Financial engineering has not had a good press of late. A whole alphabet soup of complex financial practices have been blamed for the recent financial crisis. One such process, called securitisation, saw banks bundling up thousands of loans – many of which had been made to borrowers who would have trouble meeting the repayments – into large, hugely complex products and selling them on to investors.
Even now, some of the world’s largest banks are being investigated for manipulating LIBOR, a key financial standard determining the interest rates charged to millions of borrowers.
This complicated relationship between financial innovation and wider economic, political and social considerations is not new, however, and can be traced back to the Middle Ages and even beyond.
The development of new financial instruments, such as insurance, banknotes, cheques, ATM machines and online banking can help economic growth by facilitating trade and extending access to credit (what we might term ‘good’ financial innovation). However, financial engineering throughout history has also been driven by the desire to circumvent restrictions placed on financial activities – what is euphemistically described as ‘regulatory arbitrage’ (or ‘bad’ financial innovation).
In the Middle Ages, the religious prohibition of usury – the charging of interest or ‘making money from money’ – presented the greatest obstacle to the expansion of the medieval financial sector but, with typical ingenuity, medieval merchants and bankers soon found ways around it.
There were many ways of structuring transactions in order to disguise the charging of interest. Perhaps the simplest was for the borrower to recognise that he owed a greater sum than that actually received; for instance the debtor might issue a legally binding bond for £15 when he had in fact only received £10, with the £5 difference representing interest. An example of this practice is discussed in case study 1 (see below).
Another means of disguising interest charges was for the loan agreement to include a penalty clause in case of ‘late’ repayment, where the loan was expected from the start to be repaid late. Today banks offer free current accounts, funded in part by penalty fees for being overdrawn and other infringements.
Another medieval practice with modern resonance was ‘chevisance’ or a repurchase arrangement. A borrower would sell goods to the lender at one price with the understanding that the borrower would buy them back at a higher price. A similar logic informs the shadow banking system ‘repo’ market today, in which financial institutions raise short-term funds by pledging collateral. Finally, the borrower could pay the lender a ‘donum’ or ‘voluntary’ gift on top of the principal. An example of this is given in case study 2 (see below).
The most sophisticated method of disguising interest used bills of exchange. These were foreign exchange (FX) instruments, originally developed to transfer money for trade but which also involved a credit element. The bill of exchange stated that the seller of the bill had received a sum of money in the local currency from the buyer in place A to be repaid, after a set period, in place B in another currency at a set exchange rate. The seller of a bill of exchange was effectively a borrower, and the buyer the lender.
Interest was disguised by manipulating the exchange rates at places A and B, with the interest rate being determined by the difference, or spread, between the two rates; the wider the spread, the higher the profits. However, to produce this differential or spread required the systematic adjustment of exchange rates in all major financial centres. A practical example of this is described in case study 3 (see below).
Finance and morality
But was all this financial innovation necessarily wrong? If there was no way of circumventing the usury prohibition by charging interest, then why would investors have lent to borrowers, including governments, at all? It could be argued that the bill of exchange was an example of ‘good’ financial innovation that facilitated European trade, but which was subsequently repurposed by the financial sector as a means of hiding their profits (‘bad’ financial innovation).
But this is an over-simplification. Without the system of differential exchange rates, it would have been much more difficult to profit from FX transactions. There would therefore have been no incentive for the medieval bankers to engage in FX and this would have reduced the ability of merchants to borrow money or to transfer money internationally in order to fund their trading ventures.
There are two general problems with financial engineering and innovation, then and now. First, in so far as medieval financiers sought to disguise interest charges, this could create (perhaps deliberately) informational asymmetries. In the Middle Ages, merchants were presumably better able to calculate the interest rates implied by gifts or penalties or to predict future exchange rate movements than their customers, and this might have allowed them to charge higher rates. Similarly, it has been argued that modern financial institutions operate as a ‘confusopoly’ and regulators have imposed large fines on banks for the ‘mis-selling’ of products including endowment mortgages, payment protection insurance and interest-rate swaps.
Second, finance has an inescapably political dimension. Although financial engineering may have been accepted as business as usual within the financial community, the wider public could be less understanding.
For example, Londoner Richard Lyons was deeply involved in crown finance during the last years of Edward III’s reign. In one case, he arranged a loan of 20,000 marks for the king and charged 10,000 marks in interest. This was not necessarily an excessive rate for the time but Lyons was suspected of undue profiteering. He was first impeached by parliament and subsequently beheaded by a mob during the Peasants’ Revolt of 1381. Today there is intense suspicion of the relationship between the Too Big to Fail banks and the government. Those who work in the financial sector should therefore consider not just how the system works, but how this may appear to others.
