Banks in History: Innovations and Crises

Banks in history: innovations and crises

BANKS IN HISTORY: innovations and crises Book series of the Magyar Nemzeti Bank © Magyar Nemzeti Bank, 2018 Contributors: Executive Directorate Consumer Protection and Market Supervision Directorate Credit Institutions Supervision Directorate Fiscal and Competitiveness Analysis Directorate Economic Forecast and Analysis Directorate Research Executive Directorate Macroprudential Policy Directorate Monetary Policy and Financial Market Analysis Directorate Financial Infrastructures Directorate Financial System Analysis Executive Directorate Financial Institutions Supervision Prudential Modelling and IT Supervision Directorate Regulation Department Directorate Resolution Edited by: Gergely Fábián, Barnabás Virág The editors would like to express their gratitude to the Governor György Matolcsy, Deputy Governors Ferenc Gerhardt, Márton Nagy and László Windisch for their professional comments during editing. Published by: Magyar Nemzeti Bank 1054 Budapest, Szabadság tér 9. www.mnb.hu All rights reserved. Prepress and printing: Pauker-Prospektus-SPL Consortium ISSN: 2416-3503 ISBN: 978-615-5318-21-4 2018

Contents

1. Foreword

2. Introduction

3. T he Beginnings: From Mesopotamia through Florence to London

4. The First Industrial Revolution (1769–1850)

125

5. The Second Industrial Revolution (1870–1914)

282

6. T he Third Industrial Revolution (1918–1939), the era of delayed and interrupted development

487

7. Banking systems after WWII

539

8. The effect of digitalisation on the banking sector

617

9. Digitalisation and the monetary system

674

10. Banking regulation and supervision

734

11. Acknowledgements

820

List of acronyms

822

List of boxes, charts and tables

826

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Foreword Money and later financial systems developed in parallel with the evolution of humanity and human societies. The history of how the financial system evolved has been shaped by continuous innovation, the spread of civilizations, the expansion of globalisation and the crises erupting from time to time. Regulation in response to disruptions in the banking system and the subsequent innovations were also key elements in shaping the evolution of the financial system. In past centuries, financial crises recurred on an almost regular basis. Since the 19th century, crises of varying intensity have erupted almost every decade due to external factors or the internal, autonomous functioning of the financial system. Meanwhile, innovations have changed dramatically. Technological innovations leading to fundamental changes appear ever more frequently, spreading all over the world at an unprecedented pace and extent. This book seeks to present the emergence of banking systems and the main milestones in their development through the major innovations and crises of the period. This is important so that the lessons from the history of banking can be used to better understand and put into historical perspective the challenges faced by the financial world, and the banking system in particular, today and in the near future. Financial transactions were already conducted in antiquity, and even then – just like later in the Middle Ages and during the First and Second Industrial Revolutions – innovations drove not only the development of finance but also indirectly the development of the economy and society. However, in the past innovations spread at a snail’s pace, as only a minor stratum of society had access to banking. This gave time to all players to adjust to the innovations appropriately. Nevertheless, this process gradually gained traction through the course of history, and people increasingly started using banking services. As a result —7—

Banks in history: innovations and crises

of the Third Industrial Revolution, the 20th century marked the real turning point in the world of finance. Information technology became increasingly important, while profound changes occurred in the global financial system. The Fourth Industrial Revolution, which emerged from the third, and the fifth that is closely related to the fourth represent a much more advanced level of digitalisation. In the current era, the financial system will be changed by technological innovations at lightning speed compared to earlier centuries. In the modern age, major banks find it much more difficult to retain their leading role as compared to the British banks that dominated the entire 19th century, or the Rothschilds, the Sinas, the Fuggers and the Medicis in earlier times. While the ‘reign’ of the latter in financial matters characterised a whole age, today the names in the list of the world’s top banks can change from decade to decade or even quicker. Hence, it is difficult to forecast which direction the longer-term, or as some might argue even the medium-term, development of the banking system might take. Not only do today’s innovations present tremendous opportunities, they also pose huge challenges from the perspective of financial system stability, the regulatory authorities and even monetary policy. The dilemmas and challenges faced by central banks are presented by the Magyar Nemzeti Bank’s (MNB) experts from various areas, focusing on FinTech and virtual currencies, and the book also pays special attention to concept of digital central bank money, which currently mainly interests researchers. This is the fourth volume in the Magyar Nemzeti Bank’s book series. It enriches the series by providing an economic history overview of the development of banking systems and then detailing the digitalisation challenges in the near future based on that. Therefore, it is recommended for readers who are interested in the history of banks and those curious about the future of banks, especially the challenges of the Fourth and Fifth Industrial Revolution from a banking and central banking perspective. György Matolcsy, Márton Nagy, László Windisch, Ferenc Gerhardt —8—

Introduction The idea behind the book was based on a lead article in The Economist1 from the summer of 2017, which cited another article from the French newspaper Le Petit Journal from 1893. The main argument of the article from 125 years ago was that horses had no credible alternative as the propulsion for vehicles. Of course, in hindsight it is clear that internal combustion engines quickly superseded horses, and in 2017 The Economist treaded warily with its predictions about the fate of these engines which dominated the entire 20th and the early 21st century. There is an obvious parallel with the financial system, especially with the banking system, as the impact of new innovations from banking services to money itself is increasingly debated. Among the wide range of responses, the official answers are cautious for now. Our book invites the reader on an exciting adventure through economic history, presenting the evolution of the banking system from its beginnings to the present day, with a special focus on innovations and crises. In addition, before discussing the financial system of each period, the given era’s historical and economic context is described, which is crucial for understanding the financial transactions in the given age, and which also substantially influenced the development of financial systems. We believe that the historical overview is immensely helpful in better understanding and comprehending the challenges of the present and the near future. As Winston Churchill once said, ‘those who fail to learn from history are doomed to repeat it’. Financial transactions were already conducted in antiquity, as discussed in Chapter 3. This is because the development of economic management 1

The Economist: The death of the internal combustion engine. Leaders, 12 August

2017

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Banks in history: innovations and crises

led to the greatest innovation of the age – writing – which paved the way for the evolution of finance. Writing helped in the emergence of coins, and loans engendered the interest rate, which in turn gave rise to the necessary legal and administrative background. Current accounts were already used in the Roman Empire, but crises emerged in parallel with the innovations: in their early days, banks experienced liquidity issues when the power of the Roman Empire declined, and they were wiped out after its fall. Banking was reborn only centuries later. In Italy, the first banking houses developed from money exchange. Double-entry bookkeeping and the appearance of bills of exchange played a major role in the development of finance. In the 15th century, banks already started engaging in cross-border activities. Chapter 4 discusses the First Industrial Revolution, while Chapter 5 is about the Second Industrial Revolution. Innovations developed and spread slowly over the centuries, but by the 19th century, the basis of the activities of today’s modern banks had already been established with paper money and various forms of deposit, while cross-border lending and syndicated loans emerged on the assets side. With respect to bank types, banks operating as limited companies appeared, which were pivotal in financing the Industrial Revolution, and savings cooperatives, mortgage banks and agricultural banks also emerged. The prevalence of financial services also changed considerably. Earlier, banking services were geographically constrained and were available to an even more constrained group of people, such as monarchs, the nobility, church dignitaries and merchants. By contrast, in the 19th century they increasingly covered the globe in terms of geography and society. The next great change was brought about by the Third Industrial Revolution, in parallel with the transformation of the monetary system. The world’s banking systems were fundamentally overhauled over the past roughly one hundred years, during which period first the middle class and then all social groups became potential banking customers. After the strict regulations following the Second World — 10 —

2. Introduction

War, the internationalisation of banks in the 1980s opened a whole new chapter in their history, as credit institutions significantly expanded their activities and incorporated many technological innovations into their widening product range. Technological progress eliminated geographical distance, which completed the industry’s globalisation. The appearance of online banking has enabled customers to access information about their finances or initiate transactions at any time or place. The evolution of banking systems between the two World Wars is discussed in Chapter 6, and their development after 1945 is presented in Chapter 7. This takes us to today’s (Fourth) Industrial Revolution, which is based on digitalisation that started in the years of the Third Industrial Revolution, taking it further and blurring the lines between the physical, digital and biological spheres. The 2008 crisis and its impact represented a turning point in the development of the banking system, because although the system has recovered from the crisis, it has lost its former pioneering role in the early 21st century. New innovative players have appeared that are referred to as ‘FinTech’ and are being followed by various other ‘techs’. The trends in digitalisation today and in the near future, and in particular the regulatory challenges, are discussed in Chapter 8, while Chapter 9 focuses on the central banking aspects of this, especially on virtual currencies and the concept of digital currency issued by central banks. In addition to Magyar Nemzeti Bank experts’ opinion on these topics, the current trends are also presented. Last but not least, the history of banking regulation and supervision has run parallel with the history of the financial system, and this is detailed in Chapter 10 along with the supervisory challenges of the near future and the Hungarian supervisory authority’s preparedness and attitude. As can perhaps be seen from the introduction, this book combines banking history with an outlook for the near future. The period ahead involves considerable uncertainty as to how technological progress will reshape our everyday lives and the financial system in particular. In addition to presenting various opinions about future challenges, — 11 —

Banks in history: innovations and crises

the book also discusses the history and evolution of the banking system in detail, which may help readers to form or shape their own opinion regarding the future of the banking system. Thus, the book can be of interest to those fascinated by history and those intrigued by digitalisation, from experts in the financial system through university and college teachers and students to readers interested in the topic as a hobby. Infoboxes help in understanding the key concepts and major events, and boxes also enrich and enliven this journey into banking history. By familiarising themselves with the economic history background to Hungarian and world banking history events and crises, readers may come closer to understanding the present difficulties and future challenges faced by the Hungarian banking system. We hope you enjoy the latest book in the MNB series. Gergely Fábián, Barnabás Virág

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The Beginnings: From Mesopotamia through Florence to London Attila Kiss2

The first tangible historical records of monetary transactions date back to the early 3rd millennium BC. While the survival of these sources has been influenced by a number of circumstances, the very basis of their production was writing itself, the invention of the greatest innovation in the history of mankind. Its invention can probably be traced back to the need for administrative records related to the economy. At a later stage of development, primarily in the territory of Mesopotamia, clay tablets were used to record the details of contracts, loans, and other commercial and financial transactions. All this rested on the foundations of money, and interest, a financial innovation. In the region of the ancient Near East, weighted precious metals (mainly silver) and primarily grain were used as money from the early 3rd millennium BC onwards. As trading relations intensified, the development of production required operating instruments. This prompted the establishment of ‘banking firms’, which provided a profitable occupation for extensive periods, and in many cases were family firms. Commerce went hand in hand with monetary transactions; consequently, as new hubs for the trade and transport of goods emerged on the eastern Mediterranean Coast and across the Aegean Region, older innovations spread and new ones appeared. Coins were first minted in the 7th century BC in Asia Minor, then came into use progressively throughout the broader region of the ancient Near East.

The author wishes to thank Lajos Berkó for compiling the box ‘Ecclesiastical views on interest in the Middle Ages’, Balázs Mladonyiczki for ‘The Fuggers and their connections in Hungary’, Zoltán Eperjesi for ‘Establishment of Amsterdamsche Wisselbank’, and Ágnes Nagy for ‘The Dutch tulip mania’.

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Banks in history: innovations and crises

Through its commercial activities and the colonization of the Mediterranean, Hellas had established a link between the Mediterranean and the East by the middle of the 1st millennium BC, and Athens had become the financial centre of the era. This community, the ‘Hellenized world’ itself, was inherited by the Roman Empire, the legal system of which gave an increasingly wide scope for entrepreneurship and commercial activities, and the build-up of the momentum for such activities was accompanied by the buoyancy of payments and a monetary economy. The order and peace established by the Pax Romana promoted economic development, which provided the most favourable circumstances for advancements in trade, including monetary transactions. By this time, banking operators had already become differentiated according to their social affiliations and the types of monetary transaction they were carrying out. The best-known banking and financial institution of the era was the banking house of the Sulpicii. However, the continuous public deficit of the empire from the 2nd century AD, inflation, and raids by barbarians caused increasingly serious problems for Rome. Due to the depreciation of money, bankers were constantly faced with liquidity problems, which led to their complete disappearance from the financial scene of antiquity during the 3rd century AD. The situation was exacerbated by the expenditures on military pensions granted to veterans, which placed an increasingly heavy burden on public finances. Under the burden of growing financial difficulties, the empire first broke up into two parts, then in the western territory, from the 5th century onwards new barbaric kingdoms emerged, some of them the precursors of today’s European countries. Compared to the levels of trade, economy and urbanization of the Roman age, the early Middle Ages represented a decline, wherein monetary transactions were restricted to the change of money, up to the 11th century. By this time, European countries and city-states had regained control of the western basin of the Mediterranean from Muslim conquerors, after which they launched crusades to secure their hegemony over the entire Mediterranean. Maritime trade routes were controlled by those Italian city-states where the urban traditions of Rome were the strongest. Apart from long-distance trade, they also conducted intermediary trade, linking the continental territories of western Europe with the Mediterranean, and through the various channels — 14 —

3. The Beginnings: From Mesopotamia through Florence to London

of the Silk Road, also with the East. The major fairs were concentrated in Flanders and in the territories of northern France, to the markets of which goods from distant lands were transported by the ships of Venice, Florence and Milan, and as Italian merchants entered the scene, financial markets started to develop throughout mediaeval Europe. To facilitate quick conduct of monetary transactions involved in business, the bank branches of northern Italy introduced bills of exchange, letters of credit and additional innovations by means of which certain dynasties of bankers virtually ruled over the monetary transactions of the continent. They included the Medici of Florence and the Fuggers of Augsburg, whose decisions, after a while, would make or break royal houses. The changing circumstances gradually reduced the need for fairs as merchants accompanied their goods less and less frequently, while the networks of distributing and financial companies that employed representatives in commercial centres were becoming more common. Deals were no longer struck on benches in fairs, but instead goods were delivered on order. These companies had their seats in major Italian cities and divisions throughout Europe. With the discovery of the New World, the main volume of commercial activities was shifted to navigation on the high-seas and the emphasis from the Mediterranean to the Atlantic Coast. Now conducted on a global scale, commercial activities called for the introduction of more advanced financial innovations. Although during the 16th century there were no fundamental changes in the structure of the financial market (it remained tied to the market for foreign currencies), the volume of transactions in bills of exchange started to grow, accompanied by the spread of promissory notes, the precursors to bills obligatory. The 17th century brought about the maritime, commercial and ultimately financial hegemony of the Dutch Republic, and next that of Great Britain, at the same time marking the establishment of the first national banks and exchanges. This process culminated in the accomplishments of the industrial revolution starting from England and subsequently Scotland, which significantly reinforced the power of industrial capital, leading to a major growth in exports and trade in general.

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Banks in history: innovations and crises

3.1. Civilizations of the ancient world: from Mesopotamia to Rome 3.1.1. Mesopotamia

It is appropriate that a study of the formation and development of financial systems should start with Mesopotamia. Although references to a succession of dynasties that governed various cities are already made in cuneiform script records from the classical Sumerian civilization of the 3rd millennium BC, it was Sargon of Akkad who gave rise to the first ‘world empire’ of human civilization in Mesopotamia of the 24th century BC (Cameron, 1998, 52). Subsequently, empires and dynasties succeeded one another over the course of world history, and there has always been a keen interest in examining whether these phenomena were motivated by any economic drivers, and if so, what they were, or respectively, what economic systems the established empires and dynasties followed. Although no accurate data are available on the origins of the Sumerians, the first historic people of Mesopotamia, the land along the two rivers had already been inhabited by humanity before the civilization they created. The ‘pre-Sumerian’ population had a relatively developed agriculture, and were familiar with weaving and pottery. That culture was the source of the names of the twin rivers of the Tigris and the Euphrates, but also those of a number of cities including Ur, Uruk, Shuruppak, Larsa, Nippur, Kish and Sippar, and of several professions such as herdsman, farmer, fisherman, smith, carpenter, potter and webster (Klíma, 1983, 42). Despite its subsequent rise, until the middle of the 5th millennium BC the area to the north of the Persian Gulf, between the Tigris and the Euphrates rivers, had been much more sparsely inhabited than other regions in the ancient Near East. The waterlogged ground inundated by annual floods did not favour the hoe culture of the Neolithic period. The region was virtually void of any woodlands, exploitable minerals, and stone suitable for building. Nevertheless, relying on expert management, a large and disciplined — 16 —

3. The Beginnings: From Mesopotamia through Florence to London

workforce, and supervision, canalization works commenced, and laid the foundations of highly productive irrigated agriculture. In the aggregate, emerging and spreading innovations comprised a new level of civilization that brought about a much more complex system of the division of labour and economic organization. Textiles, earthenware, metal ware and other items were produced by full-time, specialized craftsmen, and the sciences of architecture, planning and medicine came into being. Units of measurement using systematized, and incipient forms of natural science emerged.3 That said, the greatest innovation was the invention of writing,4 which can probably be traced back to the need for administrative records related to the economy, but soon came to be used for other purposes as well, such as religion and literature (Klíma, 1983, 40; Cameron, 1998, 50–51; Földi, 2015, 44).5 At a later stage of development, clay tablets were used to record the details of contracts, loans, and other commercial and financial transactions (Cameron, 1998, 51). In Mesopotamia, legal documents were drafted according to strict rules. First the precise object of the transaction was stated, followed by a list of the names of the parties. The nature of the transaction was expressed with phrases that indicated the relations between the parties, e.g. ‘Received a loan from [...]’ (Oppenheim, 1982, 345). Loan transactions record liabilities such as the delivery of certain goods or services, or the surrender of a specific amount of goods, on credit (Oppenheim, 1982, 347–348). Apart from these, bills of lading have also This intellectual and cultural development is clearly indicated by the fact that the terms denoting the crafts of jewellery making, sculpture and goldsmithery, and various areas of intellectual work, are already of Sumerian origin (Klíma, 1983, 43). 4 In Mesopotamia, the first traces of writing are commonly dated to around the turn of the 4th and the 3rd millennium BC; however, these were not cuneiform signs yet, but groups of straight and bent lines that represented specific shapes in simplified form. Cuneiform script evolved from these pictograms (Klíma, 1983, 32). 5 It remains to be determined whether the primary function of writing was linked to an economic or a religious background. Views in that regard are largely influenced by the information in source material that continues to be discovered (cf. Klíma, 1983, 40). Writing is assumed to have evolved in Egypt and China around the same time as in Mesopotamia. The evolution of hieroglyphs is dated by Egyptologists to the period from prehistory to 3150 BC, while the appearance of Chinese pictograms is commonly dated to the 3rd millennium BC (Klíma, 1983, 32). 3

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Banks in history: innovations and crises

survived from thousands of years ago, recording the destination of the caravan, the remuneration of the merchant, the composition of the goods transported (e.g. items of clothing, tin, donkeys), and the costs of the caravan, which, for example, included the expenses of armed escorts, forage for the donkeys and other needs, customs, as well as an item for ‘other expenditures’ (Klíma, 1983, 134). All this rested on the foundations of money, and interest, a financial innovation. In the Mesopotamian economy, money existed before minted coins. Money is commonly imagined as a round coin minted from precious metals of specific weight and grade, bearing an inscription whereby these features are guaranteed by the issuer. In the Ancient East, research has not produced evidence of money bearing such a description before Lydian and Persian coinage. However, as these are features of minted money rather than of money in general, the absence of minted money obviously cannot be equated automatically to the absence of money. Written records from the Ancient East, and particularly Mesopotamia, enable studies on the role of money to go as far back as the early 3rd millennium BC, and are fortunately complemented by material remains from excavations. This is how we know that for an extensive period, in Mesopotamia agricultural produce, primarily barley, was used instead of money, and was increasingly replaced in that role by metals such as gold, tin, lead, but mostly silver, from the middle of the 3rd millennium BC onwards (Vargyas, 2010, 13–14).6

So much so that in the age of Hammurabi, innkeepers were obliged under pain of death to accept not only silver but also grain in exchange for beer (Vargyas, 2010, 14): ‘Art. 108: Where an innkeeper has refused to accept grain as consideration for the price of beer, but has accepted money of “great weight”, [...] she shall be drowned’ (Dávid, 1964, 135). Apart from running their own alehouses, innkeepers were also engaged in commercial activities, which were regulated by Articles 108– 111 of Hammurabi’s laws (Klíma, 1983, 138). Remnants of a self-sustained economy survived for a long time. The duality of that economy is attested to for instance by Akkadian texts in which the verbs retail (grain) and measure (metals) are used in the sense of ‘pay’. Yet, payments in grain could be detrimental to buyers because under certain tariffs they received a smaller quantity of goods in exchange for grain compared to silver of the same value (Klíma, 1983, 135).

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3. The Beginnings: From Mesopotamia through Florence to London

According to the texts and material remains, throughout the history of southern Mesopotamia, i.e. Babylonian7 silver, and in Assyria, i.e. northern Mesopotamian silver as well as copper, tin and lead are believed to have served as means of payment. The role of silver as a measure of value was only interrupted for two temporary and approximately contemporaneous periods: in the Middle Babylonian period (1600–1150 BC; Klíma, 1983, 104) gold and silver were approximately of the same value, while in the Middle Assyrian period (1390–1080 BC; Klíma, 1983, 104), tin was adopted as the general measure of value, at least in the city of Assur (Oppenheim, 1982, 122). Notably, contradicting Oppenheim’s view, Klíma mentions tin as a means of payment in the context of the ancient Assyrian age (1950– 1750 BC; Klíma, 1983, 102), and considers copper as the original means of payment in both Assyria and Babylonia. Gold was adopted as a general equivalent only in the Kassite (Middle Babylonian) period (Klíma, 1983, 137). Oddly, in Assyria and particularly in Babylonia these metals were not found naturally (except for tin, which was found in Assyria but was only exceptionally used as money). However, in other areas money generally took the form of materials or objects that were available locally, as in the case of the Spartan iron currency. On the latter, Aristotle wrote: ‘This ancient Spartan currency was made of iron that had been immersed in vinegar while red-hot, which prevented it from being forged because through this immersion it had become fragile and useless, but was otherwise heavy and unsuitable for transportation, with a rather low purchasing power due to its large mass and bulk. Presumably, in very old times the situation may have been similar when iron or bronze spits were used as currency, which is how the custom has survived until today that the smallest unit of currency is referred to as obol, i.e. a spit, while six obols make a drachma or a “handful”, since that is as many as the hand can grasp.’ (Aristotle, 1998, 75–76). The history of Babylonia spans approximately two millennia from the late 3rd millennium BC, i.e. the Old Babylonian period, to the New Babylonian, i.e. the Hellenistic period. Babylonia was governed by a number of dynasties of various descents, and its most prominent city was the eponymous Babylon. Its territory extended from the Persian Gulf along the course of the Tigris and the Euphrates to Assyria (Oppenheim 1982, 198–210; 411–418; 431–436).

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Banks in history: innovations and crises

Nevertheless silver, in constant use across Mesopotamia, always had to be imported (Oppenheim, 1982, 122), about which a growing number of written and archaeological records from the early 3rd millennium BC onwards are available for research. This indicates that the economy of the land along the two rivers already required the use of metals in this early period (Vargyas, 2010, 14–15). A fundamental problem with money in the Ancient East is that the texts do not afford an unambiguous determination of whether silver is used only in the sense of a measure of value, or also in that of money. In our written sources, this will only become obvious from the late 7th century BC onwards. In contrast, the question is decided by evidence from archaeological material. To date, in the region of the Ancient East in its broadest sense (primarily including today’s Turkey, Syria, Israel, Egypt, Iraq and Iran) approximately 150 finds have been discovered sharing the trait of featuring metal items of various sizes, in the vast majority of cases silver broken into smaller or larger pieces. In Oppenheim’s words, as a means of payment silver was used in ingots rather than standard forms (Oppenheim, 1982, 122). According to Klíma, ‘the metal was measured in nuggets, bars or rings of silver’ (Klíma, 1983, 137). While former research considered these finds as raw material used by silversmiths even though the hidden ‘raw materials’ were never accompanied by tools, a more self-evident explanation is that these hoards were of money before coinage (Vargyas, 2010, 15–16). A similar situation prevailed for jewellery in that any item made of metal could be both jewellery and money. In most treasure troves, however, such items were discovered in rather worn conditions (at times simply broken into pieces), implying functions other than that of jewellery. In other cases, they were discovered together with objects (silver wires, broken cups, pieces of furniture, etc.) which again imply their function as a raw material measured by weight, i.e. money (Vargyas, 2010, 17–18). The question is to what extent this pervaded the overall economy, and village life in particular. Although we do not know whether money was used in villages in the course of everyday transactions, in principle there was nothing to prevent such use. However, if money had to be measured and its grade controlled — 20 —

3. The Beginnings: From Mesopotamia through Florence to London

constantly, it was not very likely for the appropriate professional such as a silversmith, and even less so for an inspector controller, to be found in small communities, as the minimal transaction volume would not earn them a decent living.8 It is also uncertain whether they were involved in all purchases and sales. This is particularly questionable in the case of small value transactions, which would have been made very expensive through such involvement. However, ‘packets of money’ measured in advance and used as minted money may have helped to overcome the problem. Several well documented treasure troves discovered over the past decades9 afford the observation that the silver had been hidden in sealed packets measured in advance. This reasonably leads research to the conclusion that such was their everyday use, since hardly anyone would bother measuring and sorting the treasure by weight in the middle of fleeing (Vargyas, 2010, 291). The treasure trove hidden in 1738 BC and discovered in the Ebabbar temple of Larsa demonstrates the extent to which the functioning of the Babylonian economy was permeated by a monetary economy. The treasure was discovered in Room 13 of the temple court, consisting of 12 silver packets bearing inscriptions, of specific weight, accompanied by the corresponding cuneiform script tablets. The silver was not sorted and packed at the temple of Larsa; well before the time of its hiding, it had been collected and taken to the royal inspector’s office in the nearby city of Ur, where the silver had its grade controlled, then it was packed in 12 small bags, according to pre-determined weights, and sealed. An inscription was carved on the seals to record the weight of each packet and the name of the measurer, the Babylonian ruler’s official. These bags functioned in exactly the same way as minted money. Where the required sum was not less than the pre-packaged silver, there was no need to open the packets, which could be counted by the piece, precisely like This is aptly supported by the fact that in the most advanced Greek polis, Athens, and its port Piraeus a total of only ten metronomoi were in charge of the oversight of weights and measures (Vargyas, 2010, 291). 9 A list and overview of Mesopotamian treasure troves is given in Vargyas (2010, 229–279). 8

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Banks in history: innovations and crises

minted money. Conversely, where a smaller sum was required than the minimum sealed quantity (approximately 2.8 grams), the packets were simply opened, and the appropriate amount was measured. As minted money was also measured by weight, it could also, and indeed was, broken into pieces, as attested to by the regular presence of broken coins in treasure troves of the Ancient East. Of the 12 packets, 9 were worth one shekel (i.e. 8.33 grams), or specific fractions of that unit. These amounts roughly corresponded to sums worth between one-half month’s and one month’s pay, and probably served to facilitate the daily transactions of the temple economy. The use of fractions of the shekel unit in packets of 1/2, 1/3 and 1/6 shekel effectively introduced the system of small change as early as the Old Babylonian period, which enabled the conduct of payments under the greatest possible variety of entitlements without measurement (Vargyas, 2010, 232; 236–237; 292). As in the 2nd millennium BC, in the 1st millennium Babylonia continued to use silver measured by weight as its means of payment. The proliferation of coinage and its rise to exclusive use in the Hellenistic period did not affect Babylonia’s use of money.10 The use of money measured by weight does not indicate that limited use was made of money, that most of the Babylonian society was excluded due to complicated measurement procedures, or that Babylonia’s economy was underdeveloped; indeed, the very opposite. Adjectives referring to the grades of silver, the names of various types of silver, and the quantity of silver in circulation show that in Babylonia, the monetary economy permeated daily life to an extent that was quite uncommon in antiquity (Vargyas, 2010, 292–293). The prominence of money in the Ancient Eastern economy is indicated, for example, by the early existence and role of interest in the economy, or the practice of the payment of taxes and rents in currency (Vargyas, 2010, In the territory of the Ancient East, coins were not used before the age of the Seleucid conquerors, i.e. 305–263 BC (Klíma, 1983, 106). It was only then that Greek coins entered circulation, which, rather typically, were predominantly measured rather than counted (Oppenheim, 1982, 122).

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291), i.e. a number of transactions that qualify as banking operations. Over the course of excavations in Mesopotamia, thousands of clay tablets were discovered that attest to the transactions of individuals and communities, which were, as regards their subject, essentially equivalent to the procedures of today’s banks: certain individuals or communities granted loans, and accepted currency, i.e. silver or other things of value, as collateral (Klíma, 1983, 141). In Babylon, the safe custody of private deposits (primarily grain) was a thriving business as early as the 3rd millennium BC. As the goods were held in royal warehouses and temples, these may be considered to have been the earliest banks (Ligeti, 2003, 17). In a narrower sense, however, our modern concepts of bankers and banks cannot be fully equated to the antique concepts of bankers and banks. In today’s economy, modern banks occupy a much more important and much more prominent role (suffice to refer here only to loan agreements between local governments and banks) compared to their precursors in antiquity. Any discussion of ancient bankers should be mindful of the fact that although many aspects of their activities resemble banking operations in the modern sense, as regards their economic functions they may only be termed bankers by means of anachronistic fiction (Pozsonyi, 2012, 52, Note 243). For instance, a major part of the archives of former Kanesh, the renowned Old Assyrian mercantile city, comprises obligations. Many records of monetary transaction also survive in the archives of the temple of Mari. These are already close approximations of modern-day cheques and letters of credit. As trade relations intensified, the development of production required operating instruments. This prompted the establishment of ‘banking firms’, which provided a profitable occupation for extensive periods. These were family firms in many cases,11 handed down from one generation to the next. The ‘firms’ carefully recorded the loans granted and the commitments undertaken by them, including the dividends, goods and monetary (silver) collateral collected. The prime costs of these businesses were extremely high, but were recovered from usurious lending, the mortgages on pledged plots of land, as well as the demand made by these businesses that sureties A number of Old Assyrian trader families are mentioned in Pálfi, 2015.

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should be liable for debtors or multiple debtors should issue surety bonds to one another (Klíma, 1983, 142). Hammurabi devoted separate paragraphs to the protection of sureties (Chart 3-1), under which, for example, the torturing to death of a surety under a nexum contract – i.e. their death caused by maltreatment – was punishable by death (Article 116) (Dávid, 1964, 136). Although, the term of a nexum contract was limited to three years, the circumstances of an indebted family were still difficult enough, because it was also common for the wife and children of the debtor to become nexi (Klíma, 1983, 143). Chart 3-1: Law Code Stele of King Hammurabi (18th century BC)

Source: upload.wikimedia.org

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Payments and in particular credit transactions were conducted by tamkāru, who also pursued commercial activities.12 Banking operations enabled the tamkāru to run wholesale businesses enabling them to accumulate capital. This made their operations highly appreciated by rulers and clerics alike, and they were often granted privileges. Hammurabi’s laws also contain several provisions specifically dedicated to the status of the tamkāru. These laws were conditional on diversified and ramified commercial activities, and an extensive network of contracting parties, suppliers and buyers. They also regulated the relationship of the tamkārum and the commercial agent, i.e. the commission agent.13 The commission agent (called samallúm14 in Akkadian) was the merchant’s right hand, who brokered orders, and was in effect a traveling salesman responsible for purchasing raw materials and selling goods (Klíma, 1983, 138–139). Hammurabi’s laws also regulated the way in which the loan was to be secured. In connection with tillage, for example, the laws provided that if a free man with full rights were to take money from a tamkārum to finance the cultivation of his land, at the time of harvest ‘he shall give to the merchant the grain equivalent to his silver which he borrowed from the merchant and the interest on it and also the expenses of the cultivation’. The debt could also be settled in currency, and if the borrower had no money to repay, then ‘in accordance with the royal edict, [either grain or] sesame according to their market value for his silver borrowed from the merchant and the interest on it.’ (Klíma, 1983, 140).15 In essence, interest is the price to be paid for the use of money. Interest occupied a prominent role in all periods of Mesopotamian The Akkadian word tamkārum also has the meaning of ‘merchant’ ascribed to it (Klíma, 1983, 138). 13 See Articles 100–107 of Hammurabi’s laws (Dávid, 1964, 134–135). 14 The original meaning of the word was ‘leather sack bearer’ (Klíma, 1983, 139). 15 See Articles 49–51 of Hammurabi’s laws (Dávid, 1964, 132); English translation given in Martha T. Roth: Law Collections from Mesopotamia and Asia Minor. 12

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economic history, as did prices and the market in economic processes.16 A characteristic of the constant need of the economy for credit is that in Babylonia, the economy would have been defunct without credit (Vargyas, 2010, 217). This is particularly striking in the Old Babylonian period,17 when credit and the associated indebtedness, as well as the ever starker economic differences became so common that they began to endanger the regular functioning of society, calling for constant state intervention (Vargyas, 2010, 218). Regardless of whether the prevailing form of ownership was by the state (temple), the community or individuals, and whether the goods were predominantly produced on large estates or by smallholders, the rate of interest was consistently very high: for at least a millennium and a half, the fair rate of interest was considered to be 20 per cent on loans granted in money, and 33.33 per cent on loans granted in grain. In the Old Babylonian period (in the first half of the 2nd millennium BC), at the time of Hammurabi, within the meaning of the ruler’s renowned laws, the fair rate of interest was considered to be 20 per cent on silver, and 33 per cent on barley. These are equivalent to the rates known from the middle of the 3rd millennium BC (Vargyas, 2010, 220; see also Klíma, 1983, 141). By the standards of economic history, they were outstandingly high. The reasons for this are uncertain, but the general consensus of opinion is that there was no usury (Vargyas, 2010, 218; 226; Klíma, 1983, 141). Namely, the provisions for usury were applicable to loans on which higher rates of interest were charged, which under Article ‘M’ of Hammurabi’s Code were punishable by the cancellation of the creditor’s entire claim (Klíma, 1983, 141).18 In practice, however, creditors would charge much higher According to research carried out by Vargyas, ‘all this disproves the allegedly predominant social role of redistribution’ (Vargyas, 2010, 287). In earlier research, the prevailing opinion was that in Babylonia, the goods delivered had been redistributed from the palace or the temples, which might appropriately be termed as a form of ‘warehouse management’. This was complemented by production on autonomous private estates (cf. Oppenheim, 1982, 124). 17 The Old Babylonian period is dated between 1900 and 1650 BC (Klíma, 1983, 102). 18 ‘ [...] If the merchant should attempt to increase and collect the interest [on the loan] [...] he shall forfeit [anything he had given’; (Dávid, 1964, 134); English translation given in Martha T. Roth: Law Collections from Mesopotamia and Asia Minor. 16

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3. The Beginnings: From Mesopotamia through Florence to London

rates of interest on their loans, depending on the level of risk involved in lending. Surviving documents indicate that in several cases interest was charged at a rate of 50 per cent, but in some other cases usurers are known to have granted loans only at 140 per cent (Klíma, 1983, 141). Admittedly, rates of interest that were much lower than the ‘standard’ are also known, the lowest of which was 8.33 per cent (Csabai, 2015, 148). The financially powerful and influential class of the tamkāru, on which rulers (i.e. their treasuries) also relied for assistance, retained its independence, and had the means to disregard the provisions of the law (Klíma, 1983, 141–143).19 The vast majority of loans were loans maturing in less than one year (Csabai, 2015, 146), where the interest charged was pro-rated to the annual rate. As attested to by documents from the New Babylonian and Achaemenid periods,20 in these periods interest was calculated on a monthly basis despite the fact that interest was in most cases payable on maturity or at the end of each year. In some instances, there were provisions requiring monthly interest payments regardless of maturity. Less frequently, annual interest rates were specified, which could nevertheless be converted accurately to monthly rates. The combination of the two procedures enabled the greatest possible variety of interest rates to be expressed. Where annual interest rates were used, the specification of monthly, and occasionally daily, rates of interest were unproblematic even for loans with very short maturities (Vargyas, 2010, 221–222). Amounts below four shekels denoted monthly rates of interest, and higher amounts annual rates. Certain interest rates could be specified using either monthly or annual denotations, but monthly values were used much more frequently. This does not mean that the interest rate would fluctuate monthly; for the Mesopotamian year during which months were interposed periodically, monthly interest rate calculations were much more reasonable compared to Similarly, provisions for minimum wages and maximum prices were also frequently recorded ‘on clay’ (Klíma, 1983, 141). 20 The New Babylonian period is dated between 625 and 539 BC, and the Achaemenid period between 539 and 331 BC (Klíma, 1983, 104; 106). 19

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Banks in history: innovations and crises

annual rates.21 Accordingly, by decreasing or increasing the amount to be repaid at monthly or annual intervals, the single standard interest rate formula could be used to specify all of the required interest rates (Vargyas, 2010, 225). There was also interest-free lending22 in the form of the so-called hubuttu, hubuttātu or hubuttūtu loans, which already occurred at the ˘ ˘ ˘ very end of the 3rd millennium BC. The three terms are synonymous and may be translated as ‘interest-free loans’. An additional term, ‘non-interest-bearing loan’ also indicates the possibility for lending transactions to be free of interest (Csabai, 2015, 141–142; 148). Seals were used to authenticate various transactions, which would substitute for the signatures of both parties, as well as of witnesses. A variety of seal substitutes were also employed, including the prints of fingernails and clothing hems, then seal rings, which came into use in the New Babylonian period (Oppenheim, 1982, 346). There were additional means to ensure the authenticity and integrity of documents. From as early as the Old Sumerian period onwards, tablets bearing script, most commonly contracts, receipts or other ‘delicate’ documents, were enclosed in clay cases, which served as envelopes that also reiterated the text of the tablets they contained, and even included ‘attachments’ of the impressions of the cylinder seals used (Klíma, 1983, 38–39; Oppenheim, 1982, 347). Another safeguard against forgery was for a document to be drawn up in several copies, one given to each party, while the existence of copies was accurately recorded in the document (Oppenheim, 1982, 347). Upon repayment of a loan, in the Old Babylonian period the creditor’s copy was destroyed (Vargyas, 2010, 221), whereas in the New Babylonian period it was often returned to the debtor (Vargyas, 2010, 221, Note 667). Monthly interest calculations were so common that they were even used where a contract did not include provisions for interest (Vargyas, 2010, 226). 22 In his book, Oppenheim cites a letter from Ugarit that includes the following stipulation: ‘Give [in the meantime] the 140 shekels which are still outstanding from your own money, but do not charge interest between us—we are both gentlemen!’ (Oppenheim, 1982, 123). 21

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3.1.2. Egypt

In other civilizations of antiquity, the level of development of the monetary economy was not even close to that in Mesopotamia, although the effects of the latter were mediated by sea trade to India in the east, and to Egypt and the eastern basin of the Mediterranean. Egypt, particularly Upper Egypt, came into contact with Mesopotamia towards the end of the 4th millennium BC via the Persian Gulf, Indian Ocean, and Red Sea route. The contact stimulated a rapid development in all aspects of civilization, and by the middle of the 3rd millennium BC Egyptian civilization had reached its zenith. Subsequently, its level of development remained unaltered until the beginning of the Christian era (Cameron, 1998, 51). Despite the proliferation of civilization, these routes do not appear to have carried large-scale or sustained traffic, because of both the lack of suitable complementary trading goods and the hazards of navigation in the monsoon region (Cameron, 1998, 56). The means of using money that were established in Mesopotamia as early as the beginning of recorded history also spread first across present-day Syria and ultimately to Egypt, and at once determined the economic history of the region (Vargyas, 2010, 21). As far as the use of money in Egypt is concerned, both texts and visual representations carry important information regarding the shape of objects used as currency. There are several instances of mural paintings in Egyptian tombs representing the ring-shaped gold and silver objects being weighed (Chart 3-2). In Egyptian royal inscriptions there are references to rings as well as to a variety of utensils, including primarily cups and glasses, brick-shaped and spherical items, and blocks of precious metal. According to inscriptions, these items were often stored in linen bags. The impressions of these textiles remain visible even today, i.e. written records and material remains are mutually reinforced (Vargyas, 2010, 16).

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Chart 3-2: Gold rings being weighed on an Egyptian mural painting (14th century BC)

Source: Williams (1999, 16, Picture 6).

In Egypt, at the time of the New Kingdom,23 metals (gold, silver and copper) were already being used as measures of value (David, 2005, 398). The primary function of such use being to facilitate trade and commerce, with all goods given a value in gold, silver or copper. Fixed weights were also introduced, but the use of a system of metal valuations – which may have been introduced from Asia – did not create a monetary system (David, 2005, 412). Barter remained the predominant means of exchange, also in foreign trade, while the commercial activities that would boost the monetary economy only played a small part in the movement of goods within Egypt. Royal gifts provided income for the nobles and private persons were paid salaries and wages in

The New Kingdom of Egypt is dated to the reign of the 18–20th dynasties between 1570 and 1085 BC, which succeeded the rule of Hyksose (Tóth, 1982, 23).

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kind. Moreover, export trade24 was a royal monopoly, which limited the development of extensive private commercial enterprise (David, 2005, 398). Accordingly, Egypt never developed a proper commercial class (David, 2005, 410; 412), which in Mesopotamia conducted banking activities. Nevertheless, there were persons conducting rudimentary banking activities, including in the empire along the Nile, because records have survived of interest-bearing loans and of charges being paid. However, the lack of a true monetary system did not encourage the development of an extensive trading or commercial class, and these people apparently carried out their activities only in their own districts. The Egyptians conducted their business using only the exchange of goods and produce, yet such primitive methods of payment nevertheless seem to have enabled them to carry out quite complicated transactions (David, 2005, 411–412). Trade continued to be characterized by the barter system even under Persian occupation, because although it was introduced during the Persian Period after 525 BC, the impact of coinage on Ancient Egypt’s economy had not been significant before the Ptolemaic Period25 (David, 2005, 406). An arbitrary standard was introduced by which the value of objects destined for exchange could be measured and compared. This was achieved by using a third common commodity, often wheat, as the standard, against which the products for exchange were measured When the kingdom was united, and the irrigation system was effectively maintained, the economy was stable. At such times, Egypt was able to produce an excess of its own essentials - grain, fish, vegetables, and fruit - that, together with gold and manufactured items such as papyrus, pottery, textiles and other luxury goods, could be traded for the wood, silver, copper, and spices that the country lacked. It was the responsibility of the state to acquire scarce products from neighbouring countries (David, 2005, 410–411). The trade and purchase of goods supervised by the central administration, i.e. the military and commercial expeditions as well as the royal expeditions launched across the borders for the extraction of minerals and their transportation to the Nile Valley, between which no sharp distinction may be made, were carried out along controlled routes, and were supported by wellorganized protection and supply (Kóthay, 2015, 81). 25 Ptolemaic Egypt, one of the states succeeding the empire of Alexander the Great, existed between 305/304–30 BC (Kertész, 1995, 331; 335). 24

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Banks in history: innovations and crises

and their market value was assessed accordingly. With this system, if there was a slight difference in the value of the two goods being compared, then a small amount of the standard commodity could be used to adjust the discrepancy. However, the standard commodity was generally not used at all in payment. In the Late Period, however, changes were introduced. Although most transactions continued to be carried out by means of payment in kind, a standard was still used, but it was now based not only on wheat but also on silver. At first the silver was measured in weight and used accordingly; even the Persian and Greek coins, that were now available, were only accepted according to their weight rather than at their face value. The concept of a monetary economy gradually began to take hold. Particularly where their quality and weight were completely consistent, coins started to be accepted at face value. The introduction of coinage was one of the major areas of foreign influence exerted upon Egypt during the Persian Period. Nevertheless, it was only in the Ptolemaic Period that a true monetary system with significant coin production was introduced; until then barter remained the predominant method of exchange (David, 2005, 412).

3.1.3. Phoenicians and Greeks

Intermediary trade between the civilization along the two great rivers, Mesopotamia, and Egypt was controlled by the Phoenicians, a seafaring people that had established themselves on the east coast of the Mediterranean around 3000 BC. The Phoenicians organized themselves into politically autonomous city-states, of which the most famous were Sidon and Tyre. These people provided the first specialized sailors and merchants, who virtually monopolized the commerce of Egypt for long periods, serving as the pharaohâ&#x20AC;&#x2122;s agents or contract merchants. It was precisely these activities that led them to develop the alphabet, which was easier to use than hieroglyphic and cuneiform writing and was subsequently adopted by the Greeks and then the Romans, along with other commercial techniques. Their commercial articles included â&#x20AC;&#x201D; 32 â&#x20AC;&#x201D;

3. The Beginnings: From Mesopotamia through Florence to London

copper from Cyprus and the fabled cedars of Lebanon, which were in constant demand in Egypt. To foster trade and relieve population pressure in the homeland, they established colonies along the North African coast, as well as in Sicily, Sardinia, the Balearic Isles, and the coast of Hispania. The most renowned of these was Carthage, which later grew into an empire in its own right, and struggled with Rome for hegemony in the western Mediterranean (Cameron, 1998, 56). The other great maritime traders of the Mediterranean were the Greeks. The natural constraints of Hellas effectively drove the Greeks to the sea: their rocky and mountainous homeland was unsuitable for cultivation, but excellent for the establishment of ports, supported by the countless islands across the Aegean Sea that allowed vessels to anchor. As early as the Mycenaean period (from the 14th to the 12th centuries BC), Greek merchants could be found throughout the Aegean and the eastern Mediterranean and as far west as Sicily.26 Although development was arrested by a ‘dark age’ occasioned by a new wave of invasions from the north,27 Greek commerce and civilization revived in the early 8th century BC. By that time the Aegean was already a Greek lake, with Greek settlements on the coast of Asia Minor as well as on the islands. The middle of the century saw the launch of Greek colonization that resulted in the foundation of Greek colonies (apoikíes) throughout the Mediterranean, from present-day Marseilles to the Black Sea coasts (Cameron, 1998, 56–58). Many new cities were founded in fertile agricultural regions and could thus supply grain to the mother city, while they also served as markets or commercial centres for the manufactured or processed wares of the metropolis. In these circumstances the mother cities became more specialized in

Indeed, in Europe their indirect connections reached out as far as the British Isles and the coast of the Baltic Sea (Sarkady, 1995, 96). 27 In this period, commercial contacts were reduced to a minimum both within the Aegean Region and with external territories. Phoenician and Cyprian sailors remained the prime movers of commercial activity (Sarkady, 1995, 109). 26

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Banks in history: innovations and crises

trade and industry.28 In addition to the newly formed apoikĂes, Greek trading posts (emporia) were also established in more distant regions such as in Al-Mina, Tell Sukas and Ras el Bassit in northern Syria, Naukratis in Egypt, and Emporion (today Ampurias) in Hispania. Greek colonization created a link between the East and the Mediterranean, and the entire region was permeated by Greek culture (Hegyi, 1995a, 124). Hellas caught up with Phoenicia: Greek sailors and merchants also became carriers for other, non-seafaring peoples such as the Egyptians (Cameron, 1998, 58). Some cities, such as Athens, concentrated a number of commercial and financial functions in much the same way as Antwerp, Amsterdam, London or New York did in subsequent eras. Banking, insurance, jointstock ventures, and several other economic institutions that developed in later centuries already existed in embryonic form in classical Greece; indeed, they had roots in ancient Babylon. These commercial and financial developments were greatly facilitated by the introduction of minted money (Cameron, 1998, 58). The earliest surviving coins, dating from the 7th century BC, came from Asia Minor (supposedly from Lydia), and were probably minted at around the turn of the 7th and 6th centuries BC (Vargyas, 2010, 290) (Chart 3-3). Rulers quickly recognized the potential of coins for profit and prestige, and monopolized coinage accordingly. The effigy of a ruler or the symbol of a city (e.g. the owl of Athens) stamped on a coin testified not only to the purity of the metal but also to the glory of the issuer. The earliest coins were apparently made of electrum, the natural alloy of gold and silver that was found This tendency is shown by the introduction of earthenware from Athens in Hispanic, Egyptian and northern Syrian ports in the 6th century BC. Although Athens only became involved in the commerce of the Mediterranean in the 7th century BC, in the span of a century Piraeus developed into a major seaport, and Athens into a powerful element of sea trade (Hegyi, 1995a, 136). Another good example of the process is provided by grapes and olives, which replaced grain as they were much better suited to the soil and climate of the Peloponnese. Their products, wine and oil, were much more valuable compared to grain, and became highly marketable commercial articles. Greek craftsmen, especially potters and metalworkers, became highly skilled, and their wares commanded a premium throughout the area of classical civilization (Cameron, 1998, 58).

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in the alluvial valleys of Anatolia. However, because of the variability in proportions of the two metals in electrum, the use of pure metals was subsequently preferred (Cameron, 1998, 59). Chart 3-3: Lydian coin (6th century BC)

Source: upload.wikimedia.org

Functions of money: measure of value, medium of exchange, means of payment, means of thesaurization (accumulation), world currency. In its function as a measure of value, money measures and expresses the value of goods. In its function as a medium of exchange, it enables the exchange of goods. The means of payment function is performed where goods are sold on credit, and when payments are made in wages and taxes, and for services. It was from the means of payment function that banknotes evolved – in this case not the same as the papers substituting money, but securities to certify commercial credit – , which were issued against bills of exchange, and could be redeemed for gold at any time. Thesaurization occurs when coined money, to which a value of its own is attached, is present in quantities in excess of the needs of exchange, the excess being accumulated (thesaurized) with private capitalists and the central bank.

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Banks in history: innovations and crises

As the volume of exchange increases, it flows back into circulation. Finally, world currency is the function of money in that it acts as a general means of purchase, a general means of payment, and a general embodiment of the economy in the international flow of goods, currency and credit (Muraközy – Zánkai, 1973, 130; 148; 157; 259; 380; 381; 513).

Although both gold and silver coins were struck, silver coins were both more frequent and more practical for commerce (Chart 3-4). The dominant role of Athens in the 5th century BC throughout the Aegean also contributed to the predominance of silver, at least among the Greeks. In fact, the two phenomena were intimately related: Athens’ state-owned silver mines at Laureion provided the resources for the construction of a new type of warship with three banks of oars that was decisive in the Greek resistance to Persian encroachments, subsequently allowing Athens to dominate the Delian League to such an extent that the Aegean and its surrounding territories effectively became an ‘Athenian Empire’. Silver from Laureion also helped finance Athens’ persistently unfavourable balance of trade, while shipping and financial services were also important sources of income (Cameron, 1998, 59). Chart 3-4: Athens dekadrachm (467–465 BC)

Source: upload.wikimedia.org

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3. The Beginnings: From Mesopotamia through Florence to London

Although the Athenian silver drachm was an internationally recognized means of payment, the potential of the silver mines at Laureion were not fully exploited in the first half of the 4th century BC. It was only around the middle of the century that the need for such exploitation, and its benefits, were recognized. Athens, if only to facilitate grain imports, used its best endeavours to stimulate commerce. In the middle of the century, it adopted a law which provided that all disputes related to commercial transactions be settled within a month. The boost in trade, particularly in sea trade, was greatly facilitated by the fact that around the same time, the Greek trapezites transformed from money changers and custodians of deposits into ‘bankers’ who were also engaged in lending (Hegyi, 1995b, 238–239). In the Athens of the 4th century BC, the archetypes of banks were already present (Ligeti, 2003, 17–18). Similarly to the Mesopotamian practice, the first banks in Hellas were also housed by temples. The primary function of these banks was to store value, especially in periods of war, but they also conducted lending transactions—much earlier than the trapezites. Given their more solid financial background, temple banks faced lower risks. In contrast, the activities of private banks carried higher risks, and the bankers could also fail. This is what happened in Athens to some private banks in 376 and 371 BC. Their more solid background allowed temple banks to grant loans at rates below the average. While private banks charged interest at rates between 10 and 33.33 per cent, very frequently 18 per cent, the rates charged by sanctuaries were occasionally as low as 6.66 per cent, and in exceptional cases only 1.66 per cent. Obviously, in each case the debtor pledged an item of property to secure his loan. Where the loan was granted for the purposes of sea trade, the merchant’s risk was reduced by the provision that the mortgage would be cancelled together with the claim if the vessel were to be shipwrecked.29 Nevertheless, following a temporary period of prosperity, in the second half of the century Athens’ markets narrowed. As the territories along the Black As will be shown later, this was also common practice in the Roman Empire.

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Banks in history: innovations and crises

Sea coast, and in Thrace and Illyria had developed their own handicraft industry, trade relations with the western Greeks declined, as attested to by archaeological finds (Hegyi, 1995b, 239). Despite Athens’ loss of prominence, the Greeks and the Hellenistic culture remained present throughout the Mediterranean, and also appeared in the East in the territories conquered by Alexander the Great (Aléxandros III). Although the empire disintegrated after the death of its founder, the cultural and economic ties remained between the Greeks and former territories of the empire (Cameron, 1998, 59). The Greek language was spoken from the Indus River to Hispania, Greeks manned the civil services of successor states, and Greek merchants established their precincts in every important city. Egyptian Alexandria - with a population of over half a million, probably the largest city in the world before the rise of Rome - was virtually a Greek city, and the most important emporium of the age. Through its markets passed not only the traditional exports of Egypt (wheat, papyrus, linen cloth, glass, etc.), but hundreds of staple and exotic products from many parts of the world, including elephants, ivory, and ostrich feathers from Africa, carpets from Arabia and Persia, amber from the Baltic, cotton from India, and silk from China (Cameron, 1998, 60–61). Not only did Alexandria as the capital of Ptolemaic Egypt have a major impact on the Hellenistic world, but the Greeks under Ptolemaic rule also influenced the trade, industry, and commerce of Egypt.30 The Greeks who came to live in Egypt brought with them a tradition of trade and commerce, and soon markets were established and developed in numerous settlements providing a wide Ptolemaic Egypt was a successor state of the empire of Alexander the Great. Occupied by the Persians in 525 BC, Egypt was taken by the Macedonians in the autumn of 332 BC. Its eponym, Ptolemy, was governor of Egypt at time of the death of the empire’s founder (323 BC). Following the model of his rivals, he assumed the title of king in 305/304 BC, whereby the Ptolemaic dynasty came to power in Egypt, which it held until the Roman conquest (30 BC). At the time of its founder’s death in 283/282 BC, Ptolemaic Egypt included Egypt as well as Cyrenaica, Kypros, southern Syria, and the coastal areas of Asia Minor, and its political influence extended to the important territories of the Greek homeland and the Aegean isles (Kertész, 1995, 303; 329–335). These holdings and that of Alexandria deservedly make it the successor to the Alexandrian empire.

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3. The Beginnings: From Mesopotamia through Florence to London

range of goods for the local population. These commercial centres were often associated with Greek temples which also served as the focus for the town’s financial offices. The rapid increase in the volume and use of currency occurred early in the Ptolemaic Period, and had a profound impact on the local economy, on the movement of goods and services between different regions, and on the development of international trade. Although coinage had been introduced into Egypt by the Persians for a variety of financial transactions, until now there had been relatively little coin production. Coinage became truly widespread from the Ptolemaic Period (David, 2005, 406).

3.1.4. The Roman Empire

The Hellenistic era leads up to the late antiquity hallmarked by the Roman Empire not only culturally, but also economically and financially. Rome had already absorbed Hellenistic culture before it came to dominate the Mediterranean, and with the latter it inherited or appropriated - Hellenistic economic achievements and institutions (Cameron, 1998, 61). The Romans were originally agricultural people; commerce, the key backdrop to monetary transactions, did not rate highly in the system of their values.31 Regardless of this, the rise of Italian trade was facilitated by the purposeful establishment of a road network branching out of Rome to distant regions of Italy. While the evolution of the issue of money in Rome bears the most faithful testimony to the development of trade, it also interactively facilitated that development. Initially, unwrought pieces of copper of measured weight (aes rude) would suffice, then from Indeed, Cato set the two activities against one another. As attested to by the preface to his work, On Agriculture, he was of the opinion that ‘[...] to obtain money by trade is sometimes more profitable [...] and likewise money-lending, if it were as honourable. [...] Our ancestors held this view and [...] required that the thief be mulcted double and the usurer fourfold; how much less desirable a citizen they considered the usurer than the thief, one may judge from this’ (cf. Cato, 1966, 87; see also Maróti, 1998, 146).

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the second half of the 4th century BC, the metal was cast in bars, which incorporated roughly stamped representations of animal figures such as bulls, eagles, and Pegasi (aes signatum). The increasing volume of trade was initially conducted using Etruscan, Greek and Carthaginian money, then copper coins (aes grave) were cast from the time of the Latin Wars. Silver coins were adopted during the period of expansion in southern Italy, more specifically at the time of the Pyrrhic War. Initially, the more advanced cities in Campania were commissioned to produce such coins, which bore the common local representations, and indicated the customer only by means of inscriptions (Roma, Romano). By way of comparison, to illustrate the underdevelopment of the Roman monetary economy, it is appropriate to mention that Tarentum started to mint silver coins in the mid-6th century BC, Cumae around 500 BC, while Carthage at the end of the 5th century BC in Sicily, but only in 350 BC in Africa. Rome made its transition to minting its own standardized silver coins in 268 BC. Its unit was denarius and weighed 4.37 grams just like the Attica drachm. Simultaneously, the weight of as, the standard unit of the earlier copper coins was reduced from 327.45 grams to a third of this for easier use, and one denarius was equated to ten asses. In practice, the basis of calculations was the sestertius, a silver coin equivalent to one-quarter of a denarius, i.e. worth two and a half asses. Even after the abolishment of nexum contracts32 in 326 BC, the development of the monetary economy led to the growing intensity of financial activities, and the buoyancy of usury. An increasingly prominent role was occupied in those activities by that wealthier class of the plebs which invested its capital in urban property or merchandise rather than land and had no public or political aspirations. At the turn of the 3rd and the 2nd centuries BC, this class evolved into the equestrian order (ordo equester), so named after the voluntary military service they gave at their own expense within the Nexum was an archaic form of debt bondage. Under a nexum contract, the debtor pledged his person as collateral for his debt, and upon expiry of the deadline for the repayment of his arrears, his creditor would take control of him, or possibly his child. The institution of nexum was abolished by Lex Poetilia Papiria, which declared that a debtor was liable to his creditor only to the extent of his wealth, but not in his person (MarĂłti, 1998, 73).

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3. The Beginnings: From Mesopotamia through Florence to London

ranks of the army alongside the cavalry formed of the 18 centuriae of the First Class of commoners equipped using public funds (Maróti, 1998, 99–100). The Roman laws, especially through the incorporation of Greek elements, allowed increasing freedom of enterprise and commercial activities, and provided for the strict enforcement of contracts and property rights, as well as the prompt and equitable settlement of disputes. As Roman law spread in the wake of the conquering legions, a uniform, coherent legal framework emerged for commercial activity throughout the empire. The urban character of the Roman Empire was both stimulated and made possible by the highly developed commercial network and the division of labour. The city of Rome alone may have had a population in excess of a million people at its height and feeding such a population from local resources was manifestly impossible. At this point, a part of the Roman fleet was organized to bring wheat from Sicily, North Africa, and especially Egypt to the centre of the empire (Cameron, 1998, 61). And although Rome never had aspirations to become a leading maritime power, and thus its fleet always played a secondary role among the services of its army, by the end of the 2nd century BC the Roman Empire had developed into a state formation whose economic - and partly political - success was secured by the ‘maritime link’ between the various parts of the Mediterranean (Grüll, 2016, 9). Of the former emporia of the Mediterranean, Rome destroyed Carthage and Corinth, and as Rhodes became less prominent, the port of Delos gained immense significance. Representatives of the Roman equestrian order also appeared shortly after this and forming merchant societies they played an active role in the organization and supervision of commercial links between the Mediterranean and distant territories in the East. In this period, Italy’s most notable port was Puteoli, and the growth of commerce went hand in hand with monetary transactions and the monetary economy (Maróti, 1998, 148). In particular, under the law regulating the taxation of the province of Asia, organized from the territory of the former Kingdom of Pergamon in Asia Minor, the collection of taxes was conferred to publican societies (societates — 41 —

Banks in history: innovations and crises

publicanorum) of the equestrian order. As a result, by the end of the 2nd century BC the role of Roman financiers significantly increased in the eastern territories (Maróti, 1998, 163). Likewise, it was with a view to protecting the interests of the equestrian order that at the very end of the century the first serious measures were taken to combat piracy. In 102 BC, Antonius Orator launched a military campaign against the pirate base in Cilicia, then a law was adopted under which allied eastern states and Greek cities were required to collaborate on arrangements for joint action to break the power of the pirates. The underlying motives were provided by the desire to protect the commercial activities of the equestrian order in the Greek and eastern territories, and to bring an end to the damage caused by piracy to maritime trade (Maróti, 1998, 169).33 The pirates were not eradicated immediately; their activities – taking advantage of the troubled situation of Rome’s internal politics – continued for a considerable time. For instance, we know that in 74 BC, Antonius Orator’s son Antonius was given a ‘mandate of extraordinary powers’ to break the maritime hegemony of the pirates, who, in alliance with Rome’s political adversaries, had also waged military campaigns against the republic that was going through a crisis, and had in effect made commercial traffic impossible in the eastern and central regions of the Mediterranean (Maróti, 1998, 190; 201). As part of the Roman action, their inland bases were taken, in response to which they relocated their main base to Crete, where in turn they defeated the Roman fleet in 71 BC. Unhappy with its commercial losses, in 67 BC the equestrian order finally granted extraordinary powers to Pompeius to lead a campaign against the pirates. For the campaign to succeed, Pompeius was invested with full powers throughout the Mediterranean and over a strip of some 75 km along its coasts, while also at his disposal was a fleet of 500 vessels, major ground forces, and 6,000 talents worth of capital, complemented by assistance from allied states and cities. In approximately 40 days, Pompeius cleansed the western Mediterranean of pirates, and the pirate organizations operating on the eastern waters Previously, the Senate of Rome was lenient towards piracy, because the slaves needed on the estates of the – mostly landed – senators were primarily supplied to the slave markets by pirates (Maróti, 1998, 169).

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were either destroyed or forced to capitulate after two more months (Maróti, 1998, 201–202). The security and stability achieved in the Mediterranean was one of the preconditions for the economic development that provided the most favourable circumstances for advancements in trade, including monetary transactions (Chart 3-5).34 By this time, the class pursuing monetary transactions had not only emerged and was flourishing, but had also become differentiated according to its members’ social affiliations and the types of monetary transaction they were carrying out. Chart 3-5: Business letter written on wooden tablets from the fort of Vindolandain northern England (1st-2nd century AD)

Source: upload.wikimedia.org

Although Rome’s legions were constantly conquering new territory, fighting neighbours or suppressing rebellions, before the 3rd century BC these events took place on the periphery of the empire, and did not disturb the most active commercial routes. Piracy and brigandage, which had been threats to shipping, were also completely eliminated (Cameron, 1998, 63).

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Interest-bearing loans were not only granted by contemporary ‘professional’ bankers, but also by the Roman elite with sufficient means – that is, senators and knights. A part of senators’ wealth comprised items of heritage and property holdings, but there was also a considerable part which they significantly increased – whether legally or otherwise – by exploiting their political power. This class qualifies as the largest creditor (Babják, 2002, 319). The classes of senators and knights were also separated. That separation was not simply a result of differences in terms of legal status and income, but was also due to the fact that they pursued different economic and financial activities, with major differences in their clienteles (Babják, 2002, 315). Finally, it may be noted that senators are also not found among Roman bankers because the former found the pursuit of the banker’s ‘profession’ to be beneath their dignity. The absence of women within the ‘banking profession’ is explained by their express prohibition from this occupation (Babják, 2002, 316). Such loans, however, are not to be confused with bank transactions. The contrast between the two major groups is not only manifest in their rather different social positions, but also in the fact that unlike those of elite financiers, the activities of bankers were not limited to ‘merely’ investing their own wealth and lending on that basis. As professional custodians, bankers also reinvested the amounts deposited with them, placed them out in loans, and used them to make payments on behalf of their customers. A number of contemporary legal sources indicate that unlike other financial groups, bankers were licensed to open current accounts (each referred to as a ratio) for their customers. Bankers pursuing the trade as a profession considered the amounts deposited with them as their business capital and handled those amounts accordingly, and their ‘approach’ and operations come closest to what is called capital today in its modern sense (Babják, 2002, 314–315). Another difference between elements of the wealthy Roman class who were also engaged in financial activities and those who appeared in Rome and pursued monetary transactions on a professional basis was — 44 —

3. The Beginnings: From Mesopotamia through Florence to London

that the latter were after all ‘craftsmen’ who stood behind benches or worked in shops carefully observing opening hours, learned finance as apprentices, and were bound by a number of professional regulations throughout their activities. In contrast, those members of the social elite who sought to augment their wealth by lending with interest were not employed by anyone; they were their own masters when they started their lending activities, which obviously they could abandon at any time, while they also benefited from the fact that they were not liable for compliance with professional requirements, given the very absence of professionalism within this group (Babják, 2002, 315). Additionally, there existed a third group, the members of which conducted financial activities—in rather large volumes, in fact —, but could they be classified neither with the argentarii nor with the nummularii, i.e. those specifically acting as money changers, foreign exchange operators and assayers of coins, nor did they belong to the elite. Nor could they, indeed since their lifestyles and business procedures significantly differed from those of the aristocracy, yet they had every opportunity to mingle with the senators and knights of the imperial elite. Most of them were negotiatores who settled outside Italy and ran their business from there. One example is provided by the family of Emperor Vespasian. Vespasian’s grandfather T. Flavius Petro was a banker, while his father T. Flavius Sabinus found his account in another field of finance: he was a publican in Asia, while he also lent money at interest throughout Helvetia. Although he was not a knight himself, he managed to marry the daughter of one. By virtue of his key position within the Asian publican society and having regard to his status as an acknowledged creditor, he was recognized among the most prominent businessmen of the empire (Babják, 2002, 316). In the context of banking activities, a difference is also apparent between the western Latin and eastern Greek parts of the empire. The Greek trapezites did not play any role in conducting auctions, unlike the Italian argentarii (Babják, 2002, 315). For example, at auctions the coactor was initially a person who made arrangements for the auction, enforced the deal struck, and as required, collected the purchase price. — 45 —

Banks in history: innovations and crises

However, by the last century of the Republican Period the coactor took on a significantly wider role in the auction procedure, and in addition to collecting bids, his established practice now also included lending the amount of the agreed purchase price to the buyer where an item of great value was sold at auction and the buyer had no means to make a prompt payment to the seller. On those grounds, the coactor appears to have acted as a banker (argentarius) of sorts; accordingly, a number of sources include the designation argentarius coactor. The economic background to that banker’s function was a choice of two payment methods at auction. In one method, the buyer at auction made a prompt cash payment of the purchase price following the auction. In the other method, the buyer’s payment of the purchase price was not made directly after the auction, but was deferred for a specific period. In cases of the second type, by the late Republican Period an economic arrangement evolved wherein a better capitalized coactor would make a prompt payment to the seller of the purchase price agreed at auction (net of his commissions), as a result of which the buyer owed the borrowed purchase price to the coactor rather than the seller (Pozsonyi, 2012, 16–17). Apart from that, it may also be argued in general that while the Latin provinces adopted Italian financial customs and were relatively consistent in that regard, local customs prevailed in the Greek territories of the empire, not to mention Egypt and Palestine, which had adhered to their own earlier customs throughout the period (Babják, 2002, 315–316). Roman bankers and financiers employed staff for a variety of duties and functions, who were either slaves or freedmen (libertini). A libertinus was allowed to act as an agent (institor) in the same way as if he had been born free. Free men, probably the patrons of libertini, would establish business relationships with libertini primarily as silent partners: they borrowed money from the libertini, whose intermediation then allowed them to enter the ‘financial market’ as creditors. In contrast, the slaves were in a different situation, either serving their masters directly, or working as agents for their masters in the shops of the latter or charged with the management of the peculium. A slave serving his dominus — 46 —

3. The Beginnings: From Mesopotamia through Florence to London

directly acted as an arcarius, a dispensator, or an actor. An arcarius was a cashier who was probably skilled in the assaying of coins, and possibly also in changing money. Arcarii had the lowest degree of involvement in financial transactions, and earned personal profits only when given a reward for their work by their masters. In contrast, actores and dispensatores were already in a much more favourable situation, as they were permitted to run their personal businesses alongside those of their domini, which gave them a fair chance of earning money for themselves. A dispensator was generally not tasked with ‘shop’ business, but was in charge of the household matters of his dominus, with particular regard to the administration of expenditures. He paid the bills and kept a record of expenditures. In effect, an actor may be defined as a representative for his dominus, who was responsible for the finances of the business or property entrusted to him, although little is known about the role of this latter position in financial transactions (Babják, 2002, 316–317). Perhaps the best-known banking and financial institution of the era was the banker dynasty of the Sulpicii. Current knowledge of the dynasty is based on the group of archaeological finds discovered in 1959 on the outskirts of Murècine near Pompeii. The documents belonging to this set of records are collectively referred to in literature as the ‘Sulpicii archive’ (Babják, 2002, 317; Pozsonyi, 2012, 9; 51). They provide an insight into bank transactions during the age of the Julius-Claudius dynasty. The Sulpicii were freedmen who operated a banking house in Puteoli of Campania. Although in the last century of the republic all publicans, financiers, usurers and entrepreneurs still came from the ranks of knights (equites), the economic reforms of Caesar and Augustus deprived the knights of the opportunity to accumulate merchant and usury capital, which made the conduct of large-scale lending transactions impossible. From the reign of Emperor Augustus, the equestrian order was assigned an increasingly wide range of functions in public administration and the economy, whereas lending, banking and — 47 —

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other entrepreneurial opportunities gradually came to be controlled by people who undertook the risk involved in such activities even without the ‘guaranteed’ sources of income provided by public contracts. These were primarily freedmen of Greek or Eastern (Syrian, Egyptian) origin – such as the Sulpicii. The 1st century AD witnessed the rising economic prominence of freedmen, and their social advancement on a massive scale (Hahn, 1998, 283–284; Babják, 2002, 316; 319). Of the documents in the archive, the earliest is dated 18 March 26, and the latest 14 July 61. At this time, being the location where Italy’s largest seaport developed from the 1st century BC, Puteoli was the scene of bustling economic activity. It received the large commercial ships carrying Rome’s grain from Egypt, the shipments of which were transhipped to smaller vessels, which then transported the grain to Ostia. In this lively commercial and economic environment, banks occupied a key role in ensuring the constant flow of credit (Pozsonyi, 2012, 51–52). This was also where the Sulpicii conducted their financial activities. In the modern study of antiquity, the view exists that the Sulpicii were faeneratores (usurers) who merely lent money with interest, but according to a more widely held opinion they were professional argentarii, whose activities also included other business matters in addition to lending.35 This theory is supported by the fact that the Sulpicii archive contains several contracts to which the banking house was not a party. An obvious explanation for this is offered by the assumption that the banking house also acted on behalf of its customers in legal matters, which is why its documents include contracts to which it was not a party. As far as professionalism is concerned, it is neatly captured by the fact that at the office of the Sulpicius banking house, the contracting phrases used in everyday economic life were available in both Latin and Greek (Pozsonyi, 2012, 52–53). This is how the Sulpicius banking house is known to have acted in specific cases as paying agents in addition to lending. As attested to by a surviving document (TPSulp. 68) Gaius Novius Eunus borrowed 1,200 sestertii from Hesychus, and in the promise to repay he undertook a commitment to repay that amount to Hesychus or C. Sulpicius Faustus upon maturity (Pozsonyi, 2012, 52, Note 244).

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The Sulpicii archive contains numerous documents that record bank transactions, including e.g. loan contracts, IOUs, receipts accompanying shipment contracts, auctions, arbitration agreements, and the lease of warehouses (Pozsonyi, 2012, 54). It is appropriate to present here an example of loan contracts, one of the most frequent bank transactions, in which all essential elements of the transaction are featured. Namely, according to the text of TPSulp. 53,36 Lucius Marius Iucundus, (presumably) a grain merchant and the freedman of Lucius Marius Dida, on 13 March 40 AD received a loan from the banker Caius Sulpicius Faustus to the amount of 20,000 sestertii, which he promised to repay in the form of a stipulatio. The document is structured as follows: lines 1–2: datelines; lines 3–5: designation of the parties, and the debtor’s statement of receiving a loan (accepisse [mutua]); line 4: acknowledgement of debt (debere); lines 6–7: confirmation of the effective receipt of cash by way of a loan (mutua et numerata accepi); and lines 7–9: a stipulation clause on the repayment of the loan (Pozsonyi, 2012, 74–75). Archaeology has made its own contribution to monetary transactions through the discovery of tesserae nummulariae, i.e. small rods of bone, ivory, and occasionally bronze. They vary between 3 and 10cm in length and between 7 and 12mm in width. Most carry inscriptions, primarily the names of slaves, but some also the names of the domini. A total of only 160 such objects have been found, all of them in Rome or more broadly in Italy, except for six. 139 of the finds carry dates, between 96 BC and 86 AD. The majority of tesserae nummulariae existing today are from the period between 79 and 40 BC. The pieces of bone carrying inscriptions are closely associated with assaying the value and authenticity of coins, and the names inscribed on them are those of the nummularii who, after a thorough examination of the cash bags presented to them, attested to the precious metal content, weight and value of the coins, then sealed the bags using small rods of bone. Presumably, the use of the sums sealed in this manner would require the After Giuseppe Camodeca, who renumbered the tablets, the group of finds are known as Tabulae Pompeianae Sulpiciorum (‘TPSulp’) (Babják, 2002, 317).

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bags to be opened only in extremely rare cases. The coins would not be released into commercial circulation separately but would be deposited as a single sum with a banker or other businessman, who would also forward the contents of the bag, or alternatively, deposit them in a temple or state treasury, as a single unit (Babják, 2002, 317–318). During the centuries of the Imperial Period, the economy appears to have been completely monetized, i.e. goods and services were exchanged for currency, and currency for goods and services. Egyptian papyri have preserved many loan contracts, in which interest was charged at rates varying between 4 and 12 per cent. These were regulated by market conditions rather than government decisions. Indeed, not even the Egyptian grain shipments of vital importance to the Roman Empire were controlled by the state, and most of the grain was transported by independent merchants for sales in the free market.37 The state contracted these maritime entrepreneurs (navicularii) in the same way as it leased the collection of taxes to the much-hated publican societies. Moreover, groups of financial investors also participated in trade finance by granting loans that were not due to be repaid in the event of a shipwreck, an indication of risk sharing. Conversely, such ‘maritime loans’ were granted at higher rates of interest (Grüll, 2015, 185). However, the ‘best years of the empire’ constituted a transitory period. Even before the death of Marcus Aurelius38 a number of problems foreshadowed the decline of the empire and the economy on which it rested. Of the greatest severity was the problem of inflation resulting from the continual debasement of the coinage by a treasury whose expenses always exceeded its revenue. This was aggravated by regular barbarian incursions, a new infestation of piracy, and the corruption of government itself. In combination, these made shipments impossible Nevertheless, a minor part was controlled by the state, as grain was distributed free to over 200,000 families in Rome. Failure to deliver might have provoked riots, to guard against which central intervention was required (Cameron, 1998, 61; 63). 38 Emperor Marcus Aurelius governed the Roman Empire between 161 and 180 (Hahn, 1998, 314). 37

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and interfered with commerce, the very guarantees for supply of resources to support the army, the imperial bureaucracy, and the urban population. By the end of the second half of the 3rd century, tax revenues were consistently several magnitudes below the expenditures of the army and the bureaucracy (Cameron, 1998, 64–65). Amid the anarchy of the period, the Roman Empire saw a rapid depreciation in the value of its money. Following one another in quick succession, most soldier emperors deliberately ordered coins to be minted in increasingly poor quality, i.e. with a continually diminishing precious metal content.39 Naturally, this situation triggered payment difficulties that were almost impossible to overcome.40 Attempts to improve the unsustainable circumstances were made through monetary reforms by the Emperors Aurelian and Diocletian. Following the elimination of military anarchy and the radical reorganization of imperial government, in 296 the latter introduced measures for comprehensive monetary regularization involving the issue of new types of coin minted from good quality precious metal, as well as the control of inflation, which had been threatening to paralyze the economy of the empire, through price maximization and tax regularization.41 And although most of the decrees were not observed (Cameron, 1998, 65) following the resignation of the emperor (305) (Hahn, 1998, 385), then his death (316), and the new currencies introduced by Diocletian, which were subsequently also withdrawn from circulation, the quality of Roman coinage improved for an extensive period. The minted money of the successors to Diocletian, primarily of Constantine the Great, preserved their high precious metal content for nearly half a century (Tóth, 1979, 133). In this period, it was not unusual for ‘silver’ coins to have a mere 0.5 per cent silver content (Tóth, 1979, 133). 40 This is well illustrated by Pannonian finds, which imply that gold coins were virtually no longer used, and as poor-quality silver was unsuitable for accumulation, it was replaced in circulation by the more valuable mints of earlier emperors (primarily Septimus Severus and his son Caracalla). Some of the coins that have been discovered had been worn to illegibility due to extensive use (Tóth, 1979, 133). 41 Nevertheless, a certain degree of order was achieved only in 301. At that point the government issued three types of money: the gold aureus, the silver argenteus, and the bronze denarius, the latter used as small change. 25 bronze denarii were worth one argenteus, and 50,000 were equivalent to the value of a pound of gold (Hahn, 1998, 382). 39

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Banks in history: innovations and crises

The ‘banking profession’ was also hit hard in this period. The effects of the financial crisis were felt particularly in the Latin-speaking territories of the Roman Empire. Coined money was rapidly losing its value, prices were soaring, and bankers, just like people of the lower classes, were struggling with continuous liquidity constraints. The severity of their situation is aptly illustrated by the fact that except for a few larger seaports such as Ostia, Portus, and Aquileia, following the first years of the 2nd century AD no traces have remained that would attest to the presence of argentarii in Italian territories outside Rome. Coactores argentarii, the operators who conducted auctions, granted loans for the purchase price of the auctioned items, and also arranged for the collection of those loans, completely disappeared from the previously diverse financial scene of antiquity during the 3rd century AD (Babják, 2002, 316). The 4th century was already clearly one of decline in the western part of the empire. Although Diocletian had stabilized the state of government, the measures placed a much heavier burden on the population than before, most of which fell on land and those cultivating it. Production for the market declined as farmers abandoned their land and placed themselves under the patronage of the powerful potentates, whose estates were exempt from taxes (Cameron, 1998, 65; Hahn, 1998, 383). Accordingly, those estates grew continually, and increasingly settled for subsistence farming. Additionally, not only did they retain the food they produced, they also introduced metal melting, the manufacture of textiles, and other similar industrial activities. Their proper function was thereby taken from the towns, which, owing to disruptions to food supplies (intensified by an atrophied trade), were already seeing their populations fall. The mechanisms of self-induced decline had been triggered. By the end of the fourth century the empire in the west was a hollow shell that gradually collapsed under its own weight (Cameron, 1998, 65–66). The last waves of migrations generated by the Huns, and the political hostility between the Latin and Greek halves of the empire led to the final division of the Roman Empire in 395 (Hahn, 1998, 410–411). While the eastern half stabilized its situation and, preserving antiquity for the Middle Ages, remained in existence — 52 —

3. The Beginnings: From Mesopotamia through Florence to London

until 1453, the Western Roman Empire was unable to overcome both its internal problems and its external struggles. 406 saw the collapse of the Rheine frontier, in the aftermath of which Britain had to be evacuated. By the first decades of the 5th century, invading Germanic tribes had occupied the greater part of Gaul and Hispania, enjoying support from the local populations. The province of Pannonia fell to the Huns, and on 24 August 410, Rome itself capitulated to the Goths. Although the early Germanic kingdoms were formed as federations, their legal status already paved the way for the emergence of the feudal states of the early Middle Ages. Losing the province of Africa (442) meant the break-up of the economic and political unity of the Mediterranean basin, and the liquidation of an essential condition for Rome’s economic life, following which the direct hegemony of the Western Roman Empire was limited to Italy and the Alpine provinces. Finally, with the sack of Rome by the Vandals on 2 June 455, this part of the empire met its fate. At that point, Rome could no longer maintain its connections with the territories (Noricum, Raetia, certain parts of Gaul) that had not yet seceded. Finally, Odovacar, chief of the Italian army made up of Germanic tribes, assumed the title of rex Italiae, had the last Roman ‘emperor’, the minor Romulus Augustulus relocated, and sent the imperial insignia to Constantinople for Zeno, emperor of the Eastern Roman Empire (Hahn, 1998, 413–416; 418–419). Box 3-1 Monetary transactions of Byzantium and the Arab world of the Middle Ages

For long centuries, the Byzantine Empire represented a transition zone between Europe of the Middle Ages and the Islamic world, while being a great civilization in its own right. Its monetary system served as an example for both its neighbours and successors. Considered today to have been the ‘dollar of the Middle Ages’, its cornerstone was the gold solidus (also called nomisma or bezant), which played a prominent role in Mediterranean commerce. From the solidus of Constantine the Great onwards, Byzantium’s gold currency embodied stability as it was available for centuries in constant quality, and also presumably in sufficient quantities (Williams, 1999, 74–75).

