’ and `seller’ for cash settlement at a specified future date

• `bill’ is typically guaranteed by an `acceptor’ (bank)• `bill’ can then be traded for cash before settlement

EC120 week 10, topic 9, slide 7

EC120 week 10, topic 9, slide 8

Long-term Finance

• Long-term debt supported markets in land – Mortgages

• Capital markets for long-term securities expand in 18C

• Vulnerable to mania and crises– Prospect of Govt. default

with onset of war

– Bubble Act, 1720, restricted joint-stock companies

• Corporate finance (for business)– Finance trade (trade credit, working or circulating

capital)

– Long-term, fixed capital demanded only in a few sectors

Financial Crises

• Role of banks in credit crises:– Highly fragmented system, vulnerable to crises– Little central (national) supervision until 19C

• Crises in long-term capital markets– Narrow impact until expansion of equity markets

in 19C– Most involve government debt

EC120 week 10, topic 9, slide 9

Economic Fluctuations

• Pervasive, irregular fluctuations and crises– More regular Trade Cycle appears later, from mid-19C

• Economic fluctuations driven by harvests• Credit crises associated with fluctuations in

trade

EC120 week 10, topic 9, slide 10

EC120 week 10, topic 9, slide 11

Finance and capital: banking system• Restoration of gold parity, 1819/20

• Restrictions on private issues of bank-notes

• Trend to banks’ amalgamation, branch banking in UK

• Recurrent credit crises result in financial distress

• Bank Charter Act, 1844 – confirmed Bank of England’s role in UK monetary system

• Emergence of central banks: `Lender of last resort’

EC120 week 10, topic 9, slide 12

Expansion of long-term capital markets

Capital markets:

• Bubble Act repealed in 1825

• Railways required large scale investment

• Limited liability became widespread from 1856

• Recurrent speculative investment mania

Joining it all up

Themes:• Governments always need revenue, partly from

borrowing• Trade requires credit and a payments mechanism• Modern industry requires long-term capitalWhat drives financial performance?• Fragility or stability of banks (and other financial

institutions)• State capacity – Gov’t borrowing/taxation to support

finance • Democratic accountability• International co-operation (or lack of it)

EC120 week 10, topic 9, slide 13