It seems that there is a continuous thread of conflicting attitudes towards financial practices in the Middle Ages and today. For those involved in the markets, ‘financial engineering’ helps to keep the markets running smoothly. From an external perspective, however, certain financial practices could seem at best amoral and at worst, illegal. It therefore confirms peoples’ pre-existing suspicion of finance when details about the innovations developed to hide usury in the Middle Ages, or to fix LIBOR today, come to light.
Case study 1: Discounting
When Matthew Paris, the 13th-century English chronicler, reported the death-bed words of Robert Grosseteste, the reforming bishop of Lincoln (died 1253), he included some financial advice. It should be noted that this source tells us more about Paris’s opinions than those of the bishop:
For example, I take up a one-year loan of a hundred marks [£66 13s 4d] for a hundred pounds. I am obliged to make and seal a bond, in which I acknowledge receipt of a loan of a hundred pounds, payable in one year. But if you should wish to repay the money that you received to the pope’s usurer within a month, or sooner, he will not receive anything other than the full hundred pounds, which terms are heavier than those of the Jews.
In this hypothetical example, the interest rate works out at 50 per cent per annum if the 100 marks were received at the start and £100 repaid at the end of one year. Were the £100 to be repaid within the year, however, then the effective annualised rate would be much higher. If it was repaid after one month, as above, the annualised interest rate would be 600 per cent. Conversely, if the debtor could delay payment beyond the year, then the annualised rate of interest would fall – if it was repaid after two years, without incurring any further charges, then the effective rate of interest would be reduced to 22.5 per cent per annum. By contrast, the Jews were not subject to the usury prohibition and could openly charge interest. The king regulated and protected this market, capping the rate at 2d in the pound (of 240d) per week for the length of the loan – corresponding to an annualised non-compounded interest rate of 43.3 per cent.
Case study 2: Gifts
From 1272 until c1342 the kings of England employed a succession of Italian merchant societies as ‘bankers to the crown’. The granting of periodic gifts to the Italians was the preferred means of paying interest. For example, in the three years 1328–31, Edward III borrowed around £42,000 from the Bardi of Florence and promised them gifts totalling £11,000. Later, after the relationship between Edward and the Bardi had broken down in the 1340s, an Exchequer official calculated that the Bardi had been promised over £84,000 since 1309 as gifts. He argued that these were ‘usury’ and that the king should not be bound to pay them.
This document records a gift made by Edward III’s father, Edward II, to his then bankers, the Frescobaldi of Florence:
Charged to Ingelard de Warley, keeper of the wardrobe on 10 July 1310 – £1,000 paid to Amerigo di Frescobaldi and his fellows, merchants of the society of the Frescobaldi of Florence, of the king’s gift, for certain damages that they sustained in the third year [1309–10] by reason of a certain loan of 10,000m [£6,666 13s 4d] made to the king by them as it appears by a wardrobe bill that they have returned. [Paid] in five tallies made to various recipients as appears in the great roll of the receipt for the same day. By order of the treasurer.
This case is particularly valuable because we have detailed information about the amounts and dates of advances and repayments. It is therefore possible to reconstruct the interest rate represented by this gift, which works out to be 23.67 per cent annually. From this and other similar examples,it seems that the English kings could normally borrow at between 15 per cent and 25 per cent per annum but, during times of financial pressure, they might have to pay interest rates of 40 per cent to 60 per cent and even higher.
Case study 3: Exchange rate manipulation
The use of bills of exchange to extend credit rather than to actually transfer money was called ‘dry exchange’ and can best be demonstrated in practice as follows (also summed up above): In Venice on 26 September 1442, Francesco Venier & Bros sold a bill of exchange for 150 ducats to Cosimo di Medici and Co, payable in London after three months at the rate of 44½ pence sterling per ducat. Medici sent the bill of exchange to his representatives in London, where they should have received £27 16s 3d (6,675d). When they presented the bill for payment on 31 December, however, Venier’s representatives refused to pay (probably by prior agreement with Medici) and the bill was ‘rechanged’ or sent back to Venice to be settled in another three months.
But this second exchange transaction took place at the rate prevailing in London, which two FX brokers testified was 41¼ pence sterling. As a result of this spread or difference of 3¼ pence between the rates in Venice and London, Venier repaid Medici not the original 150 ducats, but just under 162 ducats. In short, Venier had borrowed 150 ducats for six months and paid 12 ducats in interest, an annualised interest rate of 15.7 per cent.
This built-in spread was not, of course, the only factor influencing exchange rate movements. The pattern of international trade resulted in seasonal flows of money from one country to another while less predictable events, such as war or political unrest, could also have a significant impact. A merchant’s profits therefore depended on his ability to predict market movements and to time his trades, just like today.
This paper is based on a new interdisciplinary research project investigating Medieval Foreign Exchange, funded by the Leverhulme Trust and based at the ICMA Centre, Henley Business School, University of Reading. The research team is: Professor Adrian Bell, chair in the history of finance and head of school; Professor Chris Brooks, chair in finance and director of research; and Dr Tony Moore, research associate.