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This is one of the reasons why the Byzantine government never went bankrupt, at least until Alexios I Komnenos. Although stability was not constant, it was preserved for a long period (Bréhier, 2003, 251). Small change was initially also released into circulation in the form of gold and copper coins, but from the mid-8th century only the copper follis remained, and silver coins valued between the two were only issued periodically (Williams, 1999, 75). As the empire had been and remained essentially agricultural and rural in character, outside Constantinople and a few other cities commerce was limited to the exchange of agricultural products in small quantities. This pattern was followed by the standing of merchants, who were held in low esteem socially and depended on government regulations. At the end of the 11th century, in 1092, in the wake of reform measures by Alexios I Komnenos a new gold currency (hyperpyron) was adopted, while the scale of coins in circulation was also widened with the introduction of coins made of èlektron, as well as of silver and copper alloy. In the last era of the waning empire, the period starting from the second half of the 13th century, however, the once mighty bezant was replaced by poor quality silver and copper coins (Williams, 1999, 75–76). * Fighting Byzantium for centuries, the Arabs ‘inherited’ two essential types of monetary systems: in the western territories of the empire they used the gold-based Byzantine monetary system and solidus, whereas in the east in Sasanian Iran silver and the drachm were dominant. The former were copied with adjustments to symbolism, while in the east the dirham was modelled on Persian silver coins. The first Arab mint was established in Wasit in the early 8th century (702-703). Minters’ hands were marked by tattooing or branding, and money changers were also subject to strict controls (Williams, 1999, 87; 90–91). Muslim coins were struck using gold, silver and copper. The development of trade in gold primarily benefited towns in North Africa and those in Hispania under Islamic authority. Under Fatimid rule (909–1171) Egypt grew rich from trade, in the course of which it sold African gold to which it had easy access. From the late 12th century, silver gradually replaced gold, which had previously served

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as the foundation of monetary systems in the Near East. From this period onwards, in Fatimid Egypt gold was considered as a commodity and a unit of account, and was measured by weight as opposed to the standard Fatimid dinar, which was counted by the piece. The means of payment used in daily life were made of silver and copper (Williams, 1999, 97; 99). Similarly to the Bible, the Quran prohibits usury (riba): ‘[...] But Allah has permitted trade, and has forbidden usury’ (2:275). Notwithstanding the regulations, Muslims found a ‘solution’ to ensure that the prohibition on the collection of interest would not impede either trade or activities related to money (Williams, 1999, 86–87). As Mohammed himself had been a merchant, commerce was not regarded as an inferior pursuit. And although usurious interest was prohibited, to facilitate business Muslim merchants developed a variety of credit arrangements including letters of credit and bills of exchange (Cameron, 1998, 108). Mindful of moral considerations, in major Muslim cities financial operations were conducted through the office of the muhtasib. The muhtasib was a government official who was appointed to his post in recognition of his high degree of moral integrity, and his knowledge of Islamic law (sharia). He was responsible for ensuring that religious regulations were also observed in trade. His duties included the assaying of weights and measures, and the authenticity of currency. He had to make sure that merchants would neither charge interest nor accumulate capital. Although the latter was met with official ‘disapproval’, it was apparently a common phenomenon (Williams, 1999, 87). In Muslim states, the collection of taxes to fund expenditures was contracted by the government to tax collectors, who were remunerated with a certain percentage of the amounts collected. Trade was highly profitable for both individuals and the state. The administration collected substantial revenues from the port and customs duties levied on merchants. In the Abbasid period (750–1258) there was a regular flow of international trade between China and the Islamic world via the Indian Ocean and the aptly named the Arabian Sea. The major caravan routes linking the Mediterranean with China also led across the territory of Islamic countries. Consequently, for centuries Muslims were among the principal intermediaries in the transcontinental trade

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between Europe and Asia (Williams, 1999, 103; Cameron, 1998, 108). In the period of Fatimid Egypt, however, the focus of maritime trade shifted from the Persian Gulf to the Red Sea, then via Alexandria to the Mediterranean. In Europe, this route was primarily used for business by Italian merchants, and the Fatimid capital Fustat emerged as an emporium. This period is described as the ‘golden age of free enterprise and citizenship’, during which anyone, however limited their available capital, could take up the pursuit of trade in the hope of high profits and great wealth. The Cairo Genizah, a Jewish-Arab collection of documents, which inter alia includes merchants’ letters from the 11th century, attests to a banking and financial system that was outstandingly complex by contemporary standards. Bills of exchange could be used to settle large amounts, secured by deposits and paid with letters of credit. This arrangement was used by both merchants and government officials. In one specific transaction, a promissory note for 42,000 dinars was sent to West African Aoudaghost, the southern terminus of the Trans-Saharan trade route. According to other sources, in Isfahan of Iran 200 bankers operated in 1052, and in large cities such as Baghdad financial institutions lined entire streets – in much the same way as the rows of money changers in today’s Arab bazaars. There were private as well as royal banks, and many of the banker families were Christians, or as in Christian Europe, Jews (Williams, 1999, 103–104).

3.2. Bank transactions in the Middle Ages from Italy to the German lands 3.2.1. Italy and western Europe

The banks of antiquity did not survive the turbulences of the Migration Period; the only surviving banking transaction was money changing. The class of lenders was only formed at the time of the Crusades. With the rise of monetary and lending transactions primarily driven by increasing commercial activity. In connection with the increasing volume of monetary transactions and bank operations, there were other important factors in addition to sea navigation and trade worthy — 56 —

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of note. Such factors included metal processing and metalworking in mediaeval Europe, although the choice of ores that could be mined and processed was certainly rather limited. In addition to the most essential iron, the range included lead, tin and copper, bronze produced as a copper alloy, and among precious metals silver and gold. Any activity related to mining and metallurgy required a major investment, which led to a concentration of capital in regions where mining resources were available. Of non-metals, access to coal and salt was provided by mining, and partly open mining (Nagy, 2005, 335). This required activities that were greater in volume and, in particular, more extensive. Long-distance trade, well known from the Roman Period, first gained momentum after the turn of the first millennium along the coasts of the Mediterranean, where Roman-style urban life, shattered though it was, retained the greatest degree of continuity.42 Some of the Italian cities maintained their close ties to the Eastern Roman Empire, and that relationship not only covered political and ecclesiastical aspects, but also economic and commercial connections (Nagy, 2005, 324). The rise of early mercantile cities in Italy was intimately related to the Muslim Arab military expeditions into western Christian territories in the 9th and 10th centuries. In this period, incessant raids were staged from North African areas and the Iberian Peninsula against the coastal areas of southern Frankish territories, the southern and western littoral of Italy, and the isles of the western Mediterranean – Corsica, Sardinia and Sicily. These raids threatened the very existence of the communities in the areas concerned, whose only hope for defence lay in Urban development in mediaeval Europe is commonly discussed in a breakdown into three regions along Roman precedents and their continuity. The ‘core area’ is essentially comprised of Italy and the southern coastal territories of the Roman province of Gaul. In this region, although contemporary urbanization lost some of its prominence, it was not discontinued, and in certain cases the continuity of both the urban population and institutions may be assumed. The second region incorporates the areas falling within the Roman Limes where Roman urban development clearly made an impact but was not continuous. Finally, the third region is that of areas outside the Roman Limes, where in the absence of Roman influence mediaeval urban development rested on different foundations (Nagy, 2005, 330–331).

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the development of their own capabilities. Consequently, apart from the work on urban fortifications, they also carried out major improvements in the field of maritime warfare, which was what the defence against sea raids primarily required. These cities, including major centres of later periods such as Pisa and Genoa were increasingly forced to the seas of the western Mediterranean to defend themselves against the raiders (Cameron, 1998, 85; Nagy, 2005, 324). In the 11th century, this maritime experience made a substantial contribution to the commercial expansion of the Italian cities (Nagy, 2005, 324). Among the Italian commercial centres of the 11th century, a distinction can be made between northern and southern cities. Notably, cities of southern Italy such as Amalfi, Gaeta, or Bari of Apulia were arrested in their development by the Norman conquest and their Byzantine patronâ&#x20AC;&#x2122;s loss of prominence (Nagy, 2005, 324; 326). Among northern Italian cities, the development of Venice ran a unique course. Even without any Roman background or arable land at its disposal, its commercial network resulting from its favourable location was sufficient to ensure the viability of the city slivered by lagoons. Venice itself contributed a limited range of its own goods to trade (initially only salt distilled in the lagoons); its vast profits came from intermediary trade. While Venice established connections primarily with South German territories via Tyrol and Carinthia, after the 11th century Milan controlled trade with regions lying further to the west. By the time the Crusades started in the late 11th century, several Italian cities, including Venice, Pisa, and Genoa43 had reached a stage of development that enabled them to reap the benefits provided by their situation: at a price, they participated in the transfer of troops, and gained influence in a number of ports along the shores of the Adriatic, the Levant and North Africa. A good example is provided by the relationship between Venice and Byzantium. In the second half of the 11th century, the North Italian city-state acquired The three Italian city-states were also rivals with one another: by the 12th century Genoa had eclipsed Pisa and thereby controlled trade in the western Mediterranean, after which it started to vie with Venice for hegemony over trade in the eastern Mediterranean (Cameron, 1998, 88).

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3. The Beginnings: From Mesopotamia through Florence to London

considerable privileges in return for aid in repelling the Seljuk Turks: as a result, it obtained free access to every port in the empire without payment of customs duties or other charges – a privilege not granted even to the empire’s own merchants (Cameron, 1998, 88). Apart from Byzantium, Venice entered into a trade agreement with the Kingdom of Jerusalem as early as 1100. Its highly influential commercial ‘bases’ already existed before the establishment (under Venetian pressure) of the Latin Empire of Constantinople in 1204, and remained in existence even after its fall in 1261 (Nagy, 2005, 326; 341; 344); consequently, the fall of the Kingdom of Jerusalem (1291) and the failure of the Crusades scarcely affected the position of Italian merchants in the East; instead, the Italians signed treaties with Arabs and Turks, and continued business as usual (Cameron, 1998, 89). From the latter, they purchased cotton, dyes and spices that sold well in Europe, and Genoa went as far as participation in Black Sea trade. During the Crusades Italian cities, in concert and in rivalry, intensified their penetration in the Levant. They established colonies and special privileged enclaves from Alexandria along the Palestinian and Syrian coasts, in Asia Minor, Greece, the suburbs of Constantinople, and around the shores of the Black Sea from the Crimea to Trebizond (Cameron, 1998, 88–89). Ultimately, Genoa became involved in the commercial activity of the Golden Horde, the European Mongol state. The Golden Horde controlled the north–south Fur Route along the course of the Volga, and by virtue of its territories in the Lower Volga Region and the Crimea, also the eastern European section of the transcontinental Silk Road. The main foci of the state’s international trade were therefore concentrated in these territories. Exports were mostly handled by the ports at the Black Sea, primarily the cities built along the coasts of the Crimea and the Sea of Azov. In the procedures of this region, from the 13th century a predominant part was occupied by Italian merchants, principally the Genoese. The Genoese settled in Kaffa (present-day Feodosia) on the south-eastern shores of the Crimea from the 1260s, and successfully overshadowed the Venetians. Although formally they belonged under Tartar authority, they had complete autonomy in governing the internal affairs of their city. They were headed by a consul, who represented the Republic of — 59 —

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Genoa in Kaffa. In the 14th century the Genoese obtained trading rights in more cities. They extended their power to Matraga (Tmutarakan) opposite Kerch along the Kuban estuary, and Moncastro (i.e. Akkerman, present-day Bilhorod-Dnistrovskyi), and in 1365 Genoa gained control of the south-eastern coasts of the Crimea, including Sudak, Alushta, Gurzuf, Yalta and Balaklava. Their hegemony over trade was only broken by the rising Ottomans, who captured Kaffa in 1475, which led to the terminal decline of Genoese interests (Vásáry, 1986, 248–250). Apart from grain and spices, a leading role was occupied by alum, which was not available in Europe. Used for the finishing of wool, alum was an essential material in the cloth industry (Nagy, 2005, 326; 334). Italy’s other monopolized product, silk, is also of relevance here. Invented in China, the manufacturing method of this fabric (which was also known in Constantinople, but its weaving was an imperial monopoly) found its way to Europe through the Arabs – or more precisely, to Italy via Sicily. Lucca and Florence were among the first centres for silk manufacturing. From here it spread to French territories; however, during the Middle Ages manufacturing of the fabric essentially depended on imports of input materials, which in turn were dependent on long-distance trade (Nagy, 2005, 326–327). The effects of the wave of urbanization and prosperity were also felt soon in other territories across the continent – initially in the Low Countries and northern France. Here the exchange of goods was greatly facilitated by the transportation opportunities provided by the rivers flowing into the sea.44 While trade in Italian cities was characterized by the distribution of a relatively wide range of goods from Byzantium and the East, while the market of the Low Countries - at least in the 11th and 12th centuries - was dominated by the cloth trade. Relations were established quickly between the two early developed regions, partly benefiting the mercantile cities of the Rheine, and partly the fairs of Champagne that emerged in the late 12th century. In the 12th and 13th centuries, these fairs The area in question essentially covers the stretch of land bordered by the Seine, the Rheine and the Mosel, as well as the regions along these rivers (cf. Nagy, 2005, 331).

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developed into the continent’s key centres of long-distance trade. Initially, the fairs of Champagne, then primarily of local significance, were visited by merchants from France and Flanders, whose goods mainly included cloth and other textile products.45 The growth in the volume of trade at these fairs was due to support from the counts of Champagne and Brie. From the mid-12th century, Count Theobald (Thibaut) (†1152) and his son Henry (†1181) made major decisions that supported commercial activity. They guaranteed the security of merchants and granted them protection and safe conduct. At the court of the fairs of Champagne (commercial courts), ruling was fast and efficient by contemporary standards. Merchants’ confidence was encouraged by the assurance that although they were operating on foreign land and were subject to a foreign ruler, they would still be able to recover their claims and enforce the rulings of the court (Cameron, 1998, 92). The token of success for the fairs of Champagne was their ability to link the northern and southern economic centres of Europe, i.e. Flanders and northern Italy from the 12th century, as a result of which they provided access to goods from both regions (Nagy, 2005, 327–328). Apart from the goods of the Levant intermediated by Italian merchants, commercial articles from German and Hanseatic trade also appeared, including products that pointed far beyond the territory of Europe. Christian Europe of the Middle Ages never constituted a closed entity towards the East. It was always engaged in an almost uninterrupted exchange of goods with nearer and more Throughout the Middle Ages, the textile industry maintained its leading role among the various handicrafts. It employed the greatest number of workers, and its products were of great value in both local and long-distance trade. The branches of the textile industry consuming a variety of input materials (wool, flax, hemp, cotton, silk, etc.) are associated with the development of countless specialized trades. The outstanding importance of the textile industry was not only due to the general need for people to clothe themselves; an essential role was also occupied by the fact that in this period clothes – their materials and colours—were marks of the individual’s social standing, and thus the initial significance of clothing pointed far beyond practicality. Textiles were given their colours using various dyes of plant origin. Such dyes were produced extensively from dyer’s madder, dyer’s woad and other plants, but, for instance, the manufacturing method of crimson, which gave cardinals’ robes their characteristic colour and was extracted from a specific insect, remained the immensely profitable secret of Venice for a long time (Nagy, 2005, 334).

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distant parts of Asia. The economic connections between the approximate extremes of the two continents, i.e. Eurasia, was organized around a number of hubs through which a variety of Asian goods made their way to Europe, and vice versa. Their shared characteristic was that they were almost exclusively luxury articles.46 They were the only goods that offset the costs of long-distance transportation and the increased risk involved. Although trade with Asia was traditionally dominated by spices, the palette of goods exchanged was much more colourful. Its prime spanned over a hundred years from the mid-13th century – at this time, the Pax Mongolica established by the Mongol Empire enabled peaceful longdistance trade on a Eurasian scale. This was the period in which Marco Polo made his way to China, and Italian merchants were already familiar

There was a daunting inventory of commercial goods exchanged at various points along the Silk Road throughout Eurasia: spices, fabrics, essential dyes for the textile industry, furs, leather, a variety of metal products, and precious stones (Nagy, 2005, 328). Some of these are especially worthy of note. Pomegranates, which were later applied in medicine and gastronomy, were introduced to China at this time, and the Celestial Empire imported myrrh from Persia. China also appreciated textiles from the West, particularly Persian and Syrian brocades such as damask (bearing reference to the city of Damascus in its name), which were made with gold or silver threads woven around silk threads, just as much as items and jewellery made of coloured glass. The imperial court also consumed a variety of cosmetic articles including the ‘blue dye’ extracted from Indian indigo, the ancestor of present-day eyebrow pencils, and henna, the ‘flower of fingernails’. Persia supplied China with coriander, other prominent articles being minerals and precious stones (lazurite, turquoise, diamond, jade), as well as corals and beads. Items made of china and glass, and the base materials of scents were regular shipments on the Silk Road just like spices, the latter mainly flowing from the East (chiefly India) towards the West, as did silk (Boulnois, 1972, 103–104; 118–119; 144). Silk became the currency of transcontinental trade that ‘could be exchanged anywhere for anything, and was valid throughout continents (Ecsedy, 1979, 43), while byssus, the exotic fabric woven in the Mediterranean was also welcome in the Far East (ibid., 68). The Turkish and Persian names of merchandise mentioned in the famous Codex Cumanicus (in effect a multilingual commercial catalogue) also provide an indication as to the variety of goods that were loaded into ships at the ports of the Black Sea, to be dispatched to Western Europe. According to the Codex, the principal products were leader, felt, furs, wax, incense, grains, cheese, wine, salt, fish, spices, silk and fabrics (Vásáry, 1986, 253). Apart from these, a strong market existed for trading in slaves, which was actively pursued by the merchants of northern Italy, again with Genoa holding primacy ahead of Venice (Tardy, 1980, 69). For Crimean slave trade, see Tardy, 1980, 121.

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with the charted eastern routes (Nagy, 2005, 328; 330).47 Italian merchants with a vested interest in long-distance and intermediary trade ‘inevitably’ appeared at the fairs of Champagne, and as they entered the scene, financial markets started to develop throughout mediaeval Europe. In Champagne, fairs were hosted by the four cities of Lagny, Bar-surAube, Provins and Troyes. The latter two hosted two fairs each year. Fairs were always held in the same season of the year, and each lasted for at least six weeks. This in effect allowed merchants, who were active in long-distance trade, to find customers in Champagne throughout the year even when the breaks of one or two weeks after the close of each fair were taken into account. Each fair was conducted according to its specific procedures, which also provided opportunities for the settlement of bills and trade disputes. Namely, consideration for the deals struck at each fair was not required to be paid promptly, and it became common practice to settle the balance of purchases and sales at the close of the fair. This contributed to the limitation of cash payments, which always carried a higher risk, and to the development of more advanced commercial techniques (Cameron, 1998, 92; Nagy, 2005, 327), the impact of which was otherwise much more extensive and permanent than that of fairs themselves (Cameron, 1998, 92). The emergence of bills of exchange Bills of exchange are considered to have evolved from an arrangement called instrumentum ex causa cambii. As demonstrated by Genoese records, these ‘proto-bills’ were used in large numbers in the 1200s – generally, in such an instrument the debtor acknowledged the receipt of a certain amount in Genoa and promised to repay the equivalent of that amount in Champagne. Naturally, lenders automatically earned a profit from money transfers, which is why transfers between Genoa and Champagne were branded as ‘disguised In his trade manual of the early 14th century, La prattica della mercatura (‘The Practice of Trade’), Francesco Balducci Pegolotti, a representative for the Bardi trading house in Florence – although he never visited the East —, gives an accurate description of the route from the shores of the Black Sea to China, which in his estimate took 284 days to cover (Nagy, 2005, 330; cf. Vásáry, 1986, 253).

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loans’ by some of the clergy (Bozóky, 1972, 492). At this juncture, a brief detour seems appropriate to address the relationship between the contemporary Church and the mediaeval monetary transactions in full blossom. Drawn up in the form provided by law, a bill of exchange is an instrument (debenture) that is negotiable to a limited extent in lieu of money, wherein the drawee undertakes an obligation to pay, or order to be paid, a specific amount at a specific time and place, to the creditor or a third party. A distinction is made between house and drawn bills. House bills represent a promise to pay (acceptance facility), whereby the issuer undertakes a payment obligation. In a drawn bill, the drawer instructs a debtor (the drawee) to pay, by issuing a demand for payment (draft). In capitalist development, the bill of exchange as a particular form of financial capital played an important role in accelerating the circulation of capital. In contrast, the start of the transferability of commercial instruments appears problematic. In mediaeval times, it was generally not possible to transfer bills of exchange through endorsement. Notwithstanding their early examples, endorsements only became common in the very early 17th century. In the 17th century, lawyers professed that the transferability of commercial instruments should be permitted. This paved the way for the slow evolution of bills of exchange into payment mandates (Bozóky, 1972, 493; Közgazdasági Kislexikon, 1972, 381; Muraközy – Zánkai, 1973, 501).

Even though it was not possible for an advanced commercial system to exist without credit and the associated institution of interest (Nagy, 2005, 330), the mediaeval financial market was marked by the ecclesiastical practice wherein lending at interest was considered usury, and as such was prohibited. According to theologians and canonists, all proceeds from loans qualified as usury—usura est lucrum ex mutuo ratione mutui (Bozóky, 1972, 492). The view of the Church on the collection of interest may in part be traced to passages of the Bible, early conciliar decisions and the teachings of the Doctors of the Church, all of which clearly prohibited the collection of interest. For instance, as in a verse from the Gospel According to Luke: ‘[...] lend [...] without expecting to get anything back’ [Luke 6:35] (Bible, 2006). Published in the Carolingian era, the Capitulare missorum of Nijmegen of 806 offered brief definitions for usury (usura), — 64 —

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business (negotium), and filthy profits (turpe lucrum). Accordingly, usury was thought to occur whenever someone demanded more than what had been lent, while in the course of genuine business, goods were supposed to be sold at the same price at which they were bought. These regulations did not allow anyone to buy crops cheaply at the time of harvest, then sell them later at a margin – that would have constituted filthy, fraudulent profits. This austere prohibition was also applied in the Decretum Gratiani, closed around 1140, and was thus incorporated in the provisions of canonical law. The perception of commerce, which at the time went hand in hand with credit transactions, and of merchants carrying out the exchange of goods was similar: ‘Homo mercator vix aut nunquam potest Deo placere’, i.e. ‘a man as a merchant can seldom or never please God’. The case of ‘seldom’ required that merchandise be put to market at a ‘just price’ (iustum pretium), i.e. that merchants should not seek to maximize their gains, but merely to make a profit which, as consideration for their own efforts, would earn them a living (Nagy, 2005, 330). The Church would impose heavy sanctions for any breach of this prohibition. The Third Council of the Lateran in 1179 prohibited Church funerals for usurers, which was confirmed by the First Council of Lyons in 1274. The provision that all proceeds from lending were to be seen as usury, however, could also be construed to mean that if there was no lending, there was no usury either. And surely, other theologians were of the view that the practice of money transfer, i.e. cambium was not to be considered as lending. For instance, Alexander of Alessandria (†1314) professed that such a transaction involved merely permutatio (i.e. the substitution of one thing for another) rather than mutuum (i.e. a loan), consequently, no objection might be made to speculations in that regard as that would not qualify as usury (Bozóky, 1972, 492). Nevertheless, taking place in the crossfire of theological disputes, the commercial and financial processes were not stagnant, but kept progressing steadily despite their constant variations. Namely, Rome itself and the Pope also needed people to manage the wealth of the Church, the Roman Catholic Church being the largest economic organization in Europe during the late Middle Ages. While other states sought to collect taxes only from their own subjects, Rome was drawing — 65 —

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in money from all over Europe. On taking up his benefice, a Church dignitary was required to pay the equivalent of the first year’s income to Rome. Money arrived from all corners of Europe, and delayed payment was punishable with excommunication (excommunicatio). To transport money in cash on the roads of Europe would have been risky. In order to avoid potential losses, travellers to Rome would visit a bank somewhere west of the Rheine (as there were no banks east of it), purchase a letter of credit, then cash it on arrival in the city. Obviously, the transaction involved exchange costs and service charges, but the danger of being robbed was eliminated. The Church, then, despite all its condemnations, had a vested interest in stimulating banking business on an increasingly large scale (Parks, 2006, 33–34). Box 3-2 Ecclesiastical views on interest in the Middle Ages

Among theologians, in his Summa Theologiae Thomas Aquinas provides an exhaustive treatment of the prohibition on the collection of interest. Notwithstanding a few positive Biblical references to the collection of interest, Thomas Aquinas considers the practice unjust, and indeed, qualifies it as a sin (Bodai, 1998, 38). He deduces the prohibition on interest48 from the example of trading in ordinary goods. In the course of their consumption, ordinary goods such as grain perish, which is what warrants the payment of consideration. However, money lent does not perish in the course of its use but is repaid just as it was borrowed; consequently, it is not permissible to demand consideration for its use. A lender of money demanding money for the use of a loan is equivalent to a seller of ordinary goods demanding money even for the use of the goods in addition to their price. Thomas Aquinas argued that coins were invented for the purpose of exchange. He defined the function of money to the context of intermediating the flow of goods (goods–money–goods). In Roman law, the Latin term usura was originally used in the sense ‘use charge’, i.e. simply ‘interest’. In early usage, ‘usury’ and ‘interest’ were presumably equivalent in substance. A substantive distinction evolved in the Middle Ages, and ‘interest’ and ‘usury’ took on different meanings.

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He argued for money to be used solely as a medium of exchange and sought to prevent it from running its own course (Berkó, 2017, 12). Conversely, if the collection of interest were to be allowed, money would not be consumed but proliferate and become productive in itself and would start running its own course in deviation from its original role in the exchange of goods. In Christian Europe, the prohibition on the collection of interest was incorporated into canon law during the 12th century. Summoned by Pope Innocent II in 1139, the Second Council of the Lateran declared a prohibition on the collection of interest, which was confirmed by Third Council of the Lateran in 1179, adding that a priest burying a usurer might be punished by suspension from office. The Council of Vienne (1311–1312) declared anyone a heretic who was tolerant of lending with interest. As the prohibition on interest posed a major obstacle to the development of commercial and bank transactions, the prohibition was gradually relaxed from the 15th century. At the request of Jacob Fugger, Johann Eckert, professor of theology at the University of Ingolstadt, developed a theological position on the collection of interest. He insisted on defending his position in a public debate, which was held in 1515 at the University of Bologna. Although he failed to convince his opponent Johann Fabri, Provost of Augsburg, moving forward the Church implicitly acknowledged the placement of deposits at a rate of 5 per cent, which was subsequently approved by Pope Leo X in a decision by the Fifth Council of the Lateran. By the time of Martin Luther (1483–1546) money lending was common practice, yet Luther spoke up firmly and passionately against lending with interest. Luther declared that lending with interest was not compatible with Christian teaching. He cited a series of historical examples to demonstrate that even in antiquity sovereigns were often forced to intervene against the collection of interest in order to maintain social peace. He went back as far as Aristotle, who considered the collection of interest in all of its forms to be inconsistent with the laws of nature. Luther placed priests and schoolmasters in charge of disseminating knowledge on interest, and helping people to develop their capability of defence.

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Unlike Luther, John Calvin (1509–1564) permitted the collection of interest, and did not repudiate enrichment. He argued that lending was a legal and ethical relationship within a community, which was not forbidden by the Bible. Abuse, however, was another matter. According to Psalm 15:5, a just man would ‘lend money to the poor without interest’, i.e. would refrain from the exploitation of the distressed. For that reason, it was not acceptable to charge interest on such loans. That is precisely what Calvin himself taught. Conversely, if someone were to take a loan with economic rents in mind, it was legitimate for the creditor to partake of those rents to the extent of a fair and limited rate of interest. Calvin did not see the enrichment of pastors as an obstacle to the fulfilment of their calling; on the contrary, he saw the profitable investment of their wealth as a means of enhancing their prestige. However, it was morally reprehensible to repose in the possession of the goods accumulated, the enjoyment of wealth, and the abandonment of seeking a holy life. The Calvinist position on wealth was that however much it was personal industry, effort, intelligence and economy that earned an individual’s goods, in the final analysis that individual was not the proprietor but a mere steward of those goods. An individual’s money and life both belonged to God, and there was not, nor could there be a single aspect of an individual’s life that was not subject to God’s rule (Berkó, 2017, 18–19). This economy and simplified lifestyle greatly facilitated the generation of capital, and as Calvinists in Western Europe preferred not to invest their savings in estates partly because they were opposed to feudal forms of life per se and partly because their prosecuted status otherwise limited their access to estates, they took advantage of the opportunities in economic and commercial life that were opening up in the Modern Period. This is when accumulated family capital was utilized to launch the enterprises of merchant and industrialist families, giving rise to petit capitalism. Calvinism was certainly a favourable spiritual precondition for the evolution of petit-bourgeoisie capitalism. Following the Reformation, economic development gained momentum in England and the Netherlands, while Catholic Spain and the Muslim Ottoman Empire fell behind despite their significant military power and territorial dominance.

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Champagne fairs are assumed to have been at their zenith in the 13th century; in the 14th century, their significance started to wane as a combined effect of several factors. Apart from the political transformations, another important change was that from the late 13th century, the direct sea route from Italy to Flanders became safe, and within a few decades, rather heavily navigated. Previously, merchandise arriving via the Mediterranean would be transported to these areas on land across the great Alpine passes, which saw busier traffic than the Strait of Gibraltar. It was the late 13th and the 14th centuries that brought about the innovations in shipbuilding and navigation that triggered revolutionary changes. By the 1320s, both Genoa and Venice were dispatching a convoy each year; the famed Flanders fleets. These maritime caravans shipped Mediterranean goods directly to the great permanent market of Bruges, then of Antwerp, eliminating the need for certain functions of the Champagne fairs. Although inland trade was not completely defunct (in the 15th century Geneva played a role similar to that of Champagne earlier), a new period was clearly emerging in the economic relations between northern and southern Europe. Not only were new routes and means of transport concerned, but major changes were also taking place both in the scale of trade and the mechanisms of business organization. The latter underwent a significant structural change: although there were fairs, such as Frankfurt, that reached the peak of their prominence in the 14th century, overall the system of trade organized around large international fairs was also transformed. The need for these fairs was gradually reduced as merchants accompanied their goods less and less frequently, while the networks of distributing and financial companies that employed representatives in commercial centres were becoming more common. Deals were no longer struck at the benches in fairs, but goods were delivered on order. These companies were headquartered in major Italian cities, and had divisions throughout Europe (Cameron, 1998, 91–92; Braudel, 2004, 427; Nagy, 2005, 328). Outstanding among Italian cities was Florence (Chart 3-6), which was represented by a large number of such ‘companies’ across Europe, while its network of creditors spanned from London to Constantinople. International (intermediary) trade, — 69 —

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which flourished but nevertheless rested on new foundations, was predominantly conducted by family-owned companies – the precursors of modern banks. These merchants took deposits, so they could finance their commercial transactions, while they also granted loans to other entrepreneurs, sovereigns, nobles, and Church dignitaries, and invested in industrial and commercial undertakings. In the early 14th century, the banks of the distinguished Bardi and Peruzzi families of Florence amassed incredible fortunes. However, both banks collapsed in the 1340s when Edward III of England refused to pay his debts (Parks, 2006, 18). Also in Florence, the Medici bank was registered with the Exchangers’ Guild in 1397, and subsequently coordinated the entire lending process on a pan-European scale (Parks, 2006, 14). By the first third of the 15th century, the development of the banking house got to a point where the Medici branch in Rome handled the collection and disbursement of tithes, while its branches in Venice and Genoa controlled most payments of continental trade (Parks, 2006, 108). Chart 3-6: Tuscan banker at work (14–15th century)

Source: upload.wikimedia.org

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3.2.2. China

In connection with the emergence of banks in mediaeval Europe and their innovations, a brief overview should also be given of the monetary economy and long-distance trade of contemporary China. Not only were European financial markets inspired by the gains derived from that trade; at the Far Eastern terminus of the transcontinental route, major innovations were also introduced – among others, Marco Polo was a source of valuable information about these financial innovations. Box 3-3 The Silk Road

The Silk Road was a network of long-distance trade routes on which silk, believed to be of Chinese origin, found its way via the nomadic empires of the Eurasian steppe, and the civilized regions lying further south and interspersed with high mountains and deserts, to the Mediterranean Basin. From there, caravans and ships loaded with the luxury articles from the West returned to the Far East. However, not only premium goods but also innovations, cultural and artistic influences, and religions travelled thousands of kilometres from China to Rome, and from the Eternal City to the Celestial Empire – on land and sea. It is a peculiar point in the history of science that the term ‘Silk Road’, however classical it may sound, was only coined recently. A prominent figure in German geography, Baron Ferdinand Freiherr von Richthofen introduced the term Seidenstrasse in written discourse in 1877. Following the publication of Richthofen’s work, world languages were quick to adopt mirror translations of the term, such as the English Silk Road (Silk Route), the French Route de la soie, and the Russian Великий шёлковый путь. Richthofen named a network of routes (in effect an economic, geographical, historical and cultural complex) that had already existed for more than 2,000 years before the release of his work, and, for a long time, had been the scene of travel, war, trade and pilgrimage for thousands of envoys, soldiers, merchants and monks, who did not have the geographical and historical

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perspective to form judgments on the stage of their lives. Inevitably, the routes that for most of these people only joined two neighbouring towns would therefore not be perceived as the extensive and complex network that linked Europe (and in particular the Mediterranean) to the most remote parts of Asia, which, although covered many regions of radically different cultures, constituted a vast, contiguous and organic unit. Another result of this ‘partial knowledge’ was the very few people who travelled the route of the Silk Road in its entirety, or even in part. A rare exception was Marco Polo, who probably was not only one of the few who travelled the whole of the Silk Road (in his case, both its land and sea routes), but also of the few who left an account to posterity. Apart from silk, a ‘continental currency’, a number of other products such as china, tea, spices, precious and semi-precious stones, glassware, nonferrous and precious metals, weapons, other fabrics, etc. were exchanged along the land and sea routes of several thousand kilometres that spanned from China to the Mediterranean. In the world trade conducted along the Silk Road, the eponymous fabric had lost its exclusive character by the late Middle Ages: as silk was already produced outside of China almost at discretion, the West had no reason to source it from such a great distance. At that time, the silk trade was no longer determined by secrecy and exclusivity, but by the difference between the cost of production and the cost of transportation. Conversely, the western outlets remained willing to pay any price for products that were not otherwise available, including spices and precious stones. Nevertheless, the wide range of commercial articles was never static, because this extremely sensitive system responded quickly not only to the loss of individual participants, but also to changes in market needs, and to local features specific to certain sections of the route. The Silk Road was the main artery of the flow of not only commercial articles, but also of culture, languages, arts, religious and philosophical thoughts, information, and innovations between Asia and Europe (Felföldi, 2009, 29, 33; Felföldi, 2012, 10–12). In the words of Aurél Stein, the ‘archaeologist of the Silk Road’: ‘For centuries, this route was a thoroughfare for contemporary connections

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between ancient India and China, and West Asia, permeated by Greek civilization. This is an intriguing chapter of cultural history’ (Stein, 1936, 1). Indeed, this is what makes the history of the Silk Road a particularly important stage in the evolution of human civilization.

The economic boom of the 11–13th centuries was partly conditional on the high proliferation of currencies, and the spread of the monetary economy. At the time of the Five Dynasties,49 i.e. in the first half of the 10th century, some ten autonomous states were formed within the boundaries of the empire, each of which issued its own currency. In most of northern China, copper coins continued to be exchanged, while in many regions across southern China iron and lead coins appeared. United by the Song dynasty, in the second half of the 10th century the new empire adopted a single copper currency throughout its territory. However, due to war efforts the state was forced to issue an unprecedented quantity of copper coins. This occurred between 1038 and 1055, a period of severe military problems at the north-western borders of the empire, and in 1126, the year of the great Jurchen offensive. The greatest number of coins, six billion pieces, were cast in 1073. Despite the vast quantity of money in circulation, copper coinage was overall insufficient to cover the needs stemming from the economic boom and military expenditures. The pieces of unminted silver, that were adopted in the Five Dynasties period as a means of payment south of the lower Yangtze, also appeared in northern China during the 11th century. Here the Uyghurs, who traded with the countries of the Middle East, contributed to the spread of this payment method through their silver imports (Gernet, 2005, 257).

In the succession of traditional (legitimate) dynasties in Chinese history, the Five Dynasties period is dated between 907 and 959. The five dynasties were: Later Liang (907–923), Later Tang (923–937), Later Jin (937–947), Later Han (947–951), and Later Zhou (951–959) (Ecsedy, 1979, 235). Other sources date the Five Dynasties (‘Wu-tai’) period between 907 and 960 (Vásáry, 2003, 91–92). The difference may be a result of the possibility to date the reign of the Song dynasty, which united China, from 960 (cf. Ecsedy, 1979, 235).

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The certificates of deposit to merchants, which were issued by the representatives of provincial governments in the capital as early as the 9th century and were referred to as ‘flying money’ (feiqian) at the time, as well as the similar private certificates issued by the rich merchants and bankers of Chengdu in Sichuan somewhat later, from the late 800s, may be considered as precursors of paper money. The first government bank note was produced in Sichuan in 1024. Although widespread in the Chinese world in the 11–14th centuries, the use of paper money subsequently lost its significance and was used only rarely. In the Song period (960–1279) (Ecsedy, 1979, 235), however, it significantly contributed to the expansion of both the private and the state economy. During the reign of the Southern Song dynasty (1127–1279), it made it possible to reduce the issue of copper coinage, yet the excessive use of the new currency, the exchange rate of which was set centrally, ultimately caused the economic crisis to worsen right before the Mongol conquest (Gernet, 2005, 257–258). Known by a variety of names such as jiaozi, qianyin, kuaizi, and guanzi, paper money was the dominant form of money in the 12–13th centuries, and remained so until the end of the Mongol occupation.50 Its use was also commonly used in the Liao and Chin Empires.51 At the time of the Southern Song dynasty, the value of paper money in issue reached 400 million strings.52 Additionally, a variety of transferable instruments also came to be used in commerce: cheques, promissory notes and bills of exchange all appeared in the 11th century. The financial activities controlled by the proprietors of exchange offices (jifupu, During his reign, Kublai Khan relocated the seat of the Mongol Empire to the territory of conquered China, while he also founded a new Chinese dynasty that governed the far eastern state by the name of Yuan between 1280 and 1367 (cf. Ecsedy, 1979, 235). 51 The Liao and Chin Empires were formations named after the reigning dynasties established in northern China by the Khitans and the Jurchens on the territories that they detached from China. Governed by the Khitans, the Liao state existed between 947 and 1125, and was succeeded by the Chin state of the Jurchens (1125–1234) (Vásáry, 2003, 98). 52 A string was equivalent to 1,000 coins (cf. Gernet, 2005, 257). 50

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jinyinpu, duifang, jiaozipu, zhipu, fangzhaihu, qianhu) became one of the most important sectors of the mercantile economy in the Sung epoch (Gernet, 2005, 258). In his book, Marco Polo, who visited the court of the Mongol Khagan in China and was later admitted to Kublai Khan’s private council (Vajda, 2003, 13), gives the following account of paper money and its use: ‘Now that I have told you in detail of the splendour of this City of the Emperor’s, I shall proceed to tell you of the Mint which he hath in the same city, in the which he hath his money coined and struck, as I shall relate to you. [...] He makes them take of the bark of a certain tree, in fact of the Mulberry Tree,53 the leaves of which are the food of the silkworms [...]. What they take is a certain fine white bast or skin which lies between the wood of the tree and the thick outer bark, and this they make into something resembling sheets of paper, but black. When these sheets have been prepared they are cut up into pieces of different sizes. The smallest of these sizes is worth a half tornesel;54 the next, a little larger, one tornesel; one, a little larger still, is worth half a silver groat of Venice; another a whole groat; others yet two groats, five groats, and ten groats. There is also a kind worth one Bezant of gold, and others of three Bezants, and so on up to ten. [Every piece bears the seal of the Great Khan, otherwise it is worthless.] All these pieces of paper are [issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece a variety of officials, whose duty it is, have to write their names, and to put their seals. And when all is prepared duly, the chief officer deputed by the Kaan smears the Seal entrusted to him with vermilion, and impresses it on the paper, so that the form of the Seal remains printed upon it in red; the Money is then authentic. [...] And nobody [...] dares to refuse them on pain of death. [...] [Neither shall the subjects of foreign countries use other money in the Empire of the Great Khan.] And indeed, everybody I.e. Morus. Tornesel was a currency of French origin (Vajda, 2003, 465; Note 40).

53 54

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takes them readily, for wherever a person may go throughout the Great Kaan’s dominions he shall find these pieces of paper current, and shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold. And all the while they are so light that ten bezants’ worth does not weigh one golden bezant. [...] [A]ll merchants arriving from India or other countries [...] accept [them] readily, for in the first place they would not get [as much] from anybody else, and secondly, they are paid without any delay. And with this paper-money they can buy what they like anywhere throughout the Empire, whilst it is also vastly lighter to carry about on their journeys. [...] [T]he merchants will several times in the year bring wares to the amount of 400,000 bezants, and the Grand Sire pays for all in that paper. [...] When any of those pieces of paper are spoilt – not that they are so very flimsy neither – the owner carries them to the Mint, and by paying three per cent, on the value he gets new pieces in exchange. [...] [In one word, here the people never pay in gold or silver.]’ (Vajda, 2003, 201–204). For that matter, Kublai Khan first issued paper money in 1260 (Chart 3-7), and the fact that money was impressed on bast paper also gives an indication of the Chinese printing technique.55 At the mint, gold, silver, gems and pearls were exchanged for paper money at a handsome rate, and could also be bought for paper money when someone needed them e.g. for crafting jewellery. The very fact of a paper money economy was a revelation in 13th-century Europe (Vajda, 2003, 203–204; 465, Note 41).

Among the Mongol Khagans, Ögedei was the first to introduce it in 1236 (Vajda, 2003, 465; Note 41).

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Chart 3-7: Chinese 1 kuan note from 1375

Source: upload.wikimedia.org

In addition to financial innovations, mention must also be made of developments related to commercial navigation. The development of Chinese seafaring activities from the 11th century onwards (with the invention of the compass) was one of the most important phenomena in the history of Asia. The concordant accounts of European and Arab travellers in the 13–14th centuries all testify to that: the activity of major ports in the provinces of Fujian, Zhejiang and Guangdong at that time was on a far larger scale than that of contemporary European ports. The size of river and seagoing traffic in the Sung and Yuan periods, the increasing role of the naval fleet in the defence of the Southern Sung Empire in the 12–13th centuries and during the Mongol attempts to invade Japan and Java at the end of the 13th century, and the great maritime expeditions of the Ming period56 in the years 1405–1433, when The emperors of China were of the Ming dynasty between 1368 and 1643 (Ecsedy, 1979, 235).

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Chinese junks ventured as far as the Red Sea and the east coast of Africa, all show quite clearly that in the four and a half centuries from the consolidation of the Sung empire to the great sea voyages of the Ming empire China was the greatest maritime power in the world (Braudel, 2004, 415–416; Gernet, 2005, 258).

3.2.3. The Medici

Strictly speaking, mediaeval banks as institutions evolved from money changing. In Genoa, money changers appeared in the market as early as the 12th century, carrying out their operations on counters and benches (Ligeti, 2003, 18). The word bank originates from Italian banco (later banca), meaning ‘bench’ or ‘exchange desk’. Additionally, it might also designate the simple wooden board that could be laid across a platform to write on and count over, clearly indicating the side of the banker and the customer. That was all it took to operate the earliest banks. For most people in the Middle Ages, a bank was merely a table set up outdoors (Parks, 2006, 43). Since the bankers often did business together, they set up their tables in the same neighbourhood – e.g. in Florence in Orsanmichele, which is located in the present-day historical centre of the town. Wrapped in their long red gowns, with heavy bags of coins at their sides, Florentine bankers would serve clients at some seventy such tables. For each table covered by a green cloth, the ledger was the most important accessory, as the Exchanger’s Guild ruled that every transaction was to be recorded. The written cheque was rarely used due to the risks involved. Every transaction had to be discussed orally with the banker, in person, then recorded – in the client’s presence – with Roman numerals, in orderly columns, because these were much more difficult to falsify. The flow of money inflated administration, and all the mental calculations would have flown away if not written down. Admission to the trade required literacy. Once recorded, the transaction was read out aloud. Any member of the Guild found to have destroyed or altered his accounts was expelled promptly and without appeal. And when a banker died leaving no one to carry on the business, his ledgers — 78 —

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were held by the Guild in a chest with three locks, so that three officials each with his own key had to be present before the accounts could be consulted (Parks, 2006, 43–44). However, not all bankers were guild members. For example, pawnbrokers were ‘manifest usurers’ and so could not belong to the Exchangers’ Guild and could not be given licenses to trade. Their tables were advertised by a red cloth hanging from the arch of their door; they made modest loans in return for low interest rates, against the security of some object that could be resold if the loan was not repaid (Parks, 2006, 45). Unlike the pawnbrokers, the banche a minuto were regularly signed up members of the Guild. These were small and strictly local banks with three main functions: they sold jewels, accepting payment by instalment; they held tied deposits, on which they handed out annual ‘gifts’ amounting to 9 or 10 per cent; and they changed silver piccioli into gold florins, and vice versa. The silver coin, picciolo, was not small change for the gold florin; they were separate currencies. Since the worth of the two coins depended on the quantity of precious metals in each, their relative value was volatile. Piccioli could only be changed into florins by banks at the going rate for changing silver into gold. The picciolo was the currency of the poor, whereas luxury goods and international trade were the exclusive realm of the golden florin. The division was ordained by law (Parks, 2006, 46). In 1252, when the gold florin was first minted, it could be bought with a lira of piccioli, i.e. 20 piccioli. Around 1500, its price was as high as 7 lire, i.e. 140 piccioli. Silver depreciated partly because members of the Merchants’ Guild (Arte di Calimala) or the Silk Manufacturers’ Guild (Arte di Por San Maria) earned in florins but paid salaries in piccioli. When business was down, they encouraged the mint, which was controlled by the government, a body seating the representatives of the guilds, to reduce the silver content in the picciolo. In this way it would take fewer florins to pay workers the same salaries in piccioli (Parks, 2006, 47). A bank operating on an international scale was a banca grossa, a Medici type of bank (Parks, 2006, 46). The bank operated by the founder of the banker dynasty, Giovanni di Bicci, carried out — 79 —

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transactions in gold florins only, using the Venetian style double-entry bookkeeping with debits and credits recorded on opposite pages (Parks, 2006, 48). As the gold florin could not be broken down into smaller coins but was valued very highly, bankers needed smaller units for their daily practices in which to calculate sales and deposits. The first fraction was the lira a fiorino, worth 20/29, i.e. twenty twenty-ninths of a florin. Each lira a fiorino could be divided into 20 soldi a fiorino, which in turn could be divided into 12 denari a fiorino. Hence there were 348 denari or 29 soldi in a gold florin. However, all that existed in theory only, because in reality there were no such coins as the soldo and the denaro—bankers used abaci for conversions. Given these rates, it was not surprising that books could not always be balanced despite the application of double-entry bookkeeping (Parks, 2006, 51–52). As far as ‘core operations’ were concerned, money was exchanged in two forms: locally and internationally. The latter was essentially the equivalent of money transfer. The agreement was made in one place, but executed in another. Obviously, the distance between the two places also resulted in a time lag, which is why the transfer-exchange arrangement was combined with a credit transaction. This type of exchange was executed by means of a bill of exchange, to which there were four parties: two in making the agreement, and two in executing it. In mediaeval times, bills of exchange were issued at predetermined prices, and as the transactions were carried out in a variety of places, the financial market was controlled by foreign currencies (Bozóky, 1972, 492). Accordingly, the operations of bankers included deposits, lending and payments, and it was also in Genoa that the institution of endorsement was developed (Ligeti, 2003, 18). This utilised transferability, a key feature of bills of exchange, whereby the holder of a bill could use it for the payment of a debt. Indeed, from the 14th century onwards, bills of exchange increasingly performed the role of instrumentum ex causa cambii. In the same period, as Champagne fairs declined, Bruges, Paris and London emerged as centres of organized financial markets, while Avignon, Montpellier, Barcelona, Palma de Mallorca, Valencia and Seville also carried considerable weight. Obviously, that function was fulfilled by all major Italian cities of the 14–15th centuries. The principal bankers — 80 —

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were Italians, primarily Lombards, followed by Catalonians (Bozóky, 1972, 492; Ligeti, 2003, 18). An insight into the calculation of exchange rates is provided by manuals compiled for merchants. One option was to calculate rates against fixed units of foreign currencies. Using another method, exchange rates could vary according to comparisons of local currencies to constant quantities expressed in foreign currencies. Rates could be based either on real currencies such as Venetian ducats, or commercial currencies like the Genoese florin. In mediaeval times, bills of exchange were subject to the exchange rates applicable in the financial market, and were payable within their due dates. Due dates were determined by commercial custom depending on distance,57 and remained unchanged for a long period. In the Middle Ages, therefore, there was no distinct division between the financial market and the market for foreign currencies payable within set due dates (Bozóky, 1972, 492–493). In mediaeval times, the exchange of money fluctuated around parity, i.e. equivalence, in this case involving comparisons between the currencies of various countries in terms of their gold content (Chart 3–8). The determination of parity was complicated by the fact that certain western European countries, including France, had trimetallic monetary systems (comprising gold, silver and ‘black money’58), while Florence and Venice used a double monetary standard (gold and silver). The variety of coinage rights complicated matters further. Additionally, the exchange of money was also related to the internal rates of currencies, as the rates of gold and silver coins were often set by monetary regulations (Bozóky, 1972, 493). The Italian Exchangers’ Guild laid down the maximum times that journeys from one financial centre to another could require: Florence–Bruges: 60 days; Florence– Venice: 10 days; Florence–Venice: 30 days; Florence–Barcelona: 60 days. The longest time, 90 days, was allowed for the journey from Florence to London (Parks, 2006, 56). 58 This latter was an allowance of silver and copper, which quickly turned black with use (Braudel, 2004, 470). 57

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Chart 3-8: Gold florin of Florence (1347)

Source: upload.wikimedia.org

Therefore, by the 14th century northern Italy, and in particular Florence had become the main driver of European bank transactions. By this time, the landscape of Italyâ&#x20AC;&#x2122;s domestic politics had undergone a profound transformation: due to its northward orientation, the Holy Roman Empire effectively lost its grip on the city-states of a rapidly fragmenting Italy. Power was transferred, amid dozens of insurrections, from hereditary lords based in the country (whose seigniorial privileges had been guaranteed by the Holy Roman Emperor) to the wealthy classes of the cities, who, in turn, supported the Pope against the emperor in an attempt to free themselves of their feudal allegiance. This is how Florence also became an autonomous city-state, with a republican constitution of its own (Parks, 2006, 18; 29). Holy Roman Empire: A state formation established in the second half of the 10th century, with core territories located in present-day Germany and Austria. Its foundation is dated to 962, when Otto I was crowned emperor. In effect, this act restored the Western Empire (Restauratio Imperii). Held by the Habsburgs almost without interruption from 1438, the title of emperor was not hereditary; emperors were elected by eligible prince-electors within the terms of the Golden Bull of 1356 (Goldene Bulle).

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3. The Beginnings: From Mesopotamia through Florence to London

The Holy Roman Empire was never a firmly centralized state formation. While in the early Middle Ages the chiefs of German tribal duchies exerted significant influence in their own territories, this role was later taken over by ecclesiastical princes in their respective regions. A key step in the process was the Peace of Augsburg of 1555, which granted rulers the right to choose the official confession of the regions they controlled (Cuius regio, eius religio), giving the residents of each a choice between conformity and emigration. Following the Peace of Westphalia of 1648, princes were also allowed to pursue their own federal (foreign) policies. Accordingly, the empire did not follow the centralizing trend characteristic of several European states; sovereign efforts for centralization broke under the resistance of princes, who enjoyed an increasing degree of autonomy. As a result, the empire consisted of numerous counties, duchies, ecclesiastical principalities, and even kingdoms, of which there were over 300 by the end of the 18th century. Even the Habsburg sovereigns held indisputable power only over their own family estates (mainly in the territory of present-day Austria). Ultimately, the empire was dissolved in the early 19th century during the Napoleonic Wars, when in 1806 Francis II was forced to resign as emperor in the aftermath of the defeat in the Battle of Austerlitz in the previous year. It is to be noted that the federative structure remained a characteristic of subsequent German states as well; even the ‘unified’ German Empire, which came into existence in 1871, was comprised of several kingdoms, duchies and other states (Székely, 2005, 257–269; Vajnági, 2009, 167–190).

Just as the aristocracy were ousted by the wealthy mercantile classes, so were the merchants themselves overthrown by Florence’s poor woolworkers in the revolt of 1378 in their attempt to take over the government of the city. Having sided with the woolworkers, Silvestro de’ Medici, the most prominent member of the Medici family, became the new head of the Florentine government at this time (Parks, 2006, 19). Members of the family often had their names included in the list of Florentine priors, the nine men elected as heads of the city government. Nevertheless, it is a fact that the bank’s founder, Giovanni di Bicci de’ Medici was far from being an immensely rich man himself (Parks, 2006, — 83 —

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32–33). Yet, in his twelve-year apprenticeship in Rome, he appears to have learned everything he needed to set up a bank of his own. He saw that thriving banks had branches in the busiest commercial centres, as financial and commercial operations were inseparable (Parks, 2006, 36). In 1393 his elder cousin Vieri de’ Medici retired, and Giovanni bought out the Rome branch of the bank. Yet four years later, in 1397 he moved back to Florence to form his own bank (Parks, 2006, 39). Giovanni di Bicci de’ Medici59 himself put 5,500 florins into his new bank; by this time, he had already at least doubled his wife’s dowry of 1,500. Giovanni also had partners: one was Benedetto di Lippaccio of the Bardi family, who was working with him in Rome; he brought 2,000 florins. With the contribution of 2,500 florins by the other partner, Gentile di Baldassarre Boni, the business was set up with a capital of 10,000 florins. However, Gentile Boni pulled out after a few months, taking his capital with him. Giovanni increased his capital contribution to 6,000 florins to bring the total to 8,000, and after paying rent and salaries and setting aside a small sum for bad debts, the company got through its first eighteen months with a modest profit of 1,200 florins, i.e. 10 percent annually (Parks, 2006, 53). Over the next twenty-three years, up to Giovanni’s retirement in 1420, the bank would make total profits of 152,820 florins (6,644 p.a. on average), of which Giovanni took three quarters (Parks, 2006, 53). Power and wealth soon became entwined. Giovanni di Bicci developed close relations with the Church, the ultimate source of capital: spiritual, political, and monetary. While in Rome, he met the Neapolitan priest Baldassarre Cossa, who rose to the rank of cardinal in 1402, perhaps through Medici money – in any event, Cossa addressed the banker as ‘My most dear friend,’ in most of his letters. In 1410, Cossa was elected pope by the name of John XXIII, and the brother of Giovanni di Bicci’s partner Benedetto, director of the Medici bank’s Rome branch, became Depositary of the Papal Chamber. This pay-office of the Medici collected the pope’s revenues, held the Chamber’s cash, and also paid out its expenditures. They lent the pope money for the war against Naples and lent him Giovanni di Bicci de’ Medici was born in 1360 and died in 1429 (Martines, 2003, 397 [Appendix I]; Hibbert, 2007, 355 [Table 1]).

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even more to pay the reparations when he lost the war. Gradually and imperceptibly, the bank became involved in ecclesiastical politics, having its men placed in prominent positions, then collecting the fees due upon appointment. Throughout the careers of the founder and of his son Cosimo, half of the Medici bank’s income came from Rome. To invest that ‘holy income’, the bank opened two new branches in major Italian trading centres, Naples and Venice (Parks, 2006, 62–63). The business flourished, and the bank expanded under the control of its founder. He was succeeded by his son Cosimo di Giovanni de’ Medici,60 who continued to expand the banking network, and earned the highest returns in the family’s history. Additionally, under his control the family entered the political scene – during the wars between 1420 and 1434, the Medici family, and its head Cosimo de’ Medici became leading political figures of the Republic of Florence (Parks, 2006, 93). The Italian wars of the 15th century were fought by the Kingdom of Naples, the Papal States of Rome, the Republic of Florence, the Duchy of Milan, and the Republic of Venice. Reflecting at a later date, fellow Florentine Niccolò Machiavelli remarked that these conflicts ‘were begun without fear, carried on without danger, and ended without loss’ (Parks, 2006, 83; 88). That is, the wars were waged without much loss of life and territory, but not without the loss of huge sums of money. This was made possible by the tendency for the Italian wars of the 1400s to be fought by mercenary troops led by professional military commanders (condottieri), which allowed people to get on with their lives and business as usual, with the advantage that it was not the death of their own citizens that the states risked. War became constant, as the mercenary soldier had nothing to gain from putting himself out of work, and was paid for both victory and defeat. In this way, progress was slow, with a steady outflow of money (Parks, 2006, 88–89). By 1426, Florence’s wartime budget was depleted due to spiralling debt. The government had experimented with loans, but for a variety of reasons The second head of the banking house was born in 1389 and died in 1464 (Parks, 2006, 15); cf. Martines, 2003, 397 [Appendix I]; Hibbert, 2007, 355 [Table 1].

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their repayment was postponed indefinitely; as a result, disappointed lenders started selling their debt bonds to speculators who could still wait. At this time, the Florentine branch of the Medici bank was already the leading procurer of debt bonds, which by 1426 were trading at only 25–35 percent of face value (Parks, 2006, 93–97). Ultimately, the defeat at the hands of the Milanese led to an ignominious peace signed in 1433. To the sick, cash-starved city of Florence, Medici money seemed to possess curative powers (Parks, 2006, 107–108). However, in the anteroom of power, Cosimo de’ Medici was arrested and accused of treason (Parks, 2006, 111), and as a result sent into exile for ten years in Padua. Similar sentences were also meted out to a number of other family members, who were exiled to Naples and Venice (Parks, 2006, 115). Nevertheless, the bank’s postal service, like the bank itself, remained effective enough for the Medici to be able to spend their money elsewhere, including Venice. And as the economic situation of Florence failed to improve, and was indeed aggravated by the defeat, while much of the generous ‘displays of wealth abroad’ was business lost to Florence, the government of the city was forced to recall Cosimo de’ Medici from his exile (Parks, 2006, 115–116). Cosimo de’ Medici died in 1464, and although he was accused of every possible crime that could be invented, his return to Florence brought peace and prosperity to the city. From 1420 to the reorganization of the bank in 1435, during which time the partners were Cosimo de’ Medici, his brother Lorenzo, and Benedetto de’ Bardi’s brother Ilarione, profits were 186,382 florins (11,648 p.a.), of which Medici took two thirds. At the bank’s zenith between 1435 and 1450, profits were 290,791 florins (19,386 p.a.), of which the Medici took 70 percent. At that time, a respectable palazzo would cost 1,000 florins to build, yet the vast majority of the populace were too poor to pay so much as a single florin in tax (Parks, 2006, 53–54). After his death, his son Piero di Cosimo de’ Medici61 took over, running the family banking house for a mere five years from 1464 to 1469. He is Piero di Cosimo de’ Medici was born in 1416 and died in 1469 (Parks, 2006, 15). The same dates are given by Hibbert, 2007, 355 [Table 1], whereas Martines dates Piero’s birth to 1418 (Martines, 2003, 397 [Appendix I]).

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attributed with the introduction of the predetermined hereditary regime that replaced previous spontaneous arrangements for succession. In the course of his brief term, he was both the head of the Medici bank and heavily involved in Florentine politics. He was succeeded by his eldest son Lorenzo – in effect the last of the banker dynasty —, who came to be known as Il Magnifico (Parks, 2006, 14–15). The success of the Medici rested on the pillars of commerce and money exchange. There was, however, a risk involved in the former, as a buyer would not pay a single picciolo until he had seen the goods, to which a lot could happen on a long journey, e.g. from Italy to London. Groups of banks would often get together to underwrite possible losses on shipments; even worse, demand and prices oscillated alarmingly. ‘May God and fortune be our aid,’ implored the shipping documents. (Parks, 2006, 54–55). The merchants reacted to risk by spreading investments over a wide variety of goods. Banks set up ‘warehouses’. Along with the raw silks and wool and linen, an inventory in the Medici’s Florence warehouse in 1427 lists the horn of a narwhal or rhinoceros. In 1489 a giraffe died on its way to the duchess of Bourbon. Yet the accounts show that trade accounted for only a modest percentage of the bank’s profits. By trade alone, the Medici would not have become as fabulously wealthy as by exchange (Parks, 2006, 55). Exchange proceeded as follows. Visiting his banker, a creditworthy citizen – a merchant most probably – would offer him an exchange deal, whereby he would take florins and repay in pounds sterling, in London. In return, the merchant would draw up a bill of exchange, i.e. a cambiale on the sum received and on the amount of English currency to be repaid on a florin. Copies of the original bill of exchange would be made and sent via the bank’s own postal service to its foreign correspondent in London (often a neighbour at home). In return for a small commission, the bank’s correspondent would send a clerk to its client’s agent, who, again in return for a commission, would pay out the pounds and pennies on seeing the signed bill. Procedures usually went smoothly because the office of the merchant’s agent that the bank’s correspondent in London would go to would probably be a bank, and hence Italian, someone the lender — 87 —

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would know. The due date of payment varied according to the duration of the journey between the two financial centres concerned, which was strictly observed by the Exchangers’ Guild, and was set at ninety days between Florence and London. The sum was to be repaid upon expiry of that period, i.e. when the goods were received. Repayment could not be postponed, because in that case the whole transaction would have the appearance of a loan rather than an exchange deal (Parks, 2006, 55–57). Out of sixty-seven exchanges for which we have records out of London, Bruges, and Venice, only one resulted in a loss for the bank, while the remaining sixty-six saw the Medici making gains on the exchange of foreign currency into gold florins that ranged between 7.7 and 28.8 percent, underlying which was the requirement that the currency, quoted as a unit, should always be worth a small percentage more in the country of issue. The profits of the banking house were generated by exchange pairs based on the exchange rate differentials prevailing in the countries concerned. As far as Florence and northern Europe were concerned, the difference in the two exchange rates tended to be greatest in early spring, just before the Florentine galleys would descend on Bruges. This is when demand for credit to finance trade was highest. It then narrowed somewhat in the summer months (Parks, 2006, 57–59). The Medici banking house also introduced innovations such as the ‘one branch one company’ model. The Bardi and Peruzzi banks that had preceded the Medici collapsed in part because there was no juridical distinction between their operations in different countries, and the banks were, on the whole, liable for the debts of each of their outlets. In order to increase their profits, the Peruzzi brought a large number of partners into their monolithic organization, with the result that they eventually lost overall control over their ‘hydra-headed’ company. To avoid this, Giovanni di Bicci introduced a simple structural correction: each branch was to be a separate company. Of the profits, the branch director took between 10 and 40 percent, and the Medici bank took the rest. Not the Medici family personally, and not the parent branch in Florence, which had the same status as the other branches, but rather — 88 —

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a separate holding company located in a separate office in Florence. In this way, an unlimited number of partners could be brought in – one or two in each branch as well as in the holding – without the Medici themselves ever losing control (Parks, 2006, 63–64). A branch director would receive expenses and a considerably larger percentage of the profits than his own share of the investment would appear to warrant; this was to motivate him. In return, he was obliged under contract to live in his branch’s city and to observe the rules enforced by the Medici holding: 1. Do not lend more than 300 florins to cardinals; to courtiers no more than 200; o not give credit to any Roman merchant as they are unreliable; 2. D 3. Nor to feudal barons (i.e. the provincial aristocracy), not even if they give you firm security; 4. Never lend money to German princes, since their courts will never respect your claim (Parks, 2006, 64). Additionally, ‘Thou shalt not gamble’ was one of the commandments a Medici employee signed up to when he went to serve the bank in some distant branch (Parks, 2006, 79). Between cashiers, letter writers, messenger boys, and managers, there were about four to eight people in each branch, all working, eating, and sleeping in the same building, sharing the same one or two servants, slaves, and horses. The holding company in Florence was responsible for all staff related matters, including salaries, to prevent any complicity that might arise between the director and staff of distant branches. In addition to the official ledgers, there was also a ‘secret book’ in which the director entered the names of discretionary depositors. The same book also recorded salaries, which were strictly confidential. The secret book was kept under lock and key and was the subject of — 89 —

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discussion once a year. Each branch was therefore part of the same overall organization, but simultaneously in competition; each building had its own strategy, but under central observation (Parks, 2006, 64–65). As bankers, the Medici owed their success to the innovations that had given the Italians a virtual monopoly on European finance. These included the introduction of the bill of exchange, the letter of credit, the deposit account, and of double entry bookkeeping (Parks, 2006, 17–18), and the network of a parent bank and its branches, which could reasonably be seen as an early form of holding (Parks, 2006, 18). Finally, the leader of each Medici generation was an avid collector: of sacred relics and ceremonial armour, of manuscripts, of jewels, of gemstones. The collecting (and hoarding) habit, with its impulse toward control, order, and possession, was also particularly stimulating for the banking world (Parks, 2006, 17). The last head of the banking house, Lorenzo di Giovanni di Bicci de’ Medici62 was barely twenty years of age when he abandoned the traditional family pursuits of finance and commerce, thrusting the bank into irretrievable decline. Unlike his ancestors, he was oriented towards the aristocracy, with political ambitions pointing far beyond the aspirations of his predecessors. However, the more than three decades devoted to public affairs depleted the wealth of the family. He was succeeded by his son Piero di Lorenzo,63 of the fifth generation, who nevertheless survived only two years as head of the family and its business, fleeing Florence as French troops approached the city in 1494. The family wealth was confiscated, and the bank collapsed (Parks, 2006, 16–17).

Lorenzo di Giovanni di Bicci de’ Medici was born in 1449 and died in 1492 (Martines, 2003, 397 [Appendix I]; Hibbert, 2007, 357 [Table 1]). 63 Piero di Lorenzo was born in 1471 and died in 1503 (Martines, 2003, 397 [Appendix I]; Parks, 2006, 16; Hibbert, 2007, 356 [Table 1]). 62

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3.3. Monetary transactions in the Early Modern Period: from the discovery of the New World to London 3.3.1. The Iberian Peninsula: Spain and Portugal

The late 15th century not only marks the decline of the Medici banking house, but also, with the discovery of the New World, the beginning of the Modern Period in world history. Ultimately, the circumstances directly preceding that were economic in nature. In the second half of the 15th century, western European countries with a vested interest in sea navigation and trade sought to discover the direct maritime route to ‘Cathay’ and the ‘Indies’, the ‘land of spices’, which was also said to have vast quantities of gold. The extensive volume of trade in the Europe of the late Middle Ages required precious metals, particularly gold, which provided the basis of minted money but was available on the continent in only limited quantities. Apart from that, due to the invasions of the Ottoman Empire, countries in Western Europe found it increasingly difficult to make use of the old sea and land routes that had previously conveyed the traffic of world trade. The southern maritime routes to India were explored primarily by Portugal, whereas the other countries concerned were looking for the route via the uncharted ocean to the west. These efforts were not only attributable to the constraints referred to above; this was the period in which the Renaissance reintroduced to mainstream thought the ancient theorem about a spherical Earth, while advancements in shipbuilding and navigation64 also inspired the search for new routes (Magidovics, 1961, 123).

Three-, four- and five-masted ships, with combinations of square and lateen sails capable of sailing across the wind, replaced the oared galleys with auxiliary sails of mediaeval commerce. The hinged sternpost rudder replaced the steering oar. In combination, these changes provided far greater manoeuvrability and directional control, while dispensing with oarsmen. Ships became larger and more manageable, more seaworthy, and had greater cargo capacity, enabling them to make longer voyages. The magnetic compass, probably borrowed from the Chinese by way of the Arabs, significantly reduced the guesswork involved in navigation, while developments in cartography provided greatly improved maps and charts (Cameron, 1998, 130).

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As a result, at 2 a.m. on 12 October 1492, Rodrigo de Triana, a sailor of La Pinta, the flagship of the Spanish flotilla led by Christopher Columbus, signalled the sighting of land in the far distance. The voyage across the Atlantic took 33 days from Gomera, one of the Canary Islands to San Salvador in the Bahamas (Magidovics, 1961, 138–139). The period that followed was the ‘Age of Discovery’, in the first phase of which – despite the mobilization of rivals – the conquest of the ‘New World’ was spearheaded by Portugal and Spain. High-seas navigation triumphed over coastal navigation and laid the foundations of a global network of relations, while also triggering a pronounced shift in the location of the principal economic centres within Europe. The Portuguese discoveries deprived northern Italian cities of their monopoly on the spice trade. A series of wars involving the invasion and occupation of Italy by foreign armies further disrupted commerce and finance. The decline of Italy was not immediate or drastic, and was probably more relative because of the great increase in the volume of European commerce. Spain emerged as the new great power of Europe, and, owing to the gold and silver from their American colonies,65 the Spanish Habsburgs became the most powerful rulers of the Old World. However, both Portugal and Spain pursued policies that squandered their resources, and stifled the development of dynamic economic institutions. Despite their colonial empires, both states were in a state of full economic, political and military decline by the mid-17th century. The area that gained most from the economic changes associated with the great discoveries was the region bordering on the North Sea and the English Channel: the Low Countries, England and northern France. Opening on the Atlantic and lying midway between northern and southern Europe, this region prospered greatly in the new era of worldwide oceanic commerce. Throughout the sixteenth century, however, France also engaged in dynastic and religious wars, civil and

The flow of gold and silver from the Spanish colonies greatly increased Europe’s supplies of the monetary metals, at least tripling the quantity of money in circulation in the course of the sixteenth century (Cameron, 1998, 138) (Chart 3-9).

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international, and therefore gained less from the changes than the Netherlands and England (Cameron, 1998, 125â&#x20AC;&#x201C;126). Chart 3-9: Minting coins

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3.3.2. The Fuggers

During the 16th century there were no fundamental changes in the structure of the financial market, which remained tied to the market for foreign currencies. On the issue of interest, there was no variation in the ecclesiastical doctrine until the 16th century (see Box 3-2); however, the volume of transactions involving bills of exchange started to increase. And although bills of exchange were still in general use, northern Europe increasingly adopted promissory notes (the precursors to bills obligatory), which were used primarily by the English merchants who visited the fairs of Antwerp and Bergen op Zoom. As trade became more â&#x20AC;&#x201D; 93 â&#x20AC;&#x201D;

Banks in history: innovations and crises

extensive, handicrafts flourished, and there was an increasingly wide range of goods in supply, while commercial centres were encouraged to concentrate the components of trade and financial transactions in the same locations. This is how exchanges were created (Chart 3-10), where a variety of commodities were traded (e.g. grains, sugar, cotton, precious metals, and securities), money was exchanged, and bills of exchange were handled. While they increased in number, some cities lost this previously held function, e.g. Bruges declined around 1500, and its role was taken over by Antwerp. One of the characteristics of the 16th century was the flourishing of major fairs. Among other places, these were held in Castile, Frankfurt and Lyons. This was also the period in which Italy and the Italians lost their monopoly on banking and bill of exchange transactions (Cameron, 1998, 162; Bozóky, 1972, 493). Emergence of the exchange: In general, an exchange is defined as a concentrated market for substitutable mass products and securities, which operates at a specific location and time, within a set regulatory framework. As such, exchanges are therefore characteristic institutions of concentrated capital markets, which integrate supply and demand. They are commercial centres, where sales are transacted within an organized framework, and the realization of transactions is guaranteed by each exchange in its institutional capacity. Exchanges are commercial bodies that most commonly operate as limited companies. Their members are shareholders and professional brokers. Members’ rights and obligations are set out in exchange bylaws. Exchanges are venues for entering into transactions, where transactions may only be intermediated by professional brokers. Exchange bylaws set out the eligibility criteria for professional brokers. Exchanges play an important role in the establishment of commercial terms (general exchange terms or trading regulations, specific exchange terms or quality requirements, model exchange contracts). Exchanges are specialized as stock exchanges and commodity exchanges. Stock exchanges are venues for trading in securities, currencies and foreign exchange. In commodity exchanges, trades are made for substitutable mass products, which are purchased and sold on the basis of sample goods or set standards

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(terms). Among specialized exchanges, a prominent role is occupied by exchanges dealing with specific commodity groups (e.g. coffee, rubber, etc.), but there are other known exchanges for transportation, insurance, etc. Exchanges are important in setting prices in the world market. Exchanges were originally referred to as bourses, named after a Bruges merchant, Van der Beurse, at whose house regular merchant meetings were convened for the conduct of transactions. The name is still used as a figurative reference to business. The first exchange of international significance was the Royal Exchange founded in London in 1566 by Thomas Gresham (Közgazdasági Kislexikon, 1972, 366; Muraközy – Zánkai, 1973, 476–477). Chart 3-10: The Beurs in Amsterdam (1653)

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The most famous banker dynasty of the 16th century was the Fugger family, with its seat in Augsburg (Chart 3-11). Descendants of a weaver, some of the Fuggers became merchant manufacturers in the wool industry, eventually getting into wholesale trade in silk and spices, with a warehouse in Venice. By the end of the 15th century they were granting vast amounts of money to finance the Holy Roman emperors, as a result of which they obtained control over the output of the Tyrolean silver and copper mines and the copper mines of Hungary. Under Jacob Fugger II (1459–1525) the family firm operated branches in several German cities and in Hungary, Poland, Italy, Spain, England (London), Portugal (Lisbon), and the Low Countries (Antwerp). From the latter two cities they all but controlled the distribution of spices in Central Europe. Additionally, the accepted deposits, dealt extensively in bills of exchange, and were heavily involved in financing the monarchs of Spain and Portugal – a business that eventually led to their downfall (Cameron, 1998, 159). Namely, the wars of Philip II of Spain against the Turks cost enormous sums of money, and the Spanish public debt could not have been repaid even with all the gold in the New World. Nevertheless, in 1594–1600 the family was still able to record a profit of 575,397 guilders, but fell into irretrievable decline afterwards: the impact of the third Spanish sovereign default of 1607 on the Fugger banking house amounted to 3.25 million ducats. At that point, they withdrew most of their private assets from the company’s equity, and borrowed external funds. In order to satisfy the claims of their creditors, the Fuggers were forced to take out huge loans from their fiercest rivals, the Italian banks. By the first third of the 17th century, the company became so indebted that all of its Spanish assets were acquired by the Genoese despite its residual claim of four million ducats on the Crown. Yet, the sovereigns of Madrid were just as reluctant as the Austrian Habsburgs to repay a single guilder. By the mid-17th century, the Fuggers’ claim on the Habsburgs amounted to eight million guilders (Ogger, 1999, 407; 412–413), but was never recovered due to the collapse of the banking house.

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Box 3-4 The Fuggers and their connections in Hungary

The turn of the 15th and 16th centuries witnessed the rise of several merchant-banker families, who in addition to trading goods were also engaged in lending, investments and ‘bank transfers’ – initially as an auxiliary service and subsequently in the form of a separate business line (Klein, 1982, 93. ff.). Among the most famous were the Fuggers of Augsburg, who controlled one of the most prominent commercial and financial enterprises in 15–17th-century Europe. The Fuggers were not bankers in the present-day sense of the word; they were merchants engaged in international trade who developed specific financial services (lending and trading with bills of exchange) into a business line in its own right. Initially a village clothweaver, Hans Fugger ‘merely’ became one of the most important taxpayers of Augsburg (Baker, 2016, 4). The operations of his grandsons,66 particularly of Ulrich, Georg and Jacob Fugger (the younger, hereinafter ‘Jacob Fugger’), laid the foundations of the legendary fortune of the Fuggers, and their services (i.e. loans) to the Habsburgs were rewarded with titles of nobility. As of 1494, Jacob managed the firm on equal terms with his brothers, and after their deaths in 1506 and 1510, he assumed complete control of it (Ogger, 1999, 93; Baker, 2016, 15). In parallel, between 1494 and 1511, owing to his innovations, the average annual rate of return was 10.2 per cent, whereas according to some calculations average annual profits between 1511 and 1527 were as high as 50 per cent (Baker, 2016, 3 and 17). It has been argued, for instance by Greg Steinmetz, that Jacob Fugger was the richest man who ever lived. Due to the calculations cited by Baker, the net worth of the ‘company’ controlled by Jacob amounted approximately 1.6 per cent of the GDP of Europe at the time (Baker, 2016, 20). New business lines: One of Jacob’s innovations was the extension of the business profile of the family, which had consisted of trading in textiles and spices. 66

ans had two sons: Jacob and Andreas. The ‘corporate empire’ of the Fuggers was H established by Jacob (the elder) and his children (the Fugger von der Lilie line). However, Andreas’ line (Fugger vom Reh) went bankrupt after a few decades as a result of risky transactions.

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– At the time, merchant-bankers primarily granted loans to secular and/ or ecclesiastical potentates rather than to individuals so that they could finance their wars and maintain their expensive lifestyles. The Fuggers were among the few who were persevering lenders of the Habsburgs: Jacob regularly financed the wars of Maximilian I (1493–1519), but his debtors also included Charles V (1519–1556) (Ogger, 1999, 78. ff., 255, 326 and 384. f.). – As collateral for their loans, or as a repayment, contemporary lenders were often granted various privileges. This is how Jacob Fugger became involved in metal mining and trade, which was in high demand at the time and remained the most profitable business line of the family for decades. For instance, the Fuggers lent to mine operators in Tyrol, but also to the Habsburgs, who held sovereign rights to silver mines. In exchange, the Fuggers were granted the option to buy the silver, which they re-sold (for example to state-owned mints) at a high margin. The other half of the profits came from the silver coins transferred to German territories further to the north. The silver content of the coins used in those regions was lower, allowing 1.5 times the amount to be minted, and the differential of debasement increased the Fuggers’ profits. Another major business was related to Carpathian copper mines (see later). In addition, in the 1520s, the family invested in mercury mines in Spain (Ogger, 1999, 75. ff., 80 and 257. f.; Baker, 2016, 8. f.). The metals were exported to countries across Europe, and through the intermediation of Portuguese merchants, to India as well. Apart from these, the family had vested interests in the colonization of South America (Steinmetz, 2015, 44, 68 and 146). – Steinmetz (2015, 63) refers to Jacob Fugger as lead banker of the Vatican on account of his management of Church funds. That was largely attributable to Markus Fugger, who earned a high position in the papal administration. Instead of collecting the dues from parishes and monasteries itself, the Holy See assigned the job to private operators. The Fuggers had the advantage that under Jacob (as opposed to Italian banks) the business covered almost all of Europe, which was perfect for ‘transferring’ the Church funds of regions located north of the Alps. As a marketing stunt, they worked at an extremely low rate, attracting other ecclesiastical and secular potentates to their ‘banking services’ (Ogger, — 98 —

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1999, 99. f.). Indeed, the Fuggers required external funds, because they dealt with much more money than their own (Ogger, 1999, 160. f.). – Additionally, the Fuggers were among the few who offered investment opportunities at interest (Steinmetz, 2015, 53), which were utilized even by some of the Hungarian elite including Chancellor György Szatmári, Bishop of Pécs (Spekner, 2003, 431). The Fuggers did not owe their uniqueness to these activities (similar transactions were also carried out by merchant-bankers in Italy), but rather to their operations’ scale and scope beyond the Holy Roman Empire. Several contemporary banking houses were primarily regional operators. In contrast, the Fuggers regularly lent to sovereigns (such as the Habsburgs) and transferred Church funds of country-size territories, that granted them an influence on European politics. Additionally, in certain regions they had a monopoly on the metal trade. The success of the Fuggers was partly due to the international character of their businesses. The system of the factories (in German: Faktorei) which operated as commercial agencies, warehouses, offices and information hubs, was established by Jacob’s uncle, Lukas. These could only be managed by the most loyal employees (factors), who, due to the great distances, were often required to make decisions on their own concerning important matters. Although this was not an innovation of the family (for instance, the Italian banking house of the Peruzzi had 15 branches in several countries as early as 1335), they were perhaps able to leverage it better than anyone else at that time, and by the early 16th century the family firm had grown into a proper multinational concern with approximately 20 trading posts in nearly every European country. This enabled them to gather news from a larger area, connect to several trade routes, and ‘transfer’ funds over greater distances (Ogger, 1999, 46. f. and 173; Spekner, 2003, 429; Pohl, 1993, 43). Innovations included the Fuggers’ extensive information network, as part of which factories forwarded news by means of horseback couriers or mirrors from every corner of Europe, and on a number of occasions distorted information was published in printed ‘newspapers’ to deceive the competition (Ogger, 1999, 23. f. and 360).

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Organizational innovations: Baker (2016, 20. f.) argues that the management of a ‘corporate empire’ of such dimensions and the understanding of its financial position required the system of doubleentry bookkeeping that had virtually been unknown in Germany and was borrowed from Italian city-states, while the family also relied on quantitative records of a German type (single entry approach, Baker, 2016, 10. ff.; cf. Ogger, 1999, 72). Factors learned this system of accounting at the Augsburg headquarters (Spekner, 2003, 429). The Italian model was also followed in respect to the separation of personal assets and corporate assets (Baker, 2016, 15. f.). The political influence of the Fuggers: Church dignitaries and imperial elections Through their wealth, having debtors in key positions and bribery, the Fuggers gained major political influence. They successfully compelled the Holy See to appoint their supported candidate to certain ecclesiastical dignities (Ogger, 1999, 102. ff.). In addition, their political influence extended to the highest secular circles. Ogger notes that Maximilian Habsburg made several attempts to corner the Swabian family, but as he needed more funds to finance his wars, and several of his own men were also debtors to the Fuggers, he was unable to have the rights of the Fuggers withdrawn, and the payment of the interest due to them cancelled (Ogger, 1999, 112. f.). According to Steinmetz (2015, 44), Maximilian was aware that some of his men were financed by the Fuggers, which delighted him because he was relieved of the need to pay them himself. The political influence of the Fuggers culminated in the ability to affect the election of the Holy Roman Emperor. They already granted loans to support the election of Maximilian Habsburg, for which Jacob was rewarded with the title of a count (Ogger, 1999, 143), and was subsequently appointed as counsellor of the Emperor (Ogger, 1999, 209). The Fuggers interfered even more intensively in the election of Charles V. In 1519, the prince-electors were bribed with 550,000 guilders, to which more German and Italian banking houses added their own amounts. Subsequently, by way of a consideration, Charles granted Jacob the ownership rights over several Tyrolean mines (Baker, 2016, 18).

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The Fuggers in Hungary The mines in Upper Hungary played an important role in Jacob Fugger’s metal trading business. As the increase in German influence was not necessarily welcome locally, they operated from the background. They made János Thurzó, a mining engineer with accomplishments in mine water extraction, a partner with a participation of 50 per cent. Starting in 1495, the ‘joint Hungarian operation’ involved the lease and exploitation of copper mines in Upper Hungary, and the distribution of copper. Thurzó brought his expertise and gave his face to the deal: he acquired the rights over the mines, while the Fuggers provided the funds. In this way, the Swabian family (disguised under the name of the Thurzós) took ownership or lease of virtually every Hungarian copper mine. In reality, however, thanks to their funds it was the Fuggers who set the terms (Spekner, 2003, 429; cf. Ogger, 1999, 86. ff.). Following the defeat at the Battle of Mohács and the death of the Hungarian king, Louis II (1506-1526), their title regarding several mines was renewed by János Szapolyai (1526-1540), who considered himself as the new king (parallel to Ferdinand I) (Ogger, 1999, 331. f.). Apart from the aforementioned, the Fuggers also opened a factory at Buda in 1503, which, similarly to other factories, distributed luxury articles, arranged investment and lending transactions (including for the Hungarian court), and forwarded the share of the incomes of the Hungarian Church that was due to the Pope (Spekner, 2003, 430. f.). However, the factory closed down for good in 1533 in the wake of Turkish expansion (Spekner, 2003, 432). The Fuggers after Jacob Fugger’s death Following Jacob’s death in December 1525, the family firm flourished for a second time under its new head, Anton, who remained in control until 1560, governing the corporate empire amidst the upheavals of world politics (wars and the Reformation) and in a period of intensified competition among banker-wholesalers (Ogger, 1999, 402). The younger generation and factors often went their own way, which contributed to the difficulties. However, the subsequent decline of the family firm is attributable to other circumstances as well: the dependence of the Fuggers on the Habsburgs was increasing given that they could only hope to recover their

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outstanding claims if the Habsburgs did not fail. They therefore continued to lend them even more (Ogger, 1999, 386. ff.). Although the activities of the family were still profitable at the end of the 16th century, in the mid-17th century they had vast claims outstanding against both the Spanish and the Austrian line of the Habsburgs, which the sovereign debtors had no intention of repaying. As its assets had not provided adequate coverage for the amount of money that the family was managing or had lent, the Fuggers faced serious difficulties because of defaulting debtors. In addition, Anton’s successors were not of the same calibre as himself or Jacob – ultimately, the prominence of the Fuggers waned. It is worthy of note that at the time, given that the banking houses were ‘family firms’, their success was largely determined by the competencies of their founders, owners, and managers. Yet despite their losses, the family has remained affluent to this day. Ogger attributes this to Anton’s investment of the family assets in real property. Since 1954, one line of the Fuggers has resumed the conduct of bank transactions, with Fürst Fugger Privatbank AG operating as a regional credit institution in Swabia (Ogger, 1999, 412. f.). Chart 3-11: Jacob Fugger in his office with his clerk – the volumes behind them are labelled with the names of the cities with which the banker did business

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3.3.3. The Low Countries and England

In essence, the 17th century heralded the rise of a new commercial and financial power, the Dutch Republic, then the 18th did the same with the hegemony of the British Crown. Having broken away from Spanish rule in 1566, seven northern provinces in Flemish territory gained independence after a long period of military conflict, and formed a union under the name of United Provinces, or Dutch Republic. And although the new state was not recognized officially by the Spanish Crown, the peace treaty of 1609 does suggest this to have been the case de facto (Prak, 2004, 27). By the 17th century the Dutch merchant fleet had experienced a tenfold increase in numbers, and an even larger increase in tonnage.67 At that time it was the largest fleet in Europe (Chart 3-12), three times bigger than the English merchant fleet, which was second (Cameron, 1998, 150). This was accompanied from the mid-16th century by a gradual shift in the commercial centres of the Low Countries to the north: Bruges (Chart 3-13) surrendered its position to Antwerp, then to Amsterdam, which became the commercial and financial metropolis of 17thcentury Europe (Cameron, 1998, 126).68

The size of ships in the Atlantic trades increased from 200 to 600 tons in the course of the 16th century, some even reaching 1,500 tons (Cameron, 1998, 150). 68 The fall of Antwerp in 1585 during the uprising against the Spanish prompted an exodus of local traders. Merchants of the southern Low Countries moved to a variety of commercial centres in north-western Europe, with large numbers ending up in Rouen, Hamburg, Cologne, Frankfurt, London, Middelburg and Amsterdam. After a short time, trade concentrated in Amsterdam that had previously been hosted by Antwerp (Prak, 2004, 95–96). 67

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Chart 3-12: Dutch fluyt

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Chart 3-13: Bruges harbour crane in the Middle Ages

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Although the Dutch controlled only one region, the Baltic, they had the overwhelming advantage of being alone in having the carrying capacity, and the knowledge of shipbuilding and seafaring, to sail great distances. This combination of know-how and contacts allowed merchants to open up new markets69 in the space of a few years and to integrate the flow of goods, making the Netherlands the greatest economic power in the world for several decades (Prak, 2004, 104). To facilitate the acquisition of new markets, Dutch traders formed companies. As early as 1594, ten Amsterdam traders established the Company for Distant Lands in order to set up vessels collectively for the conduct of the spice trade. On 20 March 1602 the Dutch East India Company was set up as one of the earliest joint-stock companies, the principal shareholders of which were essentially cities rather than individuals. The majority shareholder was Amsterdam, which held 57 per cent of the shares. As a novel feature in the history of trade, the shares were tradable on the exchange, and indeed they generated the expected returns of some 300 to 500 per cent (Wittman, 1965, 155; Prak, 2004, 113).70 Enjoying a monopoly over trade with the Far East, the company acted on behalf of the Dutch state. In 1614 the Guinea Company was founded (Wittman, 1965, 154–155; Prak, 2004, 99 and 105). The interests of trade soon prompted the Netherlands to establish diplomatic relations with the Ottoman Empire. This was accomplished in 1612 by means of an economic agreement, which gave the Dutch access to Turkish ports, and provided protection against pirates. Dutch consulates were opened in Aleppo, Algeria, Tunis and Morocco, followed by the establishment of the Directorate of Levant Trade in 1625. Comprised of seven Amsterdam merchants, this body was charged with protecting Dutch trade in the Mediterranean, and carried out organizational work. In the last quarter of the 16th century, Dutch merchant ships had begun regular trading with Russia, almost completely pushing out the English competition from its markets by the early 17th century. In 1608 the Dutch Muscovy Company was set up to improve the organization of Dutch trade with Russia (Wittman, 1965, 151–152; cf. Cameron, 1998, 161). 70 In contrast, the situation of the Dutch West India Company, established in 1621, was much less favourable. Most of the American coast was already under Spanish, Portuguese and English control, essentially leaving the Dutch with growth opportunities in Asian markets (Prak, 2004, 113–114). By the middle of the century, the Netherlands had withdrawn from these territories, selling all of the Brazilian holdings to the Portuguese in 1661, and surrendering their North American territories to the English in 1667, in exchange for Suriname in South America (Wittman, 1965, 156–157). 69

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In the decades of price fluctuations and steady depreciation finances were rather difficult to manage. The inflow of precious metals from Spain’s American colonies fuelled an already high rate of inflation, and increased the complete confusion over the multitude of Dutch currencies. The currencies in use were of various origin, weight and value, including the florin, which existed in the Holland, Deventer, Zwolle and Kampen varieties, as well as the Flemish pound, the rixdal, the cruisdal, the ducat and others. Between 1544 and 1680, the Dutch florin depreciated by over 50 per cent. Obviously, depreciation and the anarchy of currencies disrupted commercial transactions, which called for the organization of banks to counterbalance these effects (Wittman, 1965, 153). To facilitate the smooth conduct of commercial transactions, the Amsterdam Exchange Bank was established in 1601 to enable merchants to deposit money for safekeeping, transfer funds, and exchange foreign currencies. The bank was housed in the town hall (Prak, 2004, 104). In 1609, the Bank of Amsterdam (Amsterdamsche Wisselbank) was established in Amsterdam, which was a commercial exchange bank without central bank and discount functions. It allowed money to be deposited and transferred between deposit books, but did not issue banknotes and did not grant loans to merchants by discounting transferable commercial papers. Its main function, which it performed excellently, was to supply stable and reliable means of payment to the city, and to all the Dutch and foreign merchants who did business there (Wittman, 1965, 153).71 Based on the model of the Bank of Amsterdam, civic authorities initiated the establishment of exchange banks in Middelburg (1616), Delft (1621) and Rotterdam (1635). Most cities also had pawn banks supervised by the municipal authorities, where credit was extended upon the deposit of collateral (Prak, 2004, 104; cf. Wittman, 1965, 195). In other words, the Bank of Amsterdam continued the tradition followed by the banks of Italian city-states, whereby it performed a number of functions including money exchange, deposit taking, clearing, the purchase of precious metals, and granting Lombard loans (Ligeti, 2003, 18).

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Box 3-5 Establishment of Amsterdamsche Wisselbank72

In the 16th and 17th centuries, it was common for European banks to mint their own coins. As a result, disorder reigned in the markets as there were some 1,000 different types of coin in circulation from every region of the world, including a number of currencies that most people were not, or hardly familiar with at all. Confusion caused by using a number of different coins facilitated illicit debasement, i.e. the continuous and tacit reduction of metal content against the corresponding adjustment to face value. This development was detrimental to operators in wealthy commercial centres, including traders in Amsterdam. In those times, trade in international business was conducted mainly in the form of short-term loan agreements, while merchants were continuously exposed to the risk of receiving coins of lower value when redeeming their bills of exchange, which could entail substantial losses in the case of wholesale deals. In 1609, in an attempt to control the situation, the municipal council of Amsterdam established Amsterdamsche Wisselbank (Chart 3-14) in order to provide more security to traders. The newly created institution was responsible for the settlement of claims between individual accounts without the use of cash–similarly to present-day credit transfers by banks. Another responsibility was for it to facilitate the smooth execution of payment transactions that were much more efficient than those previously in place. The bank accepted coins and the items of commercial transactions, which it confirmed to customers as deposits, guaranteeing the execution of transactions between account holders without the use of hard cash. For a certain fee, account holders were eligible for a return of their deposits in the form of non-depreciating coins of adequate quality, mostly in silver. Merchants had the option to have their coins exchanged at a fixed rate within a timeframe of approximately six months.

Source: http://www.beursgeschiedenis.nl/moment/de-amsterdamse-wisselbank/

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Chart 3-14: Wisselbank started its operations at the old mediaeval town hall of Amsterdam

Source: www.beursgeschiedenis.nl

Consequently, the value of bank money held with the Bank of Amsterdam proved to be stable against silver, i.e. the institution successfully tackled the problem of additional depreciation. In this way, Wisselbank’s bank money mainly appreciated against manipulated coins. This explains the rapid growth of the bank’s larger clientele. Up to this point, the Dutch institution does not appear to have been a particular novelty, because bank money had existed long before that; it was introduced by Banco della Piazza di Rialto, established in 1587 in Venice. However, the use of bank money made Wisselbank unique in its resemblance to the prototype of a modern central bank, with the single exception that the institution never issued banknotes or coins of its own. Thus, Wisselbank’s money remained bank money at all times. Accordingly, the Dutch institution may be considered to have

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pioneered central banking even though it did not performed other financial functions that at present can be seen as belonging to the operational tasks of central banks. This was the first exchange bank in Western Europe in a period that Dutch contemporaries regarded as a golden age, especially in economic relationships. For nearly 200 years, the bank functioned very well, which should be seen as outstanding performance given that the currency of the Dutch financial institution was also relied on as a developing international reserve fund. Although in the first 170 years of its existence Wisselbank successfully coped with a number of arising financial difficulties, following the end of the Fourth Anglo-Dutch War (1780–1783) it was no longer able to recover from the new problems due to the grim economic situation. Although in essence its total assets remained unchanged at approximately 20 million guilders, its business structure had undergone a profound transformation in the meantime. The failure of Wisselbank is primarily attributable to the acute crisis of its principal debtor, the Dutch East India Company. As a result, the bank experienced an utter collapse in confidence in its bank money, which had in the meantime also considerably depreciated against other currencies despite the efforts of the institution’s experts to stabilize the money-orders of the bank through major coin sale operations. While some of these problemsolving attempts brought temporary success, there was no comprehensible solution to save the bank from its final failure in 1784 due to the incurred costs and huge funding gap. As Wisselbank did not disclosed balance sheets of any kind, this critical circumstance was not known to the public; nevertheless, the bank’s money constantly depreciated on a comparable basis and customer confidence continued to decrease as well. In 1791, the city of Amsterdam decided to recapitalize its bank, which was carried out rather indecisively, and thus failed to achieve permanent stabilization. Wisselbank’s bank money, which had once equalled silver in value, continued to deteriorate sharply, and associated with the 1794 credit scandal linked to the Dutch East India Company, the institution irreversibly lost its previous excellent reputation, which brought the Wisselbank success story to an abrupt end in 1795 (Quinn–Roberds 2005, 1–56).

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In addition to Wisselbank, the Bank van Lening was set up in 1614 as an Amsterdam credit bank specifically for commercial purposes. The new banking institution helped traders to avoid expensive borrowings from rapacious usurers at high interest rates, but low rates were characteristic of Dutch financial institutions anyway in Amsterdam and in other large Dutch cities on which the emerging stock markets were increasingly resting, as the hubs of commercial transactions. In addition to the new Amsterdam bourse established in 1608, a separate grain bourse was also set up in 1616, indicating the predominant role of local brokers in the conduct of the international grain trade (Wittman, 1965, 153–154). As far as the Amsterdam bourse (exchange) was concerned, as a rule the goods displayed were not actually exchanged on the spot; they were merely samples that could be inspected for quality. After incoming orders were placed, the purchased or marketed goods would be shipped from specialized warehouses. The use of multiple credits was widespread, with most payments being made with financial instruments such as the bill of exchange, or by assignment in banks, instead of with hard cash (Cameron, 1998, 162). A strengthened Dutch financial sector went hand in hand with commerce, and in turn, trade was increasingly harmonised with foreign economic policy. Accordingly, the Dutch Republic granted loans both internally and externally to a number of countries across Europe, including major loans to the prince-elector of Brandenburg, as well as to the kings of Denmark and Sweden. The latter sovereign also pledged the world-famed copper production of Sweden, as well as the country’s customs duties. Danish trading companies were largely financed by Dutch investors, whose funds were capitalised as far as in Poland: between 1618 and 1621 the mint of the King of Poland was also rented by the Dutch (Wittman, 1965, 152–153). The ‘Dutch Golden Age’ ended somewhere between 1672 and 1715 – a more exact time cannot be established in this respect. In fact the AngloDutch wars led up to this decline. Founded with the execution of Charles I, the young Republic of England immediately engaged itself on ship building on a large scale, and between 1649 and 1651 constructed some 40 vessels that surpassed those of the Netherlands all without exception. — 110 —

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The main strategic objective was to achieve maritime hegemony. The famed Navigation Act of 1651 was adopted accordingly, which provided that merchandise from countries outside Europe was to be shipped to England only on English vessels with respective mariners, and European goods had to be transported either on ships belonging to England, or on those of the countries from which the commodities were sent. This was a severe premeditated shockwave to developed Dutch intermediary trade, which had been receiving its massive incomes by commerce with various foreign imports.73 Naturally, the Netherlands categorically refused to recognize the Navigation Act and in 1652 the conflict escalated into a severe warfare; then in 1654, despite some small Dutch victories, the United Provinces were obliged to recognize the Act dictated by their commercial and military opponent. And although the Second Anglo-Dutch War (1665â&#x20AC;&#x201C;1667) earned the Netherlands partial successes, including the right to use their own ships in order to transport certain German goods to England, the era of the Netherlands as a great military and commercial power was coming to an end. In the third war, which started in 1672, France replaced England as leader of the antiDutch coalition, which also included the emerging power of Sweden and some commercially interested German princes. From the south a huge French army attacked the United Provinces, and the latter was not able to combat its attackers in land operations. Foreign troops were invading Dutch territory, and Amsterdam was exposed to direct threat. A turnaround was brought about by the recognition of the governorship of William of Orange, who was made king of England by the protestant English opposition to James II. He ascended to the throne in January 1689 as William III, whereby England became a constitutional monarchy under parliamentary control. A personal union was therefore established between the Netherlands and England; however, instead of a revision of anti-Dutch laws, the very opposite occurred: Dutch interests were subordinated to those of England, and the Netherlands were reduced to 73

I n order for a vessel to be qualified as British, its owner, captain, and three-quarters of its crew had to be British subjects. In an effort to protect the shipbuilding industry, the law also required that ships had to be built in England, but for a long time compliance with this requirement was difficult to enforce, and for years most of the vessels serving in the British merchant fleet were built by the Dutch further on (Cameron, 1998, 199).

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a crucial instrument in order to accomplish William III’s foreign policy goals. Finally, the Dutch paying agency was forced to close in the winter of 1715 on the grounds that no funds were available for the payment of interest due to bondholders. The sovereign default lasted for nine months, following which creditors had no other choice but to accept that interest on their claims would be reduced centrally. The financial difficulties were not of an ad-hoc character, but arose as a result of severe complications that had been arising as a number of bottlenecks over several decades. Undoubtedly, protectionist commercial measures played a major role in the escalation with other aspirant competitors such as England, France or even Germany. As these mainly protective commercial regulations negatively influenced the entire Dutch economy, in a domino effect they were also felt in the more stable internal markets. Continuous military confrontations with England and France also placed a heavy burden on the Dutch state budget. By 1715 more than half of the revenues collected by the Province of Holland was earned by creditors. This was the final phase of the downfall as the Netherlands became powerless to protect its basic commercial interests (Wittman, 1965, 191–193; Prak, 2004, 232– 234). A main competitor and military rival to the Netherlands, England successfully established its maritime supremacy in the meantime, and emerged as a new commercial power of Europe. Even so, banking activities in the Netherlands still remained vivid.74 The volume of precious metals held with the Bank of Amsterdam grew immensely as the trade in precious metals intensified in the 18th century. Moreover, demand for the Dutch gold ducat remained very strong: between 1642 and 1808 fifty-seven million gold ducats were minted, to constantly flow throughout Europe and Asia. While there was a perceptible increase in the volume of credits taken abroad, Dutch interests were reduced compared to the 17th century. The greatest borrower and user of Dutch credits was England itself, with a large majority of English public debt that was backed by creditors based in the Netherlands. (Wittman, 1965, 195). 74

lthough the positions of Dutch sea navigation were undermined, the country A retained its primacy in navigation and trade until the mid-18th century. The ‘takeover’ did not occur from one moment to the next but rather gradually, and the decline was also relative rather than absolute (Cameron, 1998, 199).

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Box 3-6 The Dutch tulip mania

The dominance of 17th century Netherlands in trade and finance was comparable to the subsequent British influence of the 19th century. The development of product markets was accompanied by that of sophisticated financial mechanisms. At that time, Amsterdam emerged as the main market for short- and long-term lending, equities, and commodity futures and options. Trade in sovereign debt securities and corporate shares was also concentrated here. Thus, at the time of the tulip mania, which was part of what is known as the Dutch Golden Age, the Netherlands was a country with extensive trade, an advance financial market, and a host of skilled merchants (Garber, 2000). Initially, the trade in tulip bulbs was conducted exclusively by skilled producers, with speculators joining from 1634 onwards. Participants were given access to a variety of transactions, and a choice of various tulip bulbs. Rare and thus valuable bulbs were sold by the piece, whereas the more common and less special ones were sold by weight. The bulbs could only come into the possession of their new owners during the summer, which as such can be considered as a ‘futures’ contract. Established in 1636, formal futures markets became the primary form of trade. Initially, contracts were made in writing, but after the summer of 1636, as trade was conducted on an increasingly large scale by a growing variety of social groups, procedures became more relaxed. Subsequently, trade was mostly conducted in so-called colleges formed in pubs, where only a few rules were applicable to bidding and charges. In these colleges, as no deposits were required by either sellers or buyers, in effect not even insolvency would prevent contracts from being made (Garber 1989, 2000). On the settlement date, a buyer generally did not have the required funds, nor did the seller have the bulbs. As a matter of fact, neither party was committed to deliver on the settlement date; they merely expected payment of the difference between their contract and delivery prices. That amount was equivalent to a stake of sorts, thus the market was in essence a futures

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market. However, there were some operational differences: contracts were not recorded at market prices on a continuous basis, and no deposits were required as collateral in the event of any disruptions (Garber 1989, 2000). Due to increasing speculation, the authorities introduced several prohibitions on short selling, first in 1610, and subsequently in the 1620s. However, lenient regulations kept the market alive, and society soon became obsessed by the tulip mania; nobles, commoners, merchants, servants and sailors alike all became involved in the trade, which generated enormous demand. Moreover, driven by the hope of big profits, there was also an inflow of foreign money, pushing prices even further up. However, ‘wiser heads’ soon recognized that the craze could not last forever. It was clear that someone would have to end up with a terrible loss. As this conviction spread, prices started to fall, and never rose again (Madarász, 2009). Confidence was destroyed, and participants were thrown into a general panic. The market collapsed in the first week of February 1637. Due contracts were suspended immediately. At their meeting of 24 February, florists proposed that contracts made before 30 November 1636 be carried out in full, and for later contracts buyers be given the option of withdrawal in return for the payment of a 10 per cent fee. The authorities rejected the proposal. On April 27, the Dutch provinces decided to have all contracts suspended, granting sellers the opportunity to sell their bulbs at the prevailing market prices. The difference between contract and market prices was to be paid by buyers (Garber, 1989). However, in the absence of a provincial court that was willing to enforce that solution, in effect the case came to its close (Madarász, 2009). The first modern financial crisis is the subject of many surviving pamphlets and anecdotes, which give accounts of the rapid acquisition and loss of wealth by participants in the tulip bulb trade. There are notes about the value of a tulip bulb at the time, and lists of all the goods that could be bought for the price of a single bulb.

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Table 3-1: List of products that could be bought for a Viceroy tulip bulb worth 2,500 guilders Item

Guilders

2 lasts (≈4 tons) of wheat

448

4 lasts (≈8 tons) of rye

558

4 fat oxen

480

8 fat swine

240

12 fat sheep

120

2 hogsheads (≈500 litres) of wine

4 tuns (≈3,800 litres) of beer

2 tuns of butter

192

1,000 lbs. (≈500kg) of cheese

120

1 complete bed

100

1 suit of clothes

1 silver drinking cup

Price of one bulb of Viceroy tulip

2,500

Source: Mackay (1841).

The Dutch were so beguiled by the tulip mania that many invested all of their assets in tulip bulbs, only to lose everything when the market collapsed. That has made this strange phenomenon a much-quoted warning in respect to speculation (Chart 3-15). Chart 3-15: Black tulips

Source: cdn.pixabay.com

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The rise of England was not only attributable to the changes brought about in trade by the wars. A development of equivalent weight consisted in the fact that in England the power of industrial capital was significantly reinforced at this time, leading to a major growth in exports and trade in general. In the Netherlands, until the mid18th century industry continued to be based on dispersed artisan workshops, while industrial capital failed to gain in prominence, and was indeed held back by foreign competition (Wittman, 1965, 194). The transformation started in England and Scotland, deservedly earning Great Britain its name as ‘the first industrial country’. Prerequisites for the development of modern industry included the extensive use of machinery operated by mechanical power, the introduction of new inorganic energy sources, principally mineral fuels, and the general use of materials that do not normally occur in nature. Although the wheel, the lever or the pulley had been known to humankind since antiquity, and a fraction of inorganic natural energy had also been used by means of sails as well as wind- and watermills, a major increase in the application of machinery and water energy in the milling, textile and metal industries did not occur until the 18th century. An even more important development was the use of coal and coke as fuels to replace wood and charcoal, which became common practice in metal smelting (making metals cheaper and more extensively applicable), and boosted mining, where steam engines were introduced just as they spread in the manufacturing industry and transport (Cameron, 1998, 204–206; 219).75 Technological development was also supported by the financial sector. By the end of the 17th century, London had developed a sophisticated commercial and financial system that rivalled that of Amsterdam (Cameron, 1998, 212). Dutch banks introduced a significant innovation in the management of sovereign credit risks, and thus abandoning their previous practice, banks no longer granted large loans to sovereigns and states individually, but pooled funds in order to spread the risks. This is how the form of lending that is known today as syndicated lending came into existence. This innovation enabled Dutch banks to lend to a For the various inventions that served the industry, see Cameron (1998, 220–224).

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number of sovereigns and states by reducing their risks significantly. Over the course of the 18th century, the Kingdom of Sweden and Russia took several syndicated loans from Dutch lenders. The arrangers of large loans also realized that by issuing negotiable instruments, they could also involve smaller investors in lending operations in addition to banks and merchants. The technique of arrangements for bond issues and the underwriter function were developed at this time, and have remained in use throughout the world. A simultaneous innovation by British goldsmiths enabled reductions in the reserve ratio, meaningfully facilitating the development of the country’s financial system. Contemporary England had no stateowned banks, and the clearing process was decentralized. In return for the precious metal deposited with them, goldsmith bankers issued certificates, which turned into money as they circulated on their own. The certificates of London bankers granted deposit holders the right to a return of their money at any time on request. In order to prevent ‘runs on the bank’, goldsmith bankers also held one another’s certificates so that they could obtain funds from other bankers in the event of an unexpected run. This system of risk management enabled goldsmith bankers to issue certificates in excess of the quantity of precious metals they had in reserve. The practice was also retained following the establishment of the Bank of England in 1694. In contrast, Amsterdam kept a 100 per cent reserve ratio in place. In England’s new financial system of the late 17th century, new money was minted, accompanied by the emergence of the organized market for public and private securities. The success of the new financial system was not immediately apparent; however, by the mid-18th century, which saw England fighting a series of European and colonial wars with France, the British government had access to much cheaper loans than its rivals. Additionally, the simple, cheap and stable loans granted for public expenditures also benefited the private capital market as they provided access to the funds intended for investments in agriculture, trade and industry (Cameron, 1998, 196–197). — 117 —

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While the beginnings of England’s banking system are obscure, some prominent London goldsmiths are known to have taken up banking after the Restoration of 1660.76 They issued deposit receipts that circulated as banknotes, and granted loans to creditworthy entrepreneurs. The founding of the Bank of England in 1694, with its legal monopoly of joint-stock banking, forced the private bankers to give up their issues of banknotes, but they continued to function as banks of deposit, accepting drafts and discounting bills of exchange. Meanwhile, the provinces outside London remained without formal banking facilities, although money scriveners, lawyers, and wealthy wholesale merchants performed some elementary banking functions, such as discounting bills of exchange and remitting funds to London (Cameron, 1998, 212–213). The Bank of England was established as a board of lenders to the state. It was authorized to issue bank notes and carry out bank transactions. This marks the emergence of modern central banks (Ligeti, 2003, 18).77 The Bank of England established no branches, and its banknotes (of large denomination) did not circulate outside London. Moreover, the denomination of the Royal Mint’s gold coins was too large to be useful in paying wages or retail trading, and it minted very few silver or copper coins. This dearth of small change prompted private enterprise to fill the gap, which is how country banks (i.e. those not located in London), were created, whose growth was extremely rapid in the second half of the 18th century. By 1810 there were some 800 of them (Cameron, 1998, 213). Although the emergence of financial innovations and modern banking systems preceded economic modernization in both the Dutch and British economies, the race for the role of a leading financial centre was clearly won by England. Before the Bank of England was founded, merchants deposited their excess money with the mint or goldsmiths. With the former, the security of their assets was at risk of sovereign use, whereas with the latter, from the lending operations or bankruptcy of the goldsmith. In England, bankers evolved from goldsmiths, who took deposits of people’s valuables (gold and silver), initially for safekeeping, and in return issued certificates that could also be used as a means of payment. Goldsmith bankers realized that not all customers demanded the return of their deposits at the same time, which prompted them to issue claims on themselves against the deposits. This practice evolved into the institution of banknotes, and subsequently lending (Ligeti, 2003, 18). 77 Although the Riksbank of Sweden was founded in 1668 and as such the oldest central bank in banking history, the establishment of the Bank of England is commonly considered to be the most significant in this regard (Ligeti, 2003, 18). 76

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Key terms bills of exchange commercial centres cuneiform monetary transactions double-entry bookkeeping Fuggers general ledger interest

intermediary trade Medici banking house minted coin promissory note sea navigation state-owned banks Sulpicii

References Aristotle (1998): Görög politeiák töredékei (Fragments on Greek Politeiai). In: Államéletrajzok (State Biographies). Writings by Aristotle, Herakleides Lembos, Pseudo-Xenophon, Xenophon, Kritias and Herodes Attikos on Greek States. Osiris Kiadó, Budapest. Babják, I. (2002): Bankok és pénzügyi válságok az ókori Rómában (Banks and financial crises in ancient Rome). Aetas, 2002/2–3, pp. 314–320. Baker, C. R. (2016): Accounting and banking practices in the fifteenth and early sixteenth centuries as illustrated by the career of Jacob Fugger the Rich. Adelphi University, New-York. Bible (2006): The Holy Bible, or, Divine Treasury; containing The Old and New Testaments. Translated into Hungarian by Gáspár Károli. Magyar Bibliatársulat, Budapest. Berkó, L. (2017): Adósság a keresztyén etika tükrében (Debt as Reflected in Christian Ethics), Master’s Thesis, Károli Gáspár University of the Reformed Church in Hungary. Bodai, Zs. (1998): A pénz filozófiája (The Philosophy of Money). Volume 1. Az ókori, a középkori és a kora újkori pénzelméletek (Theories of Money in Antiquity, the Middle Ages and the Early Modern Period). Aula Kiadó. Boulnois, L. (1972): A selyemút. (Silk Road), Translated into Hungarian by Litván György. Kossuth Kiadó, Budapest. Bozóky, E. (1972): Raymond de Roover: Le marché monétaire au Moyen Age et au début des temps modernes. Problèmes et méthodes. Revue Historique, 244(1), 1970, pp. 5–40 (The Financial Market in the Middle Ages and at the Start of Modern Times), Századok, 106(2), 1972, pp. 492–493. Braudel, F. (2004): Anyagi kultúra, gazdaság és kapitalizmus (XV–XVIII. század) (Material Civilization, Economy and Capitalism, 15–18th Century). Volume I. A mindennapi élet struktúrái: a lehetséges és a lehetetlen (Structures of Everyday Life: The Possible and the Impossible). Gutta Könyvkiadó, Budapest.

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Banks in history: innovations and crises Bréhier, L. (2003): A bizánci birodalom intézményei (Institutions of the Byzantine Empire). Varia Byzantina – Bizánc világa VII (Varia Byzantina: The World of Byzantium VII). Foundation of the Institute for Byzantine Studies, Budapest. Cameron, R. (1998): A világgazdaság története – a kőkorszaktól napjainkig (A Concise Economic History of the World: From Palaeolithic Times to the Present). Maecenas – Talentum, Budapest. Cato, M. P. (1966): A földművelésről (On Agriculture) (In Latin and Hungarian); translated and annotated by József Kun, with an introductory study by Egon Maróti. Akadémiai Kiadó, Budapest. Csabai, Z. (2015): Kamatmentes és álkamatmentes kölcsönök Babilóniában (Inerest-Free and Pseudo Interest-Free Loans in Babylonia). In: Csabai, Z. – Földi, Zs. – Grüll, T. – Vér, Á. (eds.): Ökonómia és ökológia. Tanulmányok az ókori gazdaságtörténet és történeti földrajz köréből (Economy and Ecology: Studies on the Economic History and Historical Geography of Antiquity). Ókor – Történet – Írás 3 (Antiquity – History – Writing 3). University of Pécs, Department of Ancient History – L’Harmattan Kiadó, Pécs – Budapest, pp. 141–152. David, R. (2005): Élet az ókori Egyiptomban (Handbook to Life in Ancient Egypt). Gold Book, Debrecen. Dávid, A. (1964): Hammurapi törvénykönyve (The Code of Hammurabi). In: János Harmatta (ed.): Ókori keleti történeti chrestomathia (A Chrestomathy of the History of the Ancient East). Ókori történeti chrestomathia I (A Chrestomathy of Ancient History). Tankönyvkiadó, Budapest, pp. 124–150. Ecsedy, I. (1979): Nomádok és kereskedők Kína határain (Nomads and Merchants at the Borders of China). Kőrösi Csoma Kiskönyvtár 16. Akadémiai Kiadó, Budapest. Felföldi, Sz. (2009): Egy új szemléletű Selyemút-történet alapvonalaihoz (Towards the Baselines of a New Approach to the History of the Silk Road). Ókor 2009/2, pp. 29–35. Felföldi, Sz. (2012): Élet a késő ókori, kora középkori Selyemúton (Life on the Silk Road in Late Antiquity and the Early Middle Ages). A 3–4. századi Nija a régészeti leletek és az írott források tükrében (Nija in the 3th and 4th Centuries as Reflected in Archaeological Finds and Written Records). PhD Dissertation (Manuscript) I. (A volume of texts) Szeged. http://doktori.bibl.u-szeged.hu/1689/1/ Sz%C3%B6vegk%C3%B6tet.pdf (17.02.2013) Földi, Zs. (2015): Táblázatos szövegek és helyük a mezopotámiai gazdaságtörténet tanulmányozásában (Tabular Texts and their Role in the Study of the Economic History of Mesopotamia). In: Csabai, Z. – Földi, Zs. – Grüll, T. – Vér, Á. (eds.): Ökonómia és ökológia. Tanulmányok az ókori gazdaságtörténet és történeti földrajz köréből (Economy and Ecology: Studies on the Economic History and Historical Geography of Antiquity). Ókor – Történet – Írás 3 (Antiquity – History – Writing 3). University of Pécs, Department of Ancient History – L’Harmattan Kiadó, Pécs – Budapest, pp. 43–61. Garber, P. (1989): Tulipmania. The Journal of Political Economy, Vol. 97. No. 3. pp. 535–560. Garber, P. (2000): Famous First Bubbles. The MIT Press, Cambridge, Massachusetts. Gernet, J. (2005): A kínai civilizáció története (A History of Chinese Civilization). Osiris Kiadó, Budapest.

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3. The Beginnings: From Mesopotamia through Florence to London Grüll, T. (2015): Trendek és súlypontok a római gazdaságtörténet utóbbi fél évszázados kutatásában (Trends and Foci in Research of the Past Fifty Years on Roman Economic History). In: Csabai, Z. – Földi, Zs. – Grüll, T. – Vér, Á. (eds.): Ökonómia és ökológia. Tanulmányok az ókori gazdaságtörténet és történeti földrajz köréből [Economy and Ecology: Studies on the Economic History and Historical Geography of Antiquity]. Ókor – Történet – Írás 3 (Antiquity – History – Writing 3). University of Pécs, Department of Ancient History – L’Harmattan Kiadó, Pécs – Budapest, pp. 177–190. Grüll, T. (2016): A tenger gyümölcsei. A tengerek szerepe a Római Birodalom gazdaságában (Fruits of the Sea: The Role of the Seas in the Economy of the Roman Empire). Kronosz Kiadó, Pécs. Hahn, I. (1998): A római császárkor története (A History of Imperial Rome). In: Ferenczy, E. – Maróti, E. – Hahn, I.: Az ókori Róma története (A History of Ancient Rome). (ed.) János Harmatta. Nemzeti Tankönyvkiadó, Budapest, pp. 261–421. Hegyi, D. (1995a): Az archaikus és a klasszikus kor (The Archaic and Classical Ages). In: Hegyi, D. – Kertész, I. – Németh, Gy. – Sarkady, J.: Görög történelem a kezdetektől Kr. e. 30-ig (History of Greece from the Beginnings to 30 BC). Osiris Kiadó, Budapest, pp. 119–162. Hegyi, D. (1995b): A görög városállamok Kr. e. 403 és 338 között (Greek City-States 403–338). In: Hegyi, D. – Kertész, I. – Németh, Gy. – Sarkady, J.: Görög történelem a kezdetektől Kr. e. 30-ig [History of Greece from the Beginnings to 30 BC]. Osiris Kiadó, Budapest, pp. 223–252. Hibbert, Ch. (2007): A Medici-ház tündöklése és bukása (The House of Medici: Its Rise and Fall). Holnap Kiadó, Budapest. Kertész, I. (1995): A hellenizmus (Hellenism). In: Hegyi, D. – Kertész, I. – Németh, Gy. – Sarkady, J.: Görög történelem a kezdetektől Kr. e. 30-ig (History of Greece from the Beginnings to 30 BC). Osiris Kiadó, Budapest, pp. 253–356. Klein, E. (1982): Deutsche Bankengeschichte: Vol. 1.: Von den Anfängen bis zum Ende des Alten Reiches (1806), Knapp, Frankfurt. Klíma, J. (1983): Mezopotámia. Ősi civilizáció és kultúra a Tigris és az Eufratész mentén (Mesopotamia: An Ancient Civilization along the Tigris and the Euphrates). Gondolat Kiadó, Bratislava. Kóthay, K. A. (2015): Kereskedelmi utak Egyiptomban az Első Átmeneti Kor és a Középbirodalom idején (Trade Routes in Egypt during the First Intermediate Period and the Middle Kingdom). In: Csabai, Z. – Földi, Zs. – Grüll, T. – Vér, Á. (eds.): Ökonómia és ökológia. Tanulmányok az ókori gazdaságtörténet és történeti földrajz köréből (Economy and Ecology: Studies on the Economic History and Historical Geography of Antiquity). Ókor – Történet – Írás 3 (Antiquity – History – Writing 3). University of Pécs, Department of Ancient History – L’Harmattan Kiadó, Pécs – Budapest, pp. 81–98. Közgazdasági Kislexikon (Concise Lexicon of Economics) (1972): Kossuth Kiadó, Budapest. Ligeti, S. (2003): A bank általában. A bank fogalma (Banks in General: Definition]. In: Ligeti, S. – Sulyok-Pap, M. (eds.): Banküzemtan (Bank Operations). Tanszék Pénzügyi Tanácsadó és Szolgáltató Kft., Budapest, pp. 15–45.

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Banks in history: innovations and crises Mackay, C. (1841): Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, London: Richard Bentley. Madarász, A. (2009): Buborékok és legendák. Válságok és válságmagyarázatok – a tulipánmánia és a Déltengeri Társaság, I. rész (Crises and Their Explanations: The tulip Mania and the South Sea Company, Part I). Economic Review, vol. LVI, July–August 2009, pp. 609–633. Magidovics, I. P. (1961): A földrajzi felfedezések története (A History of Geographical Discoveries). Gondolat Kiadó, Budapest. Maróti, E. (1998): A Római Köztársaság és Augustus korának története (A History of the Roman Republic and the Age of Augustus). In: Ferenczy, E. – Maróti, E. – Hahn, I.: Az ókori Róma története (A History of Ancient Rome). (ed.) Harmatta, J., Nemzeti Tankönyvkiadó, Budapest, pp. 57–260. Martines, L. (2003): Firenze és a Mediciek (April Blood: Florence and the Plot against the Medici). General Press, Budapest. Muraközy, T. – Zánkai, G. (1973): Közgazdasági ABC (ABC of Economics). Mezőgazdasági Kiadó – Közgazdasági és Jogi Könyvkiadó, Budapest. Nagy, B. (2005): Távolsági kereskedelem, városfejlődés és ipari termelés (Long-Distance Trade, Urban Development and Industrial Production). In: Gábor Klaniczay (ed.): Európa ezer éve: A középkor I (A Thousand Years of Europe: The Middle Ages I). Osiris Kiadó, Budapest, pp. 324–335. Ogger, G. (1999): A Fuggerek. Császári és királyi bankárok (The Fuggers: Imperial and Royal Bankers). Európa Kiadó, Budapest. Oppenheim, A. L. (1982): Az ókori Mezopotámia – Egy holt civilizáció portréja (Ancient Mesopotamia: Portrait of a Dead Civilization). Gondolat Kiadó, Budapest. Parks, T. (2006): A Mediciek aranya. Pénz, lélek és művészet a 15. századi Firenzében (Medici Money: Banking, Metaphysics and Art in Fifteenth-Century Florence). Partvonal, Budapest. Pálfi, Z. (2015): Šalatuwar és Wahšušana: szomszédok egy óasszír nagyváros közelében (Šalatuwar and Wahšušana: Neighbours in the Vicinity of an Old Assyrian City). In: Csabai, Z. – Földi, Zs. – Grüll, T. – Vér, Á. (eds.): Ökonómia és ökológia. Tanulmányok az ókori gazdaságtörténet és történeti földrajz köréből (Economy and Ecology: Studies on the Economic History and Historical Geography of Antiquity). Ókor – Történet – Írás 3 (Antiquity – History – Writing 3). University of Pécs, Department of Ancient History – L’Harmattan Kiadó, Pécs – Budapest, pp. 15–41. Pohl, H. (1993): Europäische Bankengeschichte. Knapp, Frankfurt. Pozsonyi, N. (2012): Zálogjog a szerződési okiratok tükrében (Kauteláris praxis a preklasszikus és a klasszikus korszakban) (Lien as Reflected in Contractual Documents [Cautelar Practice in the PreClassical and Classical Ages]). PhD Dissertation (Manuscript) Szeged. http://doktori.bibl.u-szeged. hu/1641/1/Pozsonyi_Norbert_Ertekezes.pdf (10.12.2017) Prak, M. R. (2004): Hollandia aranykora (The Dutch Republic in the Seventeenth Century: The Golden Age). Osiris Kiadó, Budapest.

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3. The Beginnings: From Mesopotamia through Florence to London Quinn, S. – Roberds, W (2005): The Big Problem of Large Bills: The Bank of Amsterdam and the Origins of Central Banking (August 2005). FRB Atlanta Working Paper No. 2005-16. Sarkady, J. (1995): A görög föld ős- és koratörténete (Prehistory and Early History of the Greek Land). In: Hegyi, D. – Kertész, I. – Németh, Gy. – Sarkady, J. (eds.): Görög történelem a kezdetektől Kr. e. 30-ig (History of Greece from the Beginnings to 30 BC). Osiris Kiadó, Budapest, pp. 65–113. Spekner, E. (2003): A budai Fugger faktorátus: egy délnémet kereskedő- és bankház képviselete a késő középkori Budán 1503–1533 (The Fugger Factorship at Buda: Agency of a High German Trading and Banking House in Late Mediaeval Buda). In: Viga, Gy. – Holló Sz., A. – Cs. Schwalm, E. (eds.): Vándorutak – múzeumi örökség: tanulmányok Bodó Sándor tiszteletére 60. születésnapja alkalmából (Peregrinations— Museum Heritage: Studies in Honour of the 60th birthday of Sándor Bodó). Archaeolingua, Budapest, pp. 429–434. Stein, A. (1936): Ősi ösvényeken Ázsiában. Három kutató utam Ázsia szívében és Kína északnyugati tájain (On Ancient Asian Trails: Three Explorations in the Heart of Asia and in North-Eastern China). Franklin-Társulat, Budapest. Steinmetz, G. (2015): The Richest Man Who Ever Lived. The Life and Times of Jacob Fugger. Simon & Schuster Paperbacks, New York. Székely Gy. (2005): Cseh- és Lengyelország a késő középkorban. A Habsburgok felemelkedése (Bohemia and Poland in the Late Middle Ages. The rise of the Habsburgs). In: Klaniczay Gábor (ed.): Európa ezer éve: A középkor I. (A thousand years of Europe: The Middle Ages I.) Osiris Kiadó, Budapest, pp. 257-269. Tardy, L. (1980): A tatárországi rabszolgakereskedelem és a magyarok a XIII–XV. században (Tartar Slave Trade and Hungarians in the 13–15th Centuries). Kőrösi Csoma Kiskönyvtár 17. Akadémiai Kiadó, Budapest. Tóth, I. (1979): A rómaiak Magyarországon (Romans in Hungary). Gondolat Kiadó, Budapest. Tóth, K. (1982): A régészet és a Biblia (Archaeology and the Bible). Synodical Office of the Reformed Church in Hungary, Press Department, Budapest. Vajda, E. (2003): Marco Polo utazásai (The Travels of Marco Polo). Translation, introduction and annotations by Endre Vajda. Osiris Kiadó, Budapest. Vajnági, M. (2009): A Német Nemzet Szent Római Birodalma (The Holy Roman Empire of the German Nation). In: János Poór (ed.): A kora újkor története (A History of the Early Modern Period). Osiris Kiadó, Budapest, pp. 167–190. Vargyas, P. (2010): A pénz története Babilóniában a pénzverés előtt és után (History of Money in Babylonia Before and After Coinage). Ókor – Történet – Írás 3 (Antiquity – History – Writing 3). University of Pécs, Department of Ancient History – L’Harmattan Kiadó, Pécs – Budapest. Vásáry, I. (1986): Az Arany Horda (The Golden Horde). Kossuth Könyvkiadó, Budapest. Vásáry, I. (2003): A régi Belső-Ázsia története (A History of Old Inner Asia). Balassi Kiadó, Budapest.

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Banks in history: innovations and crises Williams, J. (1999): A pénz története (Money: A History). With contributions by Joe Cribb and Elizabeth Errington. Novella, Budapest. Wittman, T. (1965): Németalföld aranykora (The Golden Age of the Netherlands). Gondolat Kiadó, Budapest.

Internet sources of the charts and tables Chart 3-1: Source: https://upload.wikimedia.org/wikipedia/commons/6/64/P1050763_Louvre_code_ Hammurabi_face_rwk.JPG Chart 3-3: Source: https://upload.wikimedia.org/wikipedia/commons/6/61/Lydian_coin.jpg Chart 3-4: Source: https://upload.wikimedia.org/wikipedia/commons/4/4d/001-athens-dekadrachm-1.jpg Chart 3-5: Source: https://upload.wikimedia.org/wikipedia/commons/3/37/Roman_writing_tablet_02.jpg Chart 3-6: Source: https://upload.wikimedia.org/wikipedia/commons/f/f9/Cappella_migliorati_08_storie_ di_san_matteo_%28notai.JPG Chart 3-7: Source: https://upload.wikimedia.org/wikipedia/commons/7/78/British_Museum_Ming_ banknote.jpg Chart 3-8: Source: https://upload.wikimedia.org/wikipedia/commons/a/a1/Fiorino_1347.jpg Chart 3-9: Source: https://upload.wikimedia.org/wikipedia/commons/3/3a/Annaberger-Bergaltar2.jpg Chart 3-10: Source: https://upload.wikimedia.org/wikipedia/commons/b/bd/The_courtyard_of_the_Beurs_ in_Amsterdam%2C_by_Emanuel_de_Witte.jpg Chart 3-11: Source: https://upload.wikimedia.org/wikipedia/commons/0/0a/Fuggerkontor.jpg Chart 3-12: Source: https://upload.wikimedia.org/wikipedia/commons/c/c7/Wenceslas_Hollar_-_A_ Flute_%28State_2%29.jpg Chart 3-13: Source: https://upload.wikimedia.org/wikipedia/commons/8/87/Simon_Bening_-_Oktober.jpg Chart 3-14: Source: http://www.beursgeschiedenis.nl/en/moment/the-bank-of-amsterdam/#&gid=1&pid=2 Table 3-1: Source: http://hvg.hu/gazdasag/20090608_tulipanmania_penzugyi_valsag_krach Chart 3-15: Source: https://cdn.pixabay.com/photo/2017/08/12/19/11/tulips-2635062_960_720.jpg

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The First Industrial Revolution (1769—1850) Zoltán Eperjesi – Balázs Mladonyiczki

In the period from 1769 to 1850, revolutions, wars for independence and conflicts were reshaping the map of Europe. In parallel with political turnarounds, there were also major changes in the economy: in the process, known as the Industrial Revolution, new inventions emerged from the second half of the 18th century. The use of steam engines and coal was spreading, and a new workplace appeared: the factory which was characterized by increasing mechanization. Development first started in England, but after the Napoleonic wars it spread rapidly on the Continent as well, the speed of which varied from one region to another, thus it arrived in some parts of Europe with (several) decades of delay. Workforce was flowing to the factories, and the cities started to develop. Expanding colonial empires acted at the same time both as a reliable source of raw material and as a market outlet. Expansion of the railway network held an important role in industrialisation: freight and passenger transport as well as the flow of information, had accelerated. Corporate practice also followed the changes, joint-stock companies appeared that allowed the concentration of more, even remote investors’ capital. Profound changes had an impact on the financial system as well. In many countries of Europe, banks in the modern sense – or their first initiatives – emerged in the 18th and 19th centuries. However, there was no general recipe. Although the banks and regulations of some countries served as a model even outside national borders, bank developments were always dependent on the historical-political and economic background of the given state. New types of banks, such as banks concentrating owners’ capital in the form of joint-stock companies contributed greatly to the financing of the Industrial Revolution by their lending and other financial services. Partly, the financial need of the industrialisation, that is the growing demand itself, created the most relevant changes. — 125 —

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One of the key milestones in the transformation of the financial system was the emergence of central banks, which can be evaluated as a result of a complex process. The first central banks were originally founded for a completely different purpose than the implementation of monetary policy. Periods of war were constantly burdening the exchequer, and then banks of issue proved to be an effective solution to curb high state debts and, in some cases, to fund wars. The financial institutions which later became central and in certain cases also issue banks were usually founded as private companies that gradually acquired a monopoly on banknote issuance from the state in some regions. Initially, financing of governments with occasional loans was a common practice as well. All this will be revealed when examining the formation and expansion of the Bank of England, Sveriges Riksbank and Amsterdamsche Wisselbank. At the same time, due to their important financial and economic stabilization role during crises, banks of issue often had great responsibility towards both society and government. The role of central banks in history was subject to significant transformations. All this is attributable, among other things, to the innovation of money and finance as well as general political and social changes. In the era of industrialisation, demand for entirely new financial and banking services had increased. In parallel with the emergence of capital accumulation and international trade, the banking sector was expanded, part of which was the emergence of new specialized banks and varieties of banks. Finally, as a result of the great number of bank failures and crisis during the 19th century, most of industrializing countries, following the example of Great Britain, tried to centrally regulate their banks, but earlier they had also adopted the gold standard from the champion of industrialisation. In this chapter we will examine how two-tier banking systems emerge from those that are one-tier. Studying major development trends of the English and Scottish banking system, i.e. the most important cause-and-effect correlations of ten-year crises, provide insight into the United Kingdom’s still fascinating economic history. Unlike the Bank of England which usually worked closely together with the government, the Bank of Scotland was not allowed to grant loans to the government without parliamentary approval. After the Seven Years’ War, the economy grew throughout Europe, while accelerating industrialisation led to mass production. Furthermore, large businesses and intensive participation in international trade — 126 —

4. The First Industrial Revolution (1769—1850)

fuelled economic growth. In most countries, including England, Scotland or even in the Netherlands, huge amounts were invested in housing, road systems, drainage networks and other public buildings. At the same time, in industrialized countries the amount of borrowed loans rose sharply. Recent events in economic history demonstrate that a certain pattern of cyclicality has been repeated in the United Kingdom in the form of financial booms and crises. This has been characteristic of capitalist economic development for more than two centuries. However, serious banking crises were much less frequent than these cyclical fluctuations. Yet, it is a valid statement that the banking system itself was always involved in the worst crises. After the unification with England (1707) and the fall of the last uprising of Stuart supporters (1746), underdeveloped Scotland went through a very rapid economic development. In the following decades, there was not such a serious economic crisis in Scotland as in 1772 and 1773. After drawing the necessary lessons, first and foremost the Scottish banking system strengthened as a consequence of this crisis. However, it should not be forgotten that the heavily centralized English banking system with a dense network of branches had already dictated a different developmental trend for Scottish banks with a smaller network, which primarily favoured the principle of free banking. In addition, it was not a common practice of the two central banks of Scotland to finance the government, because they took parliamentary approval in this respect very seriously. It is a fact that during the 19th century most of the industrializing countries simply copied some aspects of the British model, often adapting it to their own national conditions, including the creation of central banks and the introduction of the gold standard. For Scotland, London has made the adoption of the above-mentioned standards compulsory. Regarding the development of the Austrian and Hungarian banking systems, the models and types of banks of the West appeared here with a delay of some years or decades, but the most influential was the German (and for the case of Hungary, the Austrian) model. Austria was then an absolute monarchy, and the strong central power also affected the development of the banking system. The Austrian National Bank, founded in 1816, was heavily guarded by the central control: the institution carried out most of the lending transactions with the Treasury, and the money deposited by citizens served primarily to finance state debt. Strong state involvement was reflected in the establishment — 127 —

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of the first banks and in the strict regulation of savings banks (partly based on the German model) (1844). On the other hand, Hungary was lacking in credit institutions until the 1830s and 1840s when as a result of foreign (Austrian/German) models several credit institutions were established, taking into account Hungarian characteristics. The first and, for a long time, the only Hungarian bank was the Hungarian Commercial Bank of Pest, founded in 1840, which statutes were based on those of the Austrian National Bank. Also following the Austrian and German models, but with several Hungarian characteristics, savings banks were established in the 1830s and 1840s. The establishment of banks and companies were frozen for a few years as a consequence of the Revolution and the War of Independence, but they were accelerated again from the late 1850s onward.

4.1 Geopolitical introduction, major events and states between 1769 and 1850 Below we present the history of the period between 1769 and 1850. We focus primarily on the most important international events, only the case of some major states (such as England or France) and Hungary will be addressed by tracking certain sequences of its national history. This is supplemented in a separate subchapter with an overview concerning economic history, with special attention on the Industrial Revolution. Considering the focus of the volume and the limitations of space, we concentrate first of all on Europe when presenting both historical events and the economy.

4.1.1 Consequences of the French Revolution and the Napoleonic Wars

The period between 1769 and 1850 had a rather stormy, war-torn recent past, such as the War of the Spanish Succession (1701–1714), then the War of the Austrian Succession (1740–1748) and later the Seven Years’ War (1756–1763). Eastern Europe was then characterized by a Russian-Turkish conflict: as a result of the Russian-Turkish war between 1768 and 1774, the Russians gained passage to the Black Sea (Treaty of Küçük Kaynarca). — 128 —

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The most decisive event of this period was perhaps the outbreak of the French Revolution in 1789 – historians consider it as the beginning of the Late Modern Period (1789–1914). However, the Revolution that overthrew the monarchy was not a French affair: on 27 August 1791, the Prussian and Austrian rulers issued a declaration in Pillnitz, urging European dynasties to support the outcast French King Louis XVI in the spirit of dynastic solidarity. Prussian and Austrian forces were stopped by the French in 1792, and in the following years they defeated the socalled first coalition (Prussia, Austria, England, Netherlands, Spain and Portugal). The involvement of volunteers and coercive soldiers also played a major role in this important victory. On 9 November 1799, Napoleon Bonaparte seized power through a coup d’état in France (from 1804 he governed as emperor). Between 1799 and 1809, four anti-French coalitions were set up by the European Great Powers, but Napoleon’s armies defeated them all. French successes were overshadowed by the fact that in the Battle of Trafalgar the French-Spanish fleets were defeated by the British Navy on 21 October 1805. Since England could not be broken in military terms, the island country was placed under an economic blockade by France: in the framework of the so-called Continental Blockade that had existed since November 1806, all trade with England was forbidden (although it was circumvented by the Russians who later joined the Blockade). The blockade exempted European industry from British competition but blocked the path of incoming colonial products (Vadász, 2005, 12. ff.). Napoleon’s first serious losses can be linked to the invasion against Russia. In 1812, almost 400,000 French and allied soldiers were killed. The new anti-French coalition in 1813 (unlike those previously) proved to be successful. One of its decisive battles was the Battle of Leipzig (Battle of Nations) in October 1813, which ended with France’s defeat. In March 1814, the coalition marched in Paris (First Treaty of Paris: 30 May 1814), and Napoleon was exiled to the island of Elba (Vadász, 2005, 25. f.). The new order of post-Napoleonic Europe was determined by the victorious powers at the Congress of Vienna (September 1814 – June — 129 —

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1815). Although defeated, France was also allowed to participate in the Congress. Napoleon’s return and hundred days rule (so-called ‘Hundred Days’) caused disturbance for the work of the Congress, but he was defeated by the Seventh Coalition at Waterloo on 18 June 1815. In Vienna, the repartition of Europe was carried out: the victorious powers were enriched with various territories, and France, enlarged by Napoleon, was shrunk back to its 1790 borders. One of the (military) guarantees of the Old-New Order was the Holy Alliance established by the Russian Tsar Alexander I, the Austrian Emperor and Hungarian King Francis I and the Prussian King Frederick William III on 26 September 1815. Its purpose was to maintain the monarchies and the balance of power as a kind of ‘peacebuilding cooperation’. To this end, the Great Powers convened regular meetings that took place at various locations (1818, Aachen; 1820, Troppau; 1821, Laibach; 1822, Verona). On 20 November 1815, the Quadruple Alliance was formed with England (Vadász, 2005, 26. ff.). Europe’s 1815 state borders are shown in Chart 4-1. Chart 4-1: Europe in 1815

Source: Authors’ own compilation based on upload.wikimedia.org.

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In the coming decades, the greatest challenge for the system of the Holy Alliance was the spread of nationalism and of the democratic/ liberal demands. As a consequence of this, rulers were threatened by the weakening of their monarchical power and as a chain reaction by the complete collapse of the ‘old regime’. The French Revolution gave a boost to national movements, but at the beginning of the 19th century none of these achieved any breakthrough. Such were, for example, in 1817–1819 the conventions of German students and intellectuals (they were banned), then in 1820 the Spanish, Naples and Portuguese uprisings, which demanded a liberal constitution. The policy of suppressing liberal demands was laid down in the 1820 Troppau Protocol according to which order should be restored in any country of the Alliance in case of a revolution, and the rule of revolutionary governments was declared as illegal. England did not agree, and France agreed with it only in certain cases, which shows that the Great Powers were far from being united on all issues (Vadász, 2005, 29. ff.). In autumn 1833, the Prussian, Austrian and Russian rulers signed a separate treaty, which ensured mutual support, including mutual military assistance in the event of an uprising. All this confirmed the previous Troppau Protocol. In response, the English, French, Spaniards and Portuguese established an ‘anti-alliance’ (Vadász, 2005, 39. f.). An important operation principle of the Alliance of the Great Powers was that they could intervene militarily in an event which threatened the balance, supporting each other, but none of them could gain exaggerated influence as a result. However, this did not rule out the success of certain revolutions: the decisive question was to what extent the given change affected the European balance of power. For example, in July 1830, in France, the Bourbon ruler was overthrown, which did not result in a rehabilitation attempt of the Great Powers only because a republic was not proclaimed. However, Poland’s independence attempts from Russia were unsuccessful because it was considered a Russian domestic affair in Europe. The members of the Alliance later suppressed the smaller Italian movements as well as the voices calling for a liberal constitution in the German speaking territories (Vadász, 2005, 33. ff. and 38. ff.). — 131 —

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4.1.2 Revolutions and Wars of Independence in 1848–1849

Revolutions differed slightly in each country, depending on local characteristics, and had somewhat different purposes (see Chart 4-2 for a map summary). The revolution in France wanted a republic (it was proclaimed on 25 February 1848).78 In Italy, which consisted of many smaller states, people wanted to get rid of the Habsburg influence, and greater unity was also to be achieved; in the German states, liberal claims (for example civil rights and freedom of the press) intertwined with the issue of national unity. In Austria, Metternich, the symbol of oppression of civil rights and one of the spiritual fathers of the Holy Alliance, was driven away. At first, the focus was on liberal demands and on the realization of a constitutional monarchy (the Emperor was forced to leave Vienna only in October 1848 because of the fighting). In Pest, modernization and the establishment of an independent Hungarian government was on the agenda. Most of the members of the Holy Alliance were occupied with their own revolutions, so they could not help each other (Vadász, 2005, 43. ff.). In 1849, however, the majority of the revolutions failed,79 civil national movements resulted in lasting success only in certain countries. France remained a republic, the Kingdom of Sardinia-Piedmont could preserve its liberal constitution. However, Italian and German unifications took place only in the 1860s and 1870s. In Hungary, the Austro-Hungarian Compromise of 1867 created greater independence.

he second French Republic was recognized by London in 1848, partly because the T French did not support other revolutions. 79 In Italy, Austrian troops gradually defeated the resistance. In Germany, the Agreement of Olmütz between Prussia and Austria in November 1850 restored the order of the German Confederation that existed before the Revolution. In Vienna, the imperial forces defeated the revolution in October 1848, and the Hungarian War of Independence fell as a result of Russian intervention (Surrender at Világos, August 1849). 78

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Chart 4-2: Revolutions in 1848 in Europe

Source: Authors’ own compilation based on upload.wikimedia.org.

4.1.3 Western, Central and Southern Europe

England was the first constitutional monarchy in Europe (major milestones: 1689, Bill of Rights; 1701, Act of Settlement). Its status as a Great Power was positively influenced by the Industrial Revolution (see Subchapter 4.2), the colonial empire and the fact that the Napoleonic wars had not caused devastation in its territory. England continually increased its colonies, but the emergence of the United States of America (1776) caused it a significant loss. At the end of the 18th century, the British fleet was perhaps the strongest in the world (Vadász, 2005, 11). London was the largest city in Europe at the beginning of the 19th century (with a population of about one and a half million), and approximately one third of the population lived in towns of more than 10,000 residents (Pounds, 2003, 352. f. and 356. f.; see also Vadász, 2005, 156. ff.). — 133 —

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The Great Power status of France was maintained after the Napoleonic wars, and as a sign of this it was invited to the Congress of Vienna. The country which, due to the 1763 Paris Peace Treaty and then the defeat of Napoleon, lost most of its colonies, began to build its second colonial empire from 1830 (Vadász, 2005, 42). The population of France was estimated to be about 27 million at the end of the 18th century, but in the central and southern parts of the country territories of low population density could be found as well. After London, Paris was the largest city in Europe, but its population did not reach one million (Pounds, 2003, 293 and 358; see also Vadász, 2005, 83. ff.). The Austrian Empire was founded by the Holy Roman Emperor Francis II in 1804, in response to the coronation of Napoleon as Emperor. The new state consisted partly of estates under direct Habsburg sovereignty located in the Holy Roman Empire (largely in Austria and the Czech Republic today) and partly of some Eastern European territories.80 Subsequently, as several German states joined Napoleon (establishing the Confederation of the Rhine), Francis II finally dissolved the Holy Roman Empire in 1806. The Congress of Vienna was not interested in creating and maintaining a new strong German state, thus in 1815 the looser German Confederation was established, which in addition to smaller German states included the Austrian and Bohemian regions of the Austrian Empire and the western part of Prussia. Of the German states, both Austria and emerging Prussia (which was often opposed to the Habsburgs) were counted as Great Powers. Although integration and economic development had already started in the 1830s and 1840s, these accelerated only in the second half of the 19th century. At the end of the 18th century, the population of German territories was around 20 million. There were only a few large cities, including Berlin (1815, 200,000 people) and Vienna (250,000 people) (Pounds, 2003, 295 and 358; see also Vadász 2005, 204. ff.). 80

rom the viewpoint of the Viennese Court, Hungary was an integral part of the F Austrian Empire, however, from the Hungarian perspective the country was considered as being a political entity standing outside the Empire. Although a Habsburg ruler was common, he acted as king of Hungary on the throne and not as an Austrian emperor. See in detail: Gergely, 2003, 13. f.

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Italy was characterized by fragmentation. At the end of the 18th century its territory consisted of kingdoms, principalities, the Republic of Venice and the State of the Church. In many Italian states, descendants of Habsburgs sat on the throne (Lombardy, Modena, Parma, Tuscany), the number of which has been further expanded by the Congress of Vienna (with Venice). However, their independence was only formal. In 1848, there were rebellions against the Habsburg rule in several places but without success – Italian unity and independence were only realised in the 1860s (Gergely, 2003, 11. f.; see also Vadász, 2005, 373. ff.).

4.1.4 Eastern Central and Eastern Europe

Poland suffered great losses until the beginning of the 19th century: Austria, Prussia and Russia had torn out considerable pieces from the Polish state three times (1772, 1793 and 1795). Under the terms of the Treaty of Tilsit (1807), by the will of Napoleon, the Duchy of Warsaw was created as a buffer state. In its place the Congress of Vienna created the Congress Kingdom of Poland in 1815, which came under Russian influence; the head of state was the Russian Tsar who suspended the 1815 constitution in 1832 (Pounds, 2003, 349; Vadász, 2005, 10). Russia under the rule of Catherine II (1762–1796) grew strong, however, measured by Western standards it still qualified as an underdeveloped and poorly organized empire, the power of which was ensured by its vast territory and the number of deployable soldiers. As a result of the Russian-Turkish War of 1768–1774, the Russians gained passage to the Black Sea and, in the course of subsequent wars (at the expense of Turkish interests), continued to expand westward; as from 1792 the border was the Dnieper River. Through its expansion in the East, Russia already owned the major part of Siberia and the steppe stretching to the Caspian Sea, but the Caucasus and Central Asia were not yet part of it. In the West, half-autonomous Finland and Congress Kingdom of Poland were considered as territories under Russian influence (Vadász, 2005, 9. f.; Pounds, 2003, 350; see also Vadász, 2005, 477. ff.). — 135 —

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4.1.5 Beyond Europe: the United States and colonial empires

The nominal driving force of colonization (Chart 4-3) was to promote glory and/or civilization, but the real background was to meet the growing demand for raw materials and to gain new markets (Pounds, 2003, 383). The period between 1769 and 1850 can be considered as the decades of reorganization in colonial empires. Here are just a few changes to highlight. Chart 4-3: Colonial empires in 1800

Source: Authors’ own compilation based on upload.wikimedia.org.

The border between Spanish-Portuguese colonies was designated by the Treaty of Tordesillas of 1494, roughly at longitude 46° W. Accordingly, the colonization of Brazil and West Africa was carried out by the Portuguese, whereas the rest of Central and South America was colonized by Spanish conquerors. However, in the first half of the 19th century, colonies in Central and South America became independent, and the majority of today’s South American states were formed. After that Africa was subject to Spanish expansion, and some Portuguese colonies remained in India. (Szilágyi, 2009, 393; Szántó, 2009, 438. f.; Vadász, 2005, 664. ff.). The French disposed a powerful colonial empire in North America, but were obligated to abandon it for the benefit of England and Spain under terms of the Treaty of Utrecht (1713) and of the Paris — 136 —

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Peace Treaty (1763). Although Louisiana was recaptured by the French in 1800, Napoleon sold it to the United States. Also, in the Paris Peace Treaty, France gave up most of its Indian colonies (Papp, 2009, 403. ff.). As to the English colonial empire, the secession of the United States can be considered as a major blow. Although the Declaration of Independence was proclaimed on 4 July 1776, this was acknowledged by the United Kingdom only in the treaty of 1783. Canada remained an English territory and Florida a Spanish territory. In the following years, the foundations of the United States were laid down, and the new federation of states was continually expanded to the West. In 1850, 31 states formed the United States. According to the 1823 Monroe Doctrine, any colonization attempt of Europe concerning the American continent was considered an unfriendly move by the United States. In return, the USA did not want to intervene in the affairs of existing colonies and European nations. Despite the loss of its NorthAmerican territories, the British Empire was the largest colonial empire in the 19th century, which expanded gradually, spanning nearly every continent (Szántó, 2009, 426. ff.; Vadász, 2005, 32 and 597. ff.). France started the construction of its second colonial empire in the middle of the 19th century, and as a first step it acquired Algeria by 1847. The British colonized Singapore (1818), New Zealand (1840), Nepal (1843) and North India (1849). It should be noted that there were still ‘free territories’, and the number of potential conquerors was low, therefore these territorial acquisitions have not (yet) caused conflicts between the colonizing Great Powers. A good example concerning this is that both the French and English were given the same trade preferences in the 1840s in China (Vadász, 2005, 42. f.).

4.1.6 Hungary and the Habsburgs 4.1.6.1 Hungary and the states of the Habsburgs

Neither as holders of the Holy Roman Emperor title (until 1806) nor as one of the leading powers of the German Confederation did the Habsburgs — 137 —

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have an unlimited leadership role in German territories, and with the rise of Prussia they received strong competition. The core area of the Habsburg ‘Empire’ (Chart 4-4), where – unlike Hungary – they had almost unlimited influence, consisted of Austrian Hereditary Lands (österreichische Erblande/Erbländer) as well as the Lands of the Bohemian Crown, which was expanded by the regions originating from Poland’s divisions (such as Galicia) and with Bukovina taken from the Turks in 1775. In several smaller Italian states, the descendants of the Habsburg family governed formally independent countries. The subjects of the Habsburg rulers had no common ‘national identity’, furthermore the regions and parts of the Empire disposed their own historical characteristics. However, according to the Pragmatic Sanction of 1713, the countries of the Habsburgs were to be governed uniformly and inseparably by only one person (Tóth, 2001, 302 and 306; Pounds, 2003, 349. f.; Gergely, 2003, 11. ff.). Chart 4-4: Countries and regions under Habsburg sovereignty between 1816 and 186781

Source: Authors’ own compilation based on upload.wikimedia.org.

s it was already noted, from the point of view of Hungary, the country was A considered an area outside the Austrian Empire and had an independent political entity. See also: Gergely, 2003, 13. f.

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Following the reconquest of Buda in 1686 and the subsequent campaign, sanctioned by the Karlóca Peace Treaty of 1699, Hungary was freed from Turkish rule. Temesköz was also freed from the Turks and returned to Hungary by the Peace Treaty of Pozarevac in 1718. As a result, the historical borders of Hungary (also including Croatia under the sovereignty of the Hungarian Crown) were restored (Tóth, 2001, 228. f. and 304). In 1687, the Hungarian orders (the ‘estates of the realm’) resigned from their rights to elect kings and their resistance rights defined by the Golden Bull (a kind of constitutional limit from 1222) ‘in gratitude’ (in effect, under pressure). Subsequently from then on the Habsburgs automatically inherited the throne of Hungary. From this point of view, the country became one of the countries of the Austrian dynasty. However, Hungary was an order monarchy where the power of the sovereign was, with more or less success, limited by the privileges of the orders and by the parliament. Transylvania was not attached to the country but counted as an independent ‘province’: it had its own parliament and government offices (Tóth, 2001, 230 and 303). 4.1.6.2 Major events and rulers Chart 4-5: Monarchs of Hungary between 1740 and 1916 Joseph II (1780−1790)

Maria Theresa (1740−1780)

Francis I (1792−1835)

Leopold II (1790−1792)

Francis Joseph I (1848−1916)

Ferdinand V (1835−1848)

Source: Authors’ own compilation based on Tóth (2001, 694. f.).

In the second half of the 18th century, several modernization attempts were carried out in Hungary on the initiative of the Habsburg rulers (Chart 4-5), but these have not changed the absolutist regime of the country’s governance. Many of the reforms of Maria Theresa (1740–1780) can be regarded as successful (though not free from contradictions), such as the — 139 —

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1767 Urbarium that unified the position of serfs or the Educational Reform. Her son, Joseph II (1780–1790) pursued an even more intensive reform policy, resolutely seeking to modernize the empire, but at the same time in this process he completely ignored local traditions and regional features. However, the impairment of the rights of the orders and his governance based on decrees (instead of the Parliament) resulted in resistance. As a consequence of this and military failures against the Turks, the ruler withdrew his measures in 1790 with few exceptions. During the short reign of his brother, Leopold II (1790–1792), no significant progress was made, however, Francis I (1792–1835) expressly opposed any form of modernization efforts. After 1812, Francis did not convene the Hungarian Parliament for years, he governed by decrees and further reduced the rights of Hungarian counties that served as the base of the nobility’s resistance. As a result of the unfolding resistance, Parliament was convened again in 1825, and the king contributed to the preparation of the reform works. The subsequent period known as the Reform Era is considered to be roughly the two decades preceding 1848, and most of which period coincided with the time of the reign of Ferdinand V (1835–1848). At that time, the reform climate urging civilian modernization became a dominant trend in public life, in which development was aimed not by revolution or a royal decision, but through laws adopted by the Parliament, ‘from above’. In the absence of a strong middle class the creation of a modern Hungary was urged by the social class which possessed the necessary power to participate in the realization of these goals and that was the nobility, which, however, was divided into several approaches by the question of modernization. The forums for negotiating and passing the reforms were the parliament sessions held in Pozsony (today: Bratislava) (1825–1827, 1830, 1832–1836, 1839–1840, 1843–1844), the significant figures of which were István Széchenyi, Lajos Kossuth and Ferenc Deák. Széchenyi’s publications (Hitel (Credit), Világ (Light) and Stádium (Stage)) had a major role in disseminating reform ideas. The acts on the establishment of factories and on the exchange law shall be considered as the most important ones from an economical point of view (Tóth, 2001, 307. ff., 314, 331. ff. and 341. ff.; Gergely, 2003, 191. f.). — 140 —

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Box 4-1 Credit, Light, Stage — works of István Széchenyi

The publications of Count István Széchenyi (Chart 4-6) played a major role in the emergence and unfolding of the Hungarian reform movement. Although he was not the first to formulate the basic ideas of Hitel (Credit) (1830), according to which the existing economic and political framework required a thorough modernization, but because of his influence and publications he had a far greater impact than his predecessors. According to Széchenyi, the shortage of credit hindered economic growth, however, the order-based societal structure of that era made it difficult to access credit: for example, the law of entail restricted the free disposal of noble estates. Thus, real estates subject to mortgage could not be sold. In addition, there were countless areas to be developed (abolition of ‘robots’ – obligatory labour of serfs in the fields of their lords –, guilds and internal customs, etc.). For this reason, the author saw the reform of the entire system as necessary. In his work Széchenyi did not stop at identifying deficiencies but described what to do and what to start with (Széchenyi, 1830, 153). The Count simply could not accept the situation that his home country, despite its given but partly unused potential, could not effectively make use of the opportunities offered by the age and was unable to catch up with rapidly evolving European countries. Therefore, Széchenyi analysed the situation of the country and of the national economy in depth as well as the causes of its underdevelopment. According to him, one of the activities that had been neglected in his country was mainly trade, as Hungary had ‘no trading’, and its natural assets were completely unused (Széchenyi, 1830, 108). During his foreign trips Széchenyi studied proven methods and economic systems, and for him the English model was the ideal one. József Dessewffy in his Taglalat (Anatomy)82 was in dispute with Széchenyi, but he was not opposed to modernization. Moreover, in some cases he was even more radical than the thoughts presented in Hitel (Credit). Anatomy 82

The Anatomy of Hitel (Credit). In Hungarian: A Hitel című munka taglalatja.

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wished to carry out the reforms by enlightened Hungarian ‘orders’ and by the leading social class of the counties, whereas Széchenyi entrusted the active support of the big-estate aristocracy and the government. The differences between the two original proposals were explained by Széchenyi in his writing entitled Világ (Light)83 (1831). Chart 4-6: István Széchenyi

Source: upload.wikimedia.org

In his book Stádium (Stage) Széchenyi concentrated his ideas on twelve points,84 but because of the ban by authorities he carried out the printing of his work in Leipzig, which became available to Hungarian readers only at the end of 1833, a year and a half later than planned. Thus, its original ight, that is, enlightening fragments to correct some mistakes and prejudices. In L Hungarian: Világ, vagyis felvilágosító töredékek némi hiba s előítélet eligazítására. 84 Credit law, abolishment of the entail, the inheritance law of the treasury and of the industrial/trade barriers, property acquiring rights and county representation for non-nobles, equality before the law, partial burden sharing, monitoring the use of taxes by the Parliament, enhancement of the public role of the Hungarian language, strengthening the Council of Governors, publicity of judgments and consultations. 83

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purpose, namely to influence the agenda of the parliament, could not be achieved; it had already been meeting for 11 months before the book was published (Gergely, 2003, 194. ff.). Széchenyi’s publication, which influenced public thinking even decades later, went far beyond his own time. Together with his contemporaries and the intellectual giants of the next generation they actively participated in the modernization of Hungary, thus contributing to the development of the Hungarian banking sector. This historical process could not have been achieved without the ideas and struggles of such key players like him.

With the news of the outbreak of the 1848 western revolutions (22 February, Paris; 13 March, Vienna), the idea of equality of rights, national government and constitutionality emerged in Hungary as well. As a result of the demonstrations in Pest-Buda, the Council of Governors (in Hungarian: Helytartótanács, a Hungarian governing body which consisted mainly of several high clergymen and nobles, however, was strongly influenced by the Habsburgs) abolished censorship and accepted the famous Twelve Points, which listed the reform demands. Ferdinand V approved the establishment of the Batthyány government, while negotiations with the Vienna State Conference were ongoing. The parliament began preparing the laws necessary for civil transformation (April laws). However, partly due to the Habsburg successes against Italian movements, the Austro-Hungarian relationship became more pronounced (Tóth, 2001, 377. ff.). The Hungarian Revolution became a war of independence when the military force appeared: Jelacic, the Ban of Croatia, who was walking under the Imperial flag, crossed the River Drave on 11 September 1848. He, however, did not dispose any official Royal Decree for the attack; he was appointed by Ferdinand V as Royal Commissioner of Hungary only in October. On 14 April 1849, the Hungarian Parliament, which had fled to Debrecen, declared the House of Habsburg dethroned in the Reformed Great Church of Debrecen (since December 1848 Francis Joseph had been on the throne). However, it became impossible to create a Hungarian civil state because with the help of troops of the Russian Tsar Nicholas I, the Habsburgs — 143 —

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triumphed. On 13 August 1849, the Hungarian War of Independence ended with the Surrender at Világos (Tóth, 2001, 387. ff.). Then came the imperial retaliation campaign: on 6 October 1849, Austrian General Haynau executed the 13 army generals of the Hungarian War of Independence (Martyrs of Arad) and Prime Minister Lajos Batthyány; another 150 people were sentenced to death and thousands were imprisoned. Public outcry both at home and abroad was so immediate that Franz Joseph finally dismissed Haynau from public service. Subsequently, the Age of Despotism began.

4.2 Economic history between 1769 and 1850 The most important change in the economy in the period between 1769 and 1850 was the (first) Industrial Revolution, which according to Norman J. Pounds, an English historian (2003, 319), may be called a ‘revolution’ because it brought about a rather big and fast-paced change. Two of the most important features of the Industrial Revolution were perhaps large-scale (factory) production and the utilization of machine energy powered by water, then by steam. The Industrial Revolution had brought about radical changes in agriculture as well, even in light of the fact that the process already had a considerable number of antecedents. Although the tools have not changed much for centuries (until the 19th century), at the end of the 18th century the population supplied by European agriculture was already two and a half times larger than it was in the 15th century. The reason for this was not a major innovation, but it was related to the small changes of tools and production methods that interacted with each other (Pounds, 2003, 312. f.). One of the fundamental changes in the first half of the 19th century was the abandonment of self-sufficiency, the emergence of national or larger food markets. The productivity of agriculture had increased, but employment had declined. In some countries in Western and Central Europe, more modern methods of — 144 —

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cultivation, fertilization and (in England) the use of sowing-machines had begun to spread (Pounds, 2003, 385, 417 and 427. ff.). Agricultural development also contributed to the unfolding of industrialisation: with increasing productivity fewer agricultural workers were required, and labour surplus went to cities where they could work in factories. The peasant class on the continent, as well as the size of estates and the related rights of use, were heterogeneous: in England there was an effective land lease system, while in France there were many small estates: as an achievement of the French Revolution peasants became owners and then lost their estates during the Restoration. In the western part of the German territories there was a leasing system operating; east of Elba and in several states of Eastern Europe, however, the land was cultivated in feudal terms. The liberation of serfs in Prussia eventually took place in the early 19th century and in Hungary in 1853 (Pounds, 2003, 359. ff. and 425. f.). There had been such great changes in industry that historians refer to this as a ‘revolution’. One of the most typical features of the Industrial Revolution was the appearance of factories, the real competitive advantage of which was mechanization. This process first unfolded in England, initially in the textile, later in the metal industry and then in consumer industries. In this period machines used water and then steam energy. However, the use of water for industrial purposes was limited (there was no access to a river or it was not always suitable for that purpose), which facilitated the spread of steam engines, therefore factory makers sought proximity to coal basins. The steam engine of Newcomen and Savory (1712) was so large that it was used only in mines. The breakthrough was brought about by James Watt’s steam engine (1769), which could perform rotary motion as well. It was also an important innovation to replace charcoal with hard coal in the operation of melting furnaces (coking method of Abraham Darby, 1735), and later the hard coal operated flame furnace was invented, which was used for refining crude iron (by Henry Cort, 1783). The textile industry was boosted by the development of weaving machines. — 145 —

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The factories had in most places crowded out smaller production facilities and family businesses. Nevertheless, neither handicraft nor traditional manufacturers disappeared completely: products of high quality and with a somewhat higher price were still in demand. Cottage industry survived in businesses that were difficult to mechanize (lace making, embroidery). In addition to its openness to innovations, England was a favourable venue and starting point for the Industrial Revolution because it also had a solvent market for mass products and had the necessary political stability. The emerging colonial empire (both as a source of raw material and as a market outlet) had a positive impact on the economy as well, which had an effect on the growth of British banks. All this facilitated technical innovations (Pounds, 2003, 319. ff., 330. f., 346. f., 367. f. and 434. ff.). For this reason, England was later called the ‘workshop of the world’.85 In other regions of Europe, on the ‘Continent’, these framework conditions existed only partially or were totally absent, which constituted an obstacle to industrial development (and a competitive advantage for the English industry). As a result of the Napoleonic wars, at the beginning of the 19th century, the industry of the Continent was lagging far behind England where the use of steam engines was already widespread. There were roughly 150 Watt steam engines in the island country in use, and four-fifths of the world’s coal production and half of its iron production were concentrated in England. However, the number of steam engines on the Continent amounted at most to one tenth of that. The situation of the French industry had not changed much since pre-revolutionary conditions. In the German states, modernization aspirations were limited only to a few regions (for example, smelters in Gleiwitz and Königshütte, Prussia) (Pounds, 2003, 367. f., 371. f. and 434). English-made steam engines began to spread in the Continent after 1815, which were even produced in some Belgian or German 85

ee, for example: http://www.bbc.co.uk/history/british/victorians/workshop_ S of_the_world_01.shtml

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cities. In the first half of the 19th century, steam engines played an important role in the development of the textile and metal industry (Pounds, 2003, 434. ff.). It should be noted that at that time it was not ‘England’ or ‘Germany’ that became industrialized, but certain regions, several of which could be found in England. However, moving toward the east and/or south on the Continent their number decreased. It can be concluded that the Industrial Revolution arrived in some states of Europe with (several) decades of delay compared to England due to the incompleteness of the already mentioned framework conditions and historical features. In addition, the countries were not homogeneous, there were great regional differences. The most important industrial areas of the era were, for example, the north-western industrial area (narrow strip from Lille to Dortmund, from northern France to the Ruhr Region), Lorraine with the Saarland and Upper Silesia (which belonged then to Prussia, Austria and Russia) (Pounds, 2003, 449. ff.). As a result of innovations, the number and productivity of industrial employees increased (Pounds, 2003, 385). However, in the first half of the 19th century, mechanization affected mainly the textile and metal industries, and most of the profits were recycled into production. The population was more likely to perceive development in the second half of the 19th century when developments with regard to both investment and consumer goods were widespread (Pounds, 2003, 347 and 447). The specialization and concentration that took place during the industrialisation would not have been possible without revolution in the transport sector. George Stephenson, an English engineer, developed a steam locomotive in 1814, and the first public railway linked Stockton and Darlington on 27 September 1825. After that, the dominant role of road traffic was quickly taken over by the railway in England. In the western part of the Continent the same process lasted until the 1860s and even later in the eastern part (Chart 4-7). The railway was able to deliver (heavy) goods cheaply and in large quantities on land, and its construction constituted demand for the metal industry. Flow of — 147 —

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information and passenger transport had also accelerated. By the end of the first half of the century, the railway network mainly linked England and the western, middle and central parts of continental Europe. Its development was facilitated by the fact that the British 1435 mm track gauge was adopted everywhere with the exception of the Iberian Peninsula and Russia (Pounds, 2003, 467 and 471. ff.). Railways had taken over the role of coastal shipping in many places as well, and therefore ships transported only goods of lower value or of large size (coal, building materials) (Pounds, 2003, 473). Furthermore, with the development of transportation – apart from the metal industry – the importance of proximity of coal mines to industry had decreased (Pounds, 2003, 346. f.). Chart 4-7: Date of the first relevant railway line by country in Europe86 1862

First railway line by country

1854

1856

1870 1851

1860 1847

1860 1862

1834 1830

1839 1835

1842 1835

1842

1856

1861 1839

1845 1847

1837

1848 1846

1844 1857 1872 1854 1839

1871 1869 1866

1901 1873 1917 1869

1848

1830’s 1840’s 1850’s 1860’s 1870’s 1900’s

Source: Authors’ own compilation based on upload.wikimedia.org.

I n England, the first railway line opened in 1825. However, the 1830 line between Liverpool and Manchester was the first to operate exclusively with steam locomotives.

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Growth in domestic and foreign trade which lasted until the end of the 18th century was impeded by wars at the end of the century, and the Continental Blockade imposed by Napoleon also had a negative effect. Nevertheless, England was the commercial Great Power of the era: it intensified the exchange of goods not only with the Continent but also with its colonies. In 1815, around 60 per cent of its trade was carried on outside Europe. In contrast, other colonizing powers had less and/or less developed colonies, often acquired later than those possessed by the English. These did not have as much significance as the colonies of England (Pounds, 2003, 375. f. and 383. f.). Customs were one of the most relevant barriers to trade. In-country customs were abolished in several countries during the 17th to 19th centuries. In France, many of them were eliminated in 1664, but the final cessation of customs offices took place only in 1790. In Habsburgdominated areas there was a dual customs system as from 1754 until 1850/51: external customs ‘protected’ the entire market of the empire from (often cheaper and better) foreign goods, and Hungary was cut off from the Austrian and the Bohemian regions by an internal customs border. In the German Confederation, which consisted of many smaller states, the gradually expanding Deutscher Zollverein (German Customs Union), founded in 1834, brought the end of internal customs. However, only the German Empire can be considered as a unified customs area (with some exceptions) from 1871 (Pounds, 2003, 338; Vadász, 2005, 39).

4.3 Establishment of banks of issue and formation of twotier banking systems 4.3.1 The beginnings of the financing of the Industrial Revolution – banks and joint-stock companies

Contemporary banks played a significant but not exclusive role in creating the financial backdrop of the Industrial Revolution. At the beginning of industrialisation, the necessary capital was partly secured by private — 149 —

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wealth, family and friends, and partly by state owned banks or by private banks in the hands of wealthy merchant and banker families. In the first half of the 19th century, these private banks, particularly English, French and German ones, were the most important creditors of manufacturing plants and railway constructions, and they often participated in the establishment of companies. Some banks were even co-owners of the companies responsible for railway constructions: the French branch of the Rothschild’s held 10 per cent of the capital of the French railway companies founded before 1848, and the Vienna-Győr railway line was established at the initiative of the Sina Banking House. As far as industrial companies are concerned, Pohl (1993, 205) points out that rural banks in England assisted the regional industry with short-term loans, in France in the 1820s several banks were involved in the financing of canalization, mining and metal industry, while in the German states private banks in Cologne and Württemberg did the same. Box 4-2 Rothschilds, Sinas

The Rothschilds from Frankfurt were one of the most influential banking families of the 19th century, a position achieved by the founder Mayer Amschel Rothschild (Chart 4-8) and his five sons in the first half of the century. The family disposed branches in several European cities (e.g. London, Paris and Naples), which were often considered to be the largest banks in the given city/region, and eventually became centres of excellence among the family’s respective branches. The main activity of the banking house was trading with state bonds, which was of great importance for individual countries as well. According to Pohl (1993, 202 and 221), Austria funded its military interventions in Italy in the 1820s with the money made on state bonds marketed by the Rothschilds, and the family was also involved in financing British colonial expansion. Their investments included the provision of capital for contemporary railway constructions and industrial companies. The activities of the Rothschilds were extended to Austria and Hungary as well. The Austrian branch of the family owned one of Vienna’s largest banks, and they initiated the construction of the

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4. The First Industrial Revolution (1769—1850)

first Austrian steam railway, known as the Nordbahn in 1836 (Pohl, 1993, 199. f., 203, 205, 221. f. and 318). As to their relationship with Hungary, one of the shareholders of the Hungarian Commercial Bank of Pest was the Rothschild family. Some branches of the family are still active today. The Frankfurt headquarters was closed in 1901, the branch in Vienna was ‘aryanized’ by the German Empire in 1938, but there are still credit institutions under the name of Rothschild in Paris and London. Chart 4-8: Mayer Amschel Rothschild

Source: upload.wikimedia.org

Sina was a banking family of Greek origin, with a wholesaler background, which was active (also) in the territory of Austria from the second half of the 18th century and around 1830 (besides Arnstein & Eskeles and the Vienna branch of the Rothschild’s) were considered one of the most significant Vienna banks (Pohl, 1993, 200 and 318). The family also supported the construction of Austrian-Hungarian railways. Pohl (1993, 203) notes, for example, that already before the announcement of the sale a significant part of the shares of the Vienna-Győr railway line were already in their hands. It was György Sina who raised funds to finance the construction of the Chain Bridge (1839-1849), the first and still existing permanent bridge connecting Buda and Pest. In turn, he was granted the right to collect bridge tolls for 87 years. But this lasted only for 20 years, as, after the Compromise of 1867, the Hungarian government redeemed the bridge from Simon Sina, the son and heir of György Sina.

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Joint-stock companies spread in Europe in the first half of the 19th century:87 first in England, and then moved progressively toward the east, often with decades of delay (in Hungary, for example, in the 1840s). In the framework of joint-stock companies, shareholders were able to participate remotely and with limited risk (even investing a low amount) in a company’s financing. This introduced a new, modern form of ‘venture capital’, and the amount of capital raised by shareholders made it possible to meet the increasing capital demands of industry and transport. In the first decades of industrialisation, the financing provided by private banks proved to be sufficient, but in parallel with development, the capital demand of the economy, for example for long-term loans, had increased. Pohl (1993, 214) notes that in truth it wasn’t money that was lacking, only the right ‘tool’ option for a reasonable investment of the existing capital beyond the narrower region. Generally speaking, private banks operating as family businesses were not able or, because of the considerable risks, were not willing to satisfy these needs. It was a logical step to create banks in the form of joint-stock companies, which concentrated the capital of founders (often of private banks), so they could take part in the establishment of industrial companies and in long-term lending transactions with them while the risk was shared among the various members. At that time the dominant business line of this new type of bank was investing (establishing companies, stock transactions), but they often provided a wide range of services (such as deposit and loan transactions), and thus became universal banks. Perhaps the first such credit institution was the Belgian Société de Belgique (1822) and the Banque de Belgique (1835), which were part owners of 55 joint-stock companies until 1838 and provided long-term loans as well. Many of the foundations of contemporary banks were modelled on the French Crédit Mobilier (1852), which had several business lines, for example investment banking. In Germany this type 87

I t should be noted that there had been precedents for this: for example the Dutch East India Company, founded in 1602, already operated as a joint-stock company.

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4. The First Industrial Revolution (1769—1850)

of bank spread in the 1850s (Pohl, 1993, 18, 196, 202. ff., 213. ff.; Frowde, 1909, 454. f.). Credit Mobilier was a French bank founded in 1852 and was one of the few contemporary credit institutions that were already functioning in the form of a joint-stock company, thus dividing the risk among the many smaller holdings. In addition, it was also among the first to be not only a deposit and exchange bank, but at the same time an investment bank, i.e. combining lending with company share acquisitions and stock transactions, which strongly contributed to the financing of industrialisation and railway constructions. Although due to its financial difficulties (perhaps because of its innovative and risky business policy) it ceased to exist by 1871, yet during its term it served as a model for numerous establishments of banks. Thus, its importance is indisputable (Pohl, 1993, 18, 225. f. and 253. f.).

4.3.2 Contributions to the process of formation and history of central banks

The history of the formation of central banks can be traced back to at least the 17th century. Swedish Riksbank was founded in 1668, the Bank of England (1694) and the Banque de France (1800), are the oldest, still operating central banks, but they were designed for a completely different purpose than implementing monetary policy. These central banks were primarily created as private companies, which gradually acquired a monopoly on banknote issuance from the state in some areas. William Paterson (1658–1719), who was the founder of the Bank of England, said: ‘The bank hath benefit of interest on all moneys which it creates out of nothing.’ The above quotation shows that the privilege of a central bank was very lucrative at the time of simple banking systems when access to alternative financial products, such as scriptural money or credits, was quite narrow. The transfer (sale) of the state’s money monopoly to private banks was mainly due to an emergency because they wanted to cover the high state debt that was often accumulated during military conflicts. Thus, it is no coincidence — 153 —

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that the establishment of central banks took place during or right after war periods, such as the intervention of Sweden in the Second Northern War (1655–1660), England’s intervention in the Nine Years’ War (1688– 1697) and the Napoleonic wars started by France (1792–1815). In interbank foreign exchange transactions until the beginning of the 20th century, or more precisely until the outbreak of the First World War, the gold standard was the only relevant joint measure among participants. Since the earliest precursors of today’s currencies and the existence of the foreign exchange system, societies have faced the difficulty of equalizing the various currencies. In parallel with overcoming these difficulties, international trade could evolve and develop further. It can be observed that there had already been a forex system since the middle of the 1870s.88 In academic literature, the year 1875 is usually the starting point, i.e. at about this time the basic pillars of the modern and worldwide monetary system were laid down. Thus, the new international trade framework, which had developed parallel with the above-mentioned gold standard, changed considerably. Precious metals used in trade previously as a reference, such as silver and gold in particular, had been increasingly influenced by price volatility and were therefore less and less able to fulfil their initial role as the basis for payment operations. At the same time, it was still important for the functioning of the system that trading 88

he world’s first national money system was set up in England at the end of the T 17th century, with the establishment of the Bank of England. In 1875, after the establishment of the unified German state, Europe switched to the gold-based money system. From this point on, until 1914, gold production determined the world’s money supply and prices. This system was focused on the Bank of England. Its main task was to keep gold stocks at the appropriate level. However, most of the actual commercial payments were made in pound sterling. The first formal international agreement on financial markets was born in 1876, when the gold standard method was generally accepted, meaning that each state set a fixed conversion rate that made it possible to make its own money convertible into gold at any time. This prevented arbitrary devaluations, and mostly inflation, but as a consequence of ever-expanding international trade, the gold stocks of these countries severely fluctuated at times.

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4. The First Industrial Revolution (1769—1850)

states have their own gold reserves. To determine the foreign currency standard, the currencies of participating states were converted into gold. Only this could be the basis of the forex trading in today’s sense of the expression. It appears that the role of banks of issue, the gold standard and foreign currency played a leading role in the emergence of international trade, and the concepts referenced mutually interacted in complex processes. The formation and activity of the banks of issue were decisive for the financial processes of a particular state and region, but with the development of international trade different types of banks (for example, commercial banks) became more and more involved. At the same time, with regard to the international monetary system the historical evolution of the transition from the one-tier to the two-tier banking system had set the course. The main model was determined by the second89 oldest central bank, the Bank of England,90 which was founded by William of Orange in 1694 as the King of Great Britain and Stadtholder of Holland, during the war against France. In exchange for a loan to the king, the bank was granted the right to issue banknotes, it could perform banking transactions and offer state loans. As a result, state debt had doubled in the first fifteen years of the 18th century. By the end of the century, less than half of the money in circulation was available in the form of coins, therefore the king’s influence on money supply had diminished as the emphasis had shifted from the mint operated by him to the London money market and the provincial banks. In the course of history monarchs often repaid the loans inaccurately, furthermore they had the power to prevent creditors from validating their rights. William III however, depended on Parliament support, which reflected in particular the interests of those financing the central veriges Riksbank is considered to be the oldest central bank created by directors of S the Swedish economy and finance in 1668. 90 https://www.bankofengland.co.uk/about/history 89

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Banks in history: innovations and crises

bank. Creating a bank was a guarantee to creditors, and at the same time made it easier and cheaper for the government to take out a loan. In connection with the founding of the Bank of England, it is important to note that originally goldsmith bankers started to develop banking principles as custodians and creditors at the same time, but due to the loose financial management of the Stuart kings, their previous strong position deteriorated greatly in the meantime.91 That is why more and more sides came with the idea that maybe it would be better to set up a national or state bank to mobilize the resources of the nation more efficiently. The initiators of the idea were inspired by the example of Amsterdam’s Wisselbank, but there were a number of other proposals as well. The most successful idea came from a Scottish entrepreneur named William Paterson who asked the public to invest money in a new project. Within a few weeks, the investments exceeded 1.2 million pounds. This amount was the initial capital of the Bank of England, which was lent to the government against a royal deed of gift. On 27 July 1694, the royal deed of gift was sold and the institution started its governmental banking and debt management activities. Just a few days later, the bank started business, for the time being on a temporary basis, in the Mercers Hall in Cheapside. The staff consisted of seventeen officers and two gatekeepers. Later, but in the same year, the bank moved to the Grocers’ Hall in Prince’s Street, and this became its home until 1734, when due to lack of space it bought a new building on Threadneedle Street (old building of the bank: Chart 4-9).92

aring, 1797, 2–81. http://www.ier.hit-u.ac.jp/library/Japanese/collections/fr71B 56/44-1.html 92 For official digitalized document collections see: Committee for Lawsuits Minutes 1802–1908; Committee of Treasury Minutes 1779–1991; Daily Account Books 1851– 1983; https://www.bankofengland.co.uk/archive 91

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4. The First Industrial Revolution (1769—1850)

Chart 4-9: The old building of the Bank of England, from Mansion House (from an illustration of 1730)

Source: www.british-history.ac.uk

The main features of the initial era of the banking system can be summed up this way: businesses flourished, but the national budget was very weak and the money and credit system functioned under primitive frameworks. Over the next 100 years, the bank gradually expanded and acquired the adjacent rooms on the street named after it until it reached its current 3-hectare area. Sir John Soane built a massive curtain wall around the headquarters that still forms the outer wall of the bank (Kynaston, 2017, 9–45 and 52–68). At that time, no one even thought that central banks would grow into today’s enormous institutional systems, but John Law’s proposals

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Banks in history: innovations and crises

(1716–1720) and French laws already gave a taste of the direction in which the growing central banks would evolve. For example, Law successfully convinced the regent (when King Louis XV was still a young child) to allow him to create a national bank and to order that from then on all official taxes and revenue be paid only on bank notes issued by the bank. Behind this idea was the hidden goal of reducing the enormous pressure on the indebted monarchy. After that, the bank gradually took over the largest part of public debt, and investors were persuaded to exchange bonds, namely to buy shares in the Mississippi Company, which wanted to exploit the US colonies of France. All of this led to one of the first major, speculative banking transactions. The rise in the price of the Mississippi shares greatly influenced the formation of the word: millionaire. The colonies, however, did not bring the hoped-for profit, while the business model developed by Law completely collapsed. Meanwhile, French citizens had been continuously and persistently suspicious of the hidden risks of financial speculation and paper money. Despite this huge failure, there was something left of the Law model, as paper money became a much more useful exchange tool than gold or silver, especially when larger quantities or transactions were involved.93 While in some cases private banks could issue banknotes, confidence in them was much lower than in the money issued by the central bank, which was actually supported by the government with taxation powers. Meanwhile as paper money became a suitable means of exchange, people had more opportunities for open trade and with increased economic activity, public revenue grew. During this time, governments recognized that it was a good earning opportunity to release more money when there was no sufficient reserve behind it. It had also been shown that it was not entirely unwise to suspect that central banks would probably prefer creditors to debtors (Kindleberger, 2006, 1–8 and 15–70).

oen, 2001. http://www.mshistorynow.mdah.ms.gov/articles/70/john-law-andM the-mississippi-bubble-1718-1720

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4. The First Industrial Revolution (1769—1850)

Returning to the history of the Bank of England, it can be stated that in fact the later central bank had emerged from a private bank and its initial capital was a loan to the state, that is to say, in postcommencement periods it was mainly specialized in government financing for which it had exclusive rights for coin and money issuance. The first governor of the bank was Sir John Houblon, the grandson of a French Huguenot refugee and outstanding urban merchant. Early activities of the financial institution were, above all, determined by the urgent financing needs of the then government and the issuance of new coins, but at the same time traditional banking activity, i.e. the reception of deposits, was also started. In return for the deposits placed, the institution issued bank notes where items were initially denominated in small amounts in pound, shilling and penny, but later the amounts became more and more round. Moreover, in the meantime banknotes issued by the bank had become widely accepted currency. At that time banknotes could be exchanged for gold coins at the bank, and clients rarely doubted that the payment promises on printed and coined items could be entirely converted into gold or fulfilled under various contracts by the institution.94 The close relationship between the increasingly important financial institution and the government, the wide range of private banking and the central position of the bank within the expanding city of London’s financial system are all factors that made the Bank of England the leading commercial bank of the island country on a daily basis. Interestingly, Britain introduced the gold standard on a random basis at the turn of the 18th century, after the Royal Mint had raised the value of gold relative to silver higher than it was in other countries and silver had largely flowed to overseas competitors. Since money issued by the Bank of England could be converted into gold upon request, the bank had now in fact committed itself to link the value of its currency to this metal. In a broader sense, this meant that the 94

ynaston, 2017, 9–45 and 52–68; for the Bank’s early financial strategies, see Byatt, K 1994, 12–79

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Banks in history: innovations and crises

central bank was committed to the stability of the pound sterling. Furthermore, on the one hand the real value of creditors’ assets (bonds and loans) remained the same, but on the other hand borrowers still did not have the opportunity to see inflated debts (Kindleberger, 2006, 57–60; Kynaston, 2017, 12–47). State debt was growing steadily during the eighteenth century: in the middle of the 1700s, the bank recorded a deficit of 12 million pounds, which rose to 850 million pounds by the end of the Napoleonic wars in 1815. The Napoleonic wars heavily burdened the finances of the island country, and in 1797, because of the waning gold reserves of the bank, the management at that time decided that banknotes would no longer be converted into gold. In fact, this period of restriction lasted until 1821, and during that time the bank issued for the first time 1 and 2 pound banknotes, thus trying to compensate for the lack of coins. The wider availability of banknotes had greatly contributed to the overall rise in prices and, after the Napoleonic wars, a major economic downturn occurred in the island. Low-denomination banknotes proved to be extremely tempting for counterfeiters: during the restriction period more than 300 people were hanged for counterfeiting the Bank of England’s banknotes.95 In the 19th century, state debt and inflation were already basic economic difficulties and, in order to offset these, financial experts were working hard to find the best solutions to curb the difficulties.96 It is important to note that the Bank of England was not the only banknote issuing institution at the time, as many other local banks, as well as Scottish and Irish banks issued their own banknotes, but the future of these was doomed to failure, especially in the difficult trading situation of the 1820s and 1830s (Kindleberger, 2006, 57–60, 68–70 and or the official digitized documents, see: Committee for Lawsuits Minutes, 1802– F 1908; Committee of Treasury Minutes, 1779–1991; Daily Account Books, 1851–1983; Source: https://www.bankofengland.co.uk/archive 96 Kindleberger, 2006, 75–83, 89–94, 173–176 and Kynaston, 2017, 22–89 95

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4. The First Industrial Revolution (1769—1850)

75–94). At the same time, in order to have a more reliable currency, the Bank of England changed its strategy again and started opening its own branches in the smallest cities from 1828 onwards.97 In 1708, the Bank of England received a joint-stock bank monopoly, while other banks were actually banned from associating with more than six partners. This decree effectively shaped the development of English banking activity until 1826, but from that year on the restraining order was withdrawn, and the activities of joint-stock banks were reauthorized. In the 1720s, banking activity became a specialized business branch of the island, while many private banks were established, mainly in the city of London but they operated in great numbers also in the area of London’s West End. Chart 4-10: Five pounds banknote from 1729, which was valid in Wales and England

Source: The British Museum (Edited by Catherine Eagleton and Artemis Manolopoulou).

indleberger, 2006, 60–64, and http://www.intriguing-history.com/bank-ofK england-history/

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Banks in history: innovations and crises

The first British banknotes: The banknote shown in Chart 4-10 was issued in 1729 by the bank Francis Child Esq & Co. The five pound denomination was handwritten, which was a common practice at the time. After the death of his predecessor (Robert), from 1721, Francis Child became a new partner of the bank and soon became recognized as the well-known banker of Fleet Street. The feature of the banknote shown on the picture is that it was issued and signed by the bank, guaranteeing that it would immediately pay the amount indicated in the denomination in case of redemption. This banknote is different in its function, for example, from the ‘cheque’ issued in London on 17 October 1725, which was addressed to goldsmith Abraham Fowler.98 Chart 4-11: Cheque from London (1725)

Source: www.safaribooksonline.com

owler’s bank was later developed into a prestigious private bank in London F (Goslings & Co.), which became a founding bank for Barclay & Co. in 1896.

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4. The First Industrial Revolution (1769—1850)

Spread of cheques: The printed versions of cheques began to be used in London in the 1720s (Chart 4-11), and then handwritten copies slowly dropped out of circulation. Meanwhile, the use of cheques had become so widespread that in the 1770s special audit procedures were established in London in this regard, and thus both banks and customers gained significant savings. In the meantime, the turnover of cheques increased considerably, and their scope of utilization became more and more extended, so that in the 1870s most business transactions were carried out with this tool.

London banknotes did not develop in the same way, and in the 1770s most of the capital’s private banks ceased their banknote issuing activities. The reason for this was that the widespread use of London cheques had greatly reduced the demand for banknotes, while banknotes from the Bank of England were already present on the market in large numbers and became increasingly popular when cash payments were needed. The spread of private banks in the ‘countryside’ usually occurred later than in London. Before 1750 there were only a few private banks, as shown in the following list (Table 4-1). Table 4-1: Early provincial banks in the United Kingdom Year of foundation

City

Name

Today’s equivalent

1650s

Nottingham

Thomas Smith

Royal Bank of Scotland

1685

Derby

Crompton, Newton & Co.

Royal Bank of Scotland

1716

Gloucester

James Wood

Lloyds

1737

Stafford

John Stevenson

Lloyds

1743

Dover

Fector & Minet

Royal Bank of Scotland

Source: www.britishmuseum.org

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Table 4-2: The first joint-stock banks in England Year of foundation

Name of bank

Today’s equivalent

1826

Stuckey’s Bank, Somerset

NatWest

1826

Lancaster Banking Co.

NatWest

1826

Norfolk & Norwich Banking Co.

Barclays

1827

Huddersfield Banking Co.

HSBC

1827

Bradford Banking Co.

HSBC

1829

Cumberland Union Banking Co.

HSBC

Source: www.britishmuseum.org

After 1750, the growth of rural private banks was significant: for example, in 1797, 230 provincial banks operated in the island and by 1810 their number had risen to 721. By the 1820s, every major city had its own bank, which issued its own local banknotes. At the same time this pace of expansion of private banks was mainly the explanation for the increase in bankruptcies of this type of banks. For example, the Cavenagh, Browne & Bailey Bank became insolvent in 1825. The bankruptcy of local banks was a major challenge for all concerned parties, and as a result, a large number of depositors completely collapsed financially. By the decree of 1708 already mentioned, until 1826 private banks could have only six partners, so they often did not have enough resources to overcome a financial crisis. As to preventing bankruptcy of provincial banks, the Government’s response was that, from 1826 it legally permitted banks to expand their size and resources, i.e. they could be grouped into larger joint-stock companies. This meant that people as shareholders (known as owners in contemporary literature) had the possibility of creating larger banks. Table 4-2 shows the first joint-stock banks (except the Bank of England). In 1844, 442 banks operated with about 569 branch offices in the United Kingdom and these issued a total of 30.4 million pounds in the form of banknotes (Table 4-3), of which 18.1 million pounds were issued via the Bank of England. The remaining banknotes of 12.3 million pounds came from about 280 provincial banks, of which 208 were private and — 164 —

4. The First Industrial Revolution (1769—1850)

72 operated as joint-stock companies. It should be noted that not all banks issued banknotes at that time. None of the joint-stock banks issuing banknotes managed to open branches in London. Although private banks in London had the opportunity to issue their own money, they decided not to print their own banknotes. All this constituted a very complex system and eventually the corrective measures became inevitable. Table 4-3: The banking system of the United Kingdom in 1844 Type of bank

Number of banks

Sectors represented

Banknote turnover

Bank of England

£18.1 million

London private banks

London joint-stock banks

Provincial private banks

273

£5.1 million

Provincial joint-stock banks

100

441

£7.2 million

Total

442

569

£30.4 million

Source: Crick–Wadsworth (1936, 20–25).

150 years after the founding of the Bank of England, the Bank Charter Act issued in 1844 indicated that decision-makers were planning to take serious steps in order to finally put the unstable currency on more solid ground. In the area of banknote issuance, the Charter provided a formal monopoly to the bank both in England and Wales. Indeed, one of the measures associated with the Charter had already required that Scottish banks, which, although they could continue to issue their own currencies, had to cover these with Bank of England banknotes. In fact, with the entry into force of this measure, the Bank of England became the United Kingdom’s exclusive monetary authority and this agreement is still in force today.99 Undoubtedly, this was the key decision-making package that provided favourable conditions to the financial institution in the field of banknote issuance monopoly. Taking into account the unusually high inflation fluctuations of the 99

http://www.legislation.gov.uk/ukpga/Vict/7-8/32

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era, which can be attributed to unbridled banknote issuance – while the restriction period for gold reserves was still fresh in the minds of people – in the end, the law package greatly restricted the bank in the issuance of banknotes, since the newly printed money had to be strictly consistent with the growth of gold reserves. In this way, the issue of uncovered money issuance, that is, issuances independent of gold reserves, were definitively frozen at the level of the year 1844. In addition, to make the status of the currency even more transparent, the bank became obliged to compile and publish a separate report on its own money issuing activities. According to the Bank Charter Act, that is in order to regulate banknote issuance, the Bank now was divided into two departments (Emission and Banking). This organizational structure as well as the separate bookkeeping prescribed in 1844 are still in force today, nevertheless the Bank has since then been obliged to pay the profits from money issuance directly to the Treasury.100 In 1844, by adopting the Bank Charter Act, the government began an experiment that was unique to British banking history, trying to involve all banks into a single legislative and regulatory framework. However, it was also evident that they intended to remove all banknotes from the market that were not issued by the Bank of England. It took several decades to complete this complex process, and after the last money issuance by a provincial bank, the 1921 print series of Fox & Co. in Wellington, they finally succeeded in achieving the goal of introducing a unitary banknote system in England. In the 1860s, the amendments to the law on association finally allowed the banks to have limited responsibility. This meant that in the case of a bank failure shareholders could only be held accountable in accordance with the value-proportion of shares held individually. Prior to that, the bank’s shareowners assumed unlimited liability in case of bank failure (Crick–Wadsworth, 1936, 22–37). 100

ommittee for Lawsuits Minutes, 1802–1908; Committee of Treasury Minutes, C 1779–1991; Daily Account Books, 1851–1983. Source: https://www.bankofengland. co.uk/archive

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In the light of the successive bank crises – namely those of Overend and Gurney in 1866 and then Barings in 1890 – the Bank of England established the concept of ultimate lender, i.e. it became the last resort of the banking system (Kindleberger, 2006, 75–94). Experts had developed complex scenarios on how the central bank should mobilize its own and city resources and how it should intervene effectively when a particular bank was threatened by a financial crisis. As the crisis could have escalated throughout the financial system, the principle of the scenarios was that, if necessary, the central bank would routinely apply leverage over the liquidity of the entire banking system. Their use of practical and already legitimate tools had enabled them to loan financial aid packages to troubled banks when no one else was able to do so. Of course, the interest on financial aid were set in London in accordance with the levels deemed timely and with proportionality. As long as the gold standard was in effect, the choice of interest rates was very limited, that is, the bank had to set the interest rate so high that it could maintain it in exact proportions and cover its own gold stock. Later on, interest related decisions were entrusted to the bank’s own discretion, consequently the two main elements of the modern central banking system inclusively the issuing of banknotes were already in effect (Kindleberger, 2006, 75–94 and 269–284). It is a fact that in the period between 1880 and 1920 major changes (such as bank mergers) occurred in the British banking sector. In this era, the sector of British banking joint-stock companies was also significantly expanded and strengthened. The bank structure of 1884 at the beginning of the merger movement is summarized in Table 4-4.

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Table 4-4: The banking system of the United Kingdom in 1884 Type of bank

Number of banks

Sectors represented

Banknote turnover

Bank of England

£25.1 million

London private banks

London joint-stock banks

London/local joint-stock banks

517

Provincial private banks

172

433

£1.4 million

Provincial joint-stock banks

1,052

£1.5 million

Total

326

2,075

£28 million

Source: Crick–Wadsworth (1936, 29–37).

Compared to the situation of 1844, in a number of different banks there is a reduction of about 26 per cent (from 442 to 326), but at the same time there is a 264 per cent increase (from 569 to 2075) in bank related sectoral specialization. It can be stated that the range of banking services had also been significantly expanded to the public, but these activities were now performed by far fewer banks. The phenomenon of growth in bank related sectoral specialization, coupled with a decline in the number of banks, accelerated significantly in the coming decades. Chart 4-12: Five pounds banknote issued by York Union Banking Co. Ltd. in the 1870s

Source: www.britishmuseum.org

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By then, banknotes had become an additional element of money supply, although some banks continued to maintain their local turnover. The five pound denomination banknote, issued by York Union Bank Ltd. in the 1870s (Chart 4-12), is a good example of the decorative style often used by later banking joint-stock companies. Eligibility for banknote issuance, however, was no longer an essential element of banking activity, as it had been 100 years earlier. By now the banknote had been replaced by cheques as the main means of payment, especially in the business world. Starting from 1880, following the general acceptance of limited liability, several seamless bank mergers took place in the British banking world. For about four decades, complex take-over and merger processes had taken place in the banking sector, moreover bank joint-stock companies had first taken over private banks and then other joint-stock banks as well. Banking was and remains a business process that can easily respond to economies of scale, based on the principle that the bigger you are, the cheaper you can provide services, and the more competitive it will be to provide these services. The Bank of England’s ultimate creditor position during the crisis marks a significant milestone in British banking history. The significant position of the bank of issue within the financial system quickly became apparent due to the crisis. Owing to its size and gold reserves, the English bank of issue was in the most advantageous position to support small commercial banks in times of crisis, which, in the course of local financial crises, often struggled with credit losses or because of bad crops, with other serious difficulties. During the 19th century, the demand for the ultimate creditor gradually became crystallized within the increasingly intertwined money system. The principles of the still valid stabilization policy, under which financially problematic commercial banks are supported by the bank of issue with liquidity credit packages, also go back to the 19th century. They were willing to rescue only those banks that had liquidity difficulties (i.e.

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they encountered various obstacles in the field of liquidity to meet their current financial obligations), but in principle the solvency margin was still sufficient to meet the existing obligations. Nevertheless, liquidity subsidies were provided with high interest rates. The Bank of England can be considered a pioneer in this area, though the elaboration of the lender-of-last-resort policy cannot be linked to a specific date, but evolved step by step. This process started with reactions to crises in the English financial system, for example at the time of the burst of an investment bubble in the Latin American bonds of 1825 that seriously affected the railway industry in 1847, or in the so-called Overendand-Gurney crisis in 1866, during which the protection of British gold reserves came to the fore. Since financial crises inherently carry the problem of loss of confidence, the Bank of England decided to temporarily suspend the redemption of banknotes for precious metals in order to prevent banks and the public from besieging precious gold reserves. However, according to some, this measure had the opposite effect and also contributed to the aggravation of the banking crisis. This opinion gradually prevailed over time and led to a definite political shift in the time of the upcoming collapse of the Barings Bank, which caused unsustainable credit shortages throughout South America due to the Argentine bankruptcy of 1890. To prevent, in time, the hazardous domestic consequences of bankruptcy, the Bank of England took a leading role in the consortium of banks and investors in order to preserve financial stability and provided sufficient loan capital to cover the Barings’ liabilities. Within the English banking system, the financial stability implementation practice provided by the central bank proved to be an operable concept for a long time. From the middle of the 19th century to the end of 2007, which is about 150 years, no major bank failures occurred in the island area.

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Box 4-3 The emergence of the two-tier banking system

Whether there is a one-tier or two-tier banking system in a given country, there can be no modern state without a bank of issue. The development of central banking functions can be traced back for centuries, but it was only by the early 20th century that central banks themselves became institutions at the heart of the financial system. By the end of the century, their sole purpose was to ensure price stability in accordance with the theory of liberal economics, and thus their toolbox and other tasks were subordinated to this endeavour. In fact, the emergence of banks of issue dates back to the period of mass distribution of substitutes for metallic money. Some of the commercial banks were significantly strengthened through their network of contacts, thus gaining considerable privileges against their competitors, both in issuing banknotes and in lending money. However, in exchange for the privileges they gained, they usually adopted a key role in financing state budgets. The formation of a two-tier banking system can be linked to the Bank of England, namely, the bank had acquired not only the prerogative of issuing banknotes from the English state, but in the 1850s it was also entrusted with the task of assisting troubled commercial banks with additional credits in times of crisis. Thus, the bank could also appear in the role of the lender of last resort for commercial banks at risk of insolvency. The special position of central banks is often referred to as the ‘bank of banks’ (Ziegler, 1990; Capie, 1999). The two-tier banking system, in which the central bank is above commercial banks, was finally introduced in all industrialized countries during the 19th century. In fact, in this way historical progress had gradually come to pass, which meant a transition from the one-tier to the two-tier banking system within the various banking systems of continental Europe. The state monopoly gave impetus to the rapid spread of ‘banknotes’. This led to a large-scale centralization and standardization in the field of payments. State support increased trust, meaning customers believed that

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the bank of issue would always be able to pay the amount deposited in gold (or silver). Moreover, the monopoly granted by the state provided a special position for banks of issue, which allowed them to rapidly increase in size. Banks of issue usually control and influence monetary policy and the functioning of commercial banks by means of financial economic regulators (in specialized language: bank of issue instruments).

4.3.3 Parallel developments in the global banking system

Until the 1900s, there were not more than a dozen central banks around the world that were endowed by the state with a banknote and currency monopoly. During the 19th century, most industrial countries had a free market system. Even though several of the parallel operating private banks of issue printing money were allowed to enjoy certain benefits of free competition, in most cases, this situation had become a starting point for major financial and economic problems. There was a risk that the quality of banknotes would be different within a currency area as long as there were different financial risks between the issuing commercial banks.101 Secondly, the process of issuing competing banknotes was disadvantaged by the fact that most of the countries already had their own, unified national currency, significantly weakening the benefits of widely accepted, different money forms. Under free market conditions dominating in the mid-to-late 19th century, certain banknotes could still prevail, which meant that the business banks issuing the given money had in the meantime achieved some kind of monopoly status on the market, and so they were in a similar position as central banks supported by the state. In principle, serious difficulties arising from the quality differences and lack of standardization of banknotes could be overcome by correlating paper money with precious metal. Therefore, 101

I n the German language area, it was Friedrich August von Hayek, the well-known main supporter of free banking, who presented the advantages of currency competition in his work titled Denationalization of Money (’Entnationalisierung des Geldes’; http://www.gbv.de/dms/zbw/664834973.pdf) published in 1976. However, the average citizen was hardly able to have a clear picture of the quality differences mentioned above, which ultimately undermined trust in the given currency.

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for example in industrialized countries, by law the currency was bound to gold or silver. However, this carried the risk of a too rigid cash supply. If in some cases there was a risk of the payment turnover’s being exposed to seasonal fluctuations, liquidity difficulties occurred in the months of large transaction volumes, which quickly destabilized the entire financial and banking system. In this regard, the experience of the United States of America is predominant, which waited a relatively long time before establishing a central bank and centralizing its banking system. The Federal Reserve System (Fed) was only set up in 1912 after attempts to create a permanent central bank in the United States in the first half of the 19th century failed. One of the known consequences of this was the exposure to financial instability, which manifested itself in recurring bank panics. It is interesting that historically the Fed and its immediate predecessors (i.e. the Bank of North America, the First and Second USA Bank) are considered to be the first federal banks or attempts in this regard. For example, the founding of the Bank of North America in 1782 was mainly assisted by Robert Morris, the Superintendent of Finance, whom Thomas Goddard dubbed the father of the system of credit and paper circulation in the United States. As the ratification of the Federal Charter at the beginning of 1781 extended the sovereign power of issuance of credit tickets to Congress, an emergency regulation was also issued in the very same year that modelled on the Bank of England stated that a privately owned national bank should be included as the leader of the system. At the same time, however, due to ‘alarming foreign influence and fictitious borrowing’, that is, the excessive favouritism of foreign investments and the unfair politics against less corrupt state banks, which had their own right to issue banknotes, the Bank of North America had failed to realize its purpose as a national bank. Thus, in 1785, Pennsylvania’s legislation abolished the charter of the Bank and deprived it of its right to operate within the Commonwealth. By the end of the 1700s, the main tasks of the First Bank of the United States included the collection of government financing and taxes.102 In America, the Federal Reserve Act was born in 1913, which was based on European regulatory 102

or the history of First and Second Bank of the United States, see subchapters 5.3.3 F and 5.3.4.

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models, and the Federal Reserve System was completed in 1935. Under the scheme, only the Federal Reserve Bank could be engaged in money issuance, state guarantee operations, government security issuance and deposit insurance. This era was characterized by a strong central power, where appointments were mainly dominated by the governor of the Fed. Later, after the Second World War, the US Federal Reserve Bank started implementing a financial strategy based on the reserve ratio, moreover, the regulation of anti-monopoly and competition policy was also its responsibility.103 It is a fact that in the United States the period between 1837 and 1862 was the era of free banking. Then the period between 1863 and 1913 was the time of consolidation of American national banks, since the National Bank Act of 1863 (implemented by Hugh McCulloch; Chart 4-13), in addition to regulating loans provided by efforts made in the Union, it also contained other central regulations in the Civil War, as is apparent from the following list. • Creation of the system of national banks. They now had to have higher standards regarding reserves and business practices. Recent research suggests that state monopoly banks had the lowest long run survival rates.104 The first American bank supervision office (The Office of Comptroller of the Currency) was set up to control these banks. • Creating a single national currency. To achieve this, every national bank was required to recognize each other’s currencies on the basis of nominal value and in a mutual way. In the event of a possible bank default, this measure actually eliminated the risk of loss. Banknotes had already been printed by the Comptroller of the Currency in order to better ensure uniform quality and to prevent counterfeiting. • With regard to the financing of wars, national banks had been required to secure their banknotes with adequate treasury cover. indleberger, 2006, 364–371 and https://www.minneapolisfed.org/community/ K student-resources/central-bank-history/history-of-central-banking, and see Subchapter 5.3. 104 https://www.minneapolisfed.org/research/wp/wp642.pdf 103

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All of these measures can be interpreted as the forerunners of the actual US central federal system, and greatly facilitated the formation of the Fed (1907–1913), and when it happened in 1935, its late completion was going in the direction of a bank of issue compared to the European central systems. Chart 4-13: Hugh McCulloch (1808–1895), the successful implementer of the National Bank Act of 1863

Source: media1.britannica.com

Scotland, Chile and Switzerland were, for example, countries that maintained the banking free market system for a relatively long time. Despite all the obvious benefits offered by a central bank in the field of efficient and stable cash flow, in the circles advocating free banking, deep, widespread scepticism has prevailed right up to the present against this level of consolidation of state power. Ultimately, the benefits of a uniformly and centrally issued payment instrument have actually predominated everywhere. Currently, in the vast majority of countries, there is a central bank with the privilege of issuing national currency via the bank of issue. According to the Bank for International — 175 —

Banks in history: innovations and crises

Settlements (BIS), there are currently around 200 central banks and/ or banks of issue worldwide.105 Moreover, the few countries having no central bank, do not operate within a free banking system frame, but are either organized on the basis of a planned economy, or have simply conjoined with other countries in monetary matters. So in fact, only a few remnants of the free banking system have been able to survive strong centralization processes. For example, the Clydesdale Bank in Scotland and The Hongkong and Shanghai Banking Corporation (HSBC) in Hong Kong were issuing their own banknotes already since their foundation. However, these commercial banks are by no means considered to be completely free or independent in the field of money issuance, as they also have had to comply by complex negotiations with the strict guidelines of a certain stronger central bank. Box 4-4 The classic era of gold standard and the further diffusion of central banks

Already in the ancient world the value of monetary units was expressed in precious metals. In European cultures, until the introduction of banknotes major transactions with gold coins were frequent. However, for smaller amounts covering daily demands, depending on the region, people used silver or copper coins in payment transactions. The so-called bimetallism in which gold and silver performed money functions at the same time existed for a relatively long time (until the 20th century). In this regard, one of the outstanding examples of the 19th century was the Latin Coin Union, which was created among France, Belgium, Italy, Switzerland and Greece. According to this standard, two 5 franc coins represented 45 grams of fine silver and a 10 franc coin corresponded to 2.9 grams of fine gold. On this basis, the official gold-to-silver price ratio was (approximately) 15.5 to 1. This could be calculated as follows: 45 g of silver was divided by 2.9 g of gold and the result was 45/2.9 ≈ 15.5. In the case of bimetallism, therefore, the conversion ratio between gold and 105

https://www.bis.org/cbanks.htm

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4. The First Industrial Revolution (1769—1850)

silver was formally determined. However, this definition could mean difficulties if there were significant discrepancies between the supply of precious metals and the demand for the given precious metals used for reserve maintenance. In the one-tier banking system, the liquidity ratio is the ratio between the amount of gold to be retained by the bank and the claims against the bank: if attempts are made to mass exchange gold, some of banks will collapse. In the non-monetary area, under Gresham’s law, the more valuable of the two precious metals can be deprived of its monetary function.106 As the relative price between gold and silver deviates from the official ratio, in the case of bimetallic currencies there is always a risk that, according to the Gresham’s law, ‘bad money will displace good money’. In addition, in the United States and in the Far-Eastern Cultural Sphere107 there were also parallel metallic currencies in circulation. From an economical and historical perspective, the bimetallic money system had the greatest impact in the United States, in the late 19th century, since both gold and silver were mined in great quantities in this country alone. It can be seen that this type of money system was not stable and was prone to crisis, as the market price of precious metals was greatly influenced by the rate and pace of production. At the same time, under Gresham’s law, precious metal-containing coins with a market value exceeding the nominal value were periodically taken out of circulation and were used as precious metals. This was the case in the United States at the end of the 19th century, whereby the bimetallic money system became virtually silver-based, as California silver production jumped, resulting in a significant drop in the price of silver. The following Chart (Chart 4-14) clearly shows the prices of gold and silver in dollars between 1792 and 2010. The expression ‘gold standard’ refers to the money system that was particularly characteristic of the financial world in the second half of the 19th century and early in the 20th century. The international victor of homas Gresham [1519–1579] was an adviser to Queen Elizabeth I of England, and T also the founder of the Royal Exchange in London. 107 In the Far-Eastern Cultural Sphere, copper and silver coins of the Chinese monetary system dominated even in the 20th century. 106

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gold-covered currency was primarily based on the global dominance of the British pound, which had been formally linked to gold at its latest since the end of the Napoleonic wars. This monetary system had been successfully distributed by the British colonial and industrial power around the world. The Sterling Area was a zone of relative stability of exchange rates but not a monetary union and it did not have a single central bank. Between 1870 and 1914 there existed a fixed gold ounce price that was three pounds, 17 shillings and nine pence. The English pound was the most important currency and all other countries adapted to this. The period from the 1870s to the outbreak of the First World War, is known as the era of classical gold standard, the most important characteristic of which was determining the official value of a currency in gold units. For example, the gold equivalent (so-called monetary standard) of the English pound was 7.32 g, while one US dollar equalled 1.5046 g of fine gold. Chart 4-14: The exchange rate of gold and silver 1,800

USD/oz

USD/oz 1979 silver speculation

1,600 1,400 1,200

1973 permit gold trading

1,000 800 600

EU sovereign debt crisis

40 35

Increasing demand for ‘safe haven’ assets

1971 Nixon shock

400

30 25 20 15 10 5

1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017

200

Gold exchange rate Silver exchange rate (right-hand scale) Source: Bloomberg.

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4. The First Industrial Revolution (1769—1850)

The main task of the central bank was to secure the fixed gold price. This was achieved by the obligation to return the gold, which meant that issued banknotes could be exchanged for a certain amount of gold at any time based on the current official gold price. In the free banking system this task was performed by money-issuing business banks. As long as the said commitment was completed through the issuing banks, the relevant currency was convertible. Also, the money system based on gold parity implicitly defined a fixed currency exchange rate. Thus, with the gold content of the above-mentioned example, the parity exchange rate is as follows: 7.32 g gold per pound/1.5046 g gold per dollar ≈ $4.866 per pound. Any possible differences between the current currency exchange rate and gold parity had created an opportunity to exploit the price difference, which means that speculators made use of differences in current official gold prices in different countries to gain easy profits. For example, a rate of 5 would encourage us to buy five dollars with a pound, which could be exchanged in the USA for 5 × 1.5046 g = 7.523 g of gold, which in England would already have a value of 7.523/7.32 ≈ 1.03 pounds. Thus, through such arbitrage, 1 pound could simply be ‘propagated’ by 3 per cent. However, the international differences between gold-based currencies could not last long, as, for example, according to the transaction model outlined above, demand for the dollar would increase and the exchange rate would return to around the official parity. However, the presentation so far is somewhat simplified as it neglects the costs and dangers that arise during cross-border transportation of gold. In practice, this meant that an exchange rate could have shifted to a certain extent from parity, but without the gold transactions occurring immediately. Nevertheless, in those days the differences were at most a few per cent, so compared to the fluctuations of the present system, contrary to its much more flexible rates, in fact, these seem to be clear exchange rate changes. For a country to belong to the gold standard system, it had to have enough gold reserves. Otherwise, should the occasion arise, exchanging a determined amount of currency for a fixed amount of gold would not have been feasible. This did not necessarily require a central bank because, in principle, note-issuing commercial banks could also be legally obliged

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to perform gold parity-based exchanges. Coupling the currency with gold or other precious metals and fixing the monetary standard excluded the possibility that the amount of paper money might be increased without limit and the value of currency might deteriorate completely. In contrast with the disadvantages of the free banking system, it is noteworthy that the existence of a central bank has some advantages, for example, in terms of providing money and centrally securing the gold reserves of the country as well as creating qualitatively uniform banknotes. It is, therefore, not surprising that the upsurge in the founding of central banks around the 1900s brought about a system-level quality improvement of the gold standard. Moreover, it is no coincidence that the central banks of the United States of America, Australia, South Africa, New Zealand or India, which have been established for this purpose, are also referred to as Reserve Banks to this day. To keep gold parity sustainable in the long run, serious imbalances in foreign trade were to be avoided. For example, an export surplus might indicate that a country’s financial receivables from the export of goods outweigh the obligations arising from imports. The resulting outflow of funds becomes temporarily coverable by private loans for foreign countries. The issuance of short-term commercial credits by bills of exchange was widespread under the gold standard. However, lasting export surplus could lead to the swelling of foreign exchange reserves as the many bills of exchange of monetary transactions were transferred to the central bank’s balance sheet. During the 19th century, this was particularly characteristic of the United Kingdom, which, as a result of industrialisation, became the world champion of exports and the centre of international lending. Of course, in a global context, there must always be countries that have an import surplus. In the era of the classical gold standard, these were partly colonies in Asia and Africa, and most of South America, which wanted to build a domestic economy with the help of foreign capital. However, the surplus of imports has mostly had a negative impact on international capital movements and the gold reserves of these countries. The dwindling of gold reserves made it more difficult to maintain fixed exchange rates for these central banks (Richards, 1929, 7–191 and 201–299).

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4.3.4 Discount policy, or the predecessor of modern base rate and the disadvantages of gold standard

However, the volume of international gold transactions covered only a fraction of cross-border trade. Especially at the time of the climax of the classic gold standard most foreign financing was provided by investment and commercial loans, which achieved a volume that the world could only experience again a century later (Obstfeld–Taylor, 2004, Chapter 2). The first wave of globalisation of international trade and capital movements in the 1900s raises the question of how central banks, while limiting the gold standard, were able to maintain gold parity for decades. It has already been said that the surplus of imports actually involves the outflow of gold (or drainage, to use a contemporary English term). The long-term drainage of gold reserves in a country would have prevented compliance with the obligation to make the exchange for gold possible, which would have led to serious tensions in the given monetary system.108 It turned out, however, that due to interest rate adjustments, central banks had an effective weapon in their hands against speculators involved in gold-exhaustion activities. A central bank was able to raise interest rates in order to make investments more attractive in a country and thus it could counterbalance the high capital outflow and the resulting pressure on gold reserves. The interest rates were influenced by the rediscounting of the bills of exchange, which meant the sale of securities to the central bank against a discount rate. Thus, through the discount rate it was possible to control one of the most important financial market instruments of the time: the interest rate. From the middle of the 19th century, the Bank of England began to actively use discount policy and thus it could influence the economy through a base rate that ultimately proved to be the most important tool of modern monetary policy.

108

ersons dealing with the withdrawal of gold had earned the same bad reputation P at the time as foreign currency speculators today.

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Banks in history: innovations and crises

The gold standard to this day has been surrounded by a sense of nostalgia. Regardless of whether a currency is supplied in the form of a gold coin or a gold-based banknote, its connection to a precious metal gives some value stability to the money. As long as the rules of the gold standard were respected, it was indeed impossible to expand the money supply in unlimited quantities, and thus, for example, not even general government deficit could be solved by simple cash printing strategies. In this way, larger ‘abuses’ could be avoided, which could have resulted from a problematic relationship between monetary and fiscal policies. The dogma, according to which the most important task of the central bank is to maintain the stability of the exchange rate, comes from the era of the gold standard. At the same time, it is obvious that the gold standard also had significant disadvantages which eventually led to the collapse of the system during the 20th century. In addition to the inflexibility already discussed, it is a further disadvantage that, in order to balance seasonal fluctuations in money supply, maintaining parity became, in fact, a major priority of gold-based monetary policy. In the era of the Classic Gold Standards, this meant that a central bank had to comply with the rules of the game, according to which, in the event of large gold outflows, regardless of the conjunctural situation or even inflationary risks prevailing in a country, the discount rate had to be raised anyway. The price level below the classical gold standard remained relatively stable, and in the long run even a slight decrease could be observed. For example, in the late 19th century, in the United States a deflationary trend dominated for nearly two decades. However, negative inflation may prolong recessions if consumers postpone their purchases in the hope that prices will soon be lower again. Therefore, the above mentioned deflationary phase had in fact continued, causing political tensions and ultimately led to the questioning of the gold standard in the United States. Thus, it is not surprising that the most important topics of the 1896 presidential election campaign were primarily about the advantages and disadvantages of the gold standard. Deflation hit farmers in the West and the South particularly hard, while for the northeast financial sector it also offered advantages, since the real value of incomes — 182 —

4. The First Industrial Revolution (1769—1850)

from credit transactions had in the meantime increased significantly. As a result, William Jennings Bryan, who had argued for the lifting of the gold standard, was nominated for the Western and Southern parts of the country, while William McKinley, who had chosen monetary continuity as a political goal (and won the elections), was largely supported by the votes of citizens living in the east (Mankiw, 2011, 129–141). At the time of the gold standard, permanent deflation always occurred when gold mining did not keep pace with economic growth. In fact, the increased quantity of goods, in comparison with the more or less fixed quantity of gold globally, could only produce a decline in the general price level. This usually also meant that the amount of newly mined gold determined the amount of money and ultimately the price level. The inherent weakness of the precious metals-backed currency system is that changes in the money supply depends on mining discoveries and technology changes that have nothing to do with optimal monetary policy. Thus, discovery of major gold deposits, such as around 1850 in California or around 1900 in Canada, Australia and South Africa, resulted in inflationary pressures due to the gold standard operating mechanism. Unpredictable fluctuations in prices were another problem in a monetary policy that was not consistent with price stability. It can be observed that particularly in the 19th century there were successive alternating irregular periods, when sometimes inflation, and at other times deflation dominated. For this reason, most of the working-class suffered, often those with modest and fixed wage incomes, practically unprotected against the consequences of price fluctuations. In particular, the years with high inflation meant a real decline in purchasing power for workers, which in some years exceeded 10 per cent. Of course, the stability-enhancing elements of gold currencies were only valid if the relevant rules of the game were complied with. Particularly during war, most countries temporarily withdrew the convertibility of their currency so that they could cover increased military spending through the central banks. The approximately 30 per cent inflation in the wake of the Napoleonic wars around 1800 in the United Kingdom, for example,

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was due to the abolition of gold convertibility in 1797. It had taken several decades for Great Britain to return to the gold standard. Chart 4-15 shows the United Kingdom’s price index from 1750 to 2001, which clearly indicates the relevant economic history changes discussed above. Chart 4-15: The United Kingdom’s inflation index between 1750 and 2001 1,000

Log scale

100

1,000

100 WW2 WW1

Napoleonic wars

1750 1759 1768 1777 1786 1795 1804 1813 1822 1831 1840 1849 1858 1867 1876 1885 1894 1903 1912 1921 1930 1939 1948 1957 1966 1975 1984 1993 2001

Inflation index Source: monevator.com

From the Chart, it can be easily seen how prices had fluctuated for almost 200 years in the United Kingdom; all this was largely influenced by the effects of good and bad crops and war periods. In the course of conflicts, the lack of resources and the substantial increase in money supply led to sharp price increases. It can be seen that, after the Napoleonic wars and World War I, there were periods when prices declined again to some extent. However, the price level did not decrease after World War II, but the prices went a different course and were constantly moving up in the United Kingdom. — 184 —

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Box 4-5 Agricultural cooperative model on Crédit Agricole’s example

In France during the 19th century, farmers did not have the possibility to borrow. Therefore, both in France and Germany, enlightened thinkers set up cooperative societies for the purpose of financing agriculture, which were managed by the farmers themselves. Thus, the Crédit Agricole was born from the idea of mutual assistance and solidarity. A French law adopted on 24 March 1884, established professional freedom of association. In the same year, the Poligny agricultural cooperative was established, which is one of the earliest foundations of this type in France. Louis Milcent (1846–1918) lived for a long time in Vaux-sur-Poligny (Jura), where he was Auditor of the State Council. Milcent was considered to be the initiator of Crédit Agricole and he founded its first headquarters. The financial professional was an active participant in the development of social Catholicism and also monitored the organization of Raiffeisen credit institutions in Germany. For example, in La Wantzenau (Alsace), a Raiffeisen credit union was opened in 1882. On 17 November 1884, Milcent made the following comment: ‘If the farmer goes to the clerk or the banker, the interest charged on his credit will be too high, so he does not go there. In order for the honest, diligent, reliable farmer to have the adequate capital, a cooperative based on mutual lending should be created.’109 On 17 November 1884, at the Salins-les-Bains meeting, 72 farmers initiated the establishment of the first local cooperative. In the same city of East France on 25 January 1885, the headquarters of the first Crédit Agricole cooperative was officially opened. Salins is located in the Jura department. The Jura region has always been the cradle of reciprocitybased co-operation in France. Even in texts dating from the 13th century there are references to reciprocal association forms of fruit, cheese and wine producers. For example, at the beginning of the 13th century, local fruit growers collected milk to make gruyère cheese in Jura and Franche-Comté.110 109 110

http://www.ca-fondationpaysdefrance.org/ http://journals.openedition.org/rga/2785

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Alfred Bouvet was the first president of the Crédit Agricole cooperative in Salins. The regional headquarters of the Bourgogne Franche-Comté Mutual Agricultural Credit Cooperative was established in 1890. The idea of independent lending structures based on local solidarity was rapidly widespread, and by 1898 more than 300 agricultural cooperative credit institution headquarters had been established in different parts of France, all of which were organized on the basis of the first model in Poligny. The ‘Méline’ Act, adopted on 6 November 1884, envisaged the protectionist style defence of agriculture, and from that time microcredit was also promoted in this sector. Loans were realized through solidarity, including short-term loans and grain loans, as well as medium- and long-term loans for the purchase of agricultural equipment. Meanwhile, the Crédit Agricole’s lending activity had significantly been expanded in the French and European financial markets as well. The first Crédit Agricole headquarters was in Salins (Chart 4-16). Although the original bank branch moved away, the historic part of the building remained intact and is nowadays one of the special tourist attractions of the Jura region and the salt region. Chart 4-16: The first Crédit Agricole headquarters in Salins

Source: larbredesbinoche.wordpress.com

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This is how the history of Crédit Agricole SA began, which has now become the third largest bank in France behind BNP Paribas and Société Générale. Nowadays, Crédit Agricole SA has 21,000 cooperative enterprises in France and about 1 million employees. According to data from 2017, the bank’s turnover is nearly 9 billion euros and its annual profit is over 1.7 billion euros.111 It is a fact that centuries-old organizational forms of agriculture and solidarity-based mixed lending types (also microcredit itself), that is, agricultural cooperatives played a role in the successful development of various European large-scale areas during industrialisation. The list of different cooperative models is very long, so here are just a few examples: Crédit Agricole in France; Raiffeisen in Germany; traditional (farmer economy-based) cooperative models of Denmark and the Netherlands; spontaneously created consumption cooperatives for the organization of better and cheaper supply in the commercial centres of Southern England and in Scottish industrial cities. In Hungary and in our region the Hangya Cooperative represented and extended the lending and production model that in Transylvania, under German influence, already appeared as an island-like effect in the middle of the 19th century. In conclusion, it can be pointed out that the prevalence of cooperatives within a national economy is also a kind of indicator regarding the social capital level, in particular the capital stock of the social cooperation or trust.

4.3.5 Contributions to the history of one-tier and two-tier banking systems

Based on the above, it can be stated that real money in the gold money system is the gold coin and this is money independent of banks. The entire money system basically rests on gold, but banks as independent institutions through their credit operations create money substitutes 111

https://www.Creditagricole.Info/fnca/esn_5066/histoire

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and absorb them by means of loan recovery. In the case of this type of banking system, we are speaking about free banking, which is a special case of the one-tier banking system. In the free banking system, the liquidity ratio is the ratio between the amount of gold to be retained by the bank and the claims against the bank. If customers make attempts for a mass exchange for gold, some of the banks are likely to quickly go bankrupt. Therefore, the relatively stable financial position of the economy forces public intervention. Because of this, that is by putting the centralization of the national banking system into practice, the central bank with a monopoly on banknote issuance gradually evolved. The one-tier banking system was later established, the other version being characteristic of the limited market-based economies or those strongly centralized, not operating under market economy conditions. This kind of system was much more prevalent before the 1990s than it is today. Its typical examples were developed in socialist countries, where the centrally planned economic system was served by this type of highly centralized or rather centrally monitored and strictly controlled model. Factories and other economic operators were running their only bank account at the central bank, accordingly every movement of money could be traced precisely in a single central institution. Nevertheless, the central bank decided on the granting of loans and could also check the use of the money. In Hungary, the banking system, based on the Soviet pattern in socialist countries, was characterized by the one-tier system between 1948 and 1986, which was transformed into the two-tier system on 1 January 1987. From then on, the central bank, i.e. the Magyar Nemzeti Bank (MNB), could only be in contact with commercial banks and not allowed to carry out specific banking activities for companies. The two-tier banking system is differentiated from the one-tier system in that the central bank is not directly in contact with non-banking business entities. At the top level of the system is the central bank itself which has no direct business banking functions, therefore, we cannot speak of a specifically profit oriented institution. The bottom line — 188 —

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consists of private banks or commercial banks. Thus, the central bank acts as a bank of banks and so has the potential to exercise supervision over commercial banks in some areas. In this system, the central bank has only limited money transactions with the public finance organs. In addition to cash issuance and keeping money in circulation, the bank’s key tasks include ensuring the value of the country’s currency and, at the same time, regulating cash flow. This is achieved through various strategic tools such as monetary policy, inflation control and exchange rate stability. It can be stated that the central bank has a prominent role in the two-tier banking system. Like the one-tier system typical of socialist countries, in this banking system banknotes as legal tender can only be issued by the central bank. Due to the introduction of the two-tier banking system, banknotes can be exchanged for gold only by the central bank. However, an individual cannot directly claim credit from the central bank, only banks. This is done in a credit agreement framework and at an agreed interest rate in accordance with the applicable legal norms.

4.3.6 Quantitative money theory

The foundations of quantitative money theory were established in the second half of the 16th century. Historical background is the discovery of the American continent, which resulted in the disappearance of Europe’s shortage of gold, moreover, in the meantime, an oversupply developed, which led to a rapid inflation of the precious metal. In the modern age, some monetary issues had been discussed more or less continuously since the 16th century. In these debates, an approach that was commonly referred to as ‘quantitative money theory’ usually played a central role. For more than two centuries, quantitative money theory has been the theory of general price level behaviour, according to which the cause of price level change is primarily (but not exclusively) the change in money quantity. To be scientifically justified, there are two things to prove: firstly, whether there really is a direct proportionality between money and prices, allowing the effects of other specified — 189 —

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variables; secondly, whether it is really possible to show the causal relationship between money and price level change. The name of the theory is a shortened form of the expression ‘money quantity theory of the purchasing power of money’, but it is noteworthy that it was not used in this form at all until the end of the 19th century. At the same time, these basic elements are reflected in Jean Bodin’s works on Europe’s financial deterioration following the Spanish conquest of Central and South America, while the more complex presentation of the problem was published by David Hume in 1752. Hume’s writing was also the result of an inflationary period, more precisely the ‘Mississippi Bubble’, and since then whenever an inflationary period took place, the debate on quantitative money theory became current again and again. One type of the theory – several aspects of which Hume would likely approve – is a central element of the theory system which became known as ‘monetarism’.112 The creation and history of quantitative money theory cannot be examined even briefly without the spectator being surprised by the dominant themes that have been constantly involved during the course of time, that for more than two hundred years to the present economists have been unable to answer precisely its key questions. However, it is certainly unrealistic that a thesis disputed over centuries would not change over the years, and that is exactly the case with quantitative money theory. The continuity of the theory is also noteworthy, and if we want to illuminate this aspect, it is worthwhile to start the history of the theory in the middle, that is from before the First World War. By that time, it was already defined by mathematical terms, and at the same time it was well-known by its present name. There existed two more widespread forms, and the more widely known (of that time) was expressed succinctly by Irving Fisher in his work entitled ‘Purchasing Power of Money’ (1911). Compared to this, perhaps David Hume mathematically

112

I t can, therefore, be stated that the debate of monetarists with the Keynesians about the inflation of the 1970s was, in many respects, simply a new round of centuriesold exchange of views.

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made a somewhat less precise definition of quantitative money theory in 1752. By 1911, quantitative money theory was deep in its second century of existence. If we examine the continuity between today’s ‘monetarism’ and the tradition of quantitative money theory, we should reference the Cambridge version of the theory, which is also a result of the period before World War I. This kind of approach utilized the system of demand and supply and claimed that if in an economy the quantity of money is given, its purchasing power depends on how much money the economy wants to hold. Pigou, one of the leading developers of the Cambridge approach, pointed out in 1917 that if there is a firm link between the real national income and the volume of transactions in the economy, there must also be a solid connection between Fisher’s money rotation speed and the Cambridge income rotation speed. Further, referring to Fisher, Pigou stated: ‘It is thus evident that there is no conflict between my (Cambridge) formula and that embodied in the quantity theory.’113 It is clear that, although there was no contradiction between them, the Cambridge version of quantitative money theory was more manageable (as Pigou also noted): on the one hand, because national income is much easier to measure than the number of transactions, and on the other hand, because price indices associated with national income are also easier to compile than those associated with transactions. According to this, the quantitative money theory formulated in Cambridge remained viable. The right side of the latter equality is the nominal value of national income. There is therefore a direct correlation between this version of quantitative theory and Milton Friedman’s assertion that there is a consistent, albeit not exact, relationship between money growth rate and national income growth rate both in the long and the short run. If the amount of money grows rapidly, then national income does too, and vice versa. 113

igou, Arthur C. [1917] 1952. ‘The Value of Money’, reprinted in Readings in P Monetary Theory. London: Allen & Unwin, 174

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The Friedman version of the central statement of monetarism, that is, ‘inflation is always and everywhere a monetary phenomenon’, can also be deduced directly from quantitative money theory.114 Finally, the continuity between Friedman’s monetarism and quantitative money theory is even more apparent from another statement that ‘real aggregate output is independent of interest rates’.115 Box 4-6 The process of making money and the importance of interest

The first step in making money begins at central banks and, with the help of leverage, it comes to commercial banks in the form of scriptural money. There are basically two ways to make money, irrespective of whether the banking system is one-tier or two-tier and whether it is done by a central bank or a commercial bank. These are the two modes: firstly lending, including loans in the form of securities purchase, in addition to direct lending; secondly, the purchase of foreign currency (foreign bills, foreign exchange), but it is an important factor that foreign currency is not officially considered to be domestic currency. Cash (banknotes and coins) and scriptural money (bank account money) are the technical forms of today’s modern money and one of their main features is that they can be converted into one another at any time. Scriptural money can be both central bank money and commercial bank money, however cash cannot be created by commercial banks, but only scriptural money. Generally, in the two-tier banking system, the central bank is primarily the budget bank and the bank of other domestic credit institutions, while commercial banks make up the part of the cash flow of the economic sector in the form of scriptural money. It is not a money-making process if the bank rearranges its assets, i.e. it buys or sells securities in exchange for foreign currency. Money is similar in nature to its creation, but can be eliminated in reverse transactions, and there are also two ways to do so: a) the sale of foreign currency, i.e. foreign bills, foreign exchange, and b) the repayment of a loan, including the sale of bank securities (for example, treasury bills), 114 115

isher, 1911, 32 F Fisher, 1911, 31

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in addition to direct loan repayment. Credit mechanism is of a circular nature, i.e. banks typically redirect money into the economy through loans (for example, current asset loans) to companies, and from there, money is transferred to additional sectors (e.g. the public, budget, etc.). Thus, each time the borrowing company sells its goods, it repays the borrowed money out of the money returned to it and the money will cease to rotate when it returns to the lending bank. Nevertheless, money at any stage of its circulation can get stuck with any of the money holders, even for a longer period of time, for example in the form of personal savings. A particular case of credit money creation is when the bank transfers money to the economy through a loan, not for companies but for the budget. In this case, there is no automatic guarantee for the withdrawal of cash from the money market, as government debt levels show an increasing tendency worldwide. In addition, loans to the budget only formally have a maturity date and the source of redemption and interest payment is often due to the recruitment of new loans. Thus, during the creation of money, the bank acquires assets which, in return, give rise to a claim on its own, which can be paid within the scope of its own clients. For example, some banks can make money through lending, precisely because they keep an account ‘simultaneously’ for several clients connected in a networked manner. It should be noted that not in all economies can central bank and commercial banking functions be separated. For example, in the one-tier banking system, a single bank in a merged way and at the same time fills both the role of the central bank responsible for the money supply of the economy, as well as the roles of the commercial banks operating the cash flow and credit supply of companies. Money was inherently commodity money and, under the terms of the above, it can be stated that money emerging from the 19th century has been nothing more than credit money. It is a bank liability that can perform the functions of accumulation (savings), payment and medium of exchange. Based on the above, it is clear that commercial banks act as catalysts and multipliers for money to reach us. For this reason, commercial banks

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need to receive financing from the central bank, i.e. they need credit at an interest rate because only in this way can they get ‘fresh’ money. Commercial banks are also obliged to repay the borrowed debt with the interest rates, but due to the operating formulas of the interest rates and compound interest this is, in fact, not feasible in full, that is, for the entire system. In particular, compound interest is a phenomenon which, although at first sight seems easy and logical, nevertheless, in its entirety it is often very difficult to imagine its operation. In short, it could be said that interest is like an insignificant ‘brook’ that can swell and become a river at any moment, namely when it accumulates into compound interest. So why does interest exist and where does it originate from? The history of interest rates is very long, and although among the best-known religions in the world, interest was referred to as ‘usury’, a word with a negative tone, and it was forbidden to deal with such financial transactions, yet it became widespread around the world. Interest was only created by introducing money as a simplified medium of exchange. Previously, goods (exchange of products) were exchanged directly. Due to the introduction and spread of money, kings and emperors were faced with a real dilemma, as most people preferred to hold the money with them and usually accumulate it. As a result, one of the most important elements, that is, money was missing from the economic cycle. Due to the moderate flow rate of money, consumption was low and not only revenues decreased significantly, but work was also less and less. It was necessary to find an effective solution that would bring money back into the economic cycle, and it seemed that interest was the right answer to the difficulties at that time. Therefore, people were offered the opportunity to invest their money, that is, to make it available to someone else; of course, all of this happened against financial compensation (interest). Thus, money began to flow back into the economy. Meanwhile, banks started using another method: since (at the latest, with the introduction of fiat money – money without internal value) they had the ability to create money (more precisely demand for money), they demanded more money than the borrower had received for the loan issued. Thus, the borrower was forced to work faster with the

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money borrowed than his fellowmen who had not applied for credit, to be able to repay the loan, of course, with interest as soon as possible (by the end of the year). Interest through the mechanism of compound interest gradually accumulated enormously. The operating principle can be quickly explained. As its name implies, it is a result of reinvesting an amount of money already increased by interest. Let us use an example of a loan that is not repaid, and its interest is not repaid either. In this case, after the first credit period, the debt to the bank is 105 euros. In the second period, however, 5 per cent interest is reported on the new debt stock, i.e. 5 per cent of 105 euros is equal to 5.25 euros. However, not only the 5 per cent of borrowed money is added to the debt but also the additional 5 per cent for interest. Thus, in the second period, the amount of debt is already 110.25 euros and in the third period 115.7625 euros, etc. Based on the above, it can be stated even in historical perspectives that interest, which in a broader sense encompasses all other types of yields, has in fact a central role in today’s monetary systems. It should also be added that, depending on regions, countries and historical periods, the interest mechanisms themselves were very different, but today more and more consolidation (introduction of bank mergers and standards) is the main trend. Interest and lending itself go hand in hand with money-making processes. However, money-making (= lending) against interest in its defective processes can lead to significant distortions of the entire financial system. In many cases, debts are difficult to repay (compound interest, credit trap). In addition, if interest is used to yield interest, then in an instant it will be transformed into compound interest over the system. Once, Mayer Amschel Rothschild called this mechanism the eighth miracle of the world. In fact, it includes both exponential growth and monetary assets, as well as debt. It can be seen that compound interest at the system level involves serious risks, but can individually greatly accelerate the path to financial freedom.

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4.4 The development of the English and the Scottish banking system, the causes and consequences of certain crises 4.4.1 The challenges of industrialisation and the changing face of the United Kingdom

Indeed, the (First) Industrial Revolution can be interpreted as a qualitative change of the technical basis of production, that is, the first or classical industrial revolution can be grasped as a complex economic history process leading from the manufacturer to factories as well. The process lasted between 1780 and 1860 and started out from England, and then spread to other parts of Europe. Local industries such as glassware, ceramics and rope manufacturing, as well as long-standing charcoal trade and shipbuilding, created a new boost in the north-eastern region. At the same time, the population had grown considerably at trading points, and cities became increasingly dominant. Bristol had a significant role in the economic well-being of the period. Since its inception, the city had been an important trading port and a shipbuilding centre and had been greatly benefiting from the slave trade. Shipbuilding industry and maritime trade remained key to the development of the city during the 19th century. The industrial and economic development brought about by the industrial revolution had caused significant social changes in the United Kingdom. Industrialisation resulted in explosive growth of the population and the phenomenon of urbanization, as more and more people moved to urban centres because of job search. Some had become very rich, but some were trying to survive in terrible conditions from day to day. Wealthy craftsmen, ship owners, and merchants dominated the economy by gaining wealth, but at the same time, the working class had to make do with a minimum of comfort and lived mostly in an overcrowded environment. Children were sent to work in factories where they were

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exploited. Women had also experienced significant changes in their way of life as they had been working in domestic services or in the textile industry, so leaving farming they spent much less time at home in the family environment than before. This period also brought about the creation of a middle class that could enjoy the benefits of new prosperity in different ways. People started to spend their leisure time in entertainment, so in some cities theatres and concert halls were jam packed. Thus, the entertainment industry started to evolve, while sports facilities played an increasingly important role in people’s lives and those who could do so, on weekends or during their holiday, favoured the tranquillity of the countryside over the noise of the city. However, one of the most important impacts was that 19th century Great Britain experienced significant political and social unrest as the country’s industrialisation and urbanization necessitated deep social and political changes. There was a growing demand for social welfare, education development, expansion of labour and political rights, changes in the electoral system, equality and the abolition of the slave trade. As a result, in 1807, the slave trade was legally abolished and the ‘Great Reform Law’ was approved by Parliament in 1832. Following the adoption of the reform law, cities such as Birmingham and Manchester were for the first time represented in parliament, so the nature of parliamentary policy changed significantly. It can be seen that industrialisation had brought about fundamental changes in English lifestyles. Scientific innovations and technological developments had contributed to the development of agriculture, industry, shipping and trade, the transformation of the financial system and the expansion of the economy. Due to the growth of capital and the demand for credit, banks were flourishing not only in London but also in the countryside. Craftsmen, shipbuilders, merchants and other private producers established several new provincial banks that issued their own paper money in the form of bills of exchange and various

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invoice certificates.116 New borrowings and the intensive intermediation of banks were greatly needed primarily for the payment of workers and the purchase of raw materials (Mingay, 1986, 19–229). Some improvements in the development of the English banking system, the Bank of England, and some features of the 19th century English banking system were already discussed in Subchapter 4.3.2. Below, we present some Scottish and English bank crises.

4.4.2 The beginnings of the development of the Scottish banking system and the 1772 crisis

During the examination of banking systems, it is worth highlighting Scotland because its development is unique from the perspective of bank history. The origins of the Scottish banking system can be traced back to the Middle Ages. There is some historical evidence that great Italian banks were already active in Scotland at that time. In the 17th century, two groups, namely merchants and goldsmiths, operated simple banks in Edinburgh. In particular, wealthier traders were already offering short-term loans to people, and they operated at the same time as currency changers and ‘foreign exchange market’ traders with foreign currencies. Contrary to England, thanks to the small size of the country, Scotland was characterized by the coexistence of different domestic and foreign currencies. Finally, in 1695, the Bank of Scotland was formed, with the decision of the Scottish Parliament to provide legal basis. Unlike the Bank of England, which always worked closely with the government, the Bank of Scotland was not allowed to grant loans to the government without parliamentary approval. Then, in 1727, the Royal Bank of Scotland (abbreviated: Royal) was established as the 116

s it was noted in Subchapter 4.3.2, in 1708, the Bank of England received a jointA stock bank monopoly, while other banks were banned from associating with more than six partners. This law was withdrawn in 1826 and the activities of joint-stock banks was reauthorized. It should be noted that already by the 1720s, banking activity became a specialized business branch and many private banks were established.

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second state bank. In the beginning, the two banks were characterized by rivalry and they tried to squeeze each other out of the market. However, after these attempts proved to be unsuccessful and cost more than profits, finally in 1751, both banks agreed to mutually accept the banknote of the competitor.117 Box 4-7 Banknotes in Scotland

After unification with England (1707) and the fall of the last uprising of Stuart supporters (1746), underdeveloped Scotland experienced a very rapid economic development. There was a significant improvement in the transport network and infrastructure: roads, harbours, and navigable channels were built, workshops were set up and serious efforts were made to improve land use. The rapid pace of developments promptly required professional support of the appropriate capital supply and financial system, with which two additional closely related features were coupled. One was the ‘banknote mania’ of the 1760s, when the use of paper money became essential not only in business but also in everyday consumer transactions, and gradually displaced precious metal minted coins of small denomination; and the other was the principle of ‘free banking’, which in principle denied concession banks the monopoly of banking activity including banknote issuance. Due to their own positions, concession banks firmly endeavoured to obtain a monopoly on issuing banknotes, always insisting that if almost everyone could create such a payment instrument, then it would certainly be difficult to maintain continuously the integrity of the means of payment in question. According to Adam Smith, where the release of such low denomination banknotes are allowed and widely accepted, there are many ordinary citizens who have an opportunity and incentive to become bankers. However, the regular falls that such bankers are necessarily exposed to can cause a very unpleasant situation

117

https://www.scotbanks.org.uk/history/banking-history.html

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and sometimes even serious trouble for a great many needy people who have accepted their bill of exchange as payment.118 However, small banks, who represented a significant part of public opinion, were arguing that only free banking, i.e. lending and issuance of banknotes, could provide a proper framework for prosperous commerce and industry. Sir James Steuart (1713–1780), a contemporary and academic rival of Smith, argued that the economic upsurge in Scotland was primarily attributable to concession banks and, as long as in other states of Europe where there was hardly any trade or large-scale industry they did not create similar banking structures, it would be extremely difficult to activate these complex driving forces of development.119 Steuart was generally regarded as a mercantile thinker by contemporary experts or, at best, a kind of interventionist having anachronistic views in an era dominated by liberal ideologies. These opinions suggested the general conclusion regarding Steuart that the expert was not in tune with the thinking of his own age, but with the deeper consideration of his economic, political and social ideas, this can be denied.120 In fact, however, his views on state interference were judged differently even by contemporaries, for example, some said that he had set up a sect or school for politicians to pursue the goal that the state eventually could interfere in everything.121 Steuart was very interested in the sociology unfolding at that time in his homeland, and this is not surprising since other thinkers were also influenced by historical materialism. Steuart’s historical materialism can be said to be surprisingly consistent with the work of the Scottish Historical School, and this circumstance is worth considering if we want to understand his views on state intervention. Finally, a law adopted in 1765 attempted to solve the divisional dilemma described above by prohibiting ‘banks, bank companies and bankers’ from putting banknotes of less than 1 pound into circulation and http://www.hetsa.org.au/pdf-back/29-A-1.pdf See Steuart’s work of 1767: The Principles of Political Economy 120 Sen, 1957, 2–27 121 The Annual Review, Vol. IV, 1767, 252 118 119

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using the so-called optional clause. The latter amendment to the law specifically meant that banks could choose, whether they paid banknotes they received to the bearer or with six-month postponement and with the corresponding interest, thus defending against a possible run on deposits and consequent insolvency. At the same time, however, the law still did not provide a monopoly on issuing banknotes and (unlike the English banking, financial regulation) did not restrict the creation of joint-stock banks either. This was based on the practical ‘Scottish principle’ that the freedom of banking activity is not a kind of distributable privilege but in reality, a common right of all citizens. As a result of the law, for businesses it was even more difficult to get much-needed money for investments, and concession banks responded to the increased cash demand by continuous austerity corrective measures, many times refusing to discount the foreign banknotes they received. According to Smith’s observations, in the previous 25 years Scottish banks had granted Scottish businessmen and other entrepreneurs all the support that banks and bankers could afford in their own interest, but entrepreneurs had been struggling to create even more opportunities from the outset. No doubt they thought that banks could make loans available to them whenever they wanted, and this would not pose any particular problems or significant extra costs for the banks.

However, while in the capital, that is Edinburgh, there were already two major banks, the rest of Scotland was still a blank spot on the map in terms of banking activity. Consequently, in the mid-18th century the first credit institution-type companies appeared in larger Scottish cities that offered banking services to their customers such as discount or swap transactions. In the following years, the need for additional banking services rapidly grew, and soon there were more credit institutions to bridge the remaining gaps. Most of them were smaller private banks, which originally borrowed large sums from the Edinburgh banks, then chopped up these loans into smaller units and distributed them generally to local merchants against interest. Later, in large cities of Scotland, merchants finally established their own banks.

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From the perspective of Scottish banking history, we can talk about the bank’s establishment phase.122 At that time, the law did not set limits for locals creating such financial institutions, so practically every rich Scot could open his own bank. Indeed, due to the various banknotes in circulation a major problem was soon encountered. Each bank wanted to print its own money, and as a result, a colourful mix of banknotes circulated on the market. The two state-owned banks watched this development with concern and ultimately gathered their resources so as to displace these private banks from business activities by combined efforts. However, with the exception of some small, vulnerable provincial banks, central measures were of little use.123 One bank that was formed at that time was the British Linen Company. The company was originally founded in 1746 to promote the Scottish textile (linen) industry. It later became a private bank that provided various financial services in a number of Scottish cities. Meanwhile, the institution already had a branch office in most of the major cities in Scotland, and at the same time became the pioneer of the branchbased banking system. Although, by the 1690s the Bank of Scotland had tried to build its own branch network, and then around 1730, it tried once more to do the same, all of these developments proved unsuccessful. Finally, in the 1770s, the Bank of Scotland managed to establish a viable branch network. Before that, only in Glasgow was there a long-established, successful branch office.124 After the Seven Years’ War (1756–1763), the economy started to flourish throughout Europe. Growing industrialisation led to mass production, ttp://news.bbc.co.uk/2/hi/uk_news/scotland/7620761.stm and http:// h www.lloydsbankinggroup.com/our-group/our-heritage/our-history/bank-ofscotland/ 123 http://www.lloydsbankinggroup.com/our-group/our-heritage/our-history/ bank-of-scotland/ 124 http://www.lloydsbankinggroup.com/our-group/our-heritage/our-history/ bank-of-scotland/ 122

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and intensely nourished the economy. In most countries, including England, Scotland or the Netherlands, large amounts were invested in houses, road systems, drainage networks and other public buildings. At the same time, the volume of loans increased sharply. In the beginning, the British East Indian Company benefited massively from this trend. In the meantime, the general economic situation caused some tension in the European markets, and again it was only a relatively small trigger that led to severe financial crisis in Europe. Some traders, including the Scottish banker, Alexander Fordyce, thought that share prices of the East Indian Company would soon fall. Fordyce, who together with three other bankers owned the Neale, James, Fordyce & Downe Bank, in early 1772 speculated on the fall of shares with most of his assets. However, the share price of the East Indian Company did not fall; in May 1772, the rate was 226 points, just 5 points below the highest level at the end of February 1771. Thus, Fordyce by his speculation lost the bank’s money, and so he fled London and left his debt of half a million pounds sterling with his partners. Although the partners tried to limit the growing damage, it no longer helped the catastrophic situation. In June 1772, the London Banking House of Neal, James, Fordyce and Down had to finally report bankruptcy.125 By the middle of 1772, the situation of the East India Company was also serious. The Indian famine led to a significant drop in grain exports, which had previously earned revenue for the company. In the summer of 1772, the company’s management finally admitted its insolvency publicly. After that, company stocks completely lost their value. Most investors had to acknowledge that their investment had been destroyed and later they also had to report bankruptcy. The English government stepped up as a saviour: in the spirit of urgency provided a high level of financial support to the East Indian Company, and subsequently the company’s situation slightly stabilized.126 125 126

https://www.banking-history.co.uk/bankscotland.html http://www.electricscotland.com/history/banking/chapter1.htm

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Due to bankruptcies in London, primarily a Scottish bank was affected, which was in close contact with London. In Scotland, the previous upswing of the economy had led to the emergence of more and more new private banks. In 1769, in the Scottish city of Ayr, the Douglas, Heron & Company127 joint-stock bank was set up, which later became known as Ayr Bank. In Scotland, at that time, besides the three concession banks founded by royal charter, including the Bank of Scotland and the Royal Bank of Scotland, there were 31 other banks, which covered the whole country through their network and agents. In 1771, the bank merged with the Ayr Banking Company. From 1772 onwards, the fused new venture was eventually named Ayr Bank. In 1772, the Ayr Bank Group, in addition to its two main headquarters (i.e. Edinburgh and Dumfries) had branch offices in Glasgow, Inverness, Kelso, Montrose, Campbeltown and many other locations. Among the bank’s shareholders were such famous personalities as the Duke of Queensberry, the Duke of Buccleuch, the Earl of Dumfries, the Earl of March, Sir Adam Ferguson of Kilkerran, Patrick Heron of Heron and the Honourable Archibald Douglas.128 Due to its liberal credit policy, the bank quickly attracted a new customer base and soon expanded its activities to other cities in Scotland. The ‘start’ of the new bank proved to be very successful, it really burst onto the banking world and after a short time it already managed three-quarters of Scotland’s cash flow. This was greatly facilitated by the fact that due to the limitation of credit lines entrepreneurs in a state of emergency usually tried to get money through the making of fictitious debt certificates, that is to say, through promissory note speculations, and as a result of this behaviour the lending concession banks soon Henry Scott, the third Duke of Buccleuch, was one of the founding shareholders of the Douglas, Heron & Company, founded in 1769. Between 1764 and 1766, the Duke of Buccleuch was accompanied by his tutor, Adam Smith on his grand tour of France, as in those days this was the customary way of completing the education of young dignitaries. 128 h ttps://www.banking-history.co.uk/bankscotland.html and http://www. lloydsbankinggroup.com/our-group/our-heritage/our-history/bank-ofscotland/ 127

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became more cautious regarding them. However, this lack of trust and the ever-growing number of tightening restrictions on loans only further annoyed the entrepreneurial class. The entrepreneurs presented as if their emergency situation triggered by the banks becoming necessarily more cautious posed a threat to Scotland. At the same time, they argued that this behaviour harmful to the country was entirely attributable to the underdevelopment, insecurity and bad governance of the banks that do not provide adequate, i.e. greater, support for the vigorous businesses that seek to renew, further develop and enrich their home country with all their energy. All this, however, left the banks cold because they persisted in pursuing a cautious credit policy and refused to provide additional loans to those to whom in the face of high risks they had granted too much already. In this way, concession banks decided to use the only method by which they could still protect their own credit or the public credit of Scotland.129 On the other hand, the Ayr Bank was more generous than ever regarding the issues of both overdrafts and the discounting of bills. For example, in connection with the latter it can be observed that the bank did not really make a distinction between real and revolving bills of exchange, because it discounted them equally. This was done in order to be able to provide credit for the full amount of even investments and developments with the longest payback period. The money managing generosity was also shown to the owners themselves as bank executives made it possible for the owners paying the first instalment of the founding capital to borrow money through their current account to be able to cover the following instalments. The effect of this, however, was a pittance in relation to the Bank’s attempt to cover its banknote issuances by means of a method leading to a sure decline, namely, that it itself issued bills of exchange, and when these matured, it then exchanged them increased by the interest and commission with new bills of exchange issued to the same place. As the land holdings of the bank’s owners represented assets in the 129

https://hal.archives-ouvertes.fr/hal-01251667/document

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millions of pounds and in fact they made the coverage of liabilities, the bank initially (the first two years) was quietly expanding. It should be noted that although the banking management had many honourable and respectable personalities, in fact, no one was a professional banker and thus they could not know the rigorous rules of banking operation. In addition, the bank’s independent branch offices made the verification of complete payment transactions (cash flow) difficult. Last but not least, the management of the company showed disastrous negligence in the most important decisions.130 In May 1772, that is, even before the collapse of the London Banking House of Neale, James, Fordyce and Doune, the directors of the Ayr Bank finally recognized their mistakes and desperately tried to find effective solutions. However, due to close business relations with London, the chain reaction following the London series of crashes had already sealed the position and fate of Ayr Bank. When the bank’s most important London partner became insolvent on 8 June 1772, as the Bank of England had refused to discount its bill of exchange issued for an Amsterdam currency changer, then this proved to be a farreaching decision due to which the turnover that had been operating for years collapsed. From this, it is clear that even in those days the crisis could ‘take its toll’ on the entire system. When this rumour reached Edinburgh, a sudden panic broke out in the Scottish capital: clients rushed to the banks, and the attack was mainly targeted at the Ayr Bank. Although the bank’s directors tried to get immediate help from the Bank of England which was willing to help, the loan package was subject to such strict conditions that the agreement was not finally concluded and therefore on 25 June the Ayr Bank was forced to suspend all of its payments. Therefore, it is not surprising that in contemporary Scottish newspapers there were also articles in which the Central Bank of England was primarily blamed for the bankruptcy of the Ayr Bank. At the same time, they pessimistically depicted the 130

ttps://www.scotbanks.org.uk/history/banking-history.html and http://news. h bbc.co.uk/2/hi/uk_news/scotland/7620761.stm

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imminent consequences highlighting especially mass unemployment, trade shrinking and dangerous riots.131 David Hume’s letter, written two days after the collapse of the Ayr Bank, however, was not so pessimistic: ‘On the whole, I believe, that the Check given to our exorbitant and ill grounded Credit will prove of Advantage in the long run, as it will reduce people to more solid and less sanguine Projects, and at the same time introduce Frugality among the Merchants and Manufacturers: What say you? Here is Food for your Speculation.’132 The Scottish leadership was stunned by the ominous events, and at the same time they had to come to the conclusion that in terms of the bank’s existence the answers were increasingly pointing to a total bankruptcy. Although the owners had been trying to restore the confidence of the Ayr Bank’s creditors for almost a year now, the Bank of Scotland, the Royal Bank and the British Linen Company still firmly refused to accept Ayr Bank’s banknotes. Meanwhile, London City had also frozen loan disbursements to the bank. By August 1773, there was no survival alternative whatsoever, so the Ayr Bank was forced to report bankruptcy. The total loss of the remaining 225 business partners exceeded GBP 663,396, which now amounts to more than US 100 million.133 The sudden bankruptcy of the renowned bank triggered shock throughout Scotland. The collapse of the credit institution dragged along a number of private and regional banks into the financial abyss. Those concerned included lending economies (several farmers gave guarantee with their landholding) and a number of small businesses. Only the rapid intervention of the Bank of Scotland, the Royal Bank and the British Linen Company prevented further aggravation of the highly critical situation. The aforementioned intervening institutions https://www.britishnewspaperarchive.co.uk/search http://files.libertyfund.org/files/652/1223_Bk.pdf 133 h ttps://www.banking-history.co.uk/bankscotland.html and http://www. lloydsbankinggroup.com/our-group/our-heritage/our-history/bank-ofscotland/ 131 132

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rescued some provincial banks by providing urgent financial assistance and some of them (already at that time) were aided for effective reorganization. Otherwise, these banks certainly could not have been able to meet the ever-increasing needs of their customers. The three banks’ willingness for effective crisis management gradually restored the confidence and stability of the whole Scottish banking system. In Scotland, there was never again any such serious economic crisis in the coming years as was in 1772 and 1773.134 However, the chain reaction effects of the financial crisis did not end here. As in the United Kingdom, also in the Continent mass production and warehouses with commodities were largely offset by the fact that demand had dropped significantly. In Amsterdam, the long-standing British-Dutch trading house, Clifford & Sons, acquired the majority of London East India Company shares. Due to the extensive commercial transactions, both companies were in close contact with each other and Clifford sought to support the Company in its aggravating financial situation by acquiring shares. This intervention, however, could not help the fate of the company: Until the middle of 1773, the price of shares fell to 150 points. Accordingly, in the meantime the trading house was facing a debt burden of some 5 million Dutch guilders. The Company was somehow still able to survive for a few months, but eventually under the ever-increasing debt burden, it suddenly crashed on 28 December 1773. Bankruptcy was due to the fact that the private creditors and shareholders of Clifford refused to extend short-term debt without further guarantees. As in the meantime the Bank of England, for its own protection, had completely suspended the outflow of further financial disbursements or loans, the crisis continued to intensify. After that, only in Amsterdam did some 40 trading companies announce bankruptcy, but in the meantime the rapid import of precious metals prevented the disaster from worsening. Shortly thereafter, a series of bankruptcies in 134

https://www.scotbanks.org.uk/history/banking-history.html

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Stockholm and St. Petersburg shook the economy, but overall it can be said that Europe overcame this crisis relatively easily.135 The crisis of 1772 is often referred to as the ‘crisis of Ayr Bank’, whose collapse for a long time was the most famous accident in Scottish and English bank historiography. But looking at the bankruptcy of the bank from another perspective it is important to note that speculator Alexander Fordyce had mismanaged a wholesale deal financed by a loan from his own bank. Fordyce’s bank, however, was heavily indebted to the Ayr Bank. Due to unfavourable market fluctuation (shares), Fordyce became completely ruined financially, so in June 1772 he fled to France immediately. The failure of the Ayr Bank was caused partly by two combined factors: firstly, it was exposed to Fordyce and secondly it was unable to meet financial demands. This triggered the later panic, which then quickly spread to the wider banking system and eventually led to the failure of 4 per cent of all British banks. A contemporary Scottish newspaper136 provides detailed information on contemporary thinking. The report on triggering the crisis described a ‘melancholy scene’, which began with a rumour that one of the greatest bankers was shut down, which afterwards proved true.137 The rapidity of the panic was described, saying that the newspaper expressed its indignation over Fordyce’s transactions, and as a result ‘everyone for some days appeared to be struck with amazement and terror from the dread and uncertainty with regard to those that might be affected by this accident’.138

https://www.banking-history.co.uk/bankscotland.html The Scots Magazine Source: https://www.britishnewspaperarchive.co.uk/titles/ the-scots-magazine 137 The Scots Magazine, 01/06/1772 Source: https://www.britishnewspaperarchive. co.uk/titles/the-scots-magazine 138 The Scots Magazine, 01/06/1772 Source: https://www.britishnewspaperarchive. co.uk/titles/the-scots-magazine 135 136

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The incident, called an ‘accident’, caused a distrust that ‘was never known’.139 All this led to a panic that primarily appeared in the Scottish banking system of the United Kingdom, as they were suspected of having extensive bank transactions with the Ayr Bank. ‘But as the failure of these two houses [Ayr and Fordyce’s] was supposed to be connected with many others in the country [Scotland], the gentlemen of this city were disposed to consider this a prelude to the universal bankruptcy of every safe house in that part of the kingdom.’140 The Scots Magazine, however, also observed that most banks had separated from the event and ‘went on with their usual tranquillity, to answer their engagements’.141 The panic was confined to banks which is supported by the fact that the main complaint of the contemporary newspaper was that the Scottish banking system according to the current plan could not keep pace with the country’s [Scotland] developments in agriculture, foreign and domestic trade.’142 Because the public was worried mainly about who would be ‘affected by this accident’, and since from the newspaper the situation of general developments is clear (good macroeconomic conditions), the crisis of 1772 could be defined as an externally influenced crisis due to poor risk management. Adam Smith drew two important lessons from what happened. One was the need for strict regulation of banking activity, even if it was contrary to the system of natural freedom. The other was that human action also in this case had led to consequences other than the original intentions, but here the operation of an invisible hand had negative effects.

he Scots Magazine, 01/06/1772 Source: https://www.britishnewspaperarchive. T co.uk/titles/the-scots-magazine 140 https://www.britishnewspaperarchive.co.uk/titles/the-scots-magazine 141 https://www.britishnewspaperarchive.co.uk/titles/the-scots-magazine 142 The Scots Magazine, 07/07/1772 Source: https://www.britishnewspaperarchive. co.uk/titles/the-scots-magazine 139

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The Ayr Bank was associated with serious speculations during growing speculative activities and ‘extravagant credit creation’, which undermined confidence both in Edinburgh and London (Hamilton, 1956, 17–405). In addition, instead of increasing the total amount of capital, the bank continued to lend to its investors, which increased leverage well above its balance.143 Kindleberger and Aliber considered this episode as a crisis (Kindleberger–Aliber, 2011, 58), triggered by speculation and they highlighted that the bank usually borrowed from London and when its own acceptances matured in Scotland, at the same time it filled its reserves on the basis of similar methods (Rockoff, 2009, 4–15). Therefore, the above observations regarding the bank suggest poor risk management behaviour. Such ‘foreign’ capital provided by English banks typically meant a lack of savings in Scotland, but such a lending pattern was very sensitive to customers’ mood changes (Hamilton, 1956, 27–105 and 214–302). While according to contemporary expert opinions the failure of the bank resulted from its deliberate ignorance of cautious banking rules (Rockoff, 2009, 2–17), recent research suggests it was the restrictive banking legislation introduced before the event that undermined the flexibility and power of resistance of Scottish finance (Goodspeed, 2016, 8). In 1772, the Scottish bank crisis was followed by a serious depression of two years and only in 1774 did recovery begin again. In the aftermath of the crisis, experts were occupied with the issue of how to find a balance between freedom and regulation? After drawing the necessary lessons, first and foremost, the Scottish banking system strengthened in the wake of this crisis. Meanwhile, through the merger of relatively well-functioning banks and the effective pooling of their assets, the Scottish banking system that could be called ‘small’ in a relative sense had regained people’s confidence and was again on the road to stability. The full legal responsibility of the shareholders and the fact that due to the high turnover rate of money, 143

See Rockoff, 2009, for a full case study.

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most Scottish banks had hardly any banknotes deposited at insolvent institutions, led to low deposit losses at the remaining financial institutions. This direction was also true for the coming periods, i.e. effective mutual support measures prevented a number of bankruptcies in Scotland. For example, between 1809 and 1830, the Scottish banks’ insolvency rate was even much lower than that of English banks. Thus, while Scotland continued to move relatively steadily on the road to stability, England was shaken by a number of crises.144 Box 4-8 The South Sea Bubble

In February 1711, England needed money. For a good decade, the country had been involved in the Spanish Inheritance War and fought against France. Robert Harley, the Lord High Treasurer, was desperate because he no longer knew how to fund due claims more effectively. In England of that time, in parallel with few investment opportunities, the value of savings had become relatively high. Because of this emergency, the Treasurer turned to John Blunt for advice who was the director of the Hollow Sword Blade Company which operated as an unofficial bank. With the support of the Treasurer, Blunt established two state-run gaming companies, whose revenue successfully improved the terrible state of the exchequer. Treasurer Harley was very pleased with the revenue and started a revolutionary plan with Blunt, as part of which they founded a company. The South Sea Company was established in the fall of 1711, and at first had no activity because it was restrained for the time being. The headquarters of the company was in Threadneedle Street.

144

ttps://www.banking-history.co.uk/bankscotland.html and http://www. h lloydsbankinggroup.com/our-group/our-heritage/our-history/bank-ofscotland/

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In order not to appear to be a mere investment tool of the state, the company shortly after its founding acquired a monopoly in trade with South America but as Spain was in a state of war, the commercial monopoly was in fact useless in the Spanish colonies. Moreover, England still did not gain any colonies in South America, and even in the context of the Peace of Utrecht of 1713, only concessions were achieved so that the company could send overall one ship annually to the Spanish colonies. It is clear that no significant profit could be made by this. At the same time, the company was very active in the flourishing business of slave trade at the time, after having signed a thirty-year contract with the Spanish Crown after 1713, which allowed it to transport slaves from Africa to the Spanish colonies. The company, with the exception of some misfortunes (sinking ships), worked with extremely low, i.e. 11 per cent, mortality rates in the slave transport, but the high customs tariffs imposed by the Spaniards actually wiped out most of the resulting profits. By about 1717, the relationship between England and Spain became so frustrating, that it began to become clear: no real breakthrough could be expected in the company’s real-economy activities. By then, however, the Treasury was not good either, as by itself the sum of state debt accumulated in the succession war amounted to about GBP 9 million (which today accounts for more than USD 1 billion), but by 1720 the sum of the total state debt had risen to GBP 50 million. All this put a great deal of pressure on the Lord High Treasurer and the economy. Only the year of 1719 brought greater movement to the business activities of the South Sea Company. The troops of King George I, crowned in 1714, overthrew the last coup attempt by the Stuart Dynasty to take the English throne in Scotland. A spirit of optimism had come to London, and although England had again been in a war with Spain since 1718, world trade flourished – except for the South Sea Company, which, due to the war situation, could not send ships again to Latin America. John Blunt, who was by then the director of the company, did not show excessive interest in trade anyway, but was rather interested in the Paris model, where the

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Scotsman John Law revolutionized the financial system with his bank and the Mississippi Company. Following the example of his rival in France, Blunt also for the second time successfully transformed government bonds into shares in the summer of 1719, while carefully preparing the realization of the great dream: assuming the entire state debt in England. In 1720, the company actually made capital from of its popularity, and ultimately, taking advantage of this, decided to offer the government total state debt management. About a quarter of the total state debt was already burdening the company’s balance sheets, but some GBP 31 million was still in the hands of the public, the handling of which Blunt by all means wanted to take over. Meanwhile, Blunt persuaded John Aislabie, Chancellor of the Exchequer, about the viability of the plan, which was then submitted to the Lower House. In April 1720, the Upper House and the King also accepted Blunt’s and Aislabie’s state debt reduction plan. The reason why the company wanted to take over the state debt, we illustrate with the following conversion scheme: in order for the joint-stock company to take possession of the debt of over 31 million pounds, it took upon itself the right to list the 310,000 new shares at a nominal value of 100 pounds. However, the conversion took place at the market value of the shares; i.e. if it exceeded the 100 pound nominal value, the company was not required to sell all the shares in the market for debt conversion purposes. Specifically, this meant that the amount of share sale difference coming from the market price above the nominal value, could be recorded as the company’s own profit. Therefore, management of the South Sea Company made every effort to keep the price of shares at the highest possible level (while London City also took a part in this), so as to increase the profits from sales. Thus, in a way the possibility of making money was already tied to a speculative stock market. The management realized that the size of the company could be further increased by new share issues. The specific idea was to issue additional shares and cover the Treasury’s high debts from the proceeds of this, that is, they gain profits generated by the difference. In return for the

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shares sold at nominal value, the Treasury paid interest to the company every year on the loan, from which Blunt could pay a lucrative dividend to the shareholders. Thus, the Treasury had to pay less interest, and the languishing company could quickly grow and earn a regular income, and at the same time investors were able to benefit from the results of both the state’s interest payment and a business with very good prospects. However, there was almost nothing behind the new shares, so actually the company’s real activities could not justify further capital raising, still the Treasury continued to pay a fixed amount to the company each year. Debt assumption took place in several steps, and the deal proved to be so successful that by 1720 the company was already handling more than 80 per cent of the state debt. The organizers of the company were masterly in advertising, in persuading the public, and not least in luxury. As a common result of all these factors, investors bought the advertised shares with great dedication. However, this was not enough, so a part of the amount received from the new shareholders was continuously distributed as a share between the former shareholders. This gave the impression that the company worked extremely well and would continue to pay high dividends to its shareholders, while management knew very well that this was only feasible while there were enough buyers for the new shares. The company also encouraged new buyers by providing them with loans to buy shares. Although this could in an artificial way positively influence the stock exchange rate similar to a bubble, later it became clear that as the exchange rate fell, this construct only accelerated the processes, which led to the collapse. This explains, too, that although the company had failed in several areas – such as the South American slave trade (several slave transporting ships of the company sank) – the value of the company’s shares continued to grow despite the fact that its foreign trade was collapsing due to the Spanish War. Growth, in fact, grew into a general stock market bubble, moreover, in the meantime the most risk-averse members of society also joined the speculators’ team. The severity of stock-buying mania was well

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characterized by the fact that the leaders of the newly formed joint-stock company were billing it ‘as a company for carrying out an undertaking of great advantage, but nobody knows what that is’ (Reed, 1999). At that time, Blunt in his press campaigns focused on the fabulous business opportunities in South America and the exploitation of gold and silver deposits by his company. In these circumstances, at the mere news that the business idea of the company was going to be approved, the share price started to rise, so when the consolidation law was presented to Parliament, the current 128 pound exchange rate rose to 330, and then it sprang to GBP 1000 by August 1720. Meanwhile, the shares of the South Sea Company (Chart 4-17) were also being sold in instalments. By now, even the royal family and almost the entire Lower and Upper House belonged to the company’s shareholder circle. The Board of Directors continuously took advantage of the unique opportunity, i.e. it offered newer and newer share packages to the market and initially the investors did not regret buying them. So, it continued until the shares had reached a value of GBP 1000. When the price rose to GBP 1050 in June, the London stock shock reached its climax. The details of the third package were recorded at GBP 1000 per share, and King George I of England was again present among the stockholders. The poet, Jonathan Swift, wrote to one of his friends that no matter what a Londoner was asked about, his religion or politics or the state of the economy, the answer was nothing but ‘South Sea’.145 Swift himself had also bought shares and lost a lot of money in the wake of bankruptcy. The poet, however, did not blame the company itself, but mainly the circumstances surrounding the bubble burst.146

145 146

http://journals.openedition.org/oeconomia/1021 http://journals.openedition.org/oeconomia/1021

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Chart 4-17: The stock of the South Sea Company

Source: www.fuw.ch

Euphoria had not only shown itself in relation to the stocks of South Sea. At that time, dozens of other joint-stock companies were established, all of which tried to trade their stocks on the stock exchange. They were called only ‘bubble companies’ in cafes, and most of them came out with absurd business ideas (for example, importing donkeys from Spain or making seawater drinkable), in many cases obscuring the company’s actual business scheme. What happened in the case of the South Sea Company, however, was only what in speculative bubbles of the following centuries always occurred. The circle of insiders began selling their shares in time. Blunt and the other directors were aware of the fact that their company did not have any kind of prosperous business opportunity in South America and that fabulous profit making could only continue at such a pace if they were able to keep selling new stocks at an ever-increasing price. However, the release of the fourth share package in August was already a failure, and in the meantime, for example, more prominent Dutch and other more rational investors had sold their shares in large quantities, subsequently panic broke out. After that, the fall in the stock price was unstoppable and

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by the end of the month the speculative bubble suddenly burst. The capital of the investors who purchased shares from the loan was destroyed within days, and when a new instalment had to be paid, they desperately tried to get rid of securities losing their value day by day. In September 1720, only 175 pounds were paid for a share, and borrowing stockholders could no longer cover their debts, so they all resorted to forced sale. Meanwhile, goldsmiths reported bankruptcies by the dozens. In September, even Hollow Sword Blade, i.e. the company’s background bank, collapsed. Thousands of people, from farmers to the king, were forced to watch their property being destroyed. For example, Sir Isaac Newton, who in May said that he was able to ‘calculate the movement of celestial bodies, but not the folly of the people’, lost about 20,000 pounds in company shares (which would be 3 million pounds today). The value of the company’s shares by the end of the year suddenly fell to GBP 100. In order to reduce panic, the Bank of England itself intervened and quickly began to buy up a part of the stock. In fact, this was necessary, as they could not idly watch the total bankruptcy of the state debt managing company. Nevertheless, the burst of the South Sea Bubble was caused primarily by the company’s own management, as they were aware of the fact that the company’s market value was by no means in balance with its real potentials, and they secretly started selling out the shares. However, leakage of the news triggered a damaging chain reaction on the market. It can be stated, therefore, that the irresponsible behaviour of the actors played a significant role in inflating the bubble: for example, the dividend taken out of the capital and the loan granted by the company to its own shares were unmistakably tools that resulted in the overvaluation of the shares. Financial regulation of that time did not recognize these complications, and what is more, even influential politicians ‘rewarded’ with shares had a direct interest in promoting this mania. The committee investigating the company pointed out that Chancellor Aislabie, as well as several lords and Lower House representatives, and even the king’s lover, received free shares and insider information from the South Sea

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Company.147 Aislabie, Chancellor of the Exchequer, and several executives of the company were imprisoned. Finally, in December 1720, the company was rescued by the Bank of England from total insolvency and was taken over by the British East India Company. After that, the company became completely marginalized in the business world. Hereinafter, it tried its luck in the slave trade and whaling. The company was actually never able to get to the raw materials and treasures of Latin America. In fact, the South Sea Company was officially dissolved in 1853. Today, in the company’s former headquarters at Threadneedle Street there is an Italian restaurant led by the star chef, Jamie Oliver. There is nothing to remind you that this was once the seat of the company that carried out the biggest fraud in the history of England. For a number of ‘bubble companies’, the company’s ominous case proved to be fatal, as after the mania only four of the 190 ‘bubble’ joint-stock companies managed to survive. The effects of the mania in England were felt all the way to Switzerland: for example, the Malacrida Bank House and Samuel Müller’s bank in Bern went permanently bankrupt due to the poor sales timing of the English corporate shares. The South Sea Bubble was the first serious capitalist crisis that involved several elements of the great speculative crises. In fact, the main driving force was financial innovation, that is, the introduction and spread of broad trade in shares. The history of speculative crises is as old as capitalism; the first crises emerged in early capitalist England and in the Netherlands. They were followed by France, then the USA, Latin America, Central Europe and, finally, in the twentieth century, Asia. The subject of speculation can be largely any profitable product with a real value and which is widely available at a given moment. For example, the financial crisis of 2008 is not unique, because it actually proves the pertinence of the faults of human nature and the complexities arising from them. 147

https://www.theguardian.com/books/2002/aug/10/featuresreviews.guardianreview1

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4.4.3 The 1815–1816 crisis

The main reasons for the crisis were economic recession and government policy. During the Suspension Period (1797–1821), small bank businesses with poorly controlled and inadequate capital proliferated throughout the United Kingdom. These banks often issued inconvertible expenditures against dubious collaterals. During this period of war and inflation, banks with such low capital – due to their various structural weaknesses – were particularly vulnerable to even the smallest market fluctuations. Because of the major bank crisis following the Napoleonic wars, 4 per cent of all British banks went bankrupt in 1815, and 7 per cent in 1816. For example, The Times attempted to reveal the origins of the crisis in the following manner: ‘Let them all causes of our distress be enumerated, in order to apply proper remedies. 1. A superabundant harvest; 2. foreign importation; 3. tithes; 4. poor and other rates; 5. property and other war taxes; 6. want of credit; 7. decrease in circulating medium.’148 The decline of the currency in circulation, which caused a shortage of credit, was initiated by the Bank of England, because during the preparations for the restoration of the gold standard it considerably limited its emissions. Two of the reasons listed above are directly linked to the economy, three are within the scope of government policy, while the fall in loan portfolio is the result of austerity-related central financial measures. The abundant harvest and the decline in the availability of payment instruments and loans confirmed the phenomenon of falling prices. Manufacturers and producers of commodities ‘felt the influence of a depreciation in the value of their respective articles’149 and there are countless contemporary proofs that even ‘before the peace was concluded…iron works began to fail’.150 These were the immediate he Times, 09/10/1816; https://www.gale.com/uk/c/the-times-digital-archive T The Times, 02/08/1816; https://www.gale.com/uk/c/the-times-digital-archive 150 The Times, 05/08/1816; https://www.gale.com/uk/c/the-times-digital-archive 148 149

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antecedents of the dramatic series of bankruptcies in the banking sector, and the crisis itself reached its climax in 1816. The effects of falling prices and post-war recession had increased mistrust, which directly hit the fragile banking system. During the era of financial and credit suspensions, a contemporary observer commented on how smaller banks scattered throughout the country operated, saying that ‘any sudden reverse, any unforeseen fall in the markets, occasioned at once their own ruin, and often involved that of their creditors’.151 Another contemporary commentator derided the ‘practice’ in some papers of ‘swelling every trivial failure in the mercantile world’ as ‘the bad effects of such exaggerations’ spread as quick as lightning ‘through the whole country’.152 By his message the writer suggested that this was exemplified by a ‘failure in the City’, which though minor, led to an immediate bad rumour that ‘one of our first houses [that is loan bank] in the City had asked assistance from the Bank [of England] to the amount of half a million’. Reporting on bank failures in Sunderland, the Stamford Mercury stated that the ‘stagnation of trade prior to this [failure of Cooke and Co.] was great; at the ceasing of hostilities we anticipated a trade with Holland in the export of coals’. This led to the conclusion that all this would counteract the large number of empty steamships in coastal shipping. ‘Alas! We are miserably mistaken.’153 Opinions and rumours of similar economic conditions were circulating about the bankruptcy of Bruce and Co. as due to lending to merchants the bank was in a position which was ‘fearfully ominous of the general conditions of the commercial world’.154 They regretted that xford University and City Herald, 25/05/1816 O L ondon Courier and Evening Gazette, 16/08/1815; https://www. britishnewspaperarchive.co.uk 153 Stamford Mercury, 12/07/1816; https://www.britishnewspaperarchive.co.uk/ search 154 Taunton Courier and Western Advertiser, 11/07/1816 151 152

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the ‘mercantile portion of the public’ appeared to be ‘unfortunately progressing to a most disastrous crisis,’ as international trade appeared ‘paralyzed’ with countries which were ‘in a still worse condition than this’ leading them to the conclusion that there was ‘difficulty in allowing a ray of hope to struggle through’ for a return to normal levels of international trade.155 It should be noted that, although the news articles referring to early crises were not as detailed as for example a couple of decades later, it can be seen that, before the authors proceeded to discuss the bankruptcy of the given bank, almost every report had significant implications for complaints about the disadvantaged economic situation. The above typical scenes were repeated in almost the same scenario in different cities across the United Kingdom, where a local banking business suddenly became completely insolvent. The ominous event was followed by mass unemployment and riots, and most of the smaller local banks, which might have already successfully contracted their financial assets at the local level in this situation, soon failed as well. For this reason, the crisis of 1815–1816 can be considered endogenous, caused by improper government policies (delayed reactions) and the economic downturn in post-Napoleonic Europe. Endogenous nature refers to a crisis that has arisen and appears within the organizationalstructural parts of the system. Nevertheless, Presnell’s report (Presnell, 1956, 402–479) only further supports the evidence analysed above in newspapers. After the end of the Napoleonic wars, most of the experts expected the Bank of England to strive to continue stabilizing the convertibility of sterling at least from July 1816 (Presnell, 1956, 471). This was accomplished through a contraction of banknotes (Turner, 2014, 67), which, combined with falls in government borrowing and expenditure had a ‘deflationary influence’ (Presnell, 1956, 470). The Governor of the Bank of England, 155

aunton Courier and Western Advertiser, 11/07/1816; https://www. T britishnewspaperarchive.co.uk/titles/taunton-courier-and-western-advertiser

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while promoting the policy of a return to convertibility ‘as it would eventually place the country in a better situation with regard to all foreign countries’, was conscious when interviewed that if the contraction was ‘done suddenly, it might do a great deal of mischief’. Furthermore, he agreed that the ‘effect must be a proportionate fall in the prices of commodities generally’.156 He additionally admitted that in the short run, this policy would mean that ‘the manufacturer would not be disposed to manufacture upon a low price to the same extent’.157 Prior to that, in 1815 prices fell by more than 14 per cent (Ryland–Dimsdale, 2017, 24–39), and this was further aggravated by the fact that with the end of hostilities, the overall supply began to grow continuously. Reinhart and Rogoff also cited the abundant harvest and low crop prices in addition to a general depression in property prices which affected production industries. (Reinhart–Rogoff, 2009, 387). Based on reports, it is evident that general business failures were very high in autumn 1815 and early 1816, leading one banking historian to note: ‘That bank failures were high is not surprising, for to general economic depression there was added the deflationary expectations of the Resumption of Cash Payments’ (Presnell, 1956, 471). However, with respect to the 1815–1816 crisis, it can be stated that the case for the banking system’s role in causing the recession is not at all negligible. In the United Kingdom, the fast expansion of unregulated private bank issuance, which occurred exactly during the suspension era, was sharply blamed by experts for rapidly increasing inflation and economic instability (Ó Gráda, 1994, 52), while continuous recurring failures showed the system’s ‘underlying structural weaknesses’ (Presnell, 1956, 446–447). Nonetheless, the majority of bank failures in England occurred in agricultural areas, where, as a result of arliamentary Report 1819, 32 Source: First Report of the Secret Committee on the P Expediency of the Bank resuming Cash Payments. 157 Parliamentary Report 1819, 32 156

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abundant crops, farmers had to suffer even the whirlwind low price spiral (Presnell, 1956, 471–472). This is best illustrated by the case of Ireland, a primarily agricultural economy, where deficiencies can be directly linked to the decline in agricultural prices or assets held by the banking system, which ‘led to a fall in business confidence and to a flurry of rumour and counter-rumour’ (Ó Gráda, 1994, 55); all this resulted in bank runs and a subsequent series of suspensions. Overall, it can be stated that current research also supports the conclusion that the deflationary slump immediately following the series of wars extensively influenced the weak banking structure so that bankruptcy caused bankruptcy due to chain reaction effects.

4.4.4 The crash of 1825-1826: the first modern financial crisis

Despite the fact that in the case of the aforementioned crises we can also talk about the high impact of speculations, it can already be said in advance that the financial crisis of 1825 was completely different from its predecessors. It was occasioned neither by war nor by fashion but rather by ordinary financial activity: an investment here, a loan there, conducted in good faith. The original roots of the crisis lie precisely in decisions intended to stabilize the financial system of the island and the specific interventions related to them. In June 1816, the British government instituted the first official gold standard in history. With the end of the war against France, economists, Parliamentarians, and radicals intensively campaigned to resume cash payments that had been suspended since 1797 and would have liked the country to establish a currency based on the convertibility of paper money into gold. This was the so-called ‘ancient standard of the realm’. Contrary to popular belief, before its statutory introduction in 1816, no gold standard existed in Great Britain or in any other country (Dick, 2013, 1–35 and 36–73). The specific idea was that the introduction of such a standard would limit the Bank of England’s ability to issue money at will, restrain the state debt, and prevent forgery. Non-circulating gold itself would be the standard for all other currencies, i.e. a mixture of low value — 224 —

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(redeeming) coins and limited, high-value banknotes would rotate on the money market. Finally, just about everyone accepted the newly introduced standard: from the Earl of Liverpool, Charles Jenkinson – the father of the Tory Prime Minister Robert Jenkinson – who had helped to set up the system,158 to the group of philosophical radicals led by renowned educators such as James Mill and Jeremy Bentham, as well as the successful stockbroker, David Ricardo and his protégé, the economist J. R. McCulloch. But the bankers and the government immediately realized that this kind of sudden limitation of loans and banknotes would panic the markets and ruin the country’s farmers who had sustained the war effort through cheap credit provided to them (Bordo, 1998, 75–81). Rather than suspending the gold standard and refusing to issue paper money, the government and the bank introduced a number of measures to gradually restore the economy to a self-reliant starting position without risking people’s trust in money. As a first step, the bank stockpiled a massive amount of gold from the new continent, but did not release its price in order to keep the gold price high and prevent its customers from switching their money to precious metal. As a second step, the bank issued a series of low-yield, low-risk, and reduced-rate shares.159 At that time, the government made gold legal tender, but this was only valid for transactions greater than 40 shillings (2 pounds) and then issued a new series of 3 per cent bonds, and simultaneously mounted a comprehensive construction campaign, that is to say, it collected capital for building roads, ships, gas lighting, churches, and schools. Such a level of money availability inspired the public to invest in new firms, various funds, banks, and insurance agencies. These large investments were not seen at the time to be excessive in any way. On the contrary, most of them were extensions of ordinary investment activity made possible by the increasing diversity and availability 158 159

ee Charles Jenkinson’s work published in 1805: Treatise on the Coin of the Realm S The economic historical presentation of crisis situations in the United Kingdom was based on Alexander J. Dick’s study: ‘On the Financial Crisis, 1825–26’.

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of loans and other types of funds. This had a good impact on the population, as sales volume had increased, and supply had increased significantly, too. Indeed, the positive effects of rising consumption were already felt in the agriculture and construction industries.160 In the meantime, however, sharper observers161 soon noticed that the market in precious metals had grown in the wake of new cash payments, and that due to the mines discovered in a number of newly-independent Latin American countries a good deal of the capital newly created in the island country had been going abroad. The Bank of England was shipping most of its existing metallic reserves overseas as part of the economic effort to increase its gold reserves. Consequently, due to its high demand for gold, the Bank and its customers had to work within a paper-based system. By then, in a general sense too, the demand for money, or its substitutes (gold, silver) seemed to have started increasing significantly beyond the seas. From the spring of 1825 until the outbreak of the crisis, many editorials and pamphlets dealt with the subject, suggesting that the shipment of precious metals (rather than their import, as had been proposed) could eventually destroy the whole system.162 Finally, in late April 1825, the directors of the Bank of England took action: they began to regain their lost reserves by slowly withdrawing banknotes from general circulation and called in loans to joint-stock companies. Investors began to sell their stocks and the market took a sudden dive. Many who had been encouraged by their consultants to invest in their well-being in a general sense, suffered heavy financial losses. Others tried to redeem their banknotes at local banks or to find a solution regarding their accumulated goods surplus but were met with reluctance which only intensified suspicions against the system. On 10 December, a run on local banks was declared in the press and the or contemporary recollections see Martineau, 1877, 2–12. F Source: https://www.gale.com/uk/c/the-times-digital-archive. For example, Jonathan Williams in his letter dated 2 April 1825, published in The Times, warned in time of the inevitable catastrophe. 162 https://www.gale.com/uk/c/the-times-digital-archive 160 161

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panic became even more intense. Even prominent bankers and dealers were stunned by the rapidity of the financial crash (Neal, 1992, 51–82; Forster, 1956, 100–110). The question arises: What distinguishes the financial mania of the early 1820s from earlier bubbles? The fact that the early manias of the 1820s were caused not by speculations but by the rapid diversification of the economic system. On their own, each investment can be interpreted as a tangible economic transaction with real economic consequences and benefits. Likewise, the direct consequences of the crisis were felt by those who were neither impostors nor gamblers, but clients who were merely at the mercy of the bankers whose own profits, in turn, were dependent on the clients’ full confidence. For example, Cooper argues that the fundamental problem in the market was not that investors were overextending their investments, but rather that they did not have enough information to adequately appreciate how overextended everyone else already was (Cooper, 2010, 374). It can also be seen that the money market was not completely damaged despite the fact that many institutions and individuals had gone bankrupt overnight. On the contrary, the crash probably advanced centralization processes and thus it strengthened finance more than any other collapse before it. At the time, the response of the bankers was desperate. The London bankers and their clients insisted that the government suspend cash payments, as it did it in 1797, in order to preserve the public’s confidence. Everyone made excuses saying that he was not responsible for the collapse of the system. Meanwhile, representatives of the government alleged that the smaller banks and investment firms were the real culprits for the outbreak of the panic, since they had completely squandered away capital on diverse and uncharted investments. Therefore, the government completely rejected the offers made by London bankers and the public regarding emergency measures. The gold standard was intact, furthermore, politicians thought that interference in the financial system was not necessary at all. In response, the bankers, including the Governors of the Bank of England continued to issue notes at low

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interest rates anyway. Over time, however, the banks came to see that the real causes of the crash could be attributed to complex structural problems with their own lending protocols and not only with the disproportionate credit management of smaller partners. Nevertheless, it is a fact that the government’s cautious financial market-economic interventions which did happen in the aftermath of the crash, also contributed to the complete rearrangement of the island’s finance system. Finally, the government grouped its own economic reform package around three simple proposals: firstly, the Bank of England should group smaller companies into specific sectors; secondly, London banks would be offered tender opportunities in the field of government investments; thirdly, the bank eventually had to extend the gold standard to Scotland, where it had not been in effect until now, to curtail the Scots’ reliance on paper money. The implementation of the London measures above shows that one of the main consequences of the 1825 crash was the centralization of the financial sector itself. In the context of these developments, several famous historians suggest163 that at this stage the economy of the island became not necessarily national but rather international (Gilbert–Helleiner, 1999, 47–68, 97–117, 118–121 and 122–139). With the aforementioned peer reviews, we can say that from the middle of the 1820s the relationship between the financial system and regional or national identity appeared only symbolic in the island country because its real power lay now rather in the constant flow of capital becoming more and more international. Moreover, the realization that the already established and constantly transforming financial market was already too extensive to fail completely, gradually changed the way intellectuals and economic experts thought about money and culture. One of the most interesting examples of these ideas comes from 163

ee, for example, Helleiner’s perceptive views in his timely writings, namely States S and the Reemergence of Global Finance as well as The Making of National Money: Territorial Currencies in Historical Perspective.

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McCulloch, who was one of the most prolific and perhaps prominent political economists of the decade. Since 1815, McCulloch had been considered a spokesman for free trade and the gold standard. The series of writings by the specialist was mainly published by the Edinburgh Review and the Scotsman. The central ideas of the economist can be summarized as follows: McCulloch claimed that convertibility of the currency would ensure economic stability; the blame for rising prices must be placed squarely on Parliament and the Bank of England for not understanding the principles of political economy and for overly extending credits to the entire economy, thus the burdens of this are borne mainly by the aristocratic landowners and the farmers. In February 1826, The Edinburgh Review published McCulloch’s first article on financial crisis, entitled ‘Thinking about Banking’.164 We may highlight from it ‘the vast advantages resulting from the substitution of a well-regulated paper currency in the place of gold or silver’ and that ‘the present distress has not in any degree shaken our ... opinions we formerly advanced’ on money, circulation and convertibility (McCulloch, 1826a, 264). As long as the central bank limits its issues of banknotes and bills to a proportionate quantity of gold, then there will be a natural restraint on the capital in circulation, levelling demand and supply and all this creates a climate of security and trust. ‘Unfortunately’, in the real world no such security can be given. Historical experiences show that no set of men have ever been granted with the power of making unrestricted issues of paper money, without greatly abusing it or without circulating inordinate quantities of money in the economy’ (McCulloch, 1826a, 265–266). Since the Bank of England is a profit-making enterprise and the printing of money is cheap, ‘is it to be supposed that they would not avail themselves of such an opportunity to amass wealth and riches?’ (McCulloch, 1826a, 267).

164

here are three articles in this series. See John Ramsay McCulloch: The Collected T Works of J. R. McCulloch: A discourse on political economy; Historical sketch of the Bank of England; A new bank in India; A treatise on the rate of wages. This collection volume was published in 1995.

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McCulloch acknowledged that trade had drained the island country of metals and coin, but he immediately added that this was because so much paper currency was available, that is, circulated within the system. In Scotland, where there was little gold and a much smaller population, and there were also a limited number of financial institutions, the amount of money released was easier to record. Thus, because of the orderliness, that is to say, the transparency of the internal market, customers always knew the real value of the payment instrument (McCulloch, 1826a, 280–282). By contrast, in England, in the case of hundreds of local small banks dispersed around the country and secretive metropolitan investors, it was just inevitable that the degree of mistrust of the currency fluctuated permanently and this led to further demands for credit. All this is ‘self-evident, inasmuch as the Bank of England and the local banks are the only issuers of paper, that when an over-issue does actually take place, it must be wholly owing to some erroneous proceedings on the part of one or both of these parties’ (McCulloch, 1826a, 268–269). By June, however, when he published the third article, something may have greatly shaken McCulloch’s faith, as he argued completely different than before. The title, ‘The Late Crisis in the Money Market Impartially Considered’, in itself reflects some kind of new attitude. McCulloch states that the financial crash was not the fault of ignorant greedy bankers but rather the diversification of the market. ‘The advantages which any one class of producers derives from an increased demand for their peculiar produce, are uniformly exaggerated, as well by that portion of themselves who are anxious, in order to improve on credit to magnify their gains, as by the whole body of those who are engaged in other businesses’ (McCulloch, 1826b, 70–71). But this growth can also lead to overconfidence. ‘The adventurous and sanguine ... crowd into a business which they readily believe presents the shortest and safest road to wealth and consideration; at the same time that many of that generally numerous class, who have their capitals lent to others, and who are waiting until a favourable opportunity occurs for investing them in some industrious undertaking, are tempted to follow the same — 230 —

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course. It occurs to few, that the same causes that impel one to enter into a department that is yielding comparatively high profits, are most probably impelling thousands ... A disproportionate quantity of capital being attracted to lucrative business, a glut in the market, and a ruinous depression of prices, unavoidably follow’ (McCulloch, 1826b, 71–72). The economist further claims that no artificial forms of ‘arbitrary regulation’ or ‘Legislature’ can create capital, ‘it can only force it into artificial channels’. Yet he does not deny that ‘restrictions and prohibitions are, in every instance, productive of uncertainty and fluctuation’. Indeed, he goes on to say that once the capital of the country has been veered into speculative or artificial channels where it has no business, a reaction must commence. ‘There can be no foreign vent for their surplus produce; and, whenever any change of fashion, or fluctuation in the taste of the consumers, occasions a falling off of demand, the warehouses are sure to be filled with commodities which, in a state of freedom, would never have been produced.’ Although these are actions and reactions that, according to the proper principles of economic behaviour should not happen, they do, moreover, they often have real and inevitable consequences. ‘The ignorant and the interested always ascribe such gluts to the employment of machinery or to the want of sufficient protection against foreign competition! Trust, however, that they are the necessary and inevitable result of acting on an artificial and exclusive system; and of the application of those poisonous nostrums, by which the natural and healthy state of the public economy is restricted and disturbed’ (McCulloch, 1826b, 75–76). Meanwhile, other economic thinkers were already realizing that the rational individualism that McCulloch and others of his circle proclaimed was all too polarized and they knew that economic processes cannot be interpreted in such a simplistic way. Indeed, in the first half of the 19th century, a number of English economists not only strongly rejected the theory of production costs (David Ricardo), but — 231 —

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also worked on the new foundations of value theory. Among them, we find primarily Samuel Bailey, according to whom work devoted to production of goods could only determine the value if work were the sole factor in production (Bailey, 1931, 21). Bailey also rejected the notion that capital costs could be traced back to labour costs. The latter statement was also attacked by Samuel Read and F. B. Hermann. It can be seen that already in the first half of the 19th century both cost theory and its one-sided version, the work theory, had illustrious opponents. In any case, according to Karatani, S. Bailey’s point of view later influenced Marx (Karatani, 2005, 8–9). As A. C. Waterman and Boyd Hilton showed at length, in the late 1820s and 1830s general economic theory was greatly influenced by one of the trends in Christian political economics, namely the version derived from Evangelicalism promoted, in particular, by Thomas Chalmers and Richard Whately. Evangelicalism itself began in 1730 in the United Kingdom.165 Representatives of this fundamentalist, Christian, Protestant movement presumed that human action, motivated by individual desire, entailed some degree of suffering, but such suffering was also part of a Divine plan. The application of this doctrine of ‘atonement’ led to the formulation of such important socio-economic principles as the business cycle. The idea is that, as even McCulloch accepted, all excess production caused by artificial demands will inevitably result in higher prices and eventually in an economic downturn. That the doctrine of ‘Atonement’ became increasingly popular in the economy by the end of the 1820s had a good deal to do with the charisma of writers like Chalmers, who was also a social reformer and enthusiastic preacher. At the same time, however, the negatives of the financial crash in 1825 also stimulated the popularity of Christian economics because many families in bankruptcy

165

ebbington 2008. Source: http://www.emanuel.ro/wp-content/uploads/2014/06/ B P-6.2-2008-David-W.-Bebbington-Evangelicalism-and-British-Culture.pdf

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tried to endure suffering as part of the Divine plan (see also Alexander J. Dick’s writing, On the Financial Crisis, 1825–26). The results of the 1825 financial crisis were useful to the British government. After a slight increase in debt in 1827, the state debt continued to decline during the rest of the century.166 The government’s gross income remained high and exceeded gross expenditure, except in 1827 and 1828 when it fell slightly (Mitchell, 1976, 392, 396 and 402). Due to the convenient financial situation, in terms of state debt Britain was the lowest in interest rates (compared to any European government) throughout the 19th century.167 All this was a great advantage for the island when it was necessary to mobilize its financial resources for armed conflicts around the world. This served as a basis for carrying out lasting political reforms, the process of which culminated in 1834. In the 1840s, there were significant economic reforms such as the repeal of the Corn Laws and shipping laws and the support of limited liability joint-stock companies in the 1850s and 1860s (Neal, 1992, 80–99). In recent research, experts have placed the crisis of 1825 alongside the crisis of 2008 (Turner, 2014, 53–4, 62) as the most acute banking crisis of the previous two centuries in terms of both financial casualties and output effects. Indeed, some fifty years later the Chairman of the Manchester and Liverpool Bank recalled the event as follows: ‘when people went to their business that year, they did not inquire what banks were broken, but what banks were standing’ (P. Report, 1875, 340, q. 6610). In 1825 and 1826, 6 per cent of the banks went bankrupt and 7 per cent was the total number of failed British banks. This supports the conclusions of Turner regarding the crisis: ‘this was a uniquely extreme event’ (Turner, 2014, 62).

166 167

http://www.niesr.ac.uk/sites/default/files/publications/DP478.pdf To compare British interest rates with the rest of the world, see Neal, 1992, 84–96.

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4.4.5 Background of the 1841 crisis

We can say that the main reasons for the 1841 crisis were economic depression and government policy. In terms of its nature, we can talk about an interior, that is, endogenous crisis. The crisis of 1841 occurred in the immediate aftermath of 1836–1837, which in the academic literature has received considerably more attention to date. Were this earlier crisis (1836–1837) the subject of our analysis, we could examine it as an exogenous crisis. At this time only two major banks became insolvent and, as is highlighted in current research (Turner, 2014, 72), the main reasons for the crash were, among others, aggressive risk taking and fraudulent behaviour. There is no consensus among the experts regarding timing. For example, Dimsdale and Hotson claim that the recession must have taken place between 1839 and 1842 (Dimsdale– Hotson, 2014, 27), while according to Reinhart and Rogoff the crisis was borne between 1837 and 1839 (Reinhart–Rogoff, 2009, 387). In fact, it was during the economic downturn between 1839 and 1842 that the panic level rose again considerably, because in 1841, 3 per cent of British banks collapsed. The previous year had a figure of 2 per cent, suggesting that this episode to date has received insufficient attention as a banking crisis, which is likely due to the emphasis of contemporaries on stagnant macroeconomic conditions. From contemporary newspapers it is clear that poor economic conditions preceded the bank failures of 1840 and 1841. For example, The Times already reported in the first half of 1839 that ‘business’ was ‘more than ordinarily dull’, and contemporaries associated the crisis, among other things, with ‘failure of corn crops of that and the preceding year’.168 As we may expect from the Cunliffe version of the price-specie flow theory, to rectify the balance of payments deficit which the United Kingdom experienced (see below), the central bank raised the discount 168

The Times, 01/05/1839; https://www.gale.com/uk/c/the-times-digital-archive

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rate, that is, they brought about a general price reduction. While at the end of 1838, it was 4 per cent, by the end of 1839, it had reached 6 per cent, leading to a rapid fall in prices. Such actions were heavily criticized by manufacturers in the press as having led to widespread unemployment or, by contemporary terms, ‘injuries inflicted upon the labouring classes by the operations of the Bank of England upon the currency’.169 The manufacturers also complained that unlike ‘moneyed capitalists’ who enjoyed higher prices for their silk imports in 1838, due to ‘the depreciation of the currency by the Bank of England’ the ‘manufacturing capitalist, at all times a purchaser’ now suffered ‘heavy losses’ as sales prices dropped deeply, moreover they had to bear all ancillary costs.170 The Morning Post claimed almost two years later that the fall in prices was being ‘unduly aggravated through the continual supplies furnished by persons largely indebted to their bankers, and who have been compelled, week after week, to bring them to market and dispose of them at any sacrifice in order to keep their manufactories going’.171 The banks, in turn, came under pressure from debtors who could no longer repay their loans in time, and so to avoid even greater debt accumulation they were forced to get rid of their products at lower prices. The Morning Post heavily criticized the affected banks for the unreasonably long processes to which some of them had ventured into. The vicious circle started with their granting reckless advances to cotton-makers and manufacturers in the hope of profit.172 Meanwhile, the public was increasingly confronted with the banks’ exposure in this manner, as through the reports of the committees set up he Times, 01/01/1840; https://www.gale.com/uk/c/the-times-digital-archive T Evening Mail, 01/01/1840; https://www.britishnewspaperarchive.co.uk/titles/ evening-mail 171 The Morning Post, 15/11/1841; https://www.britishnewspaperarchive.co.uk/ titles/morning-post 172 The Morning Post, 15/11/1841; https://www.britishnewspaperarchive.co.uk/ titles/morning-post 169 170

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due to ongoing bankruptcy investigations it already had access to some important information.173 Such a case was the bankruptcy of Hobhouse and Co. in Bath, as the credit institution had provided large amounts of credit to wool producers that borrowers were not able to repay at due dates from the very beginning.174 The above evidence is typical of contemporary press releases at a time when commentators focused primarily on the considerably deteriorated production conditions, linking them with dropping prices which can be traced back to ‘actions of the Bank of England upon the currency’ and banks that became insolvent (as bad creditors). Based on the above, this can be considered an endogenous crisis that is closely related to government policy and the various effects of general economic depression. Up to now, very little research is available on this bank crisis and its background. However, Bordo and his fellow researchers identify the series of events of 1841 as ‘a major emergency’ in the ‘financial condition index’ compiled by them (Bordo et al., 2003, 143–69). It is remarkable that this crisis has been recognized as a depression in England which affected both industry and agriculture, however, it has also been linked to the depressed state of Anglo-American trade (Ollerenshaw, 1987, 52– 6). Dimsdale and Hotson describe this episode as a ‘balance of payments crisis’ which, according to their understanding, occurred in 1839, and as a result, the central bank was forced to raise the base rate, which was considered a sufficiently far-seeing solution (Dimsdale–Hotson, 2014, 27–28). During a series of interviews published by the Banking Committee in 1841, this subject was addressed at length. Here, the Chairman of the Private Bankers’ Committee expressed his view on the trade deficit and its impact on the banking system: ‘when gold is going out of the country there is generally a gloom hanging over he Morning Post, 15/11/1841; https://www.britishnewspaperarchive.co.uk/ T titles/morning-post 174 Hereford Journal, 22/09/1841; https://www.britishnewspaperarchive.co.uk/ titles/hereford-journal 173

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the public mind’ and ‘that lowers prices very much’.175 In addition, members of the Banking Committee claimed that during the first eight months of 1839, the deflated foreign precious metal outflow was so severe that the Bank of England was already in a state of emergency to have to suspend the payment system for coins. That is, the only tangible solution was to reduce their turnover on the money market.176 Thus, (based on the archival material of one regional bank) it is evident that due to the growing bank interest rate, the decline in turnover and the decreasing price, as early as 1839 everyone was worried and the masses placed ‘severe pressure upon all the banks’.177 In his Business Annals, Thorp described the year 1841 in England in the following manner: ‘severe depression; many failures; widespread unemployment; foreign trade dull. Money tight’ (Thorp, 1926, 161–162). In 1857, it was recalled by a Committee witness that the distress of 1839–1841 was caused by ‘an American Pressure’, that is, the economic state of emergency might have been brought about ‘in consequence of’ an excessive ‘drain of bullion’ (Banking Committee Report, 1857, 8 and 160, 2364–2365 q.). As a conclusion, we can state that the banking crisis of 1839–1841 was caused by poor economic conditions. In support of this argument, it can be noted that in academic literature, this kind of question, namely, ‘What was the banks’ reaction to this depression?’ is particularly represented by Ollerenshaw (Ollerenshaw, 1987, 56–57).

anking Committee Report, 1841, 12, 94 q. Source: Second Report from the Select B Committee on Banks of Issue. 176 Banking Committee Report, 1841, 65, 603 and 604 q. Source: Second Report from the Select Committee on Banks of Issue. 177 Provincial Bank of Ireland Archive, 12/02/1839 175

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4.4.6 The 1866 crisis

The Crisis of 1866 has often been referred to by experts as the ‘Overend Gurney Crisis’ as the Bank of England refused to ‘bail out’ that institution. Therefore, this actually ‘rebutted the principle of “too big to fail”’; nevertheless, it is a fact that the collapse of this credit institution triggered a panic extending to the entire banking sector.178 According to most experts the crisis should be viewed as having occurred in 1866, however, recent research has shown (Turner, 2014, 82–86) that crises of a number of significant banks continued into 1867. Due to the panic effects triggered by the failure of the Overend Gurney Bank and the incorrect risk management (government and central bank), in 1866, approximately 3 per cent of the banks in the United Kingdom went bankrupt. Regarding 1866, contemporary newspaper reports and appearances focused on the view that this crisis was limited to the newly-formed finance and banking companies and at the same time was the result of lax lending safeguards, speculation and fraudulent practices. A letter from the Governor of the Bank of England to the Government was published in the Caledonian Mercury.179 The letter of the Governor is pervaded by the feeling that this crisis largely differed from those of 1847 and 1857: ‘These were periods of mercantile distress, but the vital consideration of banking credit does not appear to have been involved in them, as it is in the present [1866] crisis.’180

or current research backgrounds, see Flandreau-Ugolini, 2014. F Caledonian Mercury, 14/05/1866, Source: https://www.nls.uk/collections/ newspapers/early/caledonian-mercury 180 Caledonian Mercury, 14/05/1866, Source: https://www.nls.uk/collections/ newspapers/early/caledonian-mercury 178 179

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During the most acute month of the panic, that is May 1866, a number of articles appeared in The Times which fitted well with the Bank of England Governor’s statements above. The alarm became apparent on 12 May as ‘nothing had happened since the day before to justify such a fear as was everywhere shown’ and the panic was said by a number of calm thinkers to have ‘had no solid foundation’. Deriding recent practices, contrasting long-term lending with incredibly short-term loans provided at the same, the daily newspaper reported: ‘a particular course of unsound business has broken down, but the position of ordinary bankers and merchants remained unaffected’.181 Considering the rapidity of the formation of finance companies and the lack of capital paid up, The Times’ commentators were very suspicious.182 Turner is an expert in describing the emergence of the crisis, while always referring to the great number of recent finance company flotations which decision-makers had integrated one after another into the limited liability company frame following the Act of 1862. Most of these, however, had acquired basic or working capital under suspect circumstances. Therefore, the expert states that many of them were of ‘dubious nature’ (Turner 2014, 80). In a Committee which examined the flotation of these companies, the Chief Clerk of the Rolls explained: ‘Undoubtedly the facility for forming joint-stock companies has furnished the means of executing some of the frauds which have been committed.’ The extent of these was very great. Then he continued, saying that ‘companies [i.e. those newly-established] rose up’ simply to procure ‘promotion money’.183 Such companies had been lending against low quality securities, but with high repayment interest rates, to limited liability companies. These companies largely resorted to longterm credit and invested primarily in railway construction throughout the United Kingdom. When the railway companies began experiencing he Times, 12/05/1866; https://www.gale.com/uk/c/the-times-digital-archive T The Times 07/05/1866; https://www.gale.com/uk/c/the-times-digital-archive 183 Report from the Selective Committee on Limited Liability Acts 1867, 95, 329 and 1483–1485 q. 181 182

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financial difficulties, their own finance companies suffered strong pressure, a number of whose shareholders simply did not subscribe their full allotment and at the first few minor turbulences they began selling their shares in panic. Following a share price fall of almost 50 per cent in four months, the largest company in difficulty, Overend, Gurney and Co. finally collapsed on 10 May 1866 with losses of GBP 5 million. On the following day, that is, on ‘Black Friday’, a ‘violent panic’ descended on the money market while the Bank Act was quickly suspended, and this brought the rampant panic to an abrupt end (Turner, 2014, 81). Taking into account another angle it can be noted that Clapham argued that the crisis was not based upon real or monetary phenomena (Clapham, 1958, 266). Despite the fact that Gladstone and Lord John Russell wrote in the newspaper of the ‘intense rapidity’ with which the shock had emerged,184 it is not to be neglected that operational faults of a number of significant banks continued into 1867 until the crash occurred (Turner, 2014, 82–85). In sum, subsequent research and other contemporary reports support the conclusion that this event was not caused by macroeconomic activity, but it might have been the result of fraud and poor risk management.

184

The Times, 12/05/1866; https://www.gale.com/uk/c/the-times-digital-archive

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4.5 Banking development of Austria and Hungary until the Austro-Hungarian Compromise of 1867 Chart 4-18: Countries and regions under Habsburg rulership between 1816 and 1867185

Source: Authors’ own compilation based on upload.wikimedia.org.

4.5.1 Banking development in Austria from the 18th century to the middle of the 19th century

In different eras it varied which areas were regarded by contemporaries (and historians) as parts of ‘Austria’, given that wars and marriages continually changed the extent of Habsburg-dominated countries and 185

s already mentioned, the map denotes Hungary as part of the Austrian Empire, A but from the Hungarian viewpoint the Hungarian Kingdom was outside the Austrian Empire. See also: Gergely, 2003, 13. f.

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regions. In the following, for the sake of simplicity, the term ‘Austria’ refers to the territory of the present Republic of Austria. Accordingly, we do not deal with the banking development of the Bohemian, Moravian and other Eastern European regions, which were also under direct Habsburg sovereignty at that time. Austria, Hereditary Lands,186 Austrian Empire, Austro-Hungarian Monarchy: Since the Middle Ages, the Austrian Hereditary Lands (in German: österreichische Erblande/Erbländer) have been part of the Holy Roman Empire. Over the centuries the Austrian line of the Habsburgs gradually expanded its influence and incorporated these counties and duchies into its family estates. Thus, the current Habsburg ruler did not only rule as an emperor, but also as lord of the area (vassal). The influence of the family was therefore very strong, and the local orders were much weaker than in Hungary. When (Habsburg) Emperor Francis II founded the Austrian Empire in 1804 (and became Austrian Emperor under the name of Francis I), he made the Hereditary Lands the core area of his new realm. It should be noted that the Habsburg ‘holdings’ also included Bohemia and Moravia, as well as other regions (e.g. part of Silesia) under the Bohemian Crown where the Habsburgs inherited the throne (which areas, according to some opinions, shall be regarded therefore also as hereditary lands) and from the late 18th century some Polish and Ukrainian regions (Galicia). In addition, in several European states (including certain small Italian states or even Hungary) Habsburg rulers had been on the throne for a long time (see Chart 4-18 in relation to areas under the rule of the Habsburgs).

186

t the end of the 18th century the following areas shall be considered as Austrian A Hereditary Lands: Lower Austria, Upper Austria, Styria, Carinthia, Carniola, Tyrol and Further Austria (the latter consisting of several scattered lands, partly lying in the area of today’s Germany and Switzerland). However, Burgenland, now in Austria, was part of Hungary at that time. Salzburg and its surroundings were the property of the Archbishopric; it came only in 1816 under the authority of the Habsburgs and became part of the Austrian Empire.

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The term Austria was understood by contemporaries as all of the countries dominated by the Habsburgs – including Hungary –, but this reflected only the view of the public. Namely, in terms of the constitutional law no unified ‘Habsburg Empire’ existed until the 19th century, but only single kingdoms, duchies and other states under Habsburg sovereignty, which were connected by the dynasty with other measures (such as a customs union). Unification efforts were reflected in the Pragmatic Sanction of 1713, according to which the Habsburg state complex had to be ruled only by one person, and in the foundation of the Austrian Empire in 1804 (although according to the Hungarian conception Hungary was not part of it) (Vajnági, 2009, 257. ff.; Gergely, 2003, 11. ff.). Finally, with the foundation of the Austro-Hungarian Monarchy in 1867 a special unity of the states under Habsburg sovereignty was sought. 4.5.1.1 Austrian banks and the financing of the state

In highly centralized Austria, perhaps the most important role of the early banking system was the financing of the general government deficit. This was the purpose of the first foundations of banks (1703: Banco del Giro; 1706: Vienna City Bank (Wiener Stadtbank); 1714: Universalbancalität). The speciality of the Vienna City Bank was that it was operated by the city of Vienna, which disposed a stable financial situation, so the bank enjoyed trust among creditors. It dealt only with deposit and loan transactions: the deposits financed the state debt, and initially the institution provided loans mainly to the state. Thus, in practice it was the bank of the state (Pohl, 1993, 318; Klein, 1982, 190. ff.). In addition, the government raised loans from private banks as well (in 1847 their number was 92). The first private banks in Austria were concentrated in the hands of foreign families: Germans, Italians, from the middle of the 18th century Swiss (e.g. Geymüller) or Greek (Sina) merchant-banker dynasties, followed by bankers of Jewish origin from the 19th century (Rothschild, Arnstein & Eskeles). According to Gergely (2003, 33), from the 1810s private banks in Vienna counted as the main lenders of state expenditures (before that the government borrowed — 243 —

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mainly from Frankfurt, Amsterdam and Italian banks). In addition to lending, the (partly foreign) private banks contributed to the growth of the treasury through the distribution of government bonds, furthermore, they were also lending to the upper class of the nobility, and between 1820s and 1840s they joined the financing of horse tram and railway constructions (Pohl, 1993, 199 and 318. ff.; Klein, 1982, 253). Initially private banks had minimal significance for Hungary, because Hungarian aristocrats were rarely provided with loans (Tomka, 2000, 7. f.). Box 4-9 The first issue of banknotes in the Habsburg countries

The roots of banknote issuance can be found in the financing of the state budget. Under the reign of Maria Theresa (1740–1780) a tendency was growing according to which the financing of wars resulted in expenditure overruns that created indebtedness. Much of the state incomes, or even the whole, was swallowed up by military expenditures. In 1780, the state debt amounted to 289 million forints, while in 1820 even 896 million forints. Already under the reign of Maria Theresa, another way of financing appeared as an alternative to borrowing: the issuance of banknotes (then called Bancozettel). These were initially interest-bearing and then from 1762 (issued by the Wiener Stadtbank) non-interest-bearing ‘bills of debt’, which could be converted in a given sum into metallic money, but were more easily transportable than such. They could be used for payments to the state (such as tax payments), and the state used them for payment as well, however, private economy was not obliged to accept them until 1800. The first paper money was issued in 1761, and its volume grew steadily (between 1796 and 1811 by twenty-three-fold: from 46 million to 1061 million forints). This caused serious inflation, as production did not grow as fast, and there was no appropriate commodities collateral either. As a solution attempt in 1797, the conversion of paper money into metallic money was suspended, and from 1800 onwards the acceptance constraint was extended to private individuals as well. Then, on 20 February 1811,

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the value of the banknotes was reduced to one fifth (devaluation) by issuing so called redemption notes (Einlösungsschein) in an amount corresponding to one fifth of the nominal value. This measure, with the other requests of the court, was challenged by the Hungarian orders, so its implementation in Hungary was based on a royal edict, without the approval of the Hungarian parliament. As a result, the population lost 80 per cent of its assets in paper money. The amount of redemption notes was maximized, but since it was necessary to cover war expenses, new paper money (anticipation note, Antizipationsschein, Chart 4-19) was issued in 1813. As a result, the amount of paper money grew again (Gergely, 2003, 32. f.; Bácskai, 1993, 83. ff. and 166. ff.; Tomka, 2000, 8). Chart 4-19: Anticipation note (Antizipationsschein) from 1813 (value: 5 guilders)

Source: upload.wikimedia.org

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Some degree of currency stabilization was only achieved by the foundation of the Privileged Austrian National Bank (hereinafter referred to as OeNB) on 1 June 1816. With the support of OeNB, another devaluation was carried out in 1816: redemption and anticipation notes were exchanged for OeNB’s banknotes. With the example of Bácskai (1993, 167), after the first devaluation 100 forints was worth 20 and after the second only 8. Interestingly, both redemption and anticipation notes remained in circulation until 1858 (in the academic literature: ‘Wiener Währung’), i.e. their conversion to OeNB’s banknotes lasted for 40 years. In subsequent decades, the issue of bullion reserves and measures aimed at the limitation of money in circulation were also raised. 4.5.1.2 The Austrian National Bank as the central bank of the Habsburg countries

The Privileged Austrian National Bank (Privilegierte Österreichische Nationalbank [OeNB]), founded on 1 June 1816, was a bank with bank of issue functions, but it operated in the form of a joint-stock company.187 It had a monopoly on issuing banknotes (that is why the word ‘privileged’ appeared in its name) and the right to convert money into silver, but it also dealt with lending. Despite its regulatory role, the amount of banknotes issued was barely restricted; OeNB served the state’s credit needs until 1850 (Bácskai, 1993, 87). As Pohl (1993, 319) noted, it was the ‘state’s banker’: most of the lending transactions of the OeNB were carried out with the Treasury, and the money paid in by citizens was invested into public debt denominations and treasury bills (Bácskai, 1993, 87. ff.; Pohl, 1994, 19).

187

I nterestingly, the French central bank founded in 1800 also operated in the form of a joint-stock company, and one of its shareholders was Napoleon himself. For more details, see: Halustyik (2014) (ed.): Pénzügyi jog III. (Financial Law III), Pázmány Press, Budapest, 171.

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The right to issue banknotes was granted to OeNB for 25 years (until 1841). During that time, state control was exercised by a government commissioner with veto rights. Following the extension (1841–1862), the number of government commissioners increased to two, and the directors were also nominated by the state. Thus, the management of the bank was in the hands of the finance minister, and in case of several transactions the approval of the financial government was necessary (Pohl, 1994, 19; Bácskai, 1993, 155). An important milestone in the operation of the OeNB was the Austrian Banking Act of 1862, which sought to secure the independence of the central bank, following the English model. The bank governor was still appointed by the ruler, but this was more of a formality, therefore, the OeNB was more independent than its Prussian and French counterparts (Bácskai, 1993, 160. ff.). The operation area of OeNB extended to the Kingdom of Hungary as well, however, banknote issuance was not approved by the Hungarian Parliament. The majority of the Hungarian orders believed that OeNB was only a tool of the court’s economic policy. Later on, they also discovered the positive effects of the operation, which were manifested in the economic stimulus of paper money issued by OeNB. Nevertheless, the Hungarian orders wished to limit the radius of operation of OeNB to Austria, in order to encourage the establishment of a Hungarian central bank. Although the Hungarian Parliament did not recognize OeNB’s banknotes as an official currency, the public used them as such. The acceptance of the new paper money placed in circulation in 1841 was made mandatory by the Council of Governors. According to public opinion, Hungarian precious metals were taken out of the country via Austrian paper money (Bácskai, 1993, 90. f., 113. ff. and 122). For Hungary, it was important that the statutes of the first Hungarian bank, the Hungarian Commercial Bank of Pest, were based on those of OeNB (see Subchapter 4.5.2.4). For the purpose of redeeming (old) banknotes OeNB opened 12 offices in Habsburg countries between 1818 and 1823 (three of them were — 247 —

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located in Hungary). Branches providing broader services were opened later: Prague (1847) and Pest (1851) were the first, but by 1857 there were already 13 branches in the territories of the Austrian Hereditary Lands and 5 branches operated in the countries of the Hungarian Crown (Bácskai, 1993, 89, 91 and 177. f.; Tomka, 2000, 8). In 1878, OeNB reached the ‘height of its career’ by becoming the central credit institution of Austria-Hungary under the name of Austro-Hungarian Bank (see Subchapter 5.4.3.6). 4.5.1.3 Industrial development and banking foundations in the light of politics

The development of the Austrian industry and banking system was negatively influenced by the government’s devaluations, which reduced not only the debt but also money reserves. As a result of the deflationary policy of the 1810s, several banks withdrew from industry financing, so the development of the textile industry in the 1820s was carried out in Austria without the participation of banks. A good example of this is the credit and exchange bank founded in 1787 by wholesalers and aristocrats (k. k. privilegierte u. octroyierte Kommerzial-, Leih- und Wechselbank), which established a textile plant and granted loans to businesses, but went bankrupt after 1811. Similar is the case of the Geymüller Banking House, which became insolvent due to the deflation policy of the OeNB in 1841. Between the 1820s and 1840s, however, even private banks were involved in the financing of horse tram and railway constructions (Pohl, 1993, 319. f.). Similarly to the German states, the banking sector with the existing, limited capital was not able to satisfy the capital demands of the developing industry on its own, or due to risks was not willing to. One possible solution was to merge the capital of multiple shareholders and investors into a joint-stock company who in this way were able to join the foundation of a company or even of a bank with a small amount of capital and with limited risks. In the German states the system of Aktienbanks operating in the form of joint-stock companies contributed to the long-term financing of — 248 —

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industrialisation (e.g. through the establishment of companies, jointstock companies, stock transactions or lending. See also Subchapter 5.2.1.2).188 The intention was present also in Austria, and the multiples of the planned value of the shares could have been accumulated, but investors withdrew their capital at the first sign of a crisis. Therefore, as an Austrian characteristic, the state became involved, which realized that maintaining the Great Power status of the Empire is possible only with a modern economy. The planned solution was a state-controlled but privately-owned bank that would not only finance economic development and railway construction, but if necessary, it would also provide the state with money. In 1856, the bank was founded as the Imperial-Royal Privileged Austrian Credit Institution for Commerce and Industry189 (k. k. priv. Oesterreichische Credit-Anstalt für Handel und Gewerbe). Both foreign and domestic banks participated in the foundation, but the state retained the right of supervision for itself, and the supervisory board consisted of nobles loyal to the Emperor. Between 1857 and 1866, the bank continued to develop (by 1861 it opened six branches in the countries of the Habsburgs, including Pest), although operation was not without losses. The bank did not provide agricultural loans, for that purpose another public initiative was intended: the OeNB’s mortgage division, which was active also in Hungary (Pohl, 1993, 321. ff.). In the 1860s, purely privately founded banks became widespread in the countries of the Habsburgs (1862, Brünn; 1863, Prague; 1864, Graz). At the same time, as in the German states, the importance of family-owned private banks fell, many of them were closed or their significance decreased. The abolition of the dual customs system (in part: 1850, completely: 1851), money issuance due to the financing of wars, the Austro-Hungarian Compromise of 1867 and liberal changes in politics created an ideal basis for economic development. After 1867, flotation fever started to spread, which had a positive effect on banks as well (Pohl, 1993, 317 and 324. f.). 188 189

owever, the extent of this is subject to discussions. See Edwards–Ogilvie (1996). H The first bank in the form of a joint-stock company was in fact the Austrian National Bank, however, it did not aim at industrial development.

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4.5.1.4 Savings banks in Austria

In Austria, savings banks (Sparkasse) appeared relatively late, some German states preceded Vienna by a good twenty years (see Subchapter 5.2.2). Austrian savings banks resembled German savings banks in that they were institutions established with social objectives in mind, which aimed to support self-help by providing interest-bearing deposit facilities. The difference was that in the German states private initiative dominated only during the first foundations, but from the beginning of the 19th century most of the savings banks were founded and managed by the self-government of cities/districts. In contrast, in Austria (as in England and France) humanitarian associations were the founders (Pohl, 1982, 98. ff.; Jirkovsky, 1938, 14). In Austria, wealthy Viennese citizens founded the First Austrian Savings Bank (Erste Österreichische Sparkasse) in 1819 with philanthropic goals, which was the predecessor of today’s Erste Bank Group. Its significance was that it had provided a model for later (Hungarian and Austrian) foundations. Similarly to its German counterparts, its clientele came from poorer social classes who, at the same time, disposed some money to set aside: workers, craftsmen, day-labourers and servants. The social nature of this savings bank was stressed also by the fact that the value of deposits was maximized, and that managers did not receive any remuneration. Members were those who gifted interest-bearing government bonds to the savings bank (which therefore became entitled to the interest), and the profits were for deposit insurance purposes (Jirkovsky, 1938, 14. f.; Pohl, 1993, 212).

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Chart 4-20: Number of savings banks in Austria and in Hungary 1845, 1848 40

Number of savings banks

Number of savings banks 36

30 25

25 20

15 10

5 0

1845

1848

Austria Hungary Source: Authors’ own compilation based on Tomka (2000, 10) and Bácskai (1993, 117).

The number of foundations in Austria grew slower than in Western Europe or even in Hungary190 (Chart 4-20), which could have resulted from the strictness of Austrian regulation. On 26 September 1844, the normative Savings Banks Regulation – ‘Regulativ über die Bildung, Errichtung und Überwachung der Sparkassen’ (in Hungarian academic literature: Regulatívum) – was passed which placed all Austrian savings banks under state supervision and set certain requirements for the foundation, business lines and business practices of savings banks. The foundation of the savings banks was approved by the Court only if their statutes were in compliance with the 190

ccording to the data of Tomka (2000, 10) and Bácskai (1993, 117), until 1845, 8 A and until 1848, 17 savings banks were founded in Austria, which is less than the number of Hungarian foundations (1845: 20, 1848: 36). Jirkovsky’s (1938, 16) data show that concerning the number of savings banks Austria was lagging behind Western Europe: in 1838, there were 80 savings banks alone in Prussia, 201 in the German states, 250 in France and 484 in England.

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Regulatívum, moreover, it required them to prepare an annual business report. In Hungary, this was never fully accepted (see also Subchapter 4.5.2) (Tomka, 2000, 14; Bácskai, 1993, 117; Jirkovsky, 1938, 33. ff.).

4.5.2 The development of lending and banks in Hungary from the end of the 18th century to 1867 Although some Habsburg kings reigned in Hungary even in the Middle Ages, but due to the fact that in 1687 the Hungarian orders resigned from their rights to freely elect kings and their resistance rights defined by the Golden Bull (which could be traced back mainly to the presence of the Habsburg military force that actively participated in the liberation of the country from Turkish rule), the members of the Austrian dynasty now came to the throne by succession. Hungary was basically governed by its own laws and customs. The country was an order monarchy at the time, so the ruler had to take into account the order privileges, the Hungarian Parliament and the counties as well – i.e. in contrast to the majority of Habsburg countries and provinces, the absolutist policies of the Habsburgs could not be enforced without limits (for Hungary’s position within the Habsburg Empire see also chapter 4.1.6.1; for the historical background see Subchapter 4.1.6.2. Further literature on the subject: Tóth, 2001, 230 and 303; Gergely 2003, 19. ff.). 4.5.2.1 Hungarian economy in the decades before the Austro-Hungarian Compromise of 1867

Hungary’s economy lagged behind Western Europe in the late 18th and early 19th centuries. Upon the expiration of Turkish rule, the guilds were reorganized, and manufactures were founded mainly on royal initiative. Around 1790, the number of non-guild-type plants amounted to 125, and most of them employed up to twenty workers. The number of people living from (guild) handicrafts increased tenfold between 1785 and 1846. The Habsburgs’ customs policy since 1754 should be hereby emphasized: the dual customs system meant that external customs duties were high in and out (up to even 50 to 60 per cent), thus — 252 —

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‘protecting’ the market from (often cheaper and better) foreign goods. In addition, the internal customs duties cut off the Bohemian and Austrian territories from Hungary. While from Hungary it was cheap to ‘export’ agricultural products to the areas west of the Leitha River, Bohemian and Austrian industrial products could be ‘imported’ under favourable conditions to Hungarian areas, and they were often of better quality than the Hungarian domestic products. Customs policy adversely affected the Hungarian industry, but it was beneficial regarding the sale of agricultural products on the Austrian and Bohemian markets, as Hungarian products could not have prevailed on the Western markets against cheap colonial goods. The export comprised of mainly agricultural products (cattle, corn, wine) (Tóth, 2001, 316. ff. and 352). Although the Habsburg’s economic policy, in particular the dual customs system, has long been considered as ‘colonizing’ by historians, these hypotheses have been slightly modified by researchers since the 1970s. It was found that Hungary counted already in the 17th century as a source of raw materials and market outlet for industrial products; introducing the Habsburg customs system only made the Habsburg Hereditary Lands exclusive in this respect (Gergely, 2003, 28. ff.). Due to the Napoleonic wars, the constantly warring armies increased demand for agricultural products, which had a good impact on the Hungarian economy. The guilds were slowly pushed into villages and market-towns, while the products of capitalist manufactories and of (partly foreign) factories appeared on the market. Hungarian factories (textile and iron industry, glass and paper production) were founded by wealthy citizens and landlords partially with the purpose to meet the demands of the war boom that began in the early 19th century. After the wars industrial processing of agricultural products became dominant (sugar production, distilleries). Hungarian and Austrian industrial development required machinery and tools, consequently, in the 1840s these two sectors developed as well. Steam engines had been in use since the 1830s. This did not change the fact that the most important export products still derived from agriculture. In the 1840s, two-thirds of trade was directed to the eastern half of Austria, — 253 —

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only one-eighth outside Habsburg countries (mainly Turkey). Capital demand for development began to be covered by the emerging credit institution system (Tóth, 2001, 337 and 352. ff.). 4.5.2.2 Credit situation at the beginning of the 19th century

‘Modern’ organizations providing credit and banking initiatives appeared in Hungary only in the 1830s. This is partly due to the low level of demand. Until the early 19th century, loans played a low role in trade. The most significant borrowers were landlords who borrowed for land acquisition, keeping the estate together (paying the heirs), consumption, or perhaps for agricultural development (construction, import of western animal breeds).191 Creditors came from among people whose main profile was not the provision of financial services (landowners, ecclesiastical dignitaries, monk orders, merchants or foundations), however, by lending they had the opportunity to invest the capital they owned, which, in the absence of banks, they could not do in any other way. Usually personal trust, prestige and the lands of the borrower counted as guarantee and collateral. Several bills of debt did not specify the repayment period, so the amount borrowed may have stayed with the borrower for decades. The regulation allowed a maximum of 6 per cent of levied interest, but at the same time the borrower had to assume other obligations. Therefore, the effective interest rate could reach up to 10 to 20 per cent. This made borrowing more expensive and reduced profitability. Pledging a land could be considered a special lending transaction: instead of paying interest, the debtor transferred his land to the creditor for use. Since the law of entail did not allow the sale of noble estates, this replaced the sale – the lender often benefited from the estate for generations.

191

Kaposi (2002, 47) refers to Tibor Tóth’s research in Somogy county, according to which between 1750 and 1811, 6 per cent of the nobles’ loans were used for agricultural development, 20 per cent for redeeming pledged lands, 27 per cent for land purchasing and 40 per cent for debt repayment.

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Traders were involved in lending mainly through bills of exchange, but they also dealt with the sale of securities and ‘transfers’ abroad as well. Private banks were not founded in Hungary at this time. Because of risk and distance, Austrian banks lent to Hungary only at high interest rates, or were not willing to lend at all, so their role remained low. Only big landowners could gain significant loans, but only under unfavourable conditions. The prosperity of the Napoleonic wars increased market opportunities, more and more land acquisitions, development and construction were carried out. This was the time when Hungary began to become familiar with modern forms of lending. In addition, loans were made more attractive by the constant currency depreciations (and hence the ‘melting’ debts) (Tomka, 2000, 7. f.; Gergely, 2003, 34. f.; Bácskai, 1993, 92. f.; Kaposi, 2002, 46. f.). However, the fundamentally order-based societal structure of Hungary still had not been changed, which was the cause of the underdeveloped financial system. The transformation required a decade-long process. 4.5.2.3 Legislation in the first half of the 19th century

As Széchenyi emphasized in his publications: the lack of credit hindered the economy, on the other hand (order-based) societal structure and existing laws at the time made it difficult to access credit. For example, the law of entail made it impossible for noble land owners to have the free right of disposal regarding their real estates, so even a land seized as a pledge could not be sold. Besides the disadvantages of the current law, it was also problematic that in terms of lending and financial activities the regulation was incomplete: one of the few existing rulings maximized levied interest at 6 per cent. In addition, legal process was slow, therefore creditors could hardly have access to their legitimate claims. Even if the case was quickly dealt with, enforcement was a responsibility of the county authorities, so it could drag on for a long time. As to the respective administration: the estates had been ‘intabulated’ since 1723 regarding mortgage loans (debts on the real estate had been recorded). Mortgages were recorded — 255 —

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in the minutes of the County General Assembly, later in the Intabulation Books, so the county was the only supervisory organ regarding credits. Only the loan which was officially registered could be recovered. In case of urban properties creditors were also protected by land-registers (Tomka, 2000, 8; Gergely, 2003, 34 and 194. f.; Kaposi, 2002, 46. f.). The laws passed by the Diet (Hungarian Parliament at that time) of 1836 can be considered a significant step, which sped up the negotiation and enforcement of litigations, moreover, the Pesti Vásári Bíróság (Market Court of Pest) was officially established. An even more important step was Act XVIII of 1840 passed by the Diet in 1840, which regulated the founding of joint-stock companies, but there were also laws on bills of exchange (XV), on merchants (XVI), on factories (XVII) and on general partnerships (XVIII) (Tomka, 2000, 8; Bácskai, 1993, 119). However, the law of entail was definitively abolished only in 1852. In parallel with the introduction of legislation, Hungary was ‘reached’ by the German and Austrian credit institution/savings bank model, which served as a basis for building the Hungarian credit institution system. 4.5.2.4 Bank initiatives in the Reform Era The Reform Era coincides roughly with the two decades preceding 1848. At that time, a reform climate urging some kind of modernization became dominant aimed at the creation of a modern Hungary, which in the absence of a strong middle class, was promoted by some classes of the nobility, although they were divided into several approaches in this regard. It should be emphasized that neither revolution nor a ruler’s decision, but the laws adopted by Parliament were the desired means of modernization. (See also Subchapter 4.1.6.2 for historical background. Literature on the subject: Gergely, 2003, 191).

Financial operators were not unknown on the market even in the medieval history of Hungary – the Fugger family of Augsburg had — 256 —

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a factory (trading post, in German: Faktorei) in Buda in the 16th century (see Box 3-4) –, however, modern-day banks appeared only in the Reform Era in the country. Their predecessors were the Hungarian branch offices of the Austrian banks, which typically provided only limited services. Such were the OeNB’s branches in Buda, Temesvár and Nagyszeben established between 1818 and 1823. They functioned more like an exchange office and cannot be considered very significant. In 1827–1828, the First Austrian Savings Bank established smaller offices in eight Hungarian cities, which collected deposits through merchants. Most of them, however, were quickly abolished; those that have been operating for the longest time were located in Nagyszombat (1827–1841) and Pozsony (today: Bratislava) (1828–1841) (Tomka, 2000, 8. f.; Bácskai, 1993, 89 and 115). Chart 4-21: Mór (Móricz) Ullmann, one of the founders of the Hungarian Commercial Bank of Pest

Source: upload.wikimedia.org

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The founding of an independent Hungarian credit institution was already proposed by the committees formed by the will of the 1790– 1791 and 1825–1827 parliamentary assemblies, but in the end these were not realized (Bácskai, 1993, 93. f. and 114). At the same time, in the early 1800s, a growing number of prosperous merchants from Pest offered loans in ever higher amounts, and an additional part of the credits was provided by Austrian banking houses. The basis for the founding of Hungarian banks and the gradual development of the banking system was prepared in the 1830s, from which the already mentioned works by Széchenyi shall be highlighted. The first bank established entirely in Hungary (which was not a savings bank) was the Hungarian Commercial Bank of Pest (Pesti Magyar Kereskedelmi Bank, short: Commercial Bank of Pest). Although the wholesale merchant Mór Ullmann (in other sources, Móricz Ullmann, Chart 4-21), together with other prestigious merchants, initiated its foundation at the Council of Governors already in 1830, the patent was signed by King Ferdinand V only on 14 October 1840. The official process progressed slowly despite the fact that the circle of founders had won the patronage of the Habsburg Archduke Joseph, the Palatine (nádor, the highest-ranking office in the Kingdom of Hungary). On the Hungarian side, the situation proved to be urgent as in terms of the banking system the country lagged a century behind a number of Western European countries. The first director of the bank was Mór Ullmann himself. The first statutes were based on the OeNB’s statutes of 1817 (without the right to issue and redeem banknotes). Among its services were lending (also mortgage lending), the possibility to place deposits, the execution of discount, giro and advance payment transactions, whereby the bank was supposed to meet the capital demand of the developing Hungarian industry and trade. However, the government of Vienna took restrictive measures, under which only savings banks, not banks, were permitted to accept deposits. This provision would have made operation impossible, because credit could have been granted only from the limited stock capital. This was circumvented by the Commercial Bank of — 258 —

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Pest by accepting ‘loans’ from its clients at interest, and so the interestbearing treasury bill was created. There were also Austrian supporters of the bank: the Viennese Rothschild and Löwenthal families can be found among the largest shareholders. However, due to Hungarian ‘small shareholders’, the majority of the capital was in the hands of Hungarians (merchants of Pest, counts, barons). Among the founders of the bank, besides the many prestigious merchants (such as Sámuel Wodianer, Izrael Baumgarten), was also Count István Széchenyi. The major transactions of the new bank included the lending of 20,000 forints to the Pest Roller Mill Company (Pesti Hengermalomtársulat) as well as loans to the Hungarian Society for Factory-Founding (Magyar Gyáralapító Társulat) and the Pest Sugar Factory Association (Pesti Cukorgyár Egyesület) in 1845. On the deposit side it is worth noting the deposit of the Society for Regulation of the River Tisza (Tiszaszabályozási Társulat) in the value of 150,000 forints in 1847 (Tomka, 2000, 11. f.; Gergely, 2003, 35. f.; Bácskai, 1993, 118, 125. ff. and 138; Botos, 1991, 16. ff.). The success of the Commercial Bank of Pest is proved by the fact that around 1845 about 40 per cent of Hungarian deposits were placed in the bank, and thus it had a large capital surplus (Bácskai, 1993, 118; see Chart 4-22 for deposit growth). According to Botos (1991, 19) it was not the acquisition of capital that caused a problem for the credit institutions at that time – there were no capital shortages – but how to invest it profitably. Tomka (2000, 13) holds the opinion that this was caused by the low level of capital demand by contemporary Hungarian businesses, which they managed with earlier profits, reserves or even (business) relationships. The importance of the founding of this bank lies not just in the abovementioned transactions. In the course of its existence, the Commercial Bank of Pest had always been one of Hungary’s leading and, in fact, from 1840 until the 1860s, only ‘commercial bank’.192 Furthermore, 192

he Austrian National Bank was operating in Pest, not in a legal sense but in T practice, as a deposit branch of the Commercial Bank of Pest before the AustroHungarian Compromise of 1867, and was dealing only with Austrian clients.

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merchants remained part of the credit business as well. According to an address book of Pest from 1842, out of 55 wholesale merchants 18 were engaged in ‘financial services’ (Tomka, 2000, 7).193 From the beginning of the 19th century, the role of wholesaler dynasties of Jewish origin became more significant in financial life. In addition, in the 1830s and 1840s, lenders of middle-class origin (such as the Laibacher family of Kanizsa) also appeared in the countryside. Moreover, loans from the Austrian banking houses had a greater impact on Hungary than at the beginning of the century. The Sina banker family in Vienna, for example, participated in financing of the construction of the Hungarian railway network (Kaposi, 2002, 143). Chart 4-22: The deposit turnover of the Hungarian savings banks and the Hungarian Commercial Bank of Pest between 1843 and 1847 12,000,000

HUF

12,000,000

11,138,134 10,000,000

10,000,000 8,227,433

8,000,000

8,000,000 5,814,615

6,000,000

4,880,928 3,659,246

4,000,000

3,842,004

2,038,923 2,181,224

2,000,000 0 1842

670,901 1843

6,000,000 4,000,000 2,000,000

1,096,820

1844

1845

1846

1847

0 1848

Savings banks Hungarian Commercial Bank of Pest Source: Authors’ own compilation based on Bácskai (1993, 152).

193

here are also accessible data from before the foundation of the Commercial Bank T of Pest. A census of 1827 found that most of the wholesalers of Pest were engaged in credit and bill of exchange transactions, indeed, some of them became specialized (Gergely, 2003, 35).

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4.5.2.5 Savings banks in Hungary during the Reform Era

The founding of Hungary’s first savings banks, similarly to the establishment of the Hungarian Commercial Bank of Pest, took place in the Reform Era, more specifically in the 1830s. Like their German and Austrian counterparts, they were not profit-oriented, but institutions established with social objectives in mind. Their main goal was to combat poverty by providing interest-bearing deposits and by education promoting savings-oriented behaviour. This was later changed due to Hungarian characteristics. The first Hungarian savings bank was established in the region populated by Transylvanian Saxons, in Brassó (Brașov), by Peter Lange, the official of the Chancery in Vienna and following the model of the savings bank in Nuremberg (General Savings Bank of Brassó, 1836). The institution stood under the supervision of the city. In the absence of a pawnshop, it also offered secured loans and spent the operating profit to provide aids and support to the hospital in Brassó. In Nagyszeben, a savings bank was set up following the model of Brassó in 1841 (Tomka, 2000, 9. ff.; Bácskai, 1993, 115; Jirkovsky, 1938, 24. f.). Outside of Transylvania, the first savings bank was the First National Savings Bank of Pest (Pesti Hazai Első Takarékpénztár, short: First Savings Bank), founded in 1840 at the initiative of a judge of the Pest County Court of Appeals, András Fáy. Fáy’s plans combined the Austrian and German model supplementing them with their own ideas. The social goals of the institution (just as in the German language area) were stressed by the limitation of the size of deposits: at least 20 krajczárs, up to 200 forints, with a 5 per cent interest rate.194 It was influenced by the example of the First Austrian Savings Bank with the difference that the founders were not obliged to pay the full amount, only the interests (and only for 10 years). Fáy approached the German model in that he wanted to involve the ‘public sector’: the county should provide the premises, request the savings bank to 194

s a reminder: the applicable, law-enforced interest rate which could be levied was A a maximum 6 per cent at that time.

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fulfil a reporting obligation and, if necessary, support it with capital, furthermore carry out the registration of promissory notes and the writ of summons free of charge. Fáy’s plans were approved by the county with minimal modifications. The founders were nobles and wholesale merchants. In addition to the passive transaction of deposits, the First Savings Bank offered loans for real estates and certain securities (e.g. Austrian government bonds) as well. All in all, this foundation can be regarded as successful: in the first 5 years deposits had doubled annually. While the institution operated initially only in the county of Pest-Pilis-Solt, it already expanded its sphere of activity to ten adjacent counties and several free royal cities by 1845. In addition, it served as a model for many other establishments of savings banks (Gergely, 2003, 35; Bácskai, 1993, 115; Jirkovsky, 1938, 21. f.; Tomka, 2000, 9. f.). In contrast to savings banks established for social purposes in Germany and Austria, the Hungarian savings banks usually operated profit oriented and in the form of joint-stock companies as from the 1840s, probably following the model of two savings banks in Switzerland (Biel, Thun). These operated as deposit banks, leaving their charitable status behind. The antecedent of the change was that the company form of joint-stock companies was regulated by Act XVIII of 1840 just at that time, and was therefore rapidly spreading.195 In 1845 there were 20, in 1848 already 36 savings banks in the country, out of which 34 were joint-stock companies; only those in Brassó and Szeben continued to operate on a philanthropic basis (Tomka, 2000, 10; Bácskai, 1995, 116. f.; Jirkovsky, 1938, 29 and 31; Botos, 1991, 17). For the deposit growth of savings banks, see chart 4-22.

195

he First Savings Bank in 1845, the Arad Savings Bank (that had been founded T on its model) in 1844 was transformed into a joint-stock company (the depositmaximizing rule also ceased), and several savings banks in the 1840s were created in this form right from the outset (first in 1842 in Pozsony and Sopron).

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Table 4-5: Differences between the rules of the Ordinance and the characteristics of Hungarian joint-stock savings banks Ordinance (Hungarian regulation regarding savings banks based on the Austrian Savings Banks Regulation)

Characteristics of Hungarian joint-stock savings banks

profits are to be invested in reserves

shareholders receive dividends

at dissolution reserves shall be devoted to charitable and non-profit purposes

at dissolution assets shall be divided between shareholders

members must not be debtors of the savings bank

shareholders have the right to enter into a business relationship with the savings bank

members work without remuneration

employees of the savings bank shall be remunerated

Source: Authors’ own compilation based on Jirkovsky (1938, 38).

Economic growth, the lack of wars as well as the lack of other investment opportunities served as a background for the spread of savings banks. Only one bank, the Commercial Bank of Pest, existed in the country, and securities were only dealt with by the Vienna Stock Exchange. Depositors mainly came from the strata of wealthy citizens (as opposed to the German savings banks’ clientele from the lower classes of society) who chose savings banks as an investment option. At first, savings banks feared that they would not be able to repay deposits, so they were cautious about advancing money and provided only real estate mortgage loans under strict conditions. In order to have the capacity to pay interest on deposits, several savings banks provided later loans for bills of exchange and for Austrian government securities (Jirkovsky, 1938, 27. ff.). Initially, the operation of savings banks was not regulated at all. In July 1847, at the order of the Hungarian Royal Court Chancellery (Magyar Királyi Udvari Kancellária), the Council of Governors set out the so called Ordinance (Szabályrendelet), which was to be followed by the Hungarian savings banks, and that, apart from some modifications (eliminating the rules concerning deposit-maximizing and the exclusion of richer clients), was the rendition of the Austrian Savings — 263 —

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Banks Regulation of 1844. However, a regulation which considered savings banks as humanitarian institutions was foreign to the profitoriented Hungarian savings banks, operating in the form of joint-stock companies (the differences are summarized in Table 4-5), therefore these functioned in a way that their statutes did not comply with the Ordinance (Tomka, 2000, 14; Jirkovsky, 1938, 37. ff.). 4.5.2.6 Credit business and credit institutions in Hungary during and after the 1848–1849 War of Independence

The events of the Revolution and the War of Independence had an impact on the life of the first Hungarian credit institutions in many ways. There were more people than usual lined up to withdraw their deposits from both the Commercial Bank of Pest and from the savings banks. On the other hand, the debt repayment deadline for land owners affected by the serf liberation had been extended, which caused payment difficulties for several institutions. The First Savings Bank announced in July 1848 that it would suspend the repayment of deposits (Tomka, 2000, 14. f.; Jirkovsky, 1938, 39). Several attempts were made in order to finance state budgets and costs: the new Hungarian government ordered the issuance of interest-bearing treasury bills; on 17 June 1848, a contract regarding banknote issuance was concluded with the Commercial Bank of Pest (see Box 4-10). Furthermore, in order to finance war expenses, the issuance of paper money not covered by bullion reserves was begun on 26 August (so called Kossuth banknotes [Kossuth-bankó], named from Lajos Kossuth, the Minister of Finance of the independent Hungarian government, which has been issued between 1848 and 1849 in the amount of 61 million forints) (Bácskai, 1993, 140. ff.). As from the spring of 1849, many people tried to deposit the uncovered banknotes in credit institutions, hoping that later they would receive ‘normal’ money back, but due to warfare it was simply impossible to advance the amount, therefore, as from July 1849 the First Savings Bank no longer accepted deposits (Jirkovsky, 1938, 40).

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Box 4-10 The temporary Hungarian bank of issue

At the beginning of the 19th century, the Austrian National Bank had a monopoly on issuing banknotes in Habsburg countries. However, during the Reform Era the idea of founding a Hungarian central bank was often raised, which can be found, for example, in István Széchenyi’s writing, the Hitel (Credit) (Bácskai, 1993, 114). Taking the circumstances of the time into consideration, the Count chose his words carefully, but already in 1830 he raised the issue of the national bank: ‘Now, as far as the establishment of the National Bank is concerned, there are many good examples; and we can see both good and bad things by other nations, so that we can anticipate how to adapt these to our country: what we should accept, what we should beware of.’ (Széchenyi, 1830, 147, translation of the authors). The first Hungarian bank of issue was provisionally established at the time of the Hungarian Revolution of 1848. By this time, the legendary 12 points (which summarized the demands of the revolution and was compiled on 15 March 1848) included the establishment of an independent national bank and the founding of a responsible Hungarian finance ministry.196 The Batthyány government (the first independent Hungarian government between March 1848 and October 1848) required a bank for issuing domestic banknotes, but for economic reasons it was not implemented with the support of a new but of an already existing bank. Thus, as a result of the contract of 17 June 1848, the Hungarian Commercial Bank of Pest became the bank of issue of the revolution.197 The banknote printing press itself was in Pest, located in the quarter of the big House of Invalids surrounded by Gránátos and Városház streets. he Hungarian Ministry of Finance started its operations on 1 May 1848, and the T Minister of Finance was Lajos Kossuth. After the failure of the Revolution of 1848, the finances were again governed by the Imperial and Royal Finance Ministry in Vienna. The independent Royal Finance Ministry of Hungary, under the direction of Minister Menyhért Lónyay, could be established only after the Austro-Hungarian Compromise of 1867. 197 It should be noted that Count Emil Dessewffy believed in 1841 that the license concerning banknote issuance should be granted to the bank. 196

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The State committed itself to secure the bullion reserves in the amount of 5 million forints regarding the 12.5 million forints in banknotes. In 1848, between August and December 2,082,238 forints was collected, and from May 1848 people could contribute to it through public subscription. Based on the aforementioned agreement, 5 million forints in banknotes was taken over by the state for its own purposes, 4 million forints acted as reserves and 3.5 million forints could be used by the bank to cover its own costs and for lending purposes (as a kind of state loan). Finally, 4,186,970 forints in paper money were issued by the temporary bank of issue. Károly Conlegner, professor of the predecessor of today’s University of Technology and Economics, formulated the multilingual inscriptions of the banknotes. Kossuth entrusted him with the compilation of the Money Inventory based on the unique digits of the banknotes as well. Chart 4-23: Handwritten Kossuth-bankó (by Károly Conlegner)

Source: Móra Ferenc Museum, Szeged, Metal collection.

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When the government was forced to flee to Debrecen, the banknote printing machines were disassembled and evacuated in wintertime together with the respective tool kits. The protection of the already issued paper money was the responsibility of High Commissioner Conlegner. However, due to ongoing warfare, they had to leave Debrecen, and during the migration Conlegner prepared handwritten six-digit numbers on the banknotes. This is a unique case in the history of Hungarian paper money (Chart 4-23.). The Austrian army was burning Hungarian banknotes in the squares of Pest, while Windisch-Grätz (the supreme commander of Austrian forces) persecuted Conlegner and threatened to hang him, but Count Nádasdy hid him on his own estate as tutor. In April 1849, Windisch-Grätz who occupied the capital, seized the bullion reserves of the Hungarian government and abolished the bank of issue entitlements of the Commercial Bank of Pest. In May, the Hungarians recaptured the city, but business turnover declined, creditors were not able to repay their liabilities, and the Commercial Bank of Pest could hardly avoid insolvency. After the fall of the War of Independence, the Court in Vienna demanded compensation from the bank in the amount of 2 million forints concerning the unlawful issuance of banknotes, and the deported bullion reserves were not taken into account in this regard. This demand which seriously jeopardized liquidity was renounced by Vienna only in 1854. The Habsburg Court ordered the destruction of not only the Kossuthbankós but also of the banknotes issued by the Commercial Bank of Pest, which caused serious losses to both the bank and the savings banks, as their cash reserves had been partially annihilated.198 The viability of the Hungarian Commercial Bank of Pest was demonstrated by the fact that, despite all this, it was able to stay on its feet (Bácskai, 1993, 141. ff.; Tomka, 2000, 15. f.; Botos, 1991, 21. ff.; Jirkovsky, 1938, 40. f.).

198

fter the War of Independence, the paper money issued by the revolutionary A Hungarian government amounting to approximately 60 million forints was simply withdrawn by the Austrian government and destroyed without any compensation. Moreover, such a short deadline was available for the conversion of Hungarian paper money covered by bullion reserves that a significant part of the banknotes owned by the population could not be redeemed in time.

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Banks in history: innovations and crises

After the fall of the War of Independence, the Hungarian banking system had to face several new challenges. On 1 May 1853, the Austrian Civil Code entered into force in Hungary, which maximized the amount of collectible interests (for example in the case of mortgages 5 per cent, in other cases 6 per cent). Regarding pledges and mortgages: the official stipulation was applicable not only concerning pawn loans, but also concerning mortgage loans (which were recorded, tabulated with regard to the real estate), and even concerning advances on crops. This regulation reduced the profits, thus credit institutions could not raise their deposit interest rates economically. Therefore the Austrian government securities with a yield of 5 to 6 per cent counted as a highly competitive investment option, which distracted the capital from the shaken Hungarian credit institutions.199 For this reason, the First Savings Bank was forced to reduce its (mortgage) loan portfolio (1853: 3.56 million forints; 1856: 2.97 million forints), and in the 1850s, the Hungarian Commercial Bank of Pest simply withdrew from the practice of mortgage lending. The Austrian law also tightened other conditions. The appearance of strong foreign competition could be considered another difficulty. The Pest branch (1851) of the Austrian National Bank, which had only dealt with discounting, expanded its range of services in 1854, for example with lending transactions, which caused a problem mainly for the Commercial Bank of Pest. By 1857, OeNB already disposed 5 branches in countries of the Hungarian Crown. The (also Austrian) Credit-Anstalt für Handel und Gewerbe opened a branch in Pest in 1857, which therefore was part of the interest-group of the Rothschilds and worked with French and South German capital. However, it mainly focused on the commercial sector and provided advances on goods or offered personal loans for commercial purposes 199

I n practice, however, the interest rate maximizing threshold could be circumvented. In order to get the required loan, the debtor asked for a bill issued concerning an amount greater than what he had actually borrowed. By this, in fact, the official interest rate ban threshold could be simply annulled. Moreover, this practice guaranteed the creditor usury that exceeded several times the lawful profit, which could be fully legally or even judicially collected in the case of non-payment.

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4. The First Industrial Revolution (1769—1850)

(mainly on bills of exchange) – at that time it did not yet deal with mortgage lending. The turnover of the mortgage loan market was taken over by the Austrian National Bank, which set up a separate mortgage loan department in 1856200 that disposed of more than half of the Hungarian mortgage loan portfolio by 1860, though it provided mortgage loans only for big landowners until 1860.201 However, the price of its mortgage-bonds was significantly lower than the nominal value. The Austrian Bodenkreditanstalt, which provided most of its loans to Hungary, was also a major player in the mortgage loan market202 (Tomka, 2000, 16. ff.; Gergely, 2003, 339; Bácskai, 1993, 177; Botos, 1991, 23. ff.; März, 1968, 5. ff. and 32. ff.). The rules of the Austrian Savings Banks Regulation were made mandatory in Hungary on 14 July 1853, which did not harmonize with the existence of the profit-oriented Hungarian savings banks and could be considered a difficulty for them. The latter have been in discussion for several years with the authorities, in which they justified their operation in the form of a joint-stock company by the provision of the Austrian Savings Banks Regulation according to which savings banks could also operate within an organizational framework adapted to local conditions. During the negotiations, savings banks operated without valid statutes. Lastly, as from 1865, the (unmodified) statutes of several savings banks were approved (Jirkovsky, 1938, 42. ff.). In Jirkovsky’s words (1938, 47): the laws of economic life broke the power of absolutism.

ntil 1856, a mortgage moratorium was in force (Gergely, 2003, 339). U In 1860, Hungarian holders owed more than two-thirds of the mortgage loans amounting to 54 million directly to the OeNB. 202 The growth of the mortgage loan portfolio, compared to then current circumstances, was really slow and protracted. Compared to the moderated level of 1847, its volume was doubled only by 1857, thus reaching an amount of 19 million forints in Hungary (without Croatia). 200 201

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Banks in history: innovations and crises

Slow development began only in the late 1850s, from that time onward several credit institutions were founded.203 Some examples: in 1858–1859 a few savings banks were established, in 1864 the First Hungarian Industry Bank (Első Magyar Iparbank, the second bank of the country after the Commercial Bank of Pest) was founded, and in 1865 the Commercial and Industrial Bank of Buda (Budai Kereskedelmi és Iparbank) was established. These had been the first banking foundations since the 1840s. According to Botos (1991, 24), in 1866 there were already 85 credit institutions in the country. Based on the data of Tomka (2000, 17), in 1867 the portfolio concerning credits on bills of exchange reached a level which was eleven times higher than that of 1847. A special formation was the Hungarian Land Credit Institution (Magyar Földhitelintézet), founded in 1863, whose clients – similarly to German credit cooperatives (Kreditgenossenschaft) – were counted as members at the same time. Contrary to the German model, however, the Land Credit Institution was a mortgage bank, and mainly big landowners and prosperous medium landowners could receive loans – the strict credit conditions made it virtually impossible for any other classes to have access to loans. The true development of the institution started after the Compromise of 1867, and in 1871 several privileges were granted it (Tomka, 2000, 16. f. and 20; Gergely, 2003, 339; Lónyay, 1873, 7. ff. and 22. ff.). In 1864, the Commercial and Stock Exchange was opened in Pest, which had a positive impact on the economy and contributed to the establishment of several joint-stock companies and credit institutions in the 1860s and early 1870s. Shares were sold above nominal value, and, due to profits, the popularity of share transactions continued to grow. Many joint-stock companies were founded on a purely speculative basis. The founding fever was only increased by the fact 203

Between 1848 and 1860, the number of Hungarian credit institutions (including savings banks) grew only from 36 to 38. On the other hand, the development was fast in the following period given that by 1866 the number had reached 85.

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4. The First Industrial Revolution (1769—1850)

that banks offered loans concerning up to 90 per cent of the price of the securities in the framework of so-called ‘carry-over businesses’. Newly founded credit institutions were already dealing with the establishment of companies and even of other credit institutions, which had not yet been carried out by existing banks (Tomka, 2000, 18. f. and 22). Based on the above, the War of Independence and the subsequent unfavourable political and economic situation only caused a temporary break in the history of Hungarian credit institutions. However, the period of real development came after the Austro-Hungarian Compromise of 1867 (see Subchapter 5.4). Box 4-11 The first global crisis – stock market, trade and credit crisis of 1857

In 1857, a worldwide trading and stock market crisis marched through Europe, which seriously affected not only Vienna but also Hungary. This was the first global stock market crash in the capitalist development of the past hundred and fifty years. In the autumn of 1857, a series of bankruptcies, famine and mass unemployment swept all over the world. The crash started from the USA, and during the fall banks and trading houses were closed one after another in Great Britain as well. In the harbour town of Hamburg, goods with a value of about 500 million marks (mainly coffee and sugar, raw materials and cereals) were waylaid. Trading houses were particularly severely affected by the crash concerning the turnover of bills of exchange: despite issuing bills of exchange they were not able to pay the emoluments and bankruptcy was followed by bankruptcy. The effects of the crisis were felt in Chile, India and Indonesia as well. The elemental impact of the crash is demonstrated also by the fact that this was the first occasion when people realized that relations between the continents were closer than they had imagined. The origin of the crisis is related to Russian arable lands, given that after the Crimean War (1853–1856), in 1856 Russian grain again appeared on the European market. Therefore, American farmers who exported most

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of their crops to Europe during the war, were now unexpectedly faced with a mass of unsold goods. Then, due to more and more quantities of unmarketable American grain, prices started dropping in the USA, in addition, the amount of money flowing into the country also decreased. The crisis was essentially linked to a bank failure at that time: namely, on 24 August 1857, the Ohio Life and Trust Company which was involved in intricate bonds businesses related to high-risk railway projects, announced insolvency. During the speculation on shares, they made significant miscalculations, making the company insolvent. Given that the telegraph was already widely used at that time, the news spread with astonishing speed and this quickly triggered a massive panic reaction which spread to the stock markets as well. These soon began to decline (by 8 to 10 per cent) and within a few weeks over 1400 banks collapsed only in America. In New York, 32 of the 33 credit institutions immediately blocked their daily payments. On 13 October 1857, more than 20,000 Americans attempted to storm the city’s banks to reclaim their money, but failed (Chart 4-24). Chart 4-24: Seamen’s Savings Bank attack in 1857

Source: christophermcevasco.com

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The stock market crisis soon turned into a credit crunch followed by a commercial stagnation that spread even to Europe. The effects of the crisis lasted for over two years, but at the end of 1857, the American banks were lending again, and by the end of the decade, the American economy again registered a huge growth. As to the merchants of Hamburg, they recovered from the crisis with the support of silver loans provided by Austria. The confidence of the locals was restored with a big transfer of silver ingots into the harbour town. The ‘silver train’ on its way to the railway station of the Hansa town was at least more fortunate than the ship loaded with gold ingots from California, which was on its way from the Pacific Ocean to New York in 1857, but people on the Atlantic Coast waited for it in vain, as the ship with its three tons of gold sank in a hurricane in September.204

204

ttp://www.zeit.de/2007/42/A-Wirtschaftskrise-1857 and http://christophermh cevasco.com/2011/08/24/the-panic-of-1857/

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Key terms bank failure bank of issue banknote central bank deflation financial crisis gold standard inflation

joint-stock bank (Aktienbank) joint-stock company one-tier banking system paper money Reform Era savings banks (Sparkasse) state debt two-tier banking system

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4. The First Industrial Revolution (1769—1850) Dick, A. (2013): Romanticism and the Gold Standard. Money, Literature, and Economic Debate in Britain 1790–1830. Palgrave Macmillan UK. (eBook) Dick, A. J. (2012): On the Financial Crisis, 1825-26. BRANCH: Britain, Representation and Nineteenth-Century History. Ed. Dino Franco Felluga. Extension of Romanticism and Victorianism on the Net. http://www.branchcollective.org/ps_articles=alexander-j-dick-onthe-financial-crisis-1825-26, viewed on 04/12/2017 Dimsdale, N. – Hotson, A. (2014): Financial Crises and Economic Activity in the UK since 1825. In: Dimsdale, N. – Hotson (eds.): British Financial Crises Since 1825, 24-56. p. Oxford University Press, Oxford. Fisher, I. (1911): The Purchasing Power of Money. Its Determination and Relation to Credit, Interest, and Crises. The Macmillan Company, New York. https://eet.pixel-online.org/files/etranslation/ original/Fisher The Purchasing Power of Money.pdf Flandreau, M. – Ugolini, S. (2014): ‘The Crisis of 1866.’ In: Dimsdale, N. – Hotson (eds.): A.: British Financial Crises Since 1825, 76–93. p. Oxford University Press, Oxford. Frowde, H. (1909): The Imperial Gazetteer of India. Volume 2. Clarendon Press, Oxford. http:// dsal.uchicago.edu/reference/gazetteer/toc.html?volume=2 Gergely A. (ed.) (2003): Magyarország története a 19. században (History of Hungary in the 19th Century). Osiris Kiadó, Budapest. Gilbert, E. – Helleiner, E. (1999): Nation-States and Money: The Past, Present and Future of National Currencies (RIPE Series in Global Political Economy). Routledge, 1 edition. Goodspeed, T. (2016): Legislating Instability: Adam Smith, Free Banking and the Financial Crisis of 1772. Harvard University Press, Harvard. Hamilton, H. (1956): ‘The Failure of the Ayr Bank, 1772.’ Economic History Review 8 (3). Helleiner, E. (1994): States and the Reemergence of Global Finance. Cornell. Helleiner, E. (2003): The Making of National Money: Territorial Currencies in Historical Perspective. Cornell. Jenkinson, Ch. (1968): A Treatise on the Coins of the Realm 1805. Library of Money and Banking History. Jirkovsky S. (1938): Takarékpénztáraink és a Regulativum: adalék a magyarországi pénzintézetek történetéhez (Our Savings Banks and the Regulatory Act: Addition to the History of Hungarian Financial Institutions). Tébe, Budapest. Kaposi Z. (2002): Magyarország gazdaságtörténete 1700–2000 (Economic History of Hungary 1700– 2000). Dialóg Campus Kiadó, Budapest–Pécs. Karatani, K. (2005): Transcritique: On Kant and Marx. Trans. Sabu Kohso. First MIT P.

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Banks in history: innovations and crises Kindleberger, Ch. P. (2006): A Financial History of Western Europe. 2nd ed. Routledge, London and New York. Kindleberger, Ch. P. – Aliber, R. Z. (2011): Manias, panics and crashes: a history of financial crises. Palgrave Macmillan, New York. Klein, E. (1982): Deutsche Bankengeschichte: Band 1.: Von den Anfängen bis zum Ende des Alten Reiches (1806), Knapp, Frankfurt. Kynaston, D. (2017): A History of the Bank of England 1694–2013, Bloomsbury. Lónyay M. (1873): Közügyeinkről. Nézetek Magyarország pénzügyi állapotáról (Public Issues. Views on the Financial Condition of Hungary). Ráth Mór, Budapest. Mankiw, G. (2011): Makroökonomik, 6. Auflage. Schäffer-Poeschel Verlag. Martineau, H. (1877): A History of the Thirty Years’ Peace, A.D. 1816–1846, Volume 2. George Bell, London. März, E. (1968): Österreichische Industrie- und Bankpolitik in der Zeit Franz Josephs I. am Beispiel der k. k. privaten Österreichischen Creditanstalt für Handel und Gewerbe. Europa-Verlag, Wien. McCulloch, J. R. (1826a): Thoughts on Banking. Edinburgh Review 43. McCulloch, J. R. (1826b): Commercial Revulsions. Edinburgh Review 44. McCulloch J. R. (1995): The Collected Works of J.R. McCulloch: A discourse on political economy; Historical sketch of the Bank of England; A new bank in India; A treatise on the rate of wages. Routledge/ Thoemmes Press. (eBook). Mingay, G. E. (1986): The Making of Britain: The Transformation of Britain 1830–1939, Routledge & Kegan Paul, London. Mitchell, B. R. (1976): Abstract of British Historical Statistics, Cambridge University Press, Cambridge. Moen, J. (2001): John Law and the Mississippi Bubble: 1718–1720. October, Mississippi History Now. http://www.mshistorynow.mdah.ms.gov/articles/70/john-law-and-the-mississippibubble-1718-1720 Neal, L. (1992): The Disintegration and Re-integration of International Capital Markets in the 19th Century. Business and Economic History 21. Ó Gráda, C. (1994): Ireland: A New Economic History 1780–1939. Clarendon Press, Oxford. Obstfeld, M. – Taylor, A. M. (2004): Global Capital Markets: Integration, Crisis, and Growth, Cambridge University Press, Cambridge. Ollerenshaw, P. (1987): Banking in Nineteenth Century Ireland. Manchester University Press, Manchester.

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4. The First Industrial Revolution (1769—1850) Papp I. (2009): Az első francia gyarmatbirodalom (The First French Colonial Empire). In: Poór János (ed.): A kora újkor története (Early Modern History). Osiris Kiadó, Budapest. Pigou, A. C. (1952): The Value of Money, reprinted in Readings in Monetary Theory (1917). Allen & Unwin, London. Pohl, H. (1982): Das deutsche Bankwesen (1806–1848). In: Deutsche Bankengeschichte: Band 2, Knapp, Frankfurt. Pohl, H. (ed.) (1993): Europäische Bankengeschichte. Knapp, Frankfurt. Pohl, M. (ed.) (1994): Handbook on the History of European Banks. European Association for Banking History, Frankfurt. Pounds, N. J. G. (2003): Európa történeti földrajza (A Historical Geography of Europe). Osiris Kiadó, Budapest. Presnell, L. S. (1956) Country Banking in the Industrial Revolution, Clarendon Press, Oxford. RD Collison Black (1947): Economic Studies at Trinity College, Dublin. Hermathena LXX. Reed, C. (1999): The Damn`d South Sea. Harvard Magazine, May/June 1999. Reinhart, C. M. – Rogoff, K. S. (2009): This Time is Different: Eight Centuries of Financial Folly. Princeton University Press, Princeton. Richards, R. D. (1929): The Early History of Banking in England, London. Rockoff, H. (2009): Upon Daedalian Wings of Paper Money: Adam Smith and the Crisis of 1772. National Bureau of Economic Research (NBER) Working Paper 15594. Sen, S. R. (1957): The Economics of Sir James Steuart. HarperCollins. Szántó Gy. T. (2009): Adalékok a brit gyarmatbirodalom előtörténetéhez (Additions to the Prehistory of the British Colonial Empire). In: Poór János (ed.): A kora újkor története (Early Modern History). Osiris Kiadó, Budapest. Széchenyi I. (1830): Hitel (Credit). Petróczai Trattner J. M. és Károlyi I. Könyvnyomtató Intézet. Szilágyi Á. J. (2009): A spanyol gyarmatbirodalom (The Spanish Colonial Empire). In: Poór J. (ed.): A kora újkor története (Early Modern History). Osiris Kiadó, Budapest. Ryland, T. – Dimsdale, N. (2017): A Millennium of UK Data. Bank of England. Thorp, W. L. (1926): Business Annals. National Bureau of Economic Research (NBER), New York. Tomka B. (2000): A magyarországi pénzintézetek rövid története 1836–1947 (A Short History of Financial Institutions in Hungary 1836–1947). Aula Kiadó, Budapest. Tóth I. Gy. (2001): Millenniumi magyar történet: Magyarország története a honfoglalástól napjainkig (Hungarian Millennial History: History of Hungary from the Conquest to Our Days). Osiris Kiadó, Budapest.

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Banks in history: innovations and crises Turner, J. D. (2014): Banking in Crisis: The Rise and Fall of British Banking Stability, 1800 to the Present. Cambridge University Press, Cambridge. Vadász S. (ed.) (2005): 19. századi egyetemes történelem 1789–1914 (19th Century World History 1789–1914). Korona Kiadó, Budapest. Vajnági M. (2009): Az osztrák örökös tartományok (The Austrian Hereditary Lands). In: Poór J. (ed.): A kora újkor története (Early Modern History). Osiris Kiadó, Budapest, pp. 257–283. Ziegler, D. (1990): Das Korsett der „Alten Dame’: die Geschäftspolitik der Bank of England, 1844–1913. Schriftenreihe des Instituts für Bankhistorische Forschung e. V., Bd. 15., Published version of EUI PhD thesis, 1988, F. Knapp, Frankfurt am Main.

Parliamentary reports and archives First Report of the Secret Committee on the Expediency of the Bank resuming Cash Payments, 1819. Provincial Bank of Ireland Archive, PV 203. Provincial Bank Head Office to Thomas Spring Rice, 12 February 1839. Second Report from the Select Committee on Banks of Issue; with the Minutes of Evidence, Appendix and Index, 1841.

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4. The First Industrial Revolution (1769—1850) http://www.hetsa.org.au/pdf-back/29-A-1.pdf, viewed on 07/02/2018 http://www.ier.hit-u.ac.jp/library/Japanese/collections/fr71-56/44-1.html, Observations on the establishment of the Bank of England, and on the paper circulation of the country / by Sir Francis Baring, Bart. -- London: Printed at the Minerva Press for Sewell and Debrett, 1797 [2], viewed on 22/11/2017 http://www.intriguing-history.com/bank-of-england-history/, viewed on 22/11/2017 http://www.legislation.gov.uk/ukpga/Vict/7-8/32, viewed on 23/11/2017 http://www.lloydsbankinggroup.com/our-group/our-heritage/our-history/bank-of-scotland/, viewed on 14/12/2017 http://www.mshistorynow.mdah.ms.gov/articles/70/john-law-and-the-mississippibubble-1718-1720 (Moen, Jon: John Law and the Mississippi Bubble: 1718-1720. Mississippi Historical Society, 2001.) viewed on 22/11/2017 http://www.niesr.ac.uk/sites/default/files/publications/DP478.pdf, (Seán Kenny, Jason Lennard and John D. Turner: THE MACROECONOMIC EFFECTS OF BANKING CRISES: EVIDENCE FROM THE UNITED KINGDOM, 1750-1938. NIESR Discussion Paper No. 478. 2017), viewed on 14/12/2017 http://www.telegraph.co.uk/news/uknews/12175490/Bankers-have-not-learnt-the-lessonsof-the-Great-Crash.html, viewed on 03/12/2017 http://www.zeit.de/2007/42/A-Wirtschaftskrise-1857, viewed on 05/03/2018 https://hal.archives-ouvertes.fr/hal-01251667/document, viewed on 08/02/2018 https://www.banking-history.co.uk/bankscotland.html, viewed on 14/12/2017 https://www.bankofengland.co.uk/about/history, viewed on 21/11/2017 https://www.bankofengland.co.uk/archive, viewed on 02/12/2017 https://www.bis.org/cbanks.htm, viewed on 26/01/2018 https://www.britishnewspaperarchive.co.uk/search/results/1814-01-01/1816-1231?newspaperTitle=Oxford%20University%20and%20City%20Herald, viewed on 08/12/2017 https://www.britishnewspaperarchive.co.uk/titles/evening-mail, viewed on 10/12/2017 https://www.britishnewspaperarchive.co.uk/titles/hereford-journal, viewed on 12/12/2017 https://www.britishnewspaperarchive.co.uk/titles/morning-post, viewed on 11/12/2017 https://www.britishnewspaperarchive.co.uk/titles/taunton-courier-and-western-advertiser, viewed on 10/12/2017 https://www.creditagricole.info/fnca/esn_5066/histoire, viewed on 27/01/2018 https://www.gale.com/uk/c/the-times-digital-archive, viewed on 04/12/2017

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Banks in history: innovations and crises https://www.minneapolisfed.org/community/student-resources/central-bank-history/historyof-central-banking, viewed on 24/11/2017 https://www.minneapolisfed.org/research/wp/wp642.pdf, viewed on 26/01/2018 https://www.nls.uk/collections/newspapers/early/caledonian-mercury, viewed on 13/12/2017 https://www.scotbanks.org.uk/history/banking-history.html, viewed on 14/12/2017 https://www.theguardian.com/books/2002/aug/10/featuresreviews.guardianreview1, viewed on 06/02/2018 https://www.thoughtco.com/development-of-banking-the-industrial-revolution-1221645, (Wilde, Robert: The Development of Banking in the Industrial Revolution. 2017), viewed on 26/11/2017

Internet sources of the charts and tables Chart 4-1: Source: https://upload.wikimedia.org/wikipedia/commons/a/ac/Europe_1815_ map_en.png Chart 4-2: Source: https://upload.wikimedia.org/wikipedia/commons/2/29/Map1848.jpg Chart 4-3: Source: https://upload.wikimedia.org/wikipedia/commons/0/0e/Colonisation_1800.hu.png Chart 4-4: Source: https://upload.wikimedia.org/wikipedia/commons/0/01/Kaisertum Osterreich.png 4-6. Chart Source: https://upload.wikimedia.org/wikipedia/commons/thumb/6/69/Barabas%2C_Miklos_-_Count_Istv%C3%A1n_Sz%C3%A9chenyi_%281848%29.jpg/732px-Barabas%2C_Miklos_-_Count_Istv%C3%A1n_Sz%C3%A9chenyi_%281848%29.jpg Chart 4-7: Source: https://upload.wikimedia.org/wikipedia/commons/9/9a/First-railway-Europe-country.jpg Chart 4-8: Source: https://upload.wikimedia.org/wikipedia/commons/5/5f/Mayer_Amschel_Rothschild.jpg Chart 4-9: Source: http://www.british-history.ac.uk/old-new-london/vol1/pp453-473 Chart 4-11: https://www.safaribooksonline.com/library/view/designing-mobile-payment/ 9781449366285/ch01.html Table 4-1: Source: http://www.britishmuseum.org/research/publications/online_research_catalogues/paper_money/paper_money_of_england__wales/english_banking_history/intro_english_bankng_history2.aspx Table 4-2: Source: http://www.britishmuseum.org/research/publications/online_research_catalogues/paper_money/paper_money_of_england__wales/english_banking_history/intro_english_bankng_history2.aspx

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4. The First Industrial Revolution (1769—1850) Chart: 4-12: https://www.safaribooksonline.com/library/view/designing-mobile-payment/9781449366285/ch01.html Chart: 4-13: Source: https://media1.britannica.com/eb-media/47/10047-004-BCCCBA0C.jpg Chart: 4-15 Figure Source: http://monevator.com/a-history-of-uk-inflation/ Chart: 4-16: Source: https://larbredesbinoche.wordpress.com/louis-milcent-1846-1918/ Chart: 4-17: Source: https://www.fuw.ch/article/die-south-sea-bubble-von-1720/ (Bild: ZVG) Chart: 4-18: Source: https://upload.wikimedia.org/wikipedia/commons/0/01/KaisertumOsterreich.png Chart: 4-19: Source: https://upload.wikimedia.org/wikipedia/commons/f/f8/PVETD_5_Gulden_1813_obverse.jpg Chart: 4-21: Source: https://upload.wikimedia.org/wikipedia/commons/e/e3/Ullmann_ M% C3% B3ric.jpg Chart: 4-24: Source: http://christophermcevasco.com/2011/08/24/the-panic-of-1857/

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The Second Industrial Revolution (1870—1914) Zoltán Eperjesi – Balázs Mladonyiczki205

The period between 1870 and 1914 (the Second Industrial Revolution) was characterised by a further increase in industrial activities, the beginnings of electrification and the mass production of consumer goods. The 25 years before the Great War is often referred to as the age of modern imperialism as this was the time that saw the beginning of the struggle for redistribution of economic and political power. The era also saw the beginnings of a deeper connection between science and industry that facilitated the emergence of large enterprises. The growth of companies and the economy was supported by the strong financial institutions. The leading centre in this respect was the United Kingdom, with its London-based capital market and stock exchange. The expansion of the British Empire put British banks in an unchallenged dominant position. With the accelerated development of banks an increasing number of clients had access to banking services. The stability of the system was provided by the gold standard monetary system that ensured the exchange of banknotes to gold and also free trade in gold. The world of banking was centred in Europe in this period. This continent was the birthplace of technological and financial innovation, while international bank clearing was characterised by the dominance of the pound sterling. At the beginning of the 20th century, British banks played a leading role in international commercial banking activities. Although the modern industrialisation of Germany started in the first half of the 19th century, it gained real momentum in the second half of the century. The establishment of the modern banking system was strongly supported by the related demand for 205

he authors wish to express their acknowledgement to László Kajdi for providing T the boxed article ‘The Origins and Development of Clearing Houses’.

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capital and the respective economic and social changes. Banks operating as jointstock companies (Aktienbank) managed to concentrate enough capital to substantially contribute the financing of German industrial development (providing credit, founding companies and trading shares). Furthermore, the 19th century saw the emergence of certain credit institution types that still play a major role in the German credit institution system today. In addition to ‘traditional’ commercial banks, this was the period when mortgage banks appeared, along with savings banks that were originally founded for humanitarian goals. Cooperative banks are another type of institution that should be mentioned here: these banks were created to develop strong enterprises and involved craftsmen and farmers as members. Germany was the first country in the world where saving banks and cooperative banks were established. Following the unification of Germany (1871), the Reichsbank was founded in 1875. It later developed into the central bank of the German Empire. Although many financial institutions with the right to issue currency operated during this period, they gradually renounced to exercise these rights. The emergence of universal banks in Europe can be interpreted as an attempt to break the economic power of Great Britain and the dominance of British banks. The most important characteristic of this business model of banks is that both commercial and investment banking activities are performed within the same institution at the same time. In the bank-centred economies of continental Europe, the big banks typically still operate as universal banks even today. According to the Gerschenkron hypothesis, the model of universal banks was key to the swift economic growth of Germany in the 19th century. Universal banks provided the burgeoning German industry with cheap, abundant capital and thus facilitated economic growth. Gerschenkron argues that Germany’s universal banking model is one of the greatest institutional innovations of the 19th century. It enabled Germany to catch up with the leading powers of Europe in just a few decades following its relatively late political unification. As for the US Federal Reserve, it was actually the third central bank system in the USA. Previously, there were two attempts to create a central bank based on the English example (Bank of England), but the mandate of neither of these institutions was extended due to their unpopularity. The First Bank of the United States (1791– 1811) and the Second Bank of the United States (1816–1836) each had a charter from Congress for 20 years. The banks issued currency and provided commercial

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loans. There was strong opposition that these banks were corrupt institutions serving the interests of certain businessmen with dominating influence, instead of ordinary US citizens. President Andrew Jackson vetoed the recharter bill as in his opinion bank representatives were bribing Senate members with cheap loans, and as a result electoral votes were going in favour of the bank. In the following period, the era of ‘free banks’ returned. A number of state-level banks were chartered and then liquidated. The establishment of the Fed (1913) was preceded by a series of bank panics, the most famous of these being the panic of 1907. At that point, only private banks operated in the US, and interest rates depended on the financing needs of agriculture and industry. Hungary achieved spectacular economic growth as a part of Austria-Hungary, due to the positive effects of the industrial revolution and the protected market of the Dual Monarchy. Sándor Wekerle – who served three times as prime minister – gradually modernised the financial structure of the Monarchy: a switch was implemented from silver to gold, from the forint to the crown (korona) as the uniform currency. The interest guarantee law was introduced by the Hungarian government to support the development of the railway infrastructure: the state ensured a profit for investors even in case of a loss. This law facilitated the creation of a transportation infrastructure. Locations that were connected to the railway network enjoyed economic growth. On the other hand, locations that were traditionally important from an economic perspective but were not connected to the railway infrastructure and could not benefit from world trade were quickly marginalised. Hungary was among the most advanced countries in several industries and fields of development. This was largely due to the fact that (although on a partially parity basis) the earlier Austrian National Bank continued its key financial activities and innovations to stimulate economic growth as the AustroHungarian National Bank from 1878 onwards. The system of Hungarian credit institutions looks back on nearly 200 years of history. Starting as a system of locally active, ‘unit’ (i.e. single branch) banking institutions it gradually developed to a branch banking system based on an integrated national bank market that later integrated into modern global and European financial systems. The effectiveness of the Hungarian banking system after the Austro-Hungarian Compromise and the implementation of its traditional economic and regional development role were largely determined by historical (the Dual Monarchy) and

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macro-economic circumstances. The role of the banking system as a mediator and as a stakeholder in economic development was stronger at the end of the 19th century compared to the end of the 20th century. At the same time, credit institutions played a more important role in providing and channelling the capital required to enable the modernisation of the economy compared to the situation 100 years later. The unit banking system of the Dual Monarchy was replaced by a Budapest-centred branch banking scheme covering the entire national market, but the motivation for this kind of concentration was not primarily the Treaty of Trianon: the most important factors were the changing macro-economic environment, i.e. a natural process of concentration, the end of the inflation prosperity period and the forced mergers following the economic crisis of 1873. The concentration of the Hungarian banking system had already started at the beginning of the 20th century, although the system itself was dominated by smaller credit institutions that were mainly connected to local financial markets. The crisis of 1873 brought an abrupt end to the previous bank founding fever. However, once economic growth returned, there was a rapid increase in the number of credit institutions, especially in the countryside. Nevertheless, by 1913 half of the total equity and 60 per cent of total assets were owned by credit institutions of Budapest. The large number of banking institutions founded and the dense network characteristic of the early stages of this development was in line with the commercially-oriented improvement stage of the emerging modern fiscal system that was dominated by unit banking institutions with a high level of local/regional autonomy.

5.1. Geopolitical situation, major economic history milestones Whereas the first or early phase of the Industrial Revolution (the first appearance of steam engines and factories) occurred at the turn of the 18th and 19th centuries, the phase between 1870 and 1914 (Second Industrial Revolution) was characterised by a further increase in industrial activities, the beginnings of electrification and the mass production of consumer goods. As industrialisation gained momentum in Western Europe in the 19th century, most countries already looked back on at least a century of gradual changes that had led to the formation of densely populated industrial regions (for example, due to unfavourable conditions for agriculture or the profitable

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resources available). The changes first affected England due to political stability and innovation and then spread to certain regions of Western Europe. In the east, industrialisation started significantly later and at a much slower pace. This was a consequence of the fact that the countries of the Continent were not homogenous entities, and there were significant regional differences. Industrialisation facilitated the creation of a world market in which all parts of the world started to fully integrate. However, this development process was stalled by World War I. The 25 years before World War I is often referred to as the age of modern imperialism. This was the period when the economic division of the world became final and the struggle among Great Powers for the reallocation of it had just started. The era also saw the beginning of a tighter connection between science and industry and facilitated the formation of major enterprises. The growth of such enterprises and the economy was supported by strong financial institutions. The leading centre in this respect was the United Kingdom, with its London-based capital market and stock exchange. Although the modern industrialisation of Germany started in the 1830s and 1840s, it gained real momentum in the second half of the century. The demand for capital contributed to the formation of a modern and specific banking system, although the role that Aktienbanks (i.e. banks in a jointstock company form with considerable capitalisation that were founded after 1850) played in financing the industry is a subject of debate among academics even today. The types of credit institutions that first appeared in the 19th century still play a decisive role in the German banking world: in addition to ‘traditional’ commercial banks, this was the period when mortgage banks appeared, along with saving banks and cooperative banks. Germany was among the first countries in the world (or even the first) to create saving banks and cooperative banks. From the end of the 18th century to the middle of the 20th century, economic growth in Europe was strongly linked to the structural changes labelled as ‘industrialisation’ by historians. By definition, industrialisation is the absolute and relative growth of the industrial activity of a country. From a global historical perspective, the importance of Europe is largely due to the fact that modern industrialisation was born in Europe and for a long period it was a monopoly of Europe, which later spread to the other parts of the world.

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The US, Canada and Australia are considered to be extended territories of Europe as far as industrial development is concerned. It was industrialisation that made the 19th century the ‘century of Europe’. From the perspective of long-term economic growth, European industrialisation took place between 1750 and 1914. The process started with the pioneering role of the UK and gradually spread to Northern and Western Europe during the 19th century. It is also important to note that the strong connection between industrialisation and international trade is tied to market-oriented institutional changes. In turn, this involves the phenomenon of proto-industrialisation in the 18th century, a concept popular with western historians. The fact that westernstyle industrialisation spread later in Eastern Europe may also be tied to the phase of proto-industrialisation as this phase is missing almost entirely in this region (this topic will be discussed in detail later). Industrialisation in the 20th century is inseparable from the role of international relationships and (amongst other things) these factors had a decisive effect on the diverse conditions of the period between the two world wars and after World War II. The first or early phase of the Industrial Revolution took place at the turn of the 18th and 19th centuries when mass production using steam engines became widespread. The phase between 1870 and 1914 (Second Industrial Revolution) was characterised by swift industrialisation, the beginnings of electrification and mass production using production lines (the Ford Model T is a prime example). ‘European industrialisation’ or the ‘second phase’ cannot be described without referring to regional differences and international relationships. Structural dissimilarities show that the regional nature of industrialisation is one of the most evident, yet most often forgotten characteristic features regarding European economic history.206 The pioneering role of Great Britain at the beginning of the 19th century is well known (‘the workshop of the world’). It is important to note though that the excellent industrial productivity of Great Britain in the first half of the 19th century was primarily based on successful exports to continental Europe. Moreover, the advantage of England in productivity was not limited to leading 206

See Kiesewetter, ‘Industrialisierung’, 1996; and Kiesewetter 2000, 105–145.

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industries – it also included the agrarian sector. However, the principle of comparative advantages prevalent in international trade made Great Britain a major importer country of various agricultural goods.207 At the same time, these features of British industrialisation had a major effect on the countries of the Continent (see Chart 5-1). As discussed earlier, the states of the European continent were not a homogenous entity. In this respect, it is evident that regional differences were significant in this period. For this reason, the countries of the ‘centre’ or ‘inner Europe’ must be distinguished from those of the ‘periphery’: the former group reacted to British economic influence quickly and positively, while the latter did not.208 These profoundly different reactions are due to structural regional differences within Europe. This leads us to the question of regionalism. It is also important to note that the divergent developmental directions of international economic relationships must be examined even from the first phase of industrialisation. Although in 1870 the economies in most Western European countries had already been growing faster and some had successfully caught up with Great Britain, their development followed different paths for various reasons. The main reason for these different paths of development was the emerging role of agriculture: In England a unique mix of large estates and relatively big farmlands had facilitated the quick increase of productivity in agricultural fields since the 18th century and this process facilitated the early transfer of labour and capital to industry and services. As early as 1840 only 25 per cent of the British workforce was engaged in farming. By contrast, in countries such as Germany and France the same ratio was still nearly to 50 per cent – even three decades later (Crafts, 1985, Chapters 7 and 8).

he principle of comparative advantages was introduced by the classical English T economist David Ricardo (1772–1823). For its application, see Crafts, 1985, 141–148; and Pollard, 1981, 160–184. 208 For a more detailed description of ‘centre’ and ‘periphery’ see Arrighi and Drangel, 1986, 9–74 and Table 43 as well as Pollard’s Peaceful Conquest (1981) in particular. 207

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5. The Second Industrial Revolution (1870—1914)

Chart 5-1: Estimated GDP per capita in selected countries between 1700 and 1913 (calculated in USD 1990) 5,000

USD

5,000

1700 1760 1820 1870 1913

Portugal

Russia

Italy

Sweden

1,000

France

1,000

Germany

2,000

Denmark

2,000

Netherlands

3,000

Belgium

3,000

Switzerland

4,000

Great Britain

4,000

Source: Authors’ own compilation based on Maddison (1995).

Industrialisation started in Great Britain, and during the 19th century it spread to continental Europe through trade and the channels of international economic relationships. The German states which formed a trade and political union in 1834 (Zollverein) are also a particularly interesting case in this direction, as this was the first reaction to British industrial and trade supremacy in the ‘inner European’ region. Imports by Prussia through the Zollverein (British wool, cotton and ironware) increased from 66 per cent of all imports (1815) to more than 80 per cent by the beginning of the 1830s.209 By contrast, raw materials and food accounted for 90 per cent of exports to the United Kingdom in the same period, and this rate was still well over 70 per cent in 1860. However, these data is concealing the crucial developing 209

For more on the German Customs Union, see Tilly, (1990).

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dynamics in this complex relationship. First of all, British exports suggested to German business owners that there was a large domestic market for these products, prompting them to follow their highly successful example. Secondly, the domestic finished product industry was based on relatively cheap, good quality thread imported from the UK; moreover, this formed the basis for switching from the introduction of finished goods to the import of simple semifinished goods as German companies learned how to manufacture the new machines and how to use the new technologies in the field of manufacturing. This process led to the development of new German export markets in Eastern Europe and overseas as lower labour costs entailed a price advantage for German manufacturers over their British competitors. Consequently, the differences between the United Kingdom and Germany mirrored the shift in the comparable costs related to technical changes (see Tables 5-1 and 5-2). Railways for example were a technical innovation from Great Britain, but due to the less developed state of German industry and transport it offered relatively more advantage for the German economy compared to the economy of the UK. As an example, while in the 1830s the general practice was to import British engines and rails and employ British technicians, in the 1850s primarily only crude iron was imported to be used in domestic rail manufacturing. Thus, manufacturing related to the railway networks became one of the most important foundations of German heavy industry and the economy in general.210 Table 5-1: Length of railroads between 1840 and 1910 by country (km) Great Britain

1840

1850

1860

1870

1880

1890

1900

1910

2,390

9,797

14,603

21,558

25,060

27,827

30,079

32,182

Germany

469

5,856

11,089

18,876

33,838

42,869

51,678

61,209

France

497

2,915

9,167

15,544

23,089

33,280

38,109

40,484

Source: Authors’ own compilation based on Die Entwicklung der industriellen Gesellschaften. C M. Cipolla and K. Borchardt. Stuttgart and New York (1977, 514)

210

remdling, 1985, pp. 219–240; for technical progress, see https://www.geo. F de/magazine/geo-epoche-kollektion/16541-rtkl-industrielle-revolution-diegeschichte-der-eisenbahn

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Table 5-2: Coal and iron mining (in million tons) Coal

Crude iron

1840

1855

1877

1840

1855

1877

Great Britain

177

1,420

3,000

6,059

Germany

143

325

1,391

France

348

600

1,178

Austria-Hungary

150

225

403

Russia

250

300

Source: Authors’ own compilation based on F.-W. Henning: Die Industrialisierung in Deutschland 1800-1914, Paderborn (1973, 151)

Approximately during the same period, similar changes and progress can be seen elsewhere in the ‘inner Europe’ as region, for example in Belgium, France and Switzerland. It is important to highlight, however, that the structure of industry developed differently in each single country. This also suggests that the diverse phases of industrialisation cannot be sharply separated from each other. Although the expression ‘Industrial Revolution’ is used often, this can be strongly misleading as these processes and (regional/international) effects are strongly built on one another, and it is very hard to apply an exact chronological framework to the paths of development involved. As for the second phase of industrialisation (1870–1914), a slight change in the direction of European industrialisation was evident in the final one third of the 19th century. The second wave of industrialisation started and that also covered the first two decades of the 20th century. The 25 years before World War I is the age of modern imperialism. The term ‘imperialism’211 indicates that the politics of nations became extremely active: in many cases the goal was to ‘conquer’ other parts of the world. In other words, a struggle started among the Great Powers for the redistribution of roles related to international economic and political supremacy. Following its foundation in 1871, the German Empire became an economic superpower in a very short time, and the commercial and political differences between Great Britain and Germany became more 211

The word imperium has Latin origins, it also means order or empire.

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and more evident. These differences were further escalated by Britain. During the first wave of industrialisation, England became the leading power of the world by the end of the 18th century with the help of such commodities as coal, iron, and cotton. However, during the 19th century the economy of Great Britain shifted towards financial capitalism, i.e. a considerable amount of capital was invested by London abroad to be able to generate higher profits. As a consequence, the major financial centres of the world, London’s City and New York’s Wall Street, underwent major commercial and industrial expansion. By the end of the 19th century, this financial orientation led to the technical obsolescence of British manufacturing facilities. As a result of this, the economic output of England during the new phase of industrialisation that primarily influenced such main sectors as chemistry, electrification and the manufacturing of vehicles lagged behind that of Germany and the USA. A parallel phenomenon was strong economic competition for colonial resources that was also evident in the fields of manufacturing (technologies) and the sales of specific merchandises. Although at the beginning of the 20th century the majority of world trade was still managed by England, its advantage compared to its strongest competitors (primarily Germany, which was progressing very quickly in economic and industrial terms) was considerably diminishing. For example, in 1900 Germany alone generated more electricity than the UK and France together. Moreover, Germany practically had achieved a world monopoly in the chemical industry in the meantime. In the steel industry, although German wages were high, production costs were lower compared to Great Britain, with higher productivity, better use of raw materials and lower transportation costs. Additionally, Germany used a system of safeguard duties to impose its economic interests in the international market. Strong German industrial and economic growth was reflected in the sales markets as well. The second wave of industrialisation saw the beginning of a tighter relationship between science and industry and facilitated the creation and further development of large enterprises. In this phase, investments required

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5. The Second Industrial Revolution (1870—1914)

a vast amount of capital while monopolies were formed: for example, Standard Oil (Rockefeller) in the USA controlled most of the oil industry, the Krupp Group was the leading company of the German steel industry. Accordingly, this phase of capitalism is also called monopoly capitalism. Following this, various world organisations were formed, such as the International Red Cross, the Universal Postal Union, the International Railway Association and the International Court of Justice (The Hague). The new wave of industrialisation changed almost everything in the human world, inclusively traditional societies were redesigned and this was largely due to the systematic application of science in technical development. Besides, main political ideologies (liberalism and nationalism) suffered an existential crisis or just changed fundamentally and unfortunately most of these basic modifications became evident only later: the most visible consequence was an unprecedented conflict, the outbreak of the First World War (the Great War). George Kennan called the Great War the original catastrophe of the 20th century that marked the end of the age of colonialism and imperialism and opened the way for the Russian Revolution of 1917, while the USA and later the Soviet Union became the new world powers in a bipolar world order. Using the terminology of David Landes, the ‘Second Industrial Revolution’ started also in ‘inner Europe’, but it completely altered the relationships of Great Britain and the Western European countries (Landes, 1969, 195–196). Economy historian Douglass North called this period the ‘second revolution of the economy’ and claimed that it is as important as the ‘first revolution of the economy’ that took place around 8,000 BC that gave agriculture and ‘civilisation’ to mankind (North, 1981, 171). Modifications in the relationships between Great Britain and the countries of Western Europe are usually illustrated by using the example of Germany, although the comparison of the UK and Germany evidently highlights the most important differences in this respect. The promptly expansion of German industry in the 1870s already exhibited two major modifications compared to

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Great Britain.212 First, there were fundamentally important differences in the role of the state. Secondary and tertiary education in Germany (partially due to state subsidies) gradually turned into an ‘industry for growth’ – especially vocational schools, and faculties of science at colleges and universities.213 The main reason for the economic success was that a constant flow of extremely well-trained technicians and engineers came out of these specialized institutions. Moreover, quality research results that were often ready for industrial use in the form of up-to-date technical knowledge were promoted by various experiments with regard to technical, chemical, engineering and other innovations. Concerning the number of graduates, the number of scientific articles and patents in Great Britain, it is obvious that it lagged behind Germany because their educational structure still relied on family networks and the old apprentice system. This was especially true by considering the leading scientific fields such as chemistry and electrotechnology. The same applied for the level of education of chief executives, for example in steel industry plants.214 The second difference among the two competing countries is only indirectly connected to state interventionism processes in education. The differences in scientific orientation are well reflected in the organisational structure of larger enterprises. A clear example for this is the creation of research and development (R&D) departments that had already been created in Germany in this period and not just in the electricity and chemical industry, but also in the steel industry and machine manufacturing. However, industrial and organisational variances between the two countries were even more significant. For example, the companies of German heavy industry were integrated vertically and consequently realised more significant energy savings compared to their British competitors. Moreover, in most or a summary of the English-German conflict, see Kindleberger, 1973, pp. 253–81 F and pp. 477–504, and as a comparison, see Tilly, 1990, pp. 7–89. 213 For the systems of education and contemporary statistics, see Erickson, 1959, pp. 8–37, pp. 42–145 and pp. 150–261. 214 Regarding the steel industry, see Pierenkemper, 1979, pp. 8–45, pp. 51–117, pp. 120–189, and pp. 191–249, and Kocka, 1975, pp. 5–97, pp. 102–141, and pp. 147–167. 212

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5. The Second Industrial Revolution (1870—1914)

German industrial sectors even the production process was at a higher level of diversification compared to the industrial sectors of Britain (Hoffmann, 1965, pp. 2–109). Table 5-3 shows the consequences of Britain’s excessive concentration on its traditional key industrial sectors, -the viewer can observe its production shortfall compared to Germany. Table 5-3: Importance and rate of selected growth of industry branches in Great Britain and Germany between 1880 and 1913 Great Britain

Germany

Weights in the sector*

Growth rate**

Weights in the sector*

Growth rate**

Chemistry

2.0%

4.9%

5.0%

6.4%

Electrotechnology

0.8%

6.0%

1.5%

8.0%

Coal and textiles

30.0%

1.9%

14.0%

2.6%

Sector

Note: *Average share of industrial sectors in the growth of overall production value (industry and crafts); **year-on-year growth in net added value. Source: Tilly, Richard H.: Industrialisierung als historischer Prozess, In: Europäische Geschichte Online (EGO), Institut für Europäische Geschichte (IEG), Mainz 2010-12-03. (Table 3, 17).

Box 5-1 Industrial espionage in Great Britain in the 19th century

Starting from the mid-18th century there was an increase in new technologies in all sectors of industry that led to significant improvements in productivity. The industrial revolution itself has commenced with industrialised cotton processing. For example, in the textile industry the invention and implementation of ‘spinning jenny’ and ‘water frame’ led to a considerable increase in production, while the introduction of steam engines enabled prompt improvement in coal mining, in heavy industry and in transportation. As the latest inventions mainly came from England, productivity differences compared to the other countries of Europe quickly became evident and for this reason, i.e. in order to effectively close the significant technological gap there was a need to catch up:

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it is a historical curiosity how industrial espionage contributed to the beginnings of the industrial revolution. England simply stole the Italian spinning technology. Thomas Cotchett was the first Englishman to try to invent mechanical spinning. In 1702, he founded a water-driven mill to twist silk, but he failed to improve the machinery and the company went bankrupt in 1712. One of his employees, John Lombe planned to start a similar business. At that time, Italy was the world leading technical centre of silk-throwing. Although larger factories were never built, water-driven silk-throwing machines had already been used since 1276. Consequently, Lombe decided to travel to Italy in order to intensively study the innovative technologies. With the help of a priest who had excellent local connections he managed to gain employment in a silk factory where he bribed the supervisor to let him stay in the workshop during the night. And so he worked during the day and diagrammed the machinery during the night. He hid the designs in bales of silk and sent them by ship to his brother to England. When Lombe and the last technical drawings arrived in England safely, he founded a silk-throwing factory based on the technology stolen from Italy (1718). Naturally, he first patented the technology (he received a patent for 14 years). The silk-throwing mill proved to be a huge success (Chart 5-2). Starting from the mid-18th century, more and more qualified German craftsmen often visited England to intensively study the latest technology. For example, Alfred Krupp worked in the business world in England using a pseudonym at the end of the 1830s. For a while the British were welcoming towards the growing number of Germans arriving to ‘study’ their excellent results as they were aware of Britain’s considerable technical advantage over other nations and were keen to present their new inventions to all interested foreign visitors. At the beginning of industrialisation the British deliberately sold some of their new technologies to foreign countries to also increase their profits outside: an example is the steam engine of Matthew Boulton (Schuhmacher, 1968, p. 7–19). However, in a few decades it became quite evident that the implementation of new

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5. The Second Industrial Revolution (1870—1914)

Chart 5-2: The silk processing mill founded by Lombe

Source: www.allaboutlean.com

British technologies abroad was generating strong competition for the British and European (primarily German) industrial sectors and this being the case, the British were not any longer capable to manage to continuously keep their edge in technology. At this point, British authorities suddenly changed their attitude toward foreigners who were visiting the country in order to explicitly learn about the newest industrial developments. As an example, foreigners were no longer allowed to visit Boulton and Wegdwoods factories. Another restriction was a ban on the export of machines and parts, which was implemented to prevent others from copying British industrial technology, to suitably protect it from foreign competitors. The British aimed to defend the technological advantage of their domestic

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manufactories. For this reason it was forbidden to operate new machines abroad and also to reconstruct such kind of machines. Several bills were passed between 1750 and 1782 to ban the export of textile industry machinery and starting from 1786 a similar direction was taken in the field of metallurgy. The respective laws were updated constantly in line with the inventions of the following years (Weber, 1975, p. 293–298). It was a widespread practice to employ foreign technical experts in Germany as the most effective way to facilitate crucial technical developments, and this practice was often supported from the backgrounds by the state itself. The exceptional early performance of German railway development was partially due to the employment of a large number of British experts (Weber, 1975, p. 297–305). However, the French and Russians also tried to employ British engineers and consequently exceptionally large salaries were offered to potential foreign technicians. In order to prevent the brain-drain trend, the British authorities put a ban on the foreign employment of technical staff and also completely banned the export of main innovations, especially industrial machinery. The peak of industrial and business study trips was reached at the time of the 1851 World Fair of London. German states alone sent 8,000 visitors to learn about new technological innovations, take part in further training and experience the political freedom and the debate culture of the British Parliament. However, after 1851 foreign study trips to Britain suddenly lost their significance because German innovations became world renowned in the meantime and then it was Germany that had to fight against ever increasing foreign industrial espionage. The growth of enterprises and the economy was supported by strong financial institutions. With the advance of industrialisation, the ties between banks and industry gradually became stronger as banks supported large-scale industrial

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5. The Second Industrial Revolution (1870—1914)

investments often and intensively. This scheme was characteristic of Germany and the USA. By contrast, British banks generally provided short term-loans to conservative businesses that were not particularly keen on taking loans. Such credits were used to pay for industrial machinery and salaries. Basically, there were two exceptions to this rule, railway and ship building – in these fields large credit transactions were common from the beginning. With its Londonbased capital market, the United Kingdom was the world leader in capital transactions, and this was the time when the system of capitalism became truly global with a significant growth in international money transfers. For this reason, starting from 1870 the London stock exchange and its institutions concentrated primarily on foreign investment mainly in overseas territories: in North and South America and in the British Empire. Although this capital investment used the principle of comparative advantages and provided a profit for Britain this development strengthened the trend of neglecting domestic industry and consequently significantly reduced the potential of the ‘Second Industrial Revolution’ in their own territories.215 The contrast with the newly-formed German ‘big banks’ (high-value capital market transactions, strong connections with large industrial enterprises) was striking in the period (for related data, see Subchapter 5.2). The different systems of financing in the two compared countries may have been another factor contributing to the various changes in the growth of large enterprises and industrial production. This statement is justified by the data as presented above. Although the main financial centre of the era was the City of London with its generally used currency being the pound sterling, capital-intensive investments to finance Russian industrialisation was provided by the French, while the majority of foreign loans to construct the Turkish railway system was coming from German banks. German engineers played a significant role in the planning and building of the Turkish railways. There are numerous other similar examples related to the flow of ever more internationalised foreign capital in the period. Concurrently with this, world exhibitions can 215

For a negative interpretation, see Kennedy, 1987; for a positive evaluation see Edelstein, 1982, p. 17–359.

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be interpreted as a symbol of the victory of the industrial revolution. The first world exhibition was held in 1851 in London with 14,000 exhibits on show and 6 million visitors. After 1851 a world exhibition was held every 4 or 5 years, usually in Paris, and the number of visitors grew constantly. The second phase saw an increase in the speed of industrialisation and the crucial changes in international economic relationships. Intergovernmental economic relationships were characterised by a large number of different and more and more sophisticated financial/commercial processes. The most important connection was the growing international trade between ‘inner Europe’ (including Great Britain) and the already industrialised nations. Trade in Europe began to include the trade in industrial end products. Each country specialised in certain industrial sectors – the British exchanged services (primarily financial and shipping services) for Swiss watches, German optical products or French luxury clothing items (the list could fill pages). The patterns evolving reflected the comparative advantages of trade that were perceived as a significant change by the involved parties, which were both partners and competitors at the same time as the result of import-export businesses included the transfer of British exports to Europe and to the countries of the Empire. In fact, it is beyond doubt that this was the reason why Great Britain with the City of London (bank sector) became a top player – this was the time when England became the leading monetary and capital market in the world. Although deindustrialisation had not started in Great Britain yet, services gradually became the most important sector of the economy. Financial services and maritime shipping services gradually balanced its growing import surpluses (Imlah, 1958, 7–209). At the same time, it also had an export surplus vis-à-vis other developed countries through the Empire (Saul, 1960, p. 4–217). These mutually complementary relationships at the different levels of trade gave a great boost to industrialisation in the countries of continental Europe.216

216

or comparison: http://www.britishempire.me.uk/trade.html; http://www.bbc. F co.uk/history/british/empire_seapower/trade_empire_01.shtml and Berend– Ránki, 1980, p. 539-584.

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5. The Second Industrial Revolution (1870—1914)

The second process took place on the ‘periphery’, in countries such as Greece, Portugal, Italy and Sweden. The most important export goods of these countries in European trade were agricultural goods such as olives, wood, grain or leather. However, few of these countries managed to implement strong structural changes in order to gain sustainable long-term advantages from this kind of businesses or trade relationships (Tables 5-4 and 5-5). Table 5-4: Importance of exports and structural changes in selected countries and regions between 1840 and 1910 Export performance

With structural change

Without structural change

High growth rate

Sweden (120%)

Balkan countries* (57%)

Low growth rate

Hungary (81%)

Portugal (58%)

Note: *Serbia, Bulgaria and Romania. Source: Authors’ own compilation based on Berend — Ránki (1980).

Table 5-5: Annual average rate of growth of export and GDP per capita in selected European countries between 1860 and 1910 (calculated in USD, 1960) Per capita income in 1860

Per capita income in 1910

Growth rate of exports

Growth rate of per capita income

Hungary

230

372

2.7*

1.2

Portugal

275

290

1.7

0.1

Sweden

280

593

4.0

2.2

Country

Note: *1880—1910. Source: Authors’ own compilation based on Berend — Ránki (1980).

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Banks in history: innovations and crises

5.2. History of the German banking system in the 19th century The foundations of today’s German credit institution system were laid in the 19th century: the types of credit institutions which first appeared at that time still play a decisive role in the German banking system: in addition to ‘traditional’ commercial banks, this was the period when the first mortgage banks appeared, along with savings banks and cooperative banks. This chapter covers the early founding and development of these credit institution types, with an overview of their effect on industrialisation. It is important to note that at the beginning of the 19th century the German-speaking area consisted of countless smaller or larger secular or ecclesiastical217 territories following their own political agenda (for example dioceses, dukedoms and even independent towns) that were unified by the loose framework of the Holy Roman Empire (until 1806) and later the German Confederation (1815–1866). The German Empire, created in 1871 without the participation of Austria as a ‘unified country’, was not a strongly centralised empire. It was much rather a monarchy in the form of a federal state that consisted of several kingdoms, dukedoms and other smaller states. This is the reason why we use the term ‘German states’ emphasising the diversity of the history of German credit institutions. The history of Austrian credit institutions is not in the scope of this chapter; for more details on the beginning of the development of the Austrian banking system, see Subchapter 4.5.1.)

217

s a part of the secularisation of 1802–1803 church-owned estates were transferred A to secular rulers, and as a result of this the ‘successor states’ of the Holy Roman Empire consisted only of secular territories. For more on German church territories and the Congress of Vienna see: http://www.vr.de/pdf/titel_inhalt_und_ leseprobe/1010800/inhaltundleseprobe_9783525101230.pdf

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5. The Second Industrial Revolution (1870—1914)

Chart 5-3: The German Confederation between 1815 and 1866 THE GERMAN CONFEDERATION

1815–1866

Danemark

Baltic Sea

Holstein

North Sea

(personal union with Danemark) Mecklenburg-

Schwerin

Kingdom Oldenburg of Hanover

Netherlands

(as from 1830) m do ds ng n Ki erla ) d h 0 ite et 83 Un he N 5–1 t 81 f o (1

–

(until 1837 personal union with the United Kingdom)

5 18

rm Ge

Warsaw

Prussia

Kingdom of Poland

Anhalt

Prussia

(Russian Empire)

Waldeck

Belgium

Saxony

Electorate of Hesse

Republic of Cracow

(as from 1830)

Nassau

(as from 1846 under Habsburg sovereignty)

Luxemburg

Bavaria

Austrian Empire

Bavaria

France (as from 1848 republic, as from 1852 empire)

Württemberg Vienna

Liechtenstein

Switzerland

Savoy Kingdom of Sardinia

tio

era

d nfe

Kingdom of Lombardy–Venetia Parma

Modena Papal States

Kingdom of Hungary

Source: Authors’ own compilation based on upload.wikimedia.org.

— 303 —

Kingdom of Hungary

FL: Principality of Lichtenberg (as from 1834 part of Prussia) FW: Waldeck and Pyrmont HH: Hamburg HL: Lübeck HLB: Lauenburg (as from 1865 part of Prussia) KH: Electorate of Hesse LD: Lippe LH: Landgraviate of Hesse-Homburg MS: Mecklenburg-Streilitz OL: Oldenburg Räl: Principality of the Reuß (Elder Line) RJL: Principality of the Reuß (Junior Line) SA: Saxe-Altenburg SCG: Saxe-Coburg-Gotha SL: Schaumburg-Lippe SM: Saxe-Meiningen SR: Schwarzburg-Rudolstadt SWE: Saxe-Weimar-Eisenach Anhalt is represented after the extinction of the line Anhalt-Köthen and Anhalt-Bernburg. cities fortresses and towns

0 50 Kilometers

100

150

fortresses of the confederation 200

Banks in history: innovations and crises

Box 5-2 The Holy Roman Empire, German Confederation, German Empire and the unification of Germany

The area of current-day Austria and Germany – roughly, not considering the constant territorial changes and some exceptions – was part of the Holy Roman Empire (German: Heiliges Römisches Reich Deutscher Nation, and the term used by historians: Altes Reich) from the 10th century to 1806. The Empire was never unified: it consisted of a large number of countships, dukedoms, ecclesiastical states and kingdoms. The rulers of these entities gained more and more autonomy over the centuries, and in parallel with this the power of the emperor declined. After Francis II took the title of the Emperor of Austria in 1804 (as a reaction to the coronation of Napoleon as the Emperor of France) and became the first ruler of the Austrian Empire as Francis I, and after the German rulers supporting Napoleon created the Confederation of the Rhine (German: Rheinbund), Francis officially dissolved the Holy Roman Empire in 1806. After the Napoleonic Wars the remaining 35 German states and 4 free cities formed the loose alliance of the German Confederation in 1815 (German: Deutscher Bund, Chart 5-3). The two strongest members of the Confederation were Austria and Prussia. However, it was a long process with many phases to create a unified Germany. The German Customs Union (Deutscher Zollverein), which was founded in 1834, was expanded gradually and aimed to strengthen economic ties between its members. Nevertheless, an attempt to create political unity failed in 1848 due to the lack of the support by the king of Prussia. Finally, Germany was united in a process lead by Prussia. 1866 saw the formation of the North German Confederation (German: Norddeutscher Bund). The states of Southern Germany (except for Austria) joined the Confederation in 1870, and based on this the German Empire was created in 1871 and became one of the leading political and economic powers of Europe in the following decades. This was the realisation of the concept of a ‘smaller’ German state as Austria remained outside of the unified

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5. The Second Industrial Revolution (1870—1914)

Germany once and for all. As a prequel to this, the long-standing Prussian and Austrian hostilities culminated in a short war in 1866 that ended with the defeat of Austria. This defeat may have paved the way to the approach of the Habsburg to the Hungarians, making the Austro-Hungarian Compromise of 1867 possible.218

5.2.1. History and role of Aktienbanks until World War I In the German speaking territories, the beginnings of credit institutions can be traced back to the 13th and 14th centuries. These town exchange banks (German: städtische Wechselbank) operated as official money changers and in some cases offered other financial services as well (Klein, 1982, 84. f.). The merchant-banker families active in the 15–17th centuries dealt with credits, investments and ‘bank transfers’ first as a supplementary activity and later as separate branches of business (for example the Fugger and Welser families of Augsburg, for further details see Box 3-4) (Klein, 1982, 93. ff.). A significant milestone was the Hamburgische Giro- und Wechselbank219 founded in 1619 based on the Amsterdam Exchange Bank (Omlor, 2014, 35. f.; see also Klein, 1982, 149 and 166. ff.). The 18th century saw the emergence of familyowned private banks offering certain financial services, which continued to play a major role in the 19th century as well (see Box 5-3). However, over the long run these banks failed to meet the latest challenges of the age (partially due to their limited capital and risk taking), given that amongst other things they were not able to or willing to provide larger amounts of capital for the burgeoning industry. This market niche was filled by Aktienbanks.

or more details related to the subject see Vajnági, 2009, 167–190; Vadász 2005, F 204–309. 219 For the administration concerning the course of business and for the transfers, the bank used its own internal technical currency. This enabled the completely cashless administration of all transactions, independent of the countless different currencies in use. 218

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Box 5-3 Private banks

Private banks (in German: Privatbank) were among the most characteristic and probably most significant types of credit institutions in the 18th century and the early decades of the 19th century. They were founded by private individuals and were essentially multi-generation family businesses offering various financial services. Most private banks were originally established as trading companies that started to deal with financial services (money exchange, bills of exchange, credits, trading in state bonds), which later became dominant business lines. Klein (1982, 245) categorises these banks as merchant-bankers similarly to financial businesses flourishing centuries earlier (for example the Fuggers). Their main fields of activity were trading in securities (for example state bonds)220 and providing credit. An important feature of private banks was the strong connection with the person of the owner and the owner family. Owners had unlimited liability, and this made personal relationships extremely important: they provided credit only to those clients they personally trusted. Over the long term, this proved to be a disadvantage, as it limited their business geographically: they were mostly active in their immediate region and had to cooperate with partner banks when dealing in distant areas. In contrast to the situation in France and England, in the German states the ‘banking system’ of the age was not dominated by one particular city (such as Paris and London). Frankfurt (for example the Rothschild and the Bethmann families), Cologne (for example the Oppenheim and Schaaffhausen banking houses), Berlin and Hamburg were all significant financial centres (Wandel, 1998, 1. f.; Klein, 1982, 142. f., 245. ff.; Pohl H., 1982, 18. ff.; Pohl H., 1993, 197. ff.).

220

he Bethmann House of Frankfurt had excellent relationships with the Habsburgs T and traded a significant amount of Austrian government bonds starting from the second half of the 18th century.

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Chart 5-4: The headquarters of Metzler Bank around 1849

Source: www.metzler.com

Some private banks were founded already in the 17th century. However, these dates should be interpreted in context. In case of the Metzler Bank of Frankfurt (Chart 5-4), which is still active today, the known date of foundation is 1674. However, at that time Benjamin Metzler was running a textile trading business, and the family only started to deal with bills of exchange in 1728 in connection with trade. The first data regarding credit transactions date back to the 1760s. Financial services of the bank started to play a prominent role from this time onwards (Klein, 1982, 246. ff.). 5.2.1.1 The origins and development of Aktienbanks The German term ‘Aktienbank’ refers to credit institutions operating as joint-stock companies or as partnerships limited by shares (Kommanditgesellschaft auf Aktien). These were ‘general’ credit institutions (universal banks) and offered a full range of financial services (accounts, credits, investments), i.e. Aktienbanks were commercial and investment banks in one. Financing industry was among their most important business lines: Aktienbanks provided credits, established companies or became shareholders themselves, and later sold their shares (see also Subchapter 5.2.1.2). To fulfil this function Aktienbanks required considerably more capital

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compared to contemporary family-owned private banks. Consequently, they were often established with the cooperation of several private banks in order to concentrate the available capital. The most important predecessors of the Aktienbanks were the Société Générale (1822) of Brussels and the Société Générale de Crédit Mobilier (1852) of Paris. Banks operating as joint-stock companies had already been present in the German-speaking territories in the 1830s, but these acted as banks of issue as well: credit transactions were in their scope, but trading in stock was not. Examples are the Bayerische Hypotheken- und Wechselbank (1835) or the Bank of Leipzig (1838). The first real German Aktienbank was the Schaaffhausen’sche Bank of Cologne (see Box 5-4), but this institution was an exception due to the state’s role in its founding and the emergency situation. In the 1850s several other Aktienbanks were created (Disconto-Gesellschaft 1851, Bank für Handel und Industrie 1853, Berliner Handels-Gesellschaft 1856, Norddeutsche Bank 1856 of Hamburg, Mitteldeutsche Creditbank 1856 of Saxony). It is important to note that at that time the Prussian government221 did not support the foundation of banks operating as joint-stock companies. Consequently, Disconto-Gesellschaft of Berlin initially operated as a partnership and from 1855 onwards as a partnership limited by shares as the legal framework for these business forms were less strict. Berliner HandelsGesellschaft was founded as a partnership limited by shares for the same reason. However, the financial crisis of 1856–1857 brought an abrupt end to the bank founding fever (Edwards–Ogilvie, 1996, 428. ff.; Pohl H., 1993, 264. f.; Pohl H., 1982, 121. f.; Pohl M., 1982, 172. ff. and 191). 221

russia was a kingdom (a dukedom before 1701) with territories both within and P outside of the Holy Roman Empire (the latter are today part of Poland and of the Baltic area). Due to its modernisation in the 18th century, it became one of the strongest German states and a permanent competitor of Austria. When the Empire was dissolved in 1806, the Kingdom of Prussia became an important member of the German Confederation (1815–1866) and later a founding member both of the North German Confederation (1866–1870) and the German Empire (1871–1918). As these states had a confederate structure, Prussia kept its partial independence – it had its own king and government. Its power is perfectly indicated by the fact that Prussia accounted for half of the territory and more than half of the population of the German Empire. Finally, Berlin was the capital of both Prussia and the German Empire.

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Box 5-4 The first ‘bank resolution’ in Germany

The banking house of Abraham Schaaffhausen was a private bank founded in Cologne in 1791 that successfully provided financial services to the developing industry of the Rhineland. During the political and economic crisis of 1848, due to risky deals and overexposed credit provision the bank became insolvent on 29 March 1848. There was a risk that several industrial firms dependent on the loans of the bank would go bankrupt. The bank guaranteed its creditors that they would not suffer any losses. A committee of Cologne banking executives and businessmen was formed to negotiate options to save the bank, and a proposition was sent to the creditors on 3 July. Based on that, their claims would be transformed to shares and the bank turned into to a joint-stock company. There were multiple creditors that rejected this proposal, but their claims were guaranteed by those creditors who accepted the conditions. On 28 August, the king of Prussia222 approved the transformation and guaranteed the payment of dividends and the possibility of the conversion of shares until 1858. In return, the state received controlling functions and the right to appoint one of the directors. It is important to note that at that time these were considered to be exceptional measures and not as the next step in the development of credit institutions. Manfred Pohl (Pohl M., 1982, 175) states that the Prussian government might have deliberately avoided providing a capital injection to be able to experiment with the creation of the first Aktienbank223 (Pohl H., 1982, 121. f.; Pohl M., 1982, 173. ff.). Schaaffhausen’sche Bank existed until 1914 as one of the ten biggest banks of the country (see the headquarters in Chart 5-5) when it merged with Disconto-Gesellschaft of Berlin (Pohl M., 1982, 289). Cologne and the Rhineland were annexed by Prussia as per the decision of the Congress of Vienna (1814–1815). 223 It is interesting to see that this type of reorganisation process –not forced by the contemporary authorities – is similar to the mechanism of the bail-in resolution tool which is regulated at the EU level by Directive 2014/59/EU and in Hungary by Act XXXVII of 2014 on Resolution. 222

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Chart 5-5: Headquarters of the Schaaffhausen’sche Bank in Cologne

Source: www.wikiwand.com

The boom in the German economy and the respective establishment of many enterprises served as background for the next wave of Aktienbank foundations at the beginning of the 1870s.224 This was supported not only by technological development, but also by the following factors: after the defeat of France, war reparations amounting to 25 per cent of German GDP were paid by France; Alsace-Lorraine was annexed by the German Empire, and this gave access to the area’s mineral resources; between 1834 and 1871 Germany gradually became a unified customs area (with some exceptions) due to the expanding German Customs Union; and furthermore the country’s rising population generated growing demand. Another milestone was 11 June 1870 when the North German Confederation cancelled the state concession requirement concerning the establishment of joint-stock companies. Between 1869 and 1872, 176 banks were founded, which was in line with the joint-stock company foundation boom seen between 1871 and 1885 (when 1,963 joint-stock companies were founded). Some of the Aktienbanks founded in this period are key players of the German banking system even today: Deutsche Bank (1870), Commerz- und Disconto-Bank (1870, today’s Commerzbank) and Dresdner Bank (1872). The establishment of Deutsche Bank was still subject to 224

ee the next subchapter on the actual role of Aktienbanks in the development of S German industry.

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the state concession requirement. One of the reasons for creating this bank was to support the financing of German overseas trade, for example by providing credit, which had previously been handled by British and French banks (for further details on the bank, see Box 5-5). According to Manfred Pohl (Pohl M., 1982, 288), these three credit institutions – along with the Disconto-Gesellschaft, Bank für Handel und Industrie and Berliner Handels-Gesellschaft founded in the 1850s – were the largest credit institutions in the German banking sector in the pre-1914 period, known as the ‘big banks’ (Großbank). Besides these, a large number of smaller, regionally important Aktienbanks were also founded, for example Bayerische Vereinsbank (1869) or Bergisch-Märkische Bank (1871). However, economic and financial development did not shield the German banking system from crises. On the contrary, irresponsible investments contributed to these. Many people acquired securities without having information about the actual collateral. Some credit institutions were deliberately founded for speculative purposes (in German, these were known as ‘Gründerbank’ or ‘founder banks’). These banks founded insignificant, in some cases non-sustainable businesses or transformed such businesses to joint-stock companies and sold the stocks at a profit on the stock exchange, often using manipulative strategies. Competition was intense, and the economy became overheated. As a consequence of the speculation, the Vienna stock exchange crashed in 1873, followed by the Berlin stock exchange. A large number of businesses went bankrupt, along with many banks: approximately 100 of the newly formed credit institutions had closed by 1880. 40 banks were founded in Berlin between 1870 and 1873 and 30 of these were dissolved between 1873 and 1881. However, the crisis strengthened the biggest banks: the banking market became less competitive and they acquired some of the weakened banks. Cooperative banks and savings banks were not involved in the company founding fever and were therefore left largely untouched by the crisis. The period 1880–1914 saw continuous development, but was not completely free from recessions: 5,001 new joint-stock companies were founded between 1886 and 1912 (all potential clients of the banks), and the number of Aktienbanks also grew steadily: there were 215 in 1891, 472 in 1902, and 963 in 1911. In 1913, at the end of the pre-war period, the three biggest enterprises were banks, with — 311 —

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17 banks among the biggest 25 (Pohl H., 1993, 265. f.; Pohl M., 1982, 225. ff., 231 and 262. ff.; Wandel, 1998, 10. f. and 19; Detzer, 2017, 19). Box 5-5 The first decades of Deutsche Bank

In 1870, when the idea of the foundation of Deutsche Bank was close to fruition, fundamental changes were underway in the international world of banking. As a consequence of efficient industrialisation, the capital demand of the German industrial sector was constantly growing, and this lead to further development of the traditional banking sector as well. Several private bankers in Berlin reacted positively to the idea of founding a new bank. The most important supporter of the idea was Adelbert Delbrück, who can be considered as the ‘real founder’ of Deutsche Bank. The charter of the bank was accepted officially on 22 January 1870, and the concession was granted by the government of Prussia on 10 March 1870 (Gall et al., 1995, 15–89). This was practically the last concession in 1870 awarded to a bank operating as a joint-stock company in Prussia, and the state concession requirement was cancelled later that year. The charter of the bank highlighted the importance of foreign partners: The aim of the company is to perform all manners of banking transactions, with special emphasis on facilitating trade relationships between Germany, the other European countries, and overseas markets.225 The direct objective of founding the bank was to support German foreign trade so that it could become financially independent of the dominant role of English banks. Therefore, from the beginning the German management focused on developing international business activities. Between 1871 and 1873 Deutsche Bank founded five important branches: in Bremen, in Hamburg, in Yokohama, in Shanghai, and in London. Although the founders were foresightful and called the credit institute ‘German Bank’, they did not know at that time that they would create tough competition for themselves. Given that financing only German foreign trade was not sustainable from a business perspective over the long run, the new bank extended its activities to other areas in a short time (Gall et al., 1995, 29–102). 225

See: http://www.bankgeschichte.de/de/docs/Chronik_D_Bank.pdf

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5. The Second Industrial Revolution (1870—1914)

The bank already accepted cash deposits during the first years of its operation. This transaction is considered usual today, but at that time it was not a routine matter for a credit institution. The bank required a solid financial foundation in order to successfully perform its activities in the selected business areas (money transfer, investments), and this was the practical reason why it specialised in deposits very early. One of the widely known early co-presidents of the bank was Georg von Siemens, who quickly realised that significant capital can be collected by deposit deals. By facilitating this business activity, he not only provided the institution with a solid capital base, but supported the breakthrough in this field in the whole country. The first office of Deutsche Bank was located at 21 Französische Straße on the first floor of a modest house. However, after just one year the institution with approximately 50 employees moved to the vicinity of the Berlin Stock Exchange. The new headquarters were built in the block of Behrenstraße, Mauerstraße and Französische Straße in 1876. The early leaders of the bank aimed to integrate the two bridges connecting the buildings (Chart 5-6) into the representation of the institution. Based on the above, the first decades of the credit institution were characterised by quick expansion. In this early phase, the bank managed to find several profitable opportunities and avoid excessive risk (Gall et al., 1995, 28–106). Chart 5-6: The Berlin building of Deutsche Bank with the famous connecting bridge

Source: commons.wikimedia.org

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The importance of investment banking activities was growing in the 1880s, and in the 1890s this branch of business flourished the most. The large-scale investment activities of the bank played a key role in the development of the German electrotechnical industry; in addition, it also played an increasingly vital role in financing the iron and steel industry. The credit institution managed to reach and strengthen a key position in the domestic financial market, which enabled it to finance large-scale transactions abroad that served German interests. The enlargement of this business was a main task for the bank for several decades. One of the most famous examples of this was organising and financing the construction of the Baghdad railway. The year of 1895 marked the beginning of a new era in the bank’s development as it started to cooperate closely with significant regional banks both at the organisational and transactional levels as a partner, particularly with ones that supported the development of German industry. At the time the German banking sector was characterised by a significant concentration of the so-called communities of interest (in German: Interessengemeinschaft, see also Subchapter 5.2.1.4). It is important to note that at that time the number of branches of the Deutsche Bank was still limited: the first one was opened in Frankfurt am Main in 1886, followed by one in Munich in 1892, and branches in Dresden and Leipzig in 1901. Furthermore, to effectively support enterprises abroad, the bank recognised very early the importance of cooperation with different specialised institutions. Both the establishment of the German Overseas Bank (Deutsche Ueberseeische Bank, founded in 1886) and of the GermanAsian Bank (Deutsch-Asiatische Bank, founded in 1889) are examples where the German diplomatic corps (the Federal Foreign Office) was in the background of financial activities, working hard to gently influence the decision-makers in the countries involved and other international stakeholders. However, considering the difficult market situation, the historical context and the successful investment activities of both banks concerning the implementation of infrastructure megaprojects, it can be stated that these institutions fulfilled their initially specified targets and role (Gall et al., 1995, 33–114).226 226

For comparison, see Kindleberger, 2006, 44–46 and 117–130.

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In the spring of 1914 Frankfurter Zeitung presented Deutsche Bank as ‘the world’s biggest bank’ to its readers, but in reality at this time the credit institution was at the peak and also at the end of a successful development phase (Novak and Kerner, 2016, 14–59).227 The outbreak of World War I hindered the realisation of bold business visions, which in the past (taking into account the risks) could be realised by brave businessmen, even abroad. Following World War I, Deutsche Bank’s management had to work hard to maintain the status of the bank amidst continuously changing political and economic circumstances. The 1930s and 1940s were full of difficulties: 1931 was the peak year of the global economic and bank crisis. Under the Nazi regime from 1933 to 1945 the bank went bankrupt and became an instrument of the Nazi state. Following World War II, the bank was nationalised in the Soviet occupation zone and divided to 10 major financial institutions in the Western zones. The successor institutions were merged to form the Deutsche Bank AG in 1957 with the headquarters in Frankfurt am Main. The second part of the 20th century was a period of growth: the number of private clients of the bank increased, along with the number of domestic branches. With the growth in international business activities the bank became a global enterprise, a development that was further strengthened by branches opened and credit institutions acquired abroad (Gall et al., 1995, 99–192, 201–349 and 350–496). The unification of Germany resulted in a considerable extension of the tasks of the bank – for example in 1997 it actively contributed to the implementation of important reforms connected to the European Monetary Union. In the 21st century, the bank successfully extended its business activities especially in developing regions such as China, India and Russia. Today, Deutsche Bank ranks among the world’s leading universal banks (Gall et al., 1995, 80–496 and 501–917; Novak and Kerner, 2016, 12–87 and 221–420).

227

ee Chapter 2 (‘Die Deutsche Bank – Eine bewegte Geschichte’, and the subchapter S ‘Der Erste Weltkrieg und das Ende der Kaiserzeit’).

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Chart 5-7: The German Empire between 1871 and 1918 THE GERMAN EMPIRE 1871–1918

Sweden

Danemark

Baltic Sea

KOPENHAGEN

North Sea

MecklenburgSchwerin

Oldenburg

Prussia

Netherlands

Warsaw

eig hw Braunsc

Russian Empire t

Prussia

Anhal

Waldeck

Schwarzburg-Sondershausen

Saxony

Belgium Krakow Luxemburg

Bavaria

Ba de

A Lo lsa rra ce in e

Austrian Empire (part of Austria-Hungary)

VIENNA

France

Liechtenstein

Switzerland

Kingdom of

Kingdom of Hungary

(part of Austria-Hungary)

Württemberg

Italy

FHZ: Principality of Hohenzollern (Prussia) GH: Grand duchy of Hesse LD: Lippe OLD: Oldenburg Räl: Principality of the Reuß (Elder Line) RJL: Principality of the Reuß (Junior Line) SA: Saxe-Altenburg SCG: Saxe-Coburg-Gotha SL: Schaumburg-Lippe SMG: Saxe-Meiningen SR: Schwarzburg-Rudolstadt SWE: Saxe-Weimar-Eisenach W: Waldeck and Pyrmont

Source: Authors’ own compilation based on upload.wikimedia.org.

5.2.1.2 The role of Aktienbanks in German industrialisation Several inventions of the Industrial Revolution had already appeared in some German states in the 18th century (for example, steam engines were operating in 1783 in Prussia), but industrialisation only gained real momentum from the middle of the 19th century. There were several reasons for this. One important factor was the improvement in agriculture, medicine and hygiene conditions, which resulted in considerable population growth. The population of the German states was 23 million in 1800, growing to 40 million in 1871 and 64 million in 1910. The development of agriculture, the excess labour force

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available due to the growing population (that could be employed in industry or in factories), the new technologies, the development of the transportation network, the gradual elimination of internal German customs (the expanding German Customs Union from 1834), and of course certain political changes (the unification of Germany in 1871 – for the map of the German Empire, see Chart 5-7) all contributed to the success and scale of the German industrial revolution. Based on the data of Pounds (2003, 389), the gross GDP of ‘Germany’ increased by more than fourfold between 1850 and 1910. In the first half of the century, the metal industry and railroad building were the most important branches (see the locomotive factory of August Borsig in Chart 5-8), while in the second half of the century new industries also contributed to economic growth (for example electrotechnical and chemicals industry as well as optics). However, there were considerable regional differences, and the most characteristic German industrial centres of the age were found in the Ruhr region. Chart 5-8: Locomotive factory of August Borsig (1847)

Source: upload.wikimedia.org

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Railway building not only revolutionised personnel and freight transport and connected regions, it also created new jobs and demand for the metal industry. It also made transportation cheaper, which improved the saleability of German products abroad, and in addition, the price of imported goods decreased as well. In 1865 the length of railways in the German states was 14,169 kms, while there was already 46,560 kms in 1895 (for more information, see Subchapter 5.1, as well as Vadász, 2005, 229 and 253; Pohl M., 1982, 145. ff.). In the first half of the 19th century, there was no banking infrastructure that covered all of the German states. Most institutions with the capability to provide credit assessed the financing of new industries as being too risky. Many private banks provided credit based only on personal acquaintance, but even businesses from the immediate region known by the banks tended to only be able to access short-term loans in most cases. At the beginning of the century, state bonds were the most secure form of investment. The only exception were some private banks (mainly from Cologne) that started providing loans for the metal industry, mining and railroad building businesses as early as the 1830–1840s, and traded in stocks and bonds. Thus, these banks played an important role in the development of the Ruhr region (which was becoming a centre of industry and mining) and in the building of railroads. In many cases, the banks themselves acquired ownership rights, and thus were able to set the development direction of the companies. For example, in 1845 the Oppenheim Bank financed 30 per cent of the core capital of a joint-stock company from Stolberg, which was active in mining and in the metal industry (Aktiengesellschaft für Bergbau und Zinkfabrikation). It was also involved in financing the later mega-corporation, the Krupp Works. However, these financing transactions were only significant at the regional level. As for demand for loans: being in debt was considered to be shameful, and therefore the necessary capital for investments was either provided by the businessmen themselves and their families or they established a strategic partnership with a tradesman who had enough resources. However, this system did not enable large-scale developments. Whereas in Great Britain the industrial development was a slow, organic process, the German territories of this era can be considered (with the

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modern term) as ‘developing countries’. Businessmen required a large amount of capital in order to utilise the opportunities arising from the very swift development of technology and the economies of scale. There were no businesses that could have financed large-scale developments using only their own know-how and capital. With the development of technology, the capital requirements of railroad construction and some other industries were growing steadily. Pohl (1993, 214) claims that in the economy the appropriate ‘tool’ was missing for the reasonable investment of the existing capital beyond the narrower region. However, private banks were not able to (or due to the risks were not willing to) provide larger amounts of capital for the long term, due to their limited capital resources. The solution was the introduction of the joint-stock company business form. Buying shares offered advantages for investors as their liability was limited and they could participate from greater distances, investing even smaller amounts. It was logical to use the joint-stock company form to create banks as well. The Aktienbanks founded in the 1840s and 1850s with the cooperation of several banks had the capital to be able to participate in the foundation and financing of joint-stock companies. Aktienbanks established in this period mentioned above (Schaaffhausen’sche Bank, Bank für Handel und Industrie, Berliner Handels-Gesellschaft, Disconto-Gesellschaft) primarily concentrated on stock-related deals in the first 20 years of their operation. They founded joint-stock companies (mainly in the mining, iron, machine and metal industry, electrotechnical and chemicals industries as well as transportation), the shares of which they sold relatively quickly. Aktienbanks also traded the shares they acquired. Accounts receivable, however, were barely above 10 per cent of the balance sheet total. For example, in 1869 hardly 12 per cent of the profits of the Bank für Handel und Industrie was related to accounts receivable and bills of exchange, while the rest was linked to securities trading and shares in businesses. The numbers of Berliner Handels-Gesellschaft are very similar: 62 per cent of the profits came from securities trading, while 22 per cent was generated by interest and fees. The last three decades of the 19th century saw a change in the business policies of Aktienbanks: during this period their involvement in company foundation

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deals decreased. This was partially caused by various experiences: the crisis of 1873–1880 resulted in many companies going bankrupt, and this made banks aware of the risks of actually owning companies. Banks switched to offering credits (including overdraft facilities), and any shares acquired were kept in the bank’s portfolio only for the time which was required in order to sell them. The order of financing methods changed as well: in the 1850s and 1860s, Aktienbanks first supported the establishment of new companies and provided credit only subsequently (if at all). This order was reversed in the 1880s. Banks first provided credit for investments or for the founding of the company, and shares were sold only when this ‘pre-financing’ period was over, the company proved to be sustainable and the market situation was appropriate. This posed a risk as it could have taken years from the investment to be able to sell the shares (Pohl H., 1982, 31. f., 119. ff. and 166; Pohl M., 1982, 171. f., 189. ff. and 277. ff.; Pohl H., 1993, 205. f.; Wandel, 1998, 8; Detzer, 2017, 18; Edwards–Ogilvie, 1996, 428. f. and 439). However, the significance of these emissions and credit deals for the industry is a subject of debate among economic historians even today. Several authors argue that universal Aktienbanks played a central role in supporting industrial development and consequently in the rapid economic growth of the German states. One of the most important representatives of this theory is Gerschenkron (Gerschenkron, 1962).228 He argues (Gerschenkron, 1995, 46) that German banks successfully combined the ideas of Crédit Mobilier with the (short-term) activities of commercial banks. Thus, universal banks were born that followed industrial enterprises from the foundation to liquidation (‘from the cradle to the grave’), through all difficulties. Banks managed to have such influence on industrial companies that included business and management decisions beyond the level of financial control. This resulted in the subordinate position of the industry, a ‘master and servant’ relationship between banks and industrial firms. Gerschenkron’s argument is very similar to that of Rudolf Hilferding and his followers, except that Gerschenkron does not think that this would be a universal 228

In its 2012 whitepaper Deutsche Bank still supported the use of the model of universal banks in the 21th century. Its argument includes the wide selection of services available for customers, the use of synergies to cut costs and greater stability resulting from diversified deals (Deutsche Bank, 2012).

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rule and an inevitable logical consequence of the capitalistic type of capital accumulation. He rather used this theory to explain the development of certain countries in the 19th century. He argued that the rule of banks in Germany was a consequence of relative underdevelopment. Of course, Gerschenkron did not imply that the rate and mode of development was dependent on the level of underdevelopment only. Instead, he argued that different industrialisation patterns require different financing methods. An industrialisation process that is built primarily on the expansion of light industry requires less capital compared to a more complex one founded on heavy industry. This also means that the time when a country joins the industrialisation process has consequences in relation to capital requirements: at the beginning of the industrialisation the English way was based on the priority of the textile industry, while afterwards heavy industry had a more important role. One of the arguments that support the importance of Aktienbanks is that several of their clients were major industrial joint-stock companies, which played a key role in the German economy, and these companies were unable to manage share issuance without the assistance of financial institutions. Banks helped to raise the large amount of capital the companies needed. By doing so, Aktienbanks served as an agent within the capital market. Acquiring capital was not based on personal relationships any more as in case of private banks (Edwards–Ogilvie, 1996, 429. ff. and 433. f.; Pohl H., 1982, 121. ff.). However, Edwards–Ogilvie (1996, 430. ff. and 443) do not confirm this theory. Based on their research, Aktienbanks held only 24.2 per cent of the total assets of the German financial institutions (the share of big banks was 9.2 per cent) in 1913. This is the highest value in the period of 1860–1913 (in 1860 Aktienbanks only held 9.2 per cent of the total assets, see Chart 5-9). By way of comparison: in 1913 savings banks held 24.8 per cent, mortgage banks 22.8 per cent and credit cooperatives 6.8 per cent. The authors argue that this is partly the effect of the smooth operation of small and medium enterprises (SME). As SMEs were not targeted by Aktienbanks, and their former creditors, private banks were either transformed into Aktienbanks or ceased to exist, SMEs turned to other types of credit institutions for credit. In addition, Aktienbanks started to expand their network of branches relatively late, and therefore had not reached small savers for a long period (these did not constitute the target group for

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Aktienbanks). It is important to note that the figures above do not reflect the exact proportion of the contributions of the listed financial institutions concerning German industrialisation. Chart 5-9: Share of different types of financial institutions in the total assets of German financial institution between 1860 and 1913, in per cent 40

Per cent

5 0

0 1860

1880

1900

Central bank and banks of issue Joint-stock banks Private bankers Savings banks

1913

Credit cooperatives Mortgage banks Insurance companies Others

Source: Authors’ own compilation based on Edwards–Ogilvie (1996, 431).

Furthermore, the authors concluded that although Aktienbanks preferred joint-stock companies as business partners, these did not have such elevated significance regarding the German economy as a whole. In 1910, joint-stock companies held only 19.74 per cent of the capital stock (therefore Aktienbanks could only have contributed to the financing of this). The remaining 80 per cent was held by sole proprietors, partnerships and other businesses that were less preferred clients of Aktienbanks. Furthermore, between 1880 and 1913 joint-stock companies primarily used their internal sources to finance investments, and applied for the external resources of credit institutions only if it was unavoidable – in order to tackle problems arising from crises or in

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the case of exceptionally large investments (Edwards–Ogilvie, 1996, 435. ff. and 442). Fohlin’s (1997, 11) results also showed that 31 per cent of the 400 joint-stock companies investigated were evidently in business relationship mainly with smaller banks. Edwards–Ogilvie concluded that the importance of Aktienbanks in German industrialisation was more modest than was claimed by some economic historians. However, the weak point of the theory of Edwards–Ogilvie is that the data they used certainly cannot be considered as representative. To obtain a full picture, a detailed study would have to be carried out on the effects of all enterprises other than joint-stock companies on industrialisation, and also on the role of savings banks and other types of credit institutions concerning the financing of developments. While it is difficult to reconstruct the exact balance of the German credit institution system 150 years later, Edwards–Ogilvie undoubtedly examines the role of Aktienbanks from a perspective that many reference works disregard. It is also important to refer to the role of the banking sector in the development of the railway network. Private banks and later Aktienbanks contributed to the financing of railway construction mainly in the Rhineland and in Saxony. In other German states the railway infrastructure was built by the state. According to the calculation quoted by Edwards–Ogilvie (1996, 434), 73.3 per cent of the railway lines were built using state funds in 1850 in the German states excluding Prussia. Consequently, private banks and Aktienbanks could not contribute significantly to industrialisation (at least not from this perspective). 5.2.1.3 The relationships of Aktienbanks and joint-stock companies Another unique characteristic of the history of German credit institutions is that the representatives of larger credit institutions and Aktienbanks became supervisory board members and executives at several enterprises. Aktienbanks held direct shares in a number of companies mainly in the 1850s and 1860s. Later, to prevent the related risks, they attempted to place their representative on the supervisory board instead. Detzer (2017, 19. f.) mentions the case of Krupp. Due to financial difficulties, the company converted its short-term loan to a long-term one. In return, the creditor raised the interest rate and placed a representative on the supervisory board. According to the

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data of Manfred Pohl (Pohl M., 1982, 282. f.) Deutsche Bank had representatives on the supervisory board of 20 enterprises. The respective figure for DiscontoGesellschaft was 23 companies, and for Schaaffhausen’sche Bank 34 firms. Creditors normally have limited information regarding businesses that apply for a loan and this may discourage lending. If a company’s accounts were managed by an Aktienbank, the latter had reliable information on the financial situation and credibility of the respective enterprise. In addition, if the representative of the bank was a member of the supervisory board, this person had access to the confidential information of the management and may have influenced it in the interest of the creditor. As a result of this Aktienbanks should have been considerably more willing to provide credit for joint-stock companies, and in much larger quantities (Edwards–Ogilvie, 1996, 429. f.). Fohlin (1997, 9. ff., 17 and 20. f.) analysed the data of 400 German joint-stock companies from 1905, and concluded that the representation of Aktienbanks on supervisory boards acted not as a ‘catalyst for lending’ – the presence of the banks in the companies was rather a consequence of the development of the German economy and not its facilitator. Fohlin found that banks did not have a representative at the companies, which showed the most dynamic growth, and enterprises with a bank representative invested less than average. This either means that bank representatives were put on supervisory boards when the respective companies were at the peak of their development or that these representatives failed to fulfil their task and could not convince the management of the company to take further loans. Having a bank representative in the organisation of a company did not mean that the bank ‘controlled’ the enterprise or significantly influenced the direction of its development. Such efforts were often actively resisted by the companies. One strategy to weaken the position of the bank(s) was to deliberately slow down the development of the company and avoid larger investments that could have required external sources. Siemens was an example of this strategy. Thyssen and Krupp issued bonds to finance investments. In a paradoxical manner, it was the great industrial boom at the end of the century that contributed to the weakening of the influence of the banks. The higher degree to which companies were developed, the more capital they had to finance

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5. The Second Industrial Revolution (1870—1914)

investments from internal sources. As a result of industrial development several companies merged (and consequently, in some cases multiple credit institutions had representatives on the supervisory board), and the growing demand for capital could not be served by only a single bank – these changes strengthened the position of companies against banks that were competing one another. Thus, development resulted in a weaker influence of banks on companies, instead of strengthening it. Of course, there were exceptions: when Hörder Bergwerks- und Hütten-Verein was subject to reorganisation in 1891, one of the conditions was that the Verein may not enter into agreements with banks other than the one financing the reorganisation. However, such agreements were only possible in the case of companies in a vulnerable position (Fohlin, 1997, 6. f.; Wandel, 1998, 20; Detzer, 2017, 19. f.; Edwards– Ogilvie, 1996, 437. f. and 439. f.). 5.2.1.4 Expansion of Aktienbanks — branch network and international activities Aktienbanks initially did not have an extensive network of their own branches. According to the data of Manfred Pohl (Pohl M., 1982, 272), banks in Britain had 5,744 branches in 1910, while the 8 big banks of Berlin hardly had 250 branch offices – and only 100 of these were ‘proper’ branches, the rest in many cases were just a single agent. At this time, the 4 biggest British banks had as many branches each as the 8 biggest German banks together. The lack of a branch network had several reasons: banks did not want to bear the costs of expansion; Edwards–Ogilvie (1996, 432) presumes that big banks did not concentrate on extending their range of clientele to include small savers. In addition, Aktienbanks found another solution that allowed them to be ‘present’ in many regions: smaller Aktienbanks started to acquire private banks from the 1880s onwards.229 Another special form of cooperation existing from 1897 was the so-called communities of interest (Interessengemeinschaft), which was a partnership of a big bank and smaller Aktienbanks. It enabled big banks to be present in other regions without owning branches, and the small Aktienbanks managed to get access to considerable capital and further 229

ohl (1993, 266) refers to Pfälzische Bank that acquired 15 private banks between P 1896 and 1900.

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business opportunities. The partners kept their independence – neither a fusion was carried out nor a cartel was formed. The aim was to redistribute profits and to establish common policies concerning organisational administration. After 1914, the strategy of the banks changed: big banks made efforts to acquire the smaller members of the community of interest along with their branch network, which enabled them to grow quickly (Pohl H., 1993, 266. f.; Pohl M., 1982, 271. ff. and 284. f.). The branch network of larger Aktienbanks only started to expand in the 1890s. According to Detzer (2017, 21), the reason for this was that at that time these institutions wished to ‘capture a larger part of the country’s [depositor’s] savings’, and therefore compete with cooperative banks and savings banks, which already had significantly larger branch networks of their own.230 However, in many cases these new branches were concentrated in certain regions: 20 branches of the total of 22 branches of Schaaffhausensche Bank were located in the Rhineland, and in case of the Deutsche Bank this figure amounts 26 branches out of 54. Another option for growth was fusions: one of the most significant transactions of this kind in the pre-war period was the acquisition of Bergisch-Märkische Bank (a large regional bank) by Deutsche Bank in 1914. Due to these transactions, the respective Aktienbank acquired the branch network of the competitor as well (Fohlin, 1997, 4; Wandel, 1998, 12). During the economic boom starting in 1880, German capital exports increased, which process primarily involved well-capitalised, large banks and some private banks (Bleichröder, Oppenheim, etc.). In addition to the countries nearby (Italy, Austria-Hungary, Turkey, Russia), this capital export targeted overseas countries as well. In order to manage these deals some credit institutions and bank consortiums established separate credit institutions. In 1886, Deutsche Bank founded the Deutsche Uebersee-Bank (German Overseas Bank) of Berlin. The Buenos Aires subsidiary of this bank opened 230

anfred Pohl (Pohl M., 1982, 294) believes that 10 institutes had at least 25 branch M offices (or similar offices, agencies etc.) in 1907: Deutsche Bank had 83, Dresdner Bank 74, Commerz- und Disconto-Bank 55, and the rest of the banks had under 50 branch offices.

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its own branches in several countries in South America, which contributed to the international expansion of the institution. In 1889, 11 German credit institutions founded the Deutsch-Asiatische Bank in Shanghai to carry out business activities in Asia. In this period, German credit institutions were also active in railroad building in the USA. It is important to note though that not all business deals involving capital export were successful: several attempts to found or acquire banks resulted in a failure.231 Furthermore, German credit institutions were involved in the introduction of foreign securities to the domestic market as well. Due to the large number of international deals, the foundations of a global world economy were laid with a strong German contribution, but this progress was halted by the outbreak of World War I (Pohl M., 1982, 236. ff. and 285). 5.2.1.5 Private banks and Aktienbanks The two bank types were bound together by strong ties: several Aktienbanks were founded with the involvement of private banks to meet the long-term demands of industry using the capital collected within the framework of the Aktienbank. Thus, some of the most important German Aktienbanks were founded by cooperating private banks. The latter were still important market players in the middle of the 19th century. In 1843, approximately 424, and in 1861 642 existed in Prussia alone. The Bethmann family of Frankfurt am Main was considered to an important trader of securities for a long period, similarly to the Rothschilds, which owned one of the most significant banking houses in Europe even in the 1870s. However, private banks created their own competitors, and as Aktienbanks became stronger, they tried to gain independence (in the case of Deutsche Bank, this meant that the circle of Georg von Siemens became a stronger influencer in the management). Some wealthy Aktienbanks invested capital in family-owned private banks in order to gain influence over them. These private banks pretended to be independent financial institutions in order to

231

ome examples: La Plata Bank founded in 1872 by German, Austrian and Belgian S partners and active in South America was liquidated in 1885; the Shanghai and Yokohama branches of Deutsche Bank had to be closed after two years of operation.

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keep the generations long trust of local businesses and traders. One of the first deals of this kind was concluded in 1864 when Bank für Handel und Industrie acquired a small private bank of Frankfurt am Main to be able to set up in the city mainly dominated by private banks at that time. There were private banks that became the foundation of new Aktienbanks themselves (this is how Michael Kaskel’s bank became the Dresdner Bank in 1872) or merged into an Aktienbank due to their financial problems. Between 1895 and 1914, 50 private banks were acquired by the biggest Aktienbanks, but this figure is marginal compared to the total number of private banks. It is important to note that an act of 1896 (Börsengesetz) had negative consequences for the business of private banks. The Rothschild family was seen as a market leader in securities trading in 1870, but later they were slowly pushed out by other competitors, for example by Disconto-Gesellschaft and Deutsche Bank of Berlin (in the 1890s even from the international markets). Despite the aforementioned negative trends, the number of private banks grew, rising from 1,211 to 1,323 between 1891 and 1911 (Chart 5-10). As most private banks were unable to keep up the pace with Aktienbanks, they focused on their strengths: providing personalised advisory services and offering solutions for specific financial problems. One special form of the cooperation between private banks and Aktienbanks were bank consortiums. The first and perhaps most well-known consortium (Preußenkonsortium) was formed in 1859 to finance the Prussian state budget. It was originally founded by Disconto-Gesellschaft and several private banks, and later it was joined by additional private banks and Aktienbanks. The Consortium consisted of 28 institutions by 1902, and it was a matter of prestige to be a member. Other consortiums were formed to issue foreign state bonds, and yet another typical reason to create a consortium was to manage deals or establish banks overseas (Wandel, 1998, 9; Edwards–Ogilvie, 1996, 432; Pohl, 1993, 269; Pohl M., 1982, 159. ff., 182, 185, 191, 258. ff. and 283. ff.).

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5. The Second Industrial Revolution (1870—1914)

Chart 5-10: Number of private banks and joint-stock banks (Aktienbanks) in the German Empire 1891, 1902 and 1911 1,600

Number of banks

Number of banks 1,386

1,400

1,323

1,211

1,200

963

1,000

800

600

472

400

1,400 1,200

1,000

200

1,600

400 215

200 1891

1902

1911

Joint-stock banks (Aktienbanks) Private banks

Source: Authors’ own compilation based on Pohl (1982, 262).

5.2.2. Savings banks 5.2.2.1 About German savings banks in general A savings bank (German: Sparkasse) is a type of credit institution which was originally founded without the aim to generate profits. Motivated by Christian altruism and charity, they also had a practical purpose: to make certain financial services available for the lower classes in order to support their optimal decisions regarding saving, to increase welfare, and to prevent poverty by self-support. Thus, the initial clientele of savings banks consisted of people who were at the risk of becoming poor, but who were able to accumulate some savings: agricultural day labourers, couriers, apprentices, workers. For these clients savings accounts were opened. Later, savings banks gradually became the financial institution of the ‘middle class’ (see Chart 5-11 for the customer reception area of a savings bank) and started offering loans from the middle of the 19th century. Savings banks had a relatively dense

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Banks in history: innovations and crises

network of branches, and in many cases, these counted as the only access point of lower income-classes to financial services as they were generally not preferred as clients of larger credit institutions and/or they lived in regions where the services of other credit institutions were not available. Savings banks were willing to accept even the smallest deposits. In addition, in many cases there was an upper limit concerning deposit amounts in order to highlight social responsibility. Chart 5-11: Customer reception room of a Berlin savings bank in 1894

Source: www.dsgv.de

Although some British (Daniel Defoe: An Essay on Projects, 1697) and French thinkers (Hugues Delestre: Le Premier Plan Du Mont consacré á Dieu, 1611) had already proposed a solution for fighting poverty by the creation of savings banks type institutions, the earliest savings banks were actually founded in

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5. The Second Industrial Revolution (1870—1914)

the German speaking territories. In several countries of Europe, enlightened ‘patriotic societies’ maintained by private individuals played a vital role in the creation of this kind of institutions. For example, the Patriotic Society of Hamburg (Patriotische Gesellschaft)232 founded the General Supply Association (Allgemeine Versorgungsanstalt) in 1778 that Klein (2003, 301. ff.) claims to be the oldest savings bank in the world. Its goal was to offer interest-paying deposits for couriers, agricultural day labourers, workers and sailors, the amount of which was fixed at a minimum of 15 and maximum of 150 marks. Nevertheless, this success story was short lived, as the institution has to be closed in 1823. However, the foundation of several similar institutions followed: in Oldenburg as a part of the social policy (1786), in Kiel (1796) and in Altona (1801) on private initiation. In the 19th century, several towns and districts had created their own savings banks. The first one was founded in Göttingen in 1801, where the administration was managed by the Magistrate of the town. Between 1816 and 1830 154 savings banks were established,233 and their number grew to 280 by 1836.234 While ‘civic initiatives’ were mainly motivated by Christian/charity reasons, local governments had other, social policy related purposes: to cut costs by preventing impoverishment. This period was followed by an even stronger wave of savings bank foundations: between 1840 and 1860 more than 800 savings banks were created. Savings banks maintained by districts (Kreissparkassen) counted as a special subtype: between 1840 and 1850 19 of these were established. The advantage of this subtype was that districts had a stronger financial background compared to individual towns. This was the reason why the Prussian government made it compulsory in 1854 to establish

s Vadász (2005, 207) summarises: patriotic and non-profit societies aimed to A discuss and solve political, pedagogic, social, economic, scientific and technological problems of the age. In line with this the Patriotic Society of Hamburg worked to maintain the competitiveness of the city and supported for example inventors. 233 80 in Prussia, 32 in Bavaria, further ones in the other German states. 234 Hans Pohl’s data (Pohl H., 1982, 102) reveal interesting details about Prussia. In 1838, there were 86 savings banks in Prussian territories. 76 of these were operated by towns, 3 by districts, 2 by orders, and 5 by private individuals. 232

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Banks in history: innovations and crises

district savings banks, which could be used also by the population of the region.235 At the beginning of the 19th century, savings banks primarily handled interest-bearing deposits. Initially, savings banks invested only in the least risky instruments for security reasons. The aim of the investments was not to generate profits for the owners – returns had to cover costs and interests to be paid for clients. This policy changed only later: in the 1840s savings banks started to provide loans for the ‘small and middle enterprises’ of that age. Then, between 1870 and 1913, in the framework of their lending business they financed primarily the construction of apartments, furthermore the investments and constructions initiated by the agricultural sector or by the public sector. Klein (2003, 34) however claims that between 1850 and 1900 the main function of savings banks was still to collect relatively small deposits (Klein, 1982, 300. f. and 306; Thol, 2016, 4. ff. and 11; Pohl H., 1982, 98. ff.; Pohl M., 1982, 195. ff., 325 and 327; Pohl H., 1993, 211). The rapid growth should be interpreted in the context of the social and economic changes of the period. The freedom of industry and the abolishment of serfdom236 extended personal possibilities, but independence meant greater responsibly and included the risk of impoverishment. The services of savings banks offered a perfect way to avoid that, especially because a welfare system in today’s sense of the term was not available for most of the 19th century (Pohl H., 1982, 98). The other significant factor behind the fast increase in the number of savings banks was the support of the state and of the local governments: according to Manfred Pohl (Pohl M., 1982, 195) fighting

his was a required measurement. According to an 1851–1852 estimation, the ratio T of urban and rural population was 1 to 3, but only 10% of savings accounts were connected to rural areas. 236 In Prussia, for example, the system of serfdom was abolished by the decree of minister Heinrich Friedrich Karl vom und zum Stein in 1807. Ownerships rights concerning farmlands were introduced by a decree of 1811, but relatively few could afford the related compensation fee. The monopoly of guilds was terminated by his successor, Karl von Hardenberg in 1810 (Vadász, 2005, 212. f.), along with the introduction of the freedom of industry. 235

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5. The Second Industrial Revolution (1870—1914)

poverty had a positive effect on the finances of local governments that had the obligation to care for the poverty-stricken. Chart 5-12: Number of savings banks in Prussia between 1839 and 1913 2,000

Number of savings banks

Number of savings banks 1,765

1,800 1,493

1,600 1,318

1,400 1,200

1,711

1,000 800

517

600 400

0 1830

1,600

1,200

800

200

1,800

1,400

1,490

1,005

1,000

2,000

157

1840

234

600

323

400 200

1850

1860

1870

1880

1890

1900

1910

0 1920

Source: Authors’ own compilation based on Pohl H. (1982, 199).

The data of Detzer (2017, 20) show that the number of savings banks grew to 2,700 by 1900, and one third of the German population kept an account in one of them. By this time, very few new savings banks were founded privately; the population trusted more in savings banks managed by the public sector. The figures for Prussia alone show that the number of savings banks amounted 234 in 1850, 1,490 in 1900, and 1,765 in 1913 (Chart 5-12). Of these, 810 were managed by towns and 486 by districts, while the remaining ones were operated by other entities (for example, by associations). Development in the other German states was similarly fast-paced. In the second half of the 19th century, the scope of services grew along with the geographic coverage, and as a result of this, savings banks more and more resembled a general credit institution. A decisive step was the cheque law (Scheckgesetz) of 11 March 1908, and another law was implemented in 1909. These enabled savings banks to accept cheques, open current accounts for the clients and provide

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Banks in history: innovations and crises

overdraft facilities. As a result, savings banks could participate in cashless bank transactions. In addition, given that the branch network of savings banks was dense, clients were able to better utilise the broader selection of services,237 although each institution covered just one region individually. As Pohl (1993, 272) claims, the measures addressed above transformed savings banks from savings institutions for lower class citizens into the universal commercial banks of the middle class. The scope of new activities required the establishment of clearing houses, which were operated by clearing associations (Giroverband). The first such association was the Clearing Association of the Municipalities of Saxony (Giroverband Sächsischer Gemeinde), founded in 1908. 12 such clearing associations had been created by 1916, and all of these merged on 16 October 1916 in order to form the Central German Clearing Association (Deutscher ZentralGiroverband) (Klein, 2003, 34. ff.; Pohl M., 1982, 198. f., 325. ff. and 334. f.). Box 5-6 The savings banks of Saxony

The research of Thol (2016, 8. ff.) concentrated on the history of the 241 savings banks of a larger German state, Saxony in the 19th century. Here, the first savings bank was founded in 1818 in Königsbrück for social purposes, with the help of a count and a group of merchants. The initiative quickly won the support of the state, and a decree of 1822 urged local governments to establish savings banks. Later, such institutions even received tax concessions. However, the first few years after the founding were characterised by some difficulties typical of this era: the poorer stratum of society had no experience with banks and consequently they were quite suspicious towards them. As the number of branches was initially low, many (prospective) clients had to travel if they wanted to use the services. Savings banks were not profit oriented, and as such 237

I n 1913, the number of savings banks in the German Empire amounted 3,319 with 8,425 branches or smaller offices.

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5. The Second Industrial Revolution (1870—1914)

it was not a priority to advertise their services. Furthermore, clerks were volunteers, often untrained, and in many cases, they worked parttime, therefore opening hours were limited, usually to those hours when (potential) clients worked. Employing part-time staff was not unique to Saxony, as it was common in the German-speaking territories until the end of the 19th century (Pohl M., 1982, 196). The development of savings banks was hindered by the fact that these were treated as institutions with a social profile, even though in many cases they practically fulfilled the role of local banks (especially in rural areas, as leading banks had branches only in larger towns). Savings banks were required to avoid the riskier forms of investments, and a maximum deposit amount threshold was imposed as well. These circumstances inhibited their growth. For cautionary reasons, savings banks generally avoided taking out loans, and local governments were strongly against risky changes that would have brought bigger profits. This was the result of the fact that deposits were guaranteed by the local government. Even in 1878 the Ministry of Internal Affairs of Saxony was of the opinion that savings banks are primarily non-profit charity organisations. Despite this, these financial institutions were already aiming to gain more autonomy in the 1850–1860s. Furthermore, internal optimisation measures were introduced in order to cut costs and raise liquidity, but savings banks still remained risk-averse. Despite restrictive measures, savings banks can be considered as a success story in Saxony. According to Thol (2016, 13) in 1857 only 98 of the municipalities included in the study had a savings bank, while in 1893 only 16 did not have one. 5.2.2.2 Regulation and importance of savings banks Although the state and local governments supported savings banks and were actively involved, the respective laws were passed relatively late. The first regulations were introduced in Prussia: from 1808 onwards, Prussian towns had the right to establish savings banks (Städteordnung). The legislation was amended in 1831, and from then on state permission was required for

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Banks in history: innovations and crises

foundation. The Prussian regulation regarding savings banks was introduced in 1838 (preußische Sparkassenreglement), which covered the areas of structure, supervision and operation, but as a framework regulation it provided enough flexibility for local governments to consider local conditions as well. The Prussian example was used by numerous other German states to create their own legislation, but later the modernisation of the Sparkassenreglement was also urged by many parties. Discussions were underway for years about a unified Empire-level act on savings banks, but without a compromise and due to the strong opposition of the Prussian government such a law was never introduced in practice. Therefore, this issue was left to be solved by lowerlevel legislation. For example, the Prussian government proposed that the 1873 charter of the savings bank of the Teltow district should be used as a model. Then, at the turn of the century, certain Prussian provinces investigated the question and issued their own recommendations concerning savings bank charters. The importance of savings banks can be seen at the level of both the individuals and the entire economy. Savings increased the personal welfare of individuals, given that during this period everyone had to provide the financial means on their own to support himself in case of unemployment, old age and/or sickness. The reason for this was that for most of the 19th century there was no welfare system in today’s sense, and the financial services of other credit institutions were not accessible for most people. Bigger banks charged fees, set a minimum deposit threshold (a large number of small amount deposits resulted in less profit and more administration for the banks) and/or did not have an extensive network of branches (this situation changed only at the end of the century). Consequently, savings banks filled an important ‘market niche’. The mobilisation of the money of private individuals was important at the macro level as well: savings banks channelled large amounts of smaller savings into the economy. This would not have been possible in case of money ‘kept at home’, and these financial means would not have been accessible for other market players without the savings banks. Some calculations show that between 1851 and 1910 26 per cent of the total credit was provided by savings banks. This figure is roughly similar to that of Aktienbanks. Although it is hard to measure the effect of

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5. The Second Industrial Revolution (1870—1914)

these financial institutions on economic development, based on her results concerning Saxony Thol (2016, 16) draws the cautious conclusion that there is a connection between the number of houses built (as the indicator of economic development) and the availability of savings banks. Manfred Pohl (Pohl M., 1982, 327. ff.) emphasises that between 1870 and 1913 the majority of deposits were used to finance constructions initiated by the private and public sector, and other (often agricultural) investments. However, effectiveness was limited by the fact that savings banks worked on a local and regional basis, and as such (especially with regard to the strict rules restricting the investment options of savings banks) the money of account holders was only accessible to a limited degree for other regions and industries. From the point of view of the government, savings banks granted considerable benefits regarding social policy: this type of institution acted as an important tool in fighting poverty and the ensuing social unrest (Klein, 2003, 33; Pohl H., 1982, 101; Pohl M., 1982, 321. ff.; Detzer, 2017, 21; Thol, 2016, 4. f., 11 and 14. ff.).

5.2.3. Credit cooperatives and cooperative banks 5.2.3.1 About credit cooperatives in general The development of credit cooperatives (also called credit unions, in German: Kreditgenossenschaften) or cooperative banks (in German: Genossenschaftsbanken) is strongly connected to the German industrial revolution and the modernisation of society. The freedom of industry offered great possibilities, but if craftsmen did not have enough money to buy machines, they could be left behind in the competition against bigger factories or were forced to work as labourers. Similarly, peasants were freed from feudal obligations, therefore they had to join the competition, but the compensation fee they were required to pay their former masters was a heavy burden. A credit institution system providing loans for craftsmen and farmers could have offered a solution for the lack of money and the financing of developments, but such system did not exist at the beginning of the 19th century. Many regions did not have any credit institutions at all, and the continuously expanding network of savings banks introduced very strict requirements concerning the provision of long-term credits. Many were forced

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Banks in history: innovations and crises

to turn to loan sharks. Thinkers from France (Charles Fourier, Louis Blanc), England (Robert Owen), and Germany (Victor Aimé Huber) considered this topic, but probably the first practical implementation came from the German politician Hermann Schulze-Delitsch and the German mayor Friedrich Wilhelm Raiffeisen238 (Wandel, 1998, 4; Pohl M., 1982, 202. ff.). 5.2.3.2 The Delitsch type of credit cooperatives, people’s banks (Volksbanks) Hermann Schulze-Delitsch (his original name was Franz Hermann Schulze, Chart 5-13) established his first cooperatives in 1849 in order to acquire raw material (bypassing wholesalers) for carpenters and shoemakers in Delitsch, near Leipzig. One year later, he founded a real credit cooperative that provided credit for its members on favourable terms, and which was reorganised in 1852 based on the results of its operations. The clientele consisted mainly of craftsmen and ‘businessmen’ who primarily required short-term loans. However, credit was available for members only. The main invention of the cooperative form was that clients were also owners. Their invested money and eventually their membership fees constituted the capital of the cooperative, they had unlimited, collective liability and profits were shared among holders. The Delitsch type of credit cooperatives did not count as charity organisations: this form was created for craftsmen generating profits and not for the poor. It was fully profit oriented, and the management received salaries. Although focused primarily on craftsmen and tradesmen, the Delitsch type of credit cooperatives were open to any clients. Perhaps this is the reason for the name ‘peoples’ bank’ (Volksbank).

238

Pohl (1993, 216) mentions that the ‘Rochdale Society of Equitable Pioneers’ was established in Britain in 1844 by weavers in order to acquire raw materials, but this was not a credit cooperative.

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5. The Second Industrial Revolution (1870—1914)

Chart 5-13: Hermann Schulze-Delitsch

Source: upload.wikimedia.org

Delitsch’s example was followed in other municipalities that also established credit cooperatives for craftsmen (also called urban credit cooperatives, in German: gewerbliche Kreditgenossenschaft). The figures reflect rapid growth: the number of such cooperatives amounted 498 in 1865 (169,595 members, credit provided: 61.03 million German marks), while in 1913 there were 1,093 Volksbanks (815,065 members, credit provided: 1,791.16 million German marks). The publications of Schulze-Delitsch also contributed to this rapid growth: ‘Credit Associations as People’s Banks’ (Vorschuss-Credit-Vereine als Volksbanken) of 1855 for example contained proposals for the establishment and operation of cooperatives (Wandel, 1998, 13. f.; Pohl H., 1993, 270; Pohl H., 1982, 123; Pohl M., 1982, 204. ff., 337. f. and 343. ff.). The expansion of credit cooperatives is summarised in Table 5-6.

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Banks in history: innovations and crises

Table 5-6: Number of credit cooperatives in Germany between 1860 and 1914

Year

Total number of credit cooperatives

Of which: credit cooperatives for craftsmen

number

number of members**

number

number of members

1860

n.a.

133

31,603

1870

n.a.

740

314,656

1880

n.a.

906

460,656

1890

n.a.

1,072

518,003

1900

12,140

1,263,623*

870

511,061

1905

15,108

1,674,538

921

539,993

1910

17,493

2,302,827

939

600,387

1914

19,700

2,598,407

945

618,408

Note: *Data from 1900 instead of 1901. ** The research of Bundesbank only covers the membership figures of those credit cooperatives for which data was available. Consequently, total membership was probably higher. Source: Authors’ own compilation based on Deutsche Bundesbank (1976, 65. f.).

The activities of the Delitsch type of credit cooperatives were initially financed using the deposits of the members, but as early as 1859 there were proposals to create a central institution or a bank that could handle the loan requests of individual credit cooperatives. Finally, the German Bank of Credit Cooperatives (Deutsche Genossenschaftsbank von Soergel, Parrisius & Co) was established in 1865 with capital raised by individual cooperatives and traders. The institution soon played an important role in the refinancing of credit cooperatives. This is proved by the following data: between 1865 and 1903 the amount of transactions carried out with credit cooperatives grew from 3 million marks to 339 million marks. Furthermore, it also conducted other bank transactions (some with private individuals) and traded in state bonds. This resulted in a strong disagreement of several cooperatives. Another regular problem was that it only had two branches (Berlin and Frankfurt am Main). To solve the issues some credit cooperatives started their own initiative and established regional ‘central savings institutions’ (Zentralkassen). There were 13 of these in 1895, with the number growing to 65 by 1911 (Pohl M., 1982, 338. ff.).

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5.2.3.3 Raiffeisen type of agricultural credit cooperatives The idea of the other type of credit cooperatives, namely agricultural credit cooperatives (also called rural credit cooperatives) came from Friedrich Wilhelm Raiffeisen (Chart 5-14). In contrast to the model of Delitsch, Raiffeisen’s cooperatives focused on farmers as clients and emphasised Christian/charity related ideas. Raiffeisen’s first, short-lived cooperative initiatives concentrated primarily on helping others, instead of promoting self-help. Flammersfelder Hülfsverein established in 1849 took out loans to buy animals for poorer farmers. Later, it also provided loans. In the framework of the Heddesdorfer Wohltätigkeitsverein established in 1854 wealthy members took out credits with shared liability and transferred these to farmers in need. It also supported local employment and operated a public library. However, after a few years of operation all of the initiatives of Raiffeisen proved to be economically unsustainable. Chart 5-14: Friedrich Wilhelm Raiffeisen

Source: upload.wikimedia.org

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As a result of correspondence with Schulze-Delitsch, Raiffeisen finally established a credit cooperative in 1864. From then on, similarly to the Volksbank model, the model of agricultural credit cooperatives spread quickly: in the Prussian Rhine Province (Rheinprovinz) there were 5 in 1866 and already 75 in 1868. Some additional data regarding the gradual expansion of this initiative: 1,700 such cooperatives existed in 1890, and 9,800 in 1900. The emblem of Raiffeisenbanks: the emblem of today’s Raiffeisen bank group of Austria and that of the German Raiffeisenbanks, the two intersecting horse heads (Pferdeköpfe) is a traditional ornament from North Germany (Chart 5-15). Ornaments with horses or more rarely with other animals were applied to the planks holding the thatched roof in place. The meaning of the symbol is subject to debate, but it is a fact that the horse is among the most popular emblems in Lower Saxony, and it is also part of the coat of arms of this North German state. It has been one of the symbols of Raiffeisenbanks in Germany since 1935 and in Austria since the 1940s. Chart 5-15: Roof ornaments resembling the Raiffeisen emblem

Source: upload.wikimedia.org

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The difference between the ‘Volksbanks’ of Delitsch and the cooperatives of Raiffeisen was not just that the former concentrated on craftsmen and tradesman and the latter on farmers. While the Delitsch-type credit cooperatives predominantly offered short-term loans, agricultural cooperatives – due to the characteristics of farming – offered medium and long-term loans as well. Moreover, the latter helped members purchase farming tools and coal, and also to sell their products on the market. In addition, the charters of the Raiffeisen cooperatives included welfare goals based on the Christian love of fellow men. It is important to note that the gap between the models of Delitsch and that of Raiffeisen somewhat closed later. Today, there are many German municipalities with a Volksbank and/ or a Raiffeisenbank (note that the latter term does not refer to the Austrian bank also active in Hungary) (Wandel, 1998, 14. f.; Pohl H., 1993, 271; Pohl M., 1982, 208. f. and 350. f.). 5.2.3.4 Regulation and importance of credit cooperatives The importance of the credit cooperatives ‘system’ was that it provided access to certain financial services for a layer of society (craftsmen, farmers) in the 19th century who were not the preferred clients of larger credit institutions – while self-help was taken into consideration as well. Unlike early savings banks, the focus was not on saving, but to raise the necessary capital required for business development and expansion. According to Detzer (2017, 21), between 1851 and 1910 credit cooperatives provided 8 per cent of the total credit extended in Germany. It is important to note that credit cooperatives were not unique to the German states: similar institutions were established in Italy and even in Canada, based on the German precedent. For a long period, there was no applicable legislation regarding credit cooperatives, and as such they did not have a legal entity. Although SchulzeDelitsch started negotiations with Prussian legislators as early as 1863, their idea was to introduce concessions for the establishment of credit cooperatives, and therefore he abandoned this strategy. The first Prussian act on the regulation of (credit) cooperatives came into effect in 1867, which granted cooperatives legal entity, and the text of which was largely written based on the proposals of Schulze-Delitsch. A year later the act was extended to the

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member states of the North German Confederation (which Prussia was part of) and in 1871 to the German Empire. The proposals of Schulze-Delitsch concerning the update of the legislation were enacted in a new law in 1889 after his death, which allowed credit cooperatives to offer a broader spectrum of services and to provide overdraft facilities, and as such cooperatives started to resemble ‘normal’ banks more and more (Pohl M., 1982, 205. f. and 338; Detzer, 2017, 21).

5.2.4. Mortgage banks The idea to offer loans for properties secured by mortgage and to raise the necessary capital by issuing mortgage bonds emerged as early as the second half of the 18th century. Although the earliest institutions active in the mortgage credit business were already established at the end of the 18th century (for example the credit cooperatives of specific Prussian estate holders [knights] after 1770 – the Landschafts) and at the beginning of the 19th century (for example the Bayerische Hypotheken und Wechselbank in 1835),239 it was not until the 1860s that the first proper mortgage banks specialised in offering loans backed by mortgage appeared. Box 5-7 Landschafts, the first German mortgage credit institutions

Landschafts240 were compulsory mortgage credit cooperatives (Zwangskreditgenossenschaft) of specific estate holders (knights, in German: Ritter) of a Prussian province established to offer mortgagebased loans. Pohl (1993, 210. f.) argues that these were among the first mortgage credit institutions of Europe, preceded only by the Swiss bank Manfred Pohl (Pohl M., 1982, 212) described the Bayerische Hypotheken und Wechselbank as the first German mortgage bank: although the institution served also as a bank of issue, it was required to provide 60% of its capital to real estate owners in the form of credits. However, it received the right to issue mortgage bonds only in 1864. 240 The word itself means ‘landscape’ in German, and originally referred to all of the estates (orders) of the realm (Landstände) in the respective province and their congregation. 239

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Leu & Co founded in 1755 (which operated as an independent bank until its acquisition in 1990). This was a predominantly Prussian financial invention, but some similar corporations existed also outside of Prussia, created based on the Prussian example. The first Landschaft was founded around 1770 in Prussia, in Silesia (today a part of Poland) and supported members in their rebuilding efforts following the Seven Years’ War (1756–1763), in case they did not have enough capital for this purpose individually. All ‘knights’ of the affected Prussian province became members of the respective Landschaft automatically (this made these cooperatives compulsory and not voluntary), and they had unlimited, collective liability for the loans taken out by corporation members. Let us see how an actual deal was conducted. The Landschaft issued a mortgage bond containing the detailed rules of the loan and representing the guaranty of the Landschaft for the member who wanted to take out a loan. This member then sold the bond to a wealthy trader, to a creditor, in order to actually receive the money. Thus, a Landschaft was practically a loan agent. The Prussian state itself became a member of two Landschafts in 1808 in order to finance war reparations from the loans taken out. It is an interesting fact that in the beginning it was not compulsory for debtors to pay the credit in regular instalments - this was first regulated in Silesia in 1839. Landschafts were important for two reasons: on the one hand, they contributed to the spread of loans based on mortgages and mortgage bonds in the German states, and on the other hand Landschafts were the only possibility for the members to take out a credit, which was especially beneficiary following the devastations of war. However, commoners and farmers were only allowed to join some Landschafts, and even this became possible relatively late (in 1847 and 1849), although wealthy farmers obtained this opportunity earlier (in the case of the Eastern Prussian Landschaft in 1808). Based on the above, the system of the Landschafts was well organised, but it was limited to a region, and demand was considerably larger than the narrow supply. For this reason, many were forced to turn to loan sharks (Pohl H., 1982, 59. ff.; Pohl M., 1982, 210. f.; Pohl H., 1993, 209. f.).

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The advantage of mortgage banks (Hypothekenbank) compared to their predecessors was that these institutions offered full credit brokerage services, and debtors did not have to search for potential creditors any more. The debtor did not even receive the mortgage bond but was able to immediately access the funds: the bond was handed over to the creditor by the bank. This solution offered advantages for the buyer of the mortgage bond as well – they did not have to check the creditworthiness of the debtor any more. As it was necessary to provide long-term credit, mortgage banks had to have the necessary resources, i.e. the right to issue long-term mortgage bonds and promissory notes, which were required to be transferable so that the buyer could resell them. The first two German banks founded exclusively for mortgage credit deals were established by banker families in 1862 in Frankfurt (Frankfurter Hypothekenbank) and Meiningen (Deutsche Hypothekenbank). The model was the French Crédit Foncier de France (1852). These were followed shortly thereafter by the first two Prussian mortgage banks (Erste Preußische Hypotheken Actien-Gesellschaft 1863, Preußische Hypotheken-Actien-Bank 1864). Additional mortgage banks were established in the 1860s and 1870s (for example in Leipzig, Munich, Hamburg, Mannheim and Bremen), and again between 1893 and 1896. These establishment cycles reflect the waves of urbanisation and apartment buildings powered by industrialisation (which increased the demand for mortgage loans) and the possibilities offered by the amendments of the regulation. Wandel (1998, 16) claims that due to the limitations introduced by the Prussian legislation several mortgage banks were established outside of Prussia. In addition, there were some credit institutions that were not mortgage banks but opened departments to offer real-estate related loans. One example is Bayerische Handelsbank of Munich. The first regulation governing mortgage banks was the norm issued by the government of Prussia in 1863 that prescribed the contents of mortgage bank charters (the first Prussian mortgage credit institutions were established due to this legislation). Nevertheless, mortgage banks in the various German states had to operate based on different legal frameworks, and the unification of Germany (1871) did not change this situation. Although many demanded that the norms shall be abolished, in 1893 new central norms were issued. However, these were interpreted positively by the market, and a new wave of mortgage — 346 —

5. The Second Industrial Revolution (1870—1914)

banks establishments started. The unified, modern regulation was introduced only in 1900 when the related law (Hypothekenbankgesetz) entered into force along with the German civil code. As per the new legislation, mortgage banks had to obtain a federal license, operated under state supervision, and it also defined the services mortgage banks were allowed to offer.241 However, not all mortgage banks were successful. Many institutions became involved in deals that were outside of the limits of mortgage bank activities (real estate management, property valuation, etc.), or the debtors went bankrupt. For example, the owners of Deutsche Grundcreditbank zu Gotha did not receive dividends between 1883 and 1890. Transactions for speculative purposes resulted in problematic issues as well. Six mortgage banks in Berlin242 had a real increase of 67 million German marks in mortgage bonds and promissory notes on their books in 1907, but sold these kind of instruments in the amount of 145 million. One important function of mortgage banks was to finance apartment and industrial constructions with players from the private and public sector, as well as non-profit organisations among their clients. Consequently, what made them significant was the fact that these banks satisfied a demand (especially in the housing market) that other types of banks could not or were not willing to. It would have been impossible to carry out the great urban developments of the second half of the 19th century (for example in Berlin, Hamburg, Cologne or Munich) without the involvement of mortgage banks. However, World War I was a period of decline for these banks. The difficulties on the real-estate market started as early as 1913, and the war had a strongly negative effect on construction works and the sales of mortgage bonds (Pohl H., 1993, 209. f. and 273. f.; Pohl M., 1982, 210. ff., 214. f., 298. ff., 301. ff., 305. ff., and 314; Wandel, 1998, 15. f.).

These were the following: mortgage-related deals, providing loans for the public sector and selling bonds with regards to these demands, providing loans in small amounts and selling bonds with regards to these demands, buying and selling securities on commission, lien deals (money and other objects), acquiring bills of exchange. 242 Preußische Central-Bodencredit-Actien-Gesellschaft, Preußische Boden-CreditBank, Deutsche Hypothekenbank, Preußische Pfandbrief-Bank, Preußische Hypotheken-Actien-Bank, Berliner Hypothekenbank. 241

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5.2.5. Banks of issue and banknote issuance Banks of issue (Notenbank) of the 17–19th centuries differ from today’s central banks in many respects. In this period a ‘bank of issue’ was not an institution with a monopoly on banknote issuance and controlling monetary policy – it was basically a ‘common bank’ with the right to issue money, offering also further credit institution services (for the history of central banks, see Subchapter 4.3.2). In the case of state-founded banks of issue the aim was often to raise money in order to finance state debt. Due to the territorial fragmentation of the Holy Roman Empire and the German Confederation a relative large number of banks of issue were founded: 9 existed in 1851, and 33 in 1875 within the German states. However, this did not mean that ‘anyone’ could establish a bank of issue as the official requirement was to receive a license of the respective German state. Chart 5-16: The Reichsbank building around 1905

Source: commons.wikimedia.org

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As first in the German speaking territories it was the Prussian Royal Bank that gained the right of banknote issuance in 1766 (this licence was revoked in 1806). It was then reorganised as a joint-stock company (with the aforementioned right of issue) and was opened as Bank of Prussia on 1 January 1847. The strength of this bank is demonstrated by the fact, that around 1867 approximately two-thirds of the banknotes used in the German states were issued by this institution. With regard to this and the dominant position of Prussia within the German Empire it is not surprising that the central bank of the young Empire was built on the Bank of Prussia which became the Reichsbank (Chart 5-16) and started its operation on 1 January 1876. Shares were privately owned, but the management consisted of civil servants. The president of the advisory board was Chancellor Bismarck himself. It needs to be highlighted that the Reichsbank did not have a legal monopoly (the issue rights of the other banks of issue were not revoked), but numerous privileges were granted to it by the regulations.243 Consequently, as early as 1882, 85 per cent of the banknotes in circulation in Germany were issued by the Reichsbank. As a result of this, numerous German banks of issue renounced their rights, but it was a slow process: the last German banks of issue (other than Reichsbank) had the right to issue banknotes until 1905, and the money printed/coined by Reichsbank became the official (and only) currency of the Empire in 1909 (Chart 5-17). The standardisation was necessary as in 1871 the banknotes of 31 banks of issue from 28 German states were in circulation. In 1914, the banknotes of the Reichsbank amounted to approximately 39.3 per cent of the money in circulation, and 42 per cent were gold money.

243

nly the Reichsbank had the right to open branches anywhere within the Empire O (other banks of issue were allowed to open branches only in the respective German state where they were established), and it received a tax break. Furthermore, a new licence regarding banknote issuance could have been established only by an Empire-level law (and no such law entered into force).

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Chart 5-17: 100-mark note issued by the Reichsbank in 1908

Source: upload.wikimedia.org

While Great Britain had already introduced the use of gold currency in 1816, in the German Empire this process only started in the 1870s, when the ‘unified’ empire took over the coin and banknote issuing competencies from the numerous and smaller German states. The gold Mark of the Empire (Reichsgoldmünzen) was introduced by an act of 1871. In addition, a ban was put on minting new silver coins, and the ones in circulation could be exchanged. The next step towards the transition to a gold currency was an act

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5. The Second Industrial Revolution (1870—1914)

of 1873, which declared that the currency of the German Empire is the Mark (100 Pfennigs). Nevertheless, unification was a long process – laws allowed the use of silver coins and these had the status of official currency until 1907. The decades-long journey towards the introduction of the gold standard came to an end with an act of 1909. Before World War I the gold coverage ratio amounted to 45 per cent. Unlike the Bank of Prussia, the Reichsbank was not allowed to provide credits. Even deposits inherited from its predecessor had to be transferred to the state of Prussia. The only exception were acceptance credit and collateral loan offered to credit institutions (Pohl H., 1993, 180. f. and 192. ff.; Pohl H., 1982, 76. ff., 95 and 126; Pohl M., 1982, 154. ff., 223. ff. and 244. ff.). Box 5-8 The system of German credit institutions today

According to the statistics of the Association of German Banks (Bundesverband deutscher Banken), Germany had 1,960 credit institutions with 36,005 branches at the end of 2015. The foundations of this banking system were laid in the second half of the 19th century – this was the time when the big banks were established along with varieties of credit institutions active today. The system of German credit institutions is built on three pillars: the commercial banks, the credit institutions predominantly owned by the federation or the states and the cooperative banks. The latter two categories primarily consist of a network of smaller institutions. The four biggest commercial banks are the following: Deutsche Bank (1870), Commerzbank (originally Commerz- und Disconto-Bank (1870)), Unicredit Bank (predecessors: Bayerische Hypotheken- und Wechselbank (1835) and Bayerische Vereinsbank (1869), which merged in 1998), and Postbank (1995). Dresdner Bank belonged to this group until 2009 when it was acquired by Commerzbank. The term big bank may be misleading as the fourth big bank, Postbank, is only the 10th largest in

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Germany according to its balance sheet. Numerous private banks are still active in the commercial bank sector. Several of them have been able to maintain their independence for hundreds of years, for example Metzler (1674) or Berenberg Bank (1590), which is considered the oldest German bank. Others have been acquired, for example the Oppenheim banking house (1789) that was bought by Deutsche Bank in 2009. The category of credit institutions predominantly owned by the federation or the states or by local governments covers the savings banks network that consisted of 403 institutions in 2016 with 10,555 branches, the province banks (Landesbank), and the development banks (FĂśrderbank) supporting economic and social policy by offering loans. The biggest development bank is KfW, which was the third largest bank in the country in 2015 based on its balance sheet. The third pillar consists of cooperative banks. Their umbrella organisation incorporates both Volksbanks and Raiffeisenbanks, along with some other credit institutions working on similar principles. This category covers approximately 972 institutions with 11,787 branches. Their central institution is DZ Bank, which was the fourth largest bank in the country in 2015, based on its balance sheet (Bundesverband 2016). Box 5-9 The failure of the City of Glasgow Bank

The bankruptcy of the City of Glasgow Bank in October 1878 was the biggest bank failure in the UK until the global financial crisis of 2008. The details concerning its bankruptcy enable us to learn numerous lessons. The City of Glasgow Bank was established in 1839, and in line with the regulations of the age the owners had unlimited, collective liability for the outstanding assets.244 In parallel with the rapid development of the British economy, the bank was growing fast and opened numerous branches not 244

he joint-stock company format with limited liability of the owners was introduced T only in 1844 in Britain. See: Nobes, 2014, 24.

â&#x20AC;&#x201D; 352 â&#x20AC;&#x201D;

5. The Second Industrial Revolution (1870—1914)

just in Glasgow but in other parts of Scotland as well. The institution survived the 1857 bank panic that started in the USA and is considered to be the first global crisis245 by numerous historians, and after opening again it continued its operation. By 1870 the bank had the third largest branch network in the UK with 130 offices and was an important contributor to the financing of the local economy. Although there were already signs of a crisis at the bank in 1877 (the New York branch had to be closed), it reported a profit even in July 1878 and there was a decision to pay a 12-per cent dividend. In September 1878 there were rumours about the insolvency of the banks and due to the uncertainty of its financial situation the bank lost access to interbank resources. The management of the bank turned to the other Scottish banks for assistance. The books were audited by an independent expert and based on the result other Scottish banks refused to help. Consequently on 2 October 1878 the management was forced to announce that the City of Glasgow Bank would discontinue operation. On the last business day, the price of the shares that had a nominal value of 100 British ponds was 236 British pounds. News of bankruptcy shocked the public, especially the large number of shareholders of unlimited liability. During the liquidation process the 1,819 shareholders had to make payments multiple times to compensate for the losses of the banks and as such the majority of them also went bankrupt. Investigations were conducted to identify the cause of the collapse. Loans were extremely concentrated (75 per cent were taken out by only four debtors) and the bank made a large number of risky investments (for example, development and mining projects in India, Australia and the USA). Management falsified the books to show income, assets and share capital as being higher than the actual value and to hide uncomfortable liabilities; they manipulated the stock price and provided falsified information about the gold stocks of the bank to authorities.

245

Hughes, 1956, 194.

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As that was the biggest bank failure in British history up to that time, there had to be consequences. The trial of the management of the City of Glasgow Bank started in January 1879 at the Supreme Court of Scotland in Edinburgh. All defendants were found guilty. The head of the bank and one of the directors were sentenced to serve 18 months in prison. Five directors were sentenced to serve 8 months in prison. Following the collapse, the majority of the branches and employees of the City of Glasgow Bank were taken over by the Royal Bank of Scotland. The 1878 failure of the City of Glasgow Bank was one of the reasons why banks with unlimited owner liability lost market share. Furthermore, Great Britain became the first country with an external audit obligation first of banks, and from 1900 of other companies, with a constantly widening scope of audited financial data that was compulsory to publish.246

5.3. Historical development of the US banking system Some international financial crises originated directly from the USA, suggesting that the banking system of that country is entirely unregulated. However, a historical analysis may reveal the details. It is also a fact that there were many regulatory efforts regarding financial institutions from the time when banks first appeared in the USA. It is evident that the question of bank regulation has always been a very important part of the US political agenda, and it is also evident that the public in the USA is deeply sceptical of the requirement of financial centralisation. This notion had a major effect on the development of the different institutions. There were efforts to fight problems from different angles by various authorities, without implementing fundamental changes to the system.

246

Nobes, 2014, 25.

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5.3.1. 1690: How the first American banknote was born IOUs (documents that acknowledge a debt owed, the acronym stands for ‘I owe you’) were in use for hundreds of years as a legally binding agreement of two parties. These documents served as a written agreement of the transaction performed by the affected parties. Financial particularities of the new world required these agreements to be treated rather flexibly. Due to the delayed arrival of the recompense, the French soldiers in Canada in 1685 were paid with ‘play cards’ that were split to quarterly instalments and denominated. The cards were used to buy different goods within the garrison by the soldiers. This meant that the cards were practically used as a form of ‘portable assets’. Unlike promissory notes that were used widely and officially and that contained a detailed agreement between the parties who were named, the cards could be exchanged for goods by anyone. As such it was possible to give the card to someone else for use as the cards were not assigned to a particular person. Although this situation was paradoxical, the French government did not sanction it due to the existent emergency situation – the opinion was that these cards should not be treated as money, but a sort of personal promissory note. Expedience forced the settlers of Massachusetts Bay (Chart 5-18) to take the concept of ‘bearer’ promissory notes one step further. During the war of King Wilhelm in 1690 (Chart 5-19) legislators faced the problem that they suddenly had to bear the high costs of a military action against Canada.247

247

ttp://theticketcollector.blogspot.de/2016/06/1690-massachusetts-bay-becomesh first.html

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Chart 5-18: Map of the province of Massachusetts Bay

Source: Authors’ own compilation based on de.wikipedia.org.

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Chart 5-19: War campaigns of King William

Source: Authors’ own compilation based on en.wikipedia.org.

In early August 1690, Captain Phips set sail with 32 ships and more than 2,000 soldiers to conquer Québec which was under the command of the French Count Frontenac. Phips took the fortress under heavy siege, but finally failed and was forced to return to Boston with his fleet, which suffered heavy casualties. However, the colony did not take into consideration the possibility of a defeat. On the contrary, everyone expected the French war loot, and thought that they would get a nice dividend and the bootie would also cover the costs of the initial military expedition. In the meantime, two disgruntled groups, soldiers and creditors were waiting for their own full remuneration. As soldiers were on the verge of rebellion, the situation became serious. However, it was sure that Great Britain would not provide financial aid to the colony, and waiting a few years and raising the money by levying an extra tax was also not possible. Instead, on 10 December 1690, the General

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Court of Massachusetts was forced to allow the issue of banknotes with a total value of 7,000 pound sterling.248 This sum was the maximum threshold of the amount to be issued. This financial invention was the only solution for the otherwise insolvent colony to pay the soldiers and the creditors promptly. Nobody was aware of the fact at the time that this was the first time in the history of western civilisation that public paper money was issued. An amendment on 3 February 1691 repealed the 7,000 pound sterling threshold and enabled the authorities to issue paper money to cover all necessary credit requirements. Furthermore, the law ruled that a 5-per cent discount would be offered on tax returns paid in the new currency. The amendment also contained regulations for banknotes and bills (in some cases promissory notes) – the representatives of each town (Selectmen) travelled to Boston and represent the municipalities the colony gave credit to. The representatives collected the promissory notes issued by the colony, and exchanged these for money to cover all debts. Following this the representatives returned to their towns and distributed the money as required (The Massachusetts Archives 1691 in McFarland, 1970, 10-13). Further amendments on 21 May 1691 contained retrospective changes (maximum threshold) for the banknote issues of December 1690 and February 1691. The total sum issued was 40,000 pound sterling. Furthermore, the amendment clarified the details that had not been regulated by the previous legislation. John Foster, Captain Joseph Lynde, and Captain Samuel Ruggles created a committee to ensure the appropriate protection of the printing plates of banknotes and bills. Moreover, the committee was authorise to audit the books of the colony and ensure that bills proving deposits are recorded without any errors. Records were kept of the exchanged bills and there was an obligation to retain and destroy invalidated banknotes to prevent them from getting back to circulation (The Massachusetts Archives 1691 in McFarland, 1970, 10–13). 248

h ttps://archive.org/stream/CNLno119/CNLno119_djvu.txt Massachusetts Archives 1690 in McFarland, 1970, 10–13

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and

The

5. The Second Industrial Revolution (1870—1914)

Until October 1691, banknotes with a value of 10,000 pound sterling paid to the treasury as taxes were destroyed by the committee (The Massachusetts Archives 1691 in McFarland, 1970, 10–13). Nettels claims that in everyday transactions the citizens were less willing to accept the banknotes compared to coins. Consequently, the General Court of Massachusetts raised the threshold of the sum that was allowed to be paid in the new banknotes in the 1693– 1694 period to 30,000 pound sterling. Thus the majority of new banknotes were withdrawn from circulation and destroyed. To maximise tax income in December 1693 the General Court revoked the 5-per cent discount on taxes. However, it quickly became evident that the discount made the paper money more acceptable for the public and in a few years the discount was reintroduced (Nettels, 1934, 250–277, especially footnote 31 on page 257). It is a historical fact that the first public US currency (paper money, 1690) in the Massachusetts Bay Colony was issued to finance war efforts. Similar to establishing the value of goods in barter, earlier all currencies had a value fixed against gold, silver or copper. Perhaps for the first time in history in the 1690 case the new banknotes did not have an internal value other than the value of the paper used for printing. The actual value of the new paper money came from the guarantee of the colony that issued it. Legislation claimed that the value of the banknotes is equal to the value printed on the notes, and the colony recognised it as equal to the hard currency (coins) it minted. Also, within a few months a law offered a 5-per cent discount on taxes for those who were willing to pay their taxes in the paper money. At the same time, it was possible to exchange premium payments for coins through bills on request if the treasury of the colony had enough coins in store at the time of the request for conversion. Although the first banknote was authorised by the General Court of Massachusetts in December 1690, the first actual issue dates to an earlier date. The first banknote was issued on 3 February 1690 in America by the Massachusetts colony to pay the soldiers who took part in the campaign against the French (Québec) and the creditors who financed the expedition

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(at that time it was called a bill of credit and represented the debt the colony had vis-à-vis the soldiers) (Chart 5-20). Printed banknotes had a serial number for identification reasons in the upper corner. The indentation on the top meant that a part of the bill was cut along a decorative (usually wave shaped) line. In case of the issue shown in Chart 5-20 the upper part was used as a separator line. Chart 5-20: One of the first banknotes in America from 1690, value: 20 shillings

Source: www.worldbanknotescoins.com

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These printed bills were consecutively numbered as a means of registration and indented at the top. Indenting meant a portion of the bill was cut with a sharp blade along a border design, usually in a wavy line. For this emission the top border was used. As the bills were individually indented no two cuts would be exactly alike. The small border stub, which was cut off by the indenting, was retained by the government with the serial number from the note being recorded on it. The theory was that when the note was finally returned to the government the serial number on the note and the stub would be matched (this is not visible any more in Chart 5-20 as the note has been detached). The cut along the top of the note should perfectly fit with the unique wave pattern cut on the stub. This way the treasury could make sure that the accepted banknote is not fake. The body of the note contained an official text stating the notes would be: ‘[...] accepted by the Treasurer & receivers subordinate to him in all public payments and for any Stock at any time in the Treasury [...]’. Below was the seal of Massachusetts Bay Colony depicting an Indian saying: ‘Come over & help us.’ To the right of the seal were the signatures of three members of the committee, who were supervising the emission. The backside was totally empty. Banknotes issues between 1690 and 1691 had the following denominations: 5, 10, 20 and 50 pounds. Another issue of £33,000 followed in February, and then from November of 1702 through 1750 several emissions were printed. As there was a serious shortage of metal coins, and these were the predominant form or currency, colonists tried to meet the great demand of trade for money with issuing paper money. The example of the Massachusetts Bay Colony was soon followed by other colonies. Although according to plans the early paper money would have been based on a fixed quantity of gold or silver, the majority of colonists soon had to realise that this is just a vain hope and consequently the banknotes became worthless after a while.

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5.3.2. The American colonies and the struggle for independence By the 1730s there were 13 English colonies in America: Massachusetts, New Hampshire, Connecticut, Rhode Island, New York, Pennsylvania, New Jersey, Delaware, Maryland, Virginia, North Carolina, South Carolina and Georgia. The head of each colony was a governor appointed by the king, but they also had their own laws and public administration, although laws passed by the British Parliament also applied to them. Britain did not approve of the quick and effective economic development of the colonies. On the top of all of this, Colonial America began creating its own currency much to the dismay of the British, but their system and currency were flawed. Most colonies had developed their own coins and some had even experimented with paper currency. However, the money was not universal and many found that in some areas their money was almost worthless. To make matters worse, it was easily replicated and therefore counterfeiters had an abundance of readily available money, further damaging an already feeble (for example because of wars) economy (Great Britain and her colonies). Benjamin Franklin, the innovative genius, and jack-of-all-trades, developed a new and creative way to help secure the ever-evolving new nation’s currency by masterminding a new anti-counterfeiting method. Franklin printed money for Pennsylvania, New Jersey, and Delaware and beginning in 1739, in efforts to throw off counterfeiters, Franklin would deliberately misspell Pennsylvania on the bills (Chart 5-21).

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Chart 5-21: 15-shilling banknote printed for Pennsylvania by Benjamin Franklin249

Source: www.bellevuerarecoins.com

Franklin had the idea at the forefront that any person attempting to recreate the new currency would believe the real bill was a fake, they would then correct the spelling on their phony money. To further protect the integrity of the new paper currency, Franklin had lead casts made of actual leaves, which he used to print the said foliage’s’ image onto the back of the bills. The leaves also contained finely detailed copper engravings of the intricate veins in leaves chosen for this revolutionary idea to make counterfeiting the notes even harder. The innovative method of Franklin was not entirely understood at the time, and the brilliant idea was rediscovered by a historian only in the 1960s.250

249 250

Deliberately misspelled banknote to fight counterfeiters. h ttps://www.bellevuerarecoins.com/benjamin-franklin-created-anticounterfeiting-system-united-states/

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For years Britain had been placing restrictions on colonial paper money, and in 1764 they finally ordered a complete ban on the issuance of paper money by the colonies. However, the relationships between London and the colonies started to become particularly tense when George III tried to push the heavy burdens of the state debt resulting from the Seven Years’ War on the colonies. The colonies also detested that their representatives were not present in the Parliament of London when taxes affecting them were voted for. Thus, the motto was: ‘No taxation without representation.’ The situation escalated, and on 16 December 1773 colonists dressed as Indian warriors attacked the Boston harbour and dumped the English tea cargo into the sea after severe tea tax disputes. A few months after the ‘Boston tea party’ the First Continental Congress met. The Congress called for an economic boycott of British trade and refused to pay further fees and taxes. The British government interpreted the events as open revolt and decided to send the army to end the disobedience of colonists. The War of Independence started on 19 April 1775 and ended in 1783 with victory for the colonies. The Second Continental Congress met on 10 May 1775 in Philadelphia, a few weeks after the first armed conflicts and decided to declare independence. The Declaration of Independence was drafted by Benjamin Franklin, John Adams, Thomas Jefferson, Roger Sherman and Robert R. Livingston in June 1776. Jefferson produced the first draft, which Franklin and Adams edited. After further revisions and additions, the Declaration was finally submitted to the Continental Congress on 4 July. The Congress adopted it unanimously and the fifty-six representatives signed it on 2 August.251 In the mid-18th century, the colonies on the American continent did not have their own banking system and a common currency. In this period, British banks (later other European banks and governments) dominated the flow of capital and the most important bank transactions (mainly credit deals) in the colonies. Foreign coins and some colonial banknotes were used in parallel while barter was still a generally accepted and common form of payment overseas. Starting from 1757 an unsecured and debt free colonial money was created for public benefit. Let us quote Benjamin Franklin: ‘In the Colonies, 251

http://www.history.com/this-day-in-history/u-s-declares-independence

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we issue our own paper money. It is called Colonial Scrip. We make sure it is issued in proper proportions to make the goods pass easily from the producers to the consumers. In this manner, creating ourselves our own paper money, we control its purchasing power and we have no interest to pay to no one.’252 The Continental Congress had to do something to finance the American Revolution, so they printed the new country’s first paper money, known as ‘continentals’. For example, in 1775 the money of the colonies, the ‘continental’ had the value of one gold dollar. This was the dawn of fiat currency as we know it today (Chart 5-22). Chart 5-22: Continental one-third dollar bill

Source: en.wikipedia.org

These paper money notes did not have solid backing, were counterfeited easily, and were issued in large quantities. It is not surprising that ‘continental’ eventually fell victim to inflation. It started off mildly, but as the war dragged 252

http://www.thrivemovement.com/banking-history-timeline-follow-money

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on there was massive acceleration in inflation and the banknotes became completely worthless. This is the origin of the phrase ‘not worth a continental’ meaning something was entirely worthless. Although industrialisation started in Britain in the 18th century, the USA was following closely. Consequently, industrialisation had already started in the USA in the middle of the 19th century. Even if actual written sources or documents are not available, historians agree that the period 1865–1890 marks the beginning of the industrial boom in the USA.253 Both the population and the density of industrial facilities grew rapidly and facilitated rapid fast industrialisation. Strong urbanisation trends and largescale migration were also supporting factors. At the same time, the USA became politically independent and had the intention to be economically totally self-sustaining.

5.3.3. First Bank of the United States The history of central banking in the United States begins almost with the founding of the country. Once the USA won political independence, Congress was faced with the task of paying off the new nation’s war debts. Alexander Hamilton, the first Secretary of the Treasury, urged the Congress to also assume the heavy war debts of the individual states and then create a Bank of the United States to help refinance all these responsibilities. The bank would be the only national bank, and it would hold the federal government’s deposits and lend to the government and business. Hamilton’s proposal faced major opposition. Critics said that Hamilton’s bank was unconstitutional, would be a monopoly, and would reduce the power of the individual states. Although Hamilton won in the debate, the bank’s charter was limited to 20 years. Agrarian interests 253

https://www.globalisierung-fakten.de/industrialisierung/industrialisierung-inamerika/

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were opposed to the Bank on the grounds that they feared it would favour commercial and industrial interests over their own, and that it would promote the use of paper currency at the expense of gold and silver specie (Kidwell– Peterson, 1993, 54-55). Ownership of the Bank was also an issue. By the time the Bank’s charter was up for renewal in 1811, about 70 per cent of its stock was owned by foreigners. Although foreign stock had no voting power to influence the Bank’s operations, outstanding shares carried an 8.4 per cent dividend. Another twenty-year charter, it was argued, would result in about $12 million in already scarce gold and silver being exported to the bank’s foreign owners (Hixson, 1993, 114–115). Although in the end Hamilton won in the acrimonious debate as he managed to convince president Washington (Dunne, 1960, 18–20) of his goals and as such the First Bank of the United States was established in 1791, with the charter of the bank limited to 20 years by Congress. All in all, it is evident that the activities of the bank helped to transform the country into a more unified national economy. The First Bank was not a central bank in the modern sense, especially since the country had few banks. Nevertheless, with branches in eight port cities, its large size and broad geographic presence gave it influence over the economy, particularly as changes in its lending policies influenced state banks’ lending practices. Like other banks, the First Bank made business loans, accepted deposits, and issued notes that circulated as currency and were convertible into gold or silver. Unlike state banks’ notes, however, First Banknotes were valid for payment of federal taxes. The First Bank served as the federal government’s fiscal agent, receiving its revenues, holding its deposits, and making its payments. This was the largest bank of the country and its activities primarily included lucrative loan and other interest transactions and largescale bank deals. The Bank started with capitalisation of $10 million and gradually managed to pay off most of the government’s heavy war debts.

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Although the bank was organised in an effective manner, its banknotes were widely known and accepted, and it generated a considerable profit, its critics and primarily the representatives of the ‘hard money’ direction (who preferred standardised coins to banknotes) claimed that the overly cautious tax policy of the First Bank was a serious obstacle to the independent economic development of the individual states of the union. Consequently, in 1811 Congress (both Houses, with no dissenting votes) rejected the renewal of the charter of the Bank. All banknotes of the First Bank were withdrawn, which means that the examples that exist today are generally all counterfeit. Later it was not possible to exchange banknotes and other types of paper money to ‘liquid funds’ that is to other types of paper money of dubious value. Chart 5-23: First Bank of the United States of America

Source: upload.wikimedia.org

In early US history, the operation of banks and the use of paper money was extremely controversial until the Civil War, but the federal government did

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not issue a large sum of banknotes. In 1799, Thomas Jefferson founded the Democratic-Republican Party. One of the most important goals of the party was to continuously fight against the centralisation of banks. In the same year, a group of New York investors established the Manhattan bank that was created to build the water works for New York and received its charter from this state. Industrialisation brought the gradual formation of the new class of traders and manufacturers, while the demand for capital investment grew considerably. The US economy developed rapidly between 1815 and 1819 and an increasing number of banks were established. However, the USA had very bad international reputation as a developing country due to some unpaid loans and as such the majority of European banks no longer provided credit to the US government. The Farmers’ Exchange Bank was founded in Glo(u)cester in 1804 with a capitalisation of USD 100,000 (Rhode Island) and failed in four years. It became the first bank in the United States to fail. Box 5-10 The first and the second American banks that failed

The Farmers Exchange Bank is famous for being the first bank in the history of the United States to fail. Started in 1804 in the village of Chepachet in Glocester, it issued far more currency (Chart 5-24) than it could ever cover with assets. On March 24, 1809 it was closed, causing a panic at other banks and generating wide-ranging distrust of the people against paper money. John Harris was the president of the bank. Daniel Owen, Simon Smith, Timothy Wilmarth, James Aldrich, John Harris, John Wilkinson, Elisha Mathewson, Solomon Owen, Samuel Winsor, Daniel Smith, Simeon Smith, Mowry Smith (cashier) and Daniel Tourtellot were appointed directors of the bank. Daniel Owen resigned in March 1804, and William Rhodes was elected to fill his place. According to the final report of the Assembly’s committee of Rhode Island assigned to examine the bank, the books of the bank were kept in a confused state. The directors did not have at any time a proper knowledge of the management of the bank (Kamensky, 2008, 14–45).

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Chart 5-24: Farmers’ Exchange Bank 10-dollar bill from 1808

Source: thesaltysailor.com

In 1808, nearly all the directors sold off their shares. John Harris continued to be president, and in 1808 William Colvvell was appointed cashier; Elisha Fairbanks and Samuel Dexter were made directors. It was evident to men doing business with the bank that there was great mismanagement with some of the officers, and that the affairs of the bank needed very soon to be officially examined. A bank business meeting was called in 1809, and the following new directors were appointed: Obadiah Brown, Seth Hunt, Jr., Mark Steere, Jesse Mowry, and Samuel Fenner. They were the ones to hand over the books and account of the bank to the General Assembly in March 1809 when it appointed a committee to investigate all the concerns of the Glocester Bank. The report of the committee presented a summary of most of the irregularities found at the bank. The cashier, Mr. Colwell, was committed to close confinement, no person being allowed to converse with him. The president of the bank left the State, and his estates were put under attachment. All the members of the General Assembly manifested a full determination to take the most vigorous and decided measures to thoroughly probe this iniquitous deed to its very centre. The cashier and directors were cited and appeared before the General Assembly with bank books and papers. By this examination it was ascertained that the bank had issued bills in an enormous amount, far beyond their capital; that they

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had taken notes from Andrew Dexter, Jr., in Boston, without an endorser, payable at the expiration of eight years from November 1808, at two per cent interest for upwards of $800,000. The president of the bank was then in Boston, and the plates on which the bills were impressed (Kamensky, 2008, 45–127) as well. An article in The American, a newspaper published in Providence, March 1809, discloses the following: ‘The funeral of the Farmers’ Exchange Bank, in Glocester, is on its way to the General Assembly at East Greenwich. It appears on examination of the books and papers at Glocester, by a committee appointed for that purpose, that a certain well-known trader in bank stock, living in Boston, had got out of that bank something more than half a million of dollars, for which he had given only his note without an endorser, payable at the end of the year, with two per cent interest, to the cashier, his successors in office or order. The bank is shut, and probably never to be opened again for similar business. The sign is taken down and the keys are in the vicinity.’254 ‘Obadiah Brown, Esq., and Seth Hunt, Jr., both of Providence, were appointed a committee by the General Assembly to take into possession all the effects, books and papers of the Farmers’ Exchange Bank, and to collect and present an account of the same at the next meeting of the Assembly. This they did, and a report of the committee before the Assembly, in February 1809, was published in a pamphlet of forty-three pages.’255 It is an interesting fact that the Tiverton Bank also failed (Chart 5-25) making it the second bank in the USA to do so, but more exact historical details are not known about this case (possibly between 1865 and 1868).

254 255

https://libraryguides.missouri.edu/c.php?g=663252&p=4668662 https://archive.org/details/briefhistoryofto00perr

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Chart 5-25: One-dollar banknote from the Tiverton Bank

Source: thesaltysailor.com

It is a fact that in 1865, Congress imposed a prohibitive 10-per cent tax on State Banknotes which effectively stopped State Banks from issuing banknotes. It was generally believed that this would make the public better off by doing away with inferior brands of currency while also helping to finance the Civil War by enhancing bond sales. However, the actual purpose of the 10-per cent tax was not to improve the quality of the currency, nor to enhance bond sales. National currency and banknotes were suffering from high inflationary pressures due to the expense of the Civil War. The actual purpose of this tax was to offset the effects of inflation on the National Banknotes. The enactment of this tax not only drove the State Banks out of the business of producing Banknotes, but also forced many of the State Banks to become members of the Federal Bank system. In 1863 there were 1,466 State Banks in existence, however by 1868 there were only 247 remaining.256

256

http://thesaltysailor.com/rhodeisland-philatelic/rhodeisland/commercial46.htm

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5.3.4. Second Bank of the United States of America (1816—1836) The United States emerged from the War of 1812 in a chaotic monetary state. Congress tried to restore order and finance debts from the war by establishing a second Bank of the United States (Chart 5-26). This was the next attempt of the US government to establish a central bank. Like the First Bank, it was given again a 20-year charter. Despite a rocky start, the Second Bank under Philadelphian Nicholas Biddle became quite effective in managing the nation’s finances. But Biddle was a better banker than politician. He underestimated the opposition of state banks and frontiersmen, who said that the Second Bank helped only the East’s commercial classes. The establishment and operation of the Second Bank played a key role in the re-election of President Andrew Jackson, who was a fierce opponent of the concept of a central banking system. Until the Second Bank’s charter ran out in 1836 this was the strongest financial institution of the world. After that stage, central banking as such in the USA was not revived for about 80 years (the Federal Reserve Bank started operation on 16 November 1914). The main tasks of the Second Bank included handling the finances of the federal government and finance interstate economic development policies with the help of loans. However, similarly to its predecessor the Second Bank had to face a strong political opposition as the main representatives of both fractions (‘easy money’ and ‘hard money’) with a major influence on monetary policy criticised the special and strong standardisation-oriented fiscal policy of the bank stating that it was overly conservative. Andrew Jackson was one of the influential spokespersons of the ‘hard money’ faction (those arguing for the use of standardised coins) and had already condemned the Second Bank during his electoral campaign. When he won the elections in 1828, he took measures to weaken the bank and finally to close it. In 1833, the president announced that the government would no longer deposit federal funds in the Second Bank and gradually cut all relevant Federal subsidies. As a result of these measures the bank closed in 1836 and it was liquidated. The bank still managed to find a new framework to be able to continue operation though. In 1836 the bank was reorganised and received a charter from the state of Pennsylvania and continued to operate until 1841. Although this period is

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sometimes referred to as the Third Bank of the United States, it is important to note that this bank was not aÂ federal institution with extensive and central tasks anymore as the previous ones. Chart 5-26: Second Bank of the United States of America

Source: upload.wikimedia.org

Even if the decentralised Fed was based on the example of these two banks it is evident that both the First Bank and the Second Bank fell victim to the suspicion of centralised political power. What is more important, both banks had direct connections with federal politics, but both were unable to find the balance and independence that would have been particularly vital to be able to effectively cover the financial needs of an enormous and diverse country.257

257

https://www.philadelphiafed.org/education/teachers/resources/history-ofcentral-banking

â&#x20AC;&#x201D; 374 â&#x20AC;&#x201D;

5. The Second Industrial Revolution (1870—1914)

By 1819, there were more than 420 banks in the United States. All were printing banknotes and making loan deals. In this year the Second Bank of the United States called its loans, and it caused the first major bank panic in the USA. Consequently, many banks failed, and there were approximately 300 banks operating in 1820. In 1829 New York was the first state to adopt an insurance plan for bank obligations. Between 1829 and 1866, five other states adopted similar strategies. Comly Rich house was established in Philadelphia in 1831. This was the first US financial institution financed by a savings and loan association. Rich, a maker of combs, received a loan in 1831 from the Oxford Provident Building Association, the nation’s first savings institution. With the demise of the Second Bank of the United States in 1837, only state-chartered banks subsequently existed.258 The mid-1830s witness an economic boom in the northern part of the United States. This economic boom was characterised by inflation and speculation in public land sales and road and canal projects. The speculation was fuelled, in part, by the following three policies: the removal of federal funds from the Bank of the United States and from other banks; a distribution of the federal surplus from these banks to state banks; a requirement that specie (gold or silver coin) can be used to purchase public lands. This situation led to falling land sales and specie shortages. The pressure on many banks increased and a lack of confidence in the state banks was increasing (by investors and the public). During this period, known as the Free Banking Era, state chartering standards often were not very stringent, and many new banks were formed. This is the reason why the resulting bank panic in 1837 caused many banks to fail over several years. This panic was followed by a sharp depression, tied to a general downturn in the business cycle that lasted until 1841. The timeline suggests that the banking system of the US became more and more chaotic. The first real crisis hit in 1837 and was followed by a crisis that lasted until 1843. Soon after, in the middle of 1849, the gold rush began.

258

https://dca.lib.tufts.edu/features/wriston/about/bankingtimeline.html

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Box 5-11 The Gold Rush in the USA

On 24 January 1848 James W. Marshall found gold on the Sacramento River estate of Swiss Johann August Sutter. He gave explicit orders to keep the discovery secret, but the news had already spread in North California by the end of January. Rumours of the sensational discovery of gold were confirmed by San Francisco newspaper publisher and merchant Samuel Brannan. He hurriedly set up a store to sell gold prospecting supplies. This made him very wealthy indeed. On 19 August 1848, the New York Herald was the first major newspaper on the East Coast to report the gold find. On 5 December 1848, US President James Polk confirmed the gold discovery in an address to the Congress. From this point on, the sensational news spread very quickly all over the world. This news and other rumours attracted treasure hunters from around the world. The first gold diggers came from Mexico, but later people from South America, Europe and the east coast of the USA started the long and dangerous journey. Some came even from Australia, and some Native Americans joined the gold hunt as well. There was no easy way to get to California for the participants of the first world-class gold rush: 1. At first, most Argonauts, as they were also known, travelled by sea. From the East Coast, a sailing voyage around the tip of South America would take five to eight months, and cover approximately 33,000 kilometres. An alternative route that took months less was to sail to the Atlantic side of the Isthmus of Panama, and take canoes and mules for a week through the jungle (the railway crossing the Isthmus of Panama was completed by 1855). 2. From 1851 there was a route that crossed Nicaragua. 3. Many gold-seekers took the long overland route across the continental United States, along the California Trail.259 259

http://slideplayer.hu/slide/12138511/

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While in Europe the spring of nations was underway (a series of revolutions), the New World saw the start of the first and greatest gold fever and US history came to a turning point. With a strong desire for riches, a carefree life and a longing for gold, masses were moving to live near the gold deposits, and by 1849 the number of ‘treasure hunters’ grew to 80,000. Just a few years later 250,000 adventurers were looking for gold and rare gems. Consequently, new towns were founded one after the other in areas that had been uninhabited or barely habited before. The countdown of intensive urbanisation of these regions has started. The process of immigration and settlement led to the formation of states such as Colorado, California, and Oregon, and partially this was the reason why the port of San Francisco suddenly started to flourish. For example, there was a rapid population growth in California: initially there were approximately 14,000 inhabitants and this figure rose to 230,000. Cities such as San Francisco and Denver, Colorado became significant commercial and industrial hubs. These cities retained their significance even after the gold rush. The gold-rush mood spread to Canada, and the country was developing so fast that the railway network had to be extended accordingly. However, the prospects of miners for gold and riches were quite bleak. Very rich deposits did exist indeed (although very few in numbers), but these were depleted very soon. Gold panning and digging made but a few people and their families actually richer and, giving them a carefree life. Most miners fell victim to the gold rush, and if some did manage to find some gold, they were unable to amass considerable wealth. Indeed both Marshall and Sutter were soon poor. Although Sutter was confident that his growing business would not collapse due to the gold found in the river at his mills, disappointment soon came: when gold was discovered, James Marshall and his team of workers left him immediately to seek out new deposits. Thus, Sutter was left alone and soon went bankrupt. Marshall also died a poor man.

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The gold rush of California ended quickly: miners were trying their luck in Colorado in the 1860s and 1870s, while by the end of the 1880s the new place of the latest rush was the Klondike River. However, California saw quick development (primarily due to the gold deposits and the increased population) and in 1850 it became the 31st state of the United States of America. Although the first gold rush, officially starting on 24 January 1848 is connected to California, the fame should go North Carolina in the southeastern part of the country. However, the gold found there did not get as much publicity as the gold found in California. It is a fact that by the time gold was discovered at Sutter’s mill, the first, original gold fever had been underway for 50 years in Cabarrus County in North Carolina. 30,000 adventure seeking miners were searching for gold in the hope of a better future in the 10th most populous state of the United States. It is an interesting, although less well-known, fact that for three decades the US was minting coins exclusively from the precious metals mined in North Carolina. Later, when the United States Mint at San Francisco (Chart 5-27) was founded (1854) the gold of California became the official currency of the United States. Chart 5-27: The original United States Mint in San Francisco

Source: www.us-coin-values-advisor.com

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In exchange for specie banks issued notes. Trade thrived and brought wealth for businesses active in hospitality, catering, travel organisation and sales of supplies. Transport changed fundamentally: a direct steam boat service was opened between San Francisco and Panama (as well as a postal service); work started on the western sections of the First Transcontinental Railway and consequently soon it only took a few days to get to California. The effects of the gold rush were felt everywhere around the world – producers in Chile, Australia, and Hawaii found a huge export market for their goods; among many other products China exported clothes and semi-prefabricated houses to the United States. The expression ‘fool’s gold’ refers to Pyrite. Its cubical form resembles to that of gold. Several people fell victim to confounding the two things. Moreover, natives of the area fell victim to epidemics, hunger and genocide – their numbers sank from 150,000 to 30,000 in just three decades. Crime was a serious problem and gold made people to rob, steal, and kill each other. Towns expanded very quickly, but consequently thousands had lost their previous residence. Intensive migration brought epidemics (this is the reason for the high mortality rates of some settlements). Generally, the price of quick development was paid with considerable suffering. As the gold fever subsided, after that another wave of migration started. Certain towns were completely deserted and the number of people who were willing to believe in the dream of becoming rich as a gold miner, being open for this risky life-style, decreased considerably. Nevertheless, this was the greatest wave of migration of US history.260 At the same time, this historical event is important also because it was the period of the gold fever and the subsequent period when the significance of industrialisation became weighty in the United States. As resources such as gold and precious stones were scarce, locals turned to such abundant resources as iron, lead and copper. This resulted in the development of mining technologies: ‘forty-niners’ were first using primitive methods, that is using pans to retrieve manually the gold from the sediments of rivers

260

https://mult-kor.hu/20130129_nepvandorlassal_jart_a_kaliforniai_aranylaz

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and creeks, but soon special, mechanised mining technologies appeared (for pictures of gold panning and gold digging, see Charts 5-28, 5-29, and 5-30). Chart 5-28: Gold panner at the Mokelumne River (1860)

Source: hu.wikipedia.org

After the turn of the century, with the development of drilling machines and drilling heads it became possible to extract resources effectively and in industrial quantities. Mining, processing and use of these resources was followed by the industrial upturn and the realisation of another American dream – the USA was on the way to developing into a strong industrial country.

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Chart 5-29: Gold miners working in a river bed with the water diverted

Source: hu.wikipedia.org

Chart 5-30: Quartz Stamp Mill in Grass Valley261

Source: hu.wikipedia.org

261

uartz was stamped in mills like this before retrieving gold. The ‘by-products’ of Q gold mining, which is sludge, dynamite explosions and rubble caused significant environmental damage.

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5.3.5. Economic growth in the USA and the country’s role in the Industrial Revolution Against all expectations, the young United States of America managed to play a significant role in global trade following the Revolutionary War and the Civil War. This was largely due to the large quantities of valuable minerals available. Although far-off Europe also had significant mineral deposits that were used continuously and effectively, the Old World did not have nearly as much minerals and other natural resources as the new American country. Moreover, the individual US states quickly realised the wealth of resources they possessed and the resulting economic advantages, and were able to use these resources effectively and continuously develop the related mining technologies. Thus, the abundantly available and processed resources were used primarily to build a sophisticated railway network and to combine them with other infrastructure elements. However, for a long time only mining and raw material sales were the focus. The US had almost perfected its mining and exports cycle by the end of the 19th century and it became a tough competitor not only of Asian producers but increasing of those from Europe as well. At that point it was time for the US to take further steps to continue industrialisation and take it to the next development cycle. This was also supported by the robust demand for industrial workplaces. All sectors of industry were developing explosively everywhere in the country, not just in the north-eastern region. With its abundant natural resources the US went beyond just manufacturing railway-related goods: it was experimenting with the manufacturing of other products with increasing export success. However, as the different sectors of industry were still completely new for many people in the US, incentives were needed to increase the interest of professionals. Apart from lucrative wages, these government incentives manifested as other financial/housing advantages, such as free real estate. In many cases houses or apartments near the industrial centres were offered with discounts (subsidies and free official lodgings).

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The concept of state and industrial subventions worked well, and first the small, high-profile industrial cities started to grow quickly, such as New York, Philadelphia, and Chicago. This direction required further steps to be taken as in the meantime more housing and workplaces were needed. Engineers chose to expand the new buildings upwards: the first skyscrapers were born that changed not only the look of cities, but also the overall architectural impression of America. Ancient Egyptian pyramids and other building were used as the pattern for the building of the world’s first skyscrapers.262 Between 1832 and 1864 there were several types of currency in circulation in the United States. When the Second Bank of the United States went out of business in 1832, state governments took over the role of supervising banks. This supervision often proved to be inadequate. In those days, banks made loans by issuing their own currency. These banknotes were supposed to be convertible, on demand, into cash, that is, into gold or silver. It was the job of the bank examiner to visit the bank and certify that it had enough cash on hand to redeem its outstanding currency. As this was not always done, many banknote holders often found themselves stuck with worthless paper. It was sometimes difficult or impossible to detect which notes were sound and which were not, because of their staggering variety. By 1860 more than 10,000 different banknotes circulated throughout the country.263

5.3.6. Financing the Civil War as a monetary turning point The Civil War has often been called the first ‘modern’ (industrialised) war, as both society and the economy served the war efforts more than ever before in history. Also, war efforts had to be financed: in the 1850 the Federal government spent $1 million a week, and $1.5 million a day in the middle of 1861, while by 1865 daily expenditure was $3.5 million. Between 1861 and 1865 the debt obligation of the Federal government increased from $60 million

ttp://www.loc.gov/teachers/classroommaterials/primarysourcesets/industrialh revolution/pdf/teacher_guide.pdf 263 https://www.factmonster.com/math/money/brief-history-us-banking 262

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to $2.7 billion (Giroux, 2012, 83–104). Such high expenditures can only be managed by a government in three ways: by applying the tools of taxation, debt or inflation. North America implemented and revolutionised all three serviceable tools, but their contribution to the war effort were different over time. 25 per cent of the Union’s war expenditure was financed by revenues, 18 per cent by inflation and 53 per cent by debt. From the point of view of the monetary system of the US the most important is the innovation of the Union regarding inflation.264 Nevertheless, the newly discovered forms of state centralism were strongly interconnected. Treasury Secretary Salmon P. Chase attempted to cover the war costs in 1861 by issuing treasury bonds and demand notes (it was possible to exchange these for coins). As these issues were of low denomination, they soon became the first national paper money after the ‘continentals’. However, the public did not trust paper money and continued to demand more and more gold and silver from the banks as collateral. Consequently, by the end of 1861 the conversation obligation of banks of paper money to silver and gold was suspended again. The Treasury followed the example of the bank quickly and (if there were enough reserves) paid its debts only in gold. For the first time since the Revolutionary War the American monetary system became totally unsecured. Congress used the situation in February 1862 to pass the Legal Tender Act which enabled the Treasury to issue unsecured public paper money for the first time, which was predestined to be a legal currency for all state debt in order to finance the expensive war efforts. These US banknotes (called ‘greenbacks’ for the colour of the ink used) replaced the currency that lost its value and became the first centralised fiat currency of the Federal state. Both ‘demand notes’ and ‘greenbacks’ are still valid today, and can be exchanged to today’s dollar notes at denomination value.265

264 265

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From the date of the issue, the greenbacks gradually lost their value compared to gold. This was the reason why Treasury Secretary Chase started an intensive campaign against the gold market from 1863. He employed the following implements: heavy taxes on gold purchases; selling large gold reserves all at once to lower the market price of gold; and a ban on contracts that required payments to be made in gold. However, these measures only decreased the public’s trust in paper money and as such in the value of greenbacks. At the same time, inflation lead to the outflow of specie and coins so much so that the government of the Union was forced to issues stamps that were used as a currency. In 1864 numerous limits were lifted and Chase resigned.266 By this time, greenbacks had nearly lost their value and as a result from 1864 Federal government was forced to almost exclusively rely on taxes and debt to create money. Originally, both sides expected a short conflict and estimated that taxes and debt instruments would be enough to finance the war period (especially as this made possible to avoid very unpopular tax increases). However, as it became clear that the civil war would last over several years, the Union put a radical tax burden on the population (Giroux, 2012, 94–119). In August 1861, the Revenue Act was passed. It was a unique law in the US as this was the first time that a unified income tax was introduced: The tax was 3 per cent on income above USD 800. Furthermore, new custom duties were introduced for imports. Finally, in 1862 another Revenue Act was passed to replace the first one in the hopes that it would considerably increase tax revenues in the following years. This law replaced the previous solution with a progressive income tax (3 per cent tax for income between USD 600 and 10,000, 5 per cent for income over USD 10,000); a consumption tax was imposed on practically all goods and services (from alcohol to billiard tables); and for the first time an inheritance tax was also introduced. The large number of new taxes was aimed at filling the Treasury and lowering inflation because a part of the greenbacks would have returned to the state as taxes and this would have helped better control money supply. In order to be able to 266

https://www.barrons.com/articles/SB5000142405297020399010457619106120778 6514

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effectively collect taxes, the Department of Internal Revenue was created that enabled the state to confiscate private property if tax payment was denied or in case of tax evasion. Progressive income tax rules were modified again in 1864: a 5-per cent tax for income between USD 600 and 5,000; a 7.5-per cent tax for income between USD 5,000 and 10,000; and 10 per cent for income over USD 10,000. These income tax levels were declared unconstitutional in 1872, but the 16th Amendment of the Constitution revived them in 1913.267 However, the Union’s largest income did not come from inflation or taxes, but rather from the sales of state bonds (wartime bonds). In this context, the most important player was a businessman, Jay Cooke, a close friend of Salmon P. Chase. It was Cooke who helped Chase to get the position of Secretary of the Treasury. In return for the favour, he gave the monopoly of the sales of wartime bonds to his friend in 1862. War bonds matured in a minimum of 5 years and paid annual interest (to be paid in gold). As a unique solution however, besides selling to banks, Cooke also sold war bond directly to citizens. He used propaganda methods such as patriotic newspaper ads and hiring agitators and managed to convince middle-class and upper-class citizens to buy his war bonds. This is the reason why various historians think that mass propaganda was Cooke’s invention – indeed, from this point on it was an inherent part of all bigger wars. In sum, Cooke managed to involve around 1 million citizens in the North, who contributed around USD 2 billion to the war effort.268 With respect to the Legal Tender Act of 1862, it should be emphasised that people must have enough money to be able to buy state debt. The fact that it was possible to reproduce the new greenbacks on demand ensured this from the legislator’s part. The friendship of Chase and Cooke could have had farreaching consequences on the US as they worked to create a stable market for wartime bonds. To this end, they also made plans for an entirely new type of banking system. Cooke used his newspaper connections to advertise the new

https://www.barrons.com/articles/SB5000142405297020399010457619106120778 6514 268 https://eh.net/encyclopedia/the-economics-of-the-civil-war/ 267

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system and, in this way, made it familiar to the public. In the end, two acts were passed in 1863 and 1864 on national banks that enabled them to carry out their financial plans. These laws ended the age of free banking of 1836–1865 and marked the end of the strict separation between the Federal government and the banking system. A centralised bank cartel was created that became the actual monetary heritage of the Civil War. Through the new agency Office of the Comptroller of the Currency (OCC), the Federal government was enabled to charter national banks that had the mandate to issue a national currency269 (backed by government securities) under state supervision (these were the National Banknotes). There were three types of central banks: central reserve city banks (banks of New York), reserve city banks (banks of cities of more than 500,000 residents) and state banks (all other national banks). Central reserve city banks were required to back 25 per cent of their financial resources by specie or greenbacks. Reserve city banks were required to back only 12.5 per cent of their money supply at the local level, while the other 12.5 per cent could only be kept as bank balance at other reserve city banks. State banks were required to back only 15 per cent of the money supply. 40 per cent of it had to be backed at the local level, the other 60 per cent could only be deposited as backing in central reserve city bank or reserve city bank accounts. This system made it possible to manage inflation on a national level. Reserve city banks purchased the new money and increased the accounts there, which means it was allowed to inflate their own money supply as their backing at central reserve city banks increased.270 The cycle went beyond this: the possibility of monetary expansion was tied to owning state bonds. This meant that the national bank system was dependent on the government or its debt. A bank was allowed to increase the supply of its National Banknotes only if it deposited the account value of the necessary state bonds at the Treasury. However, this process created even more money for the government to finance the war. This in turn created the much coveted 269 270

https://eh.net/encyclopedia/the-economics-of-the-civil-war/ https://eh.net/encyclopedia/the-economics-of-the-civil-war/

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and secure internal market for state bonds, that is the more banks purchased state debt, the more it was allowed to the new, pyramid type of bank system to inflate its own supply of money.271 The other reason to create a national bank system was to deliberately weaken the resiliency and power of decentralised state banks. As the new National Bank acts prohibited state banks from issuing their own paper money, the architects of the system assumed that these banks would voluntarily apply for membership at the national bank cartel. However, as this assumption proved to be false, Congress passed a law in 1865 to impose a 10-per cent tax on all pending state banknotes. As a result of this the circulation of paper money of the state banks stopped, and it was increasingly true that the only official currency was the centrally issued Federal paper money (besides gold and silver). Besides this imperative shift of balance, the number of state banks fell from 1,466 (1863) to 297 (1866), while the number of national banks increased from 66 to 1,634 in the same period. In a few years state banks stabilised and their numbers started to grow again, but from then on they accepted subordination to national banks becoming the fourth layer of the pyramid of the new banking system. This is how the Federal government managed to gain the monopoly of issuing money that it holds till this day.272

5.3.7. Certain relationships between the railway network and industrial, commercial and financial development From the mid-1800s, European banks financed 30,000 miles of railway track in the US: this marked a new phase in high finance. These megaprojects had a potential for large returns. It is no surprise that in a short time railroads became the driving force of the economy. The development of railroads opened up the West and provided demand for the new steel industry, which opened new commercial paths and made novel industries possible. Completely

https://www.barrons.com/articles/SB5000142405297020399010457619106120778 6514 272 https://rogerransom.com/uploads/Civil_War_In_Econ_Hist.pdf 271

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new cities were emerging along the railways, and commerce organised around these conurbations. Speculators played a very important role in these businesses as they were always seeking new ventures in order to invest their capital. As an example, around 1914 there were 253,000 miles of track in the United States. Prior to the Civil War, the US had a loose system of finance and banking. As the nation started to grow in all directions, it also demanded a more mature financial system, taking a significant movement in that direction. In 1857, the panic of the panics came. At that time the entire economy was quite fragile because of overbuilding of railroads and overextension by banks to finance railway construction. Several hundred banks involved in these businesses simply failed. Most banks suspended specie payments, such as gold coins. Unemployment increased sharply. As the panic slowly subsided a new discovery energised the US: in 1859 oil was discovered in Titusville, Pennsylvania. The huge profit potential of the new resource gradually made the economy more dynamic than ever. Oil exploration, extraction and processing became the basis of complex industrial sectors. Accordingly, this had a major effect on the financial sector. By 1860 there were 1,562 state banks in the Unites States. However, it is also important to note that by 1861 about 7,000 different banknotes were in circulation. Also, according to estimations there were 5,500 fraudulent banknotes on the money market. In the 18th century, multiple currencies were in use in North America. In addition to British pounds and the peso of the Spanish colonies, the ‘leeuwendaalder’ or ‘lion dollar’ of the Dutch territories was also widely used. By the second half of the century, the lion dollar was not in circulation any more, but the name stuck as the peso was usually called the Spanish dollar. The situation became even more complex with the War of Independence, which also involved several economic conflicts. The 13 revolting colonies needed their own currency to finance the war and using their newly found freedom each issued its own paper money, while Congress issued its own currency, the ‘continental’. Due to the turmoil and the severe economic problems caused by the war by 1778 the value of the continental was hardly half of its face value. By 1781 it had practically lost its value and was out of circulation. Following the failure of the currency in 1785 Congress decided to create the American dollar. Thus, the name of the national currency was

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simply borrowed from the previous, distorted Dutch term. Even the now world-famous dollar sign was not an individual invention: it probably originated from the short form of peso (‘ps’) adding another line to the strikethrough S that abbreviated the Spanish dollar at that time. The real birth date of the US dollar is not 1785 however, but 1792: on 2 April 1792 the US Congress passed the Coinage Act that created the US mint to introduce a currency that was identical to the Spanish dollar with regard to value, specie content and format. The use of European currency depicting kings was abandoned immediately. The new coins depicted stylised American natives and figures from Greek and Roman mythology. Learning from their previous mistakes, US legislators made minting a government responsibility and it was strictly forbidden for individual federal states to create their own currencies. These were the humble beginnings of the dollar that later conquered the world: the new currency helped greatly to stabilise the economy of the newly independent United States. However, it was only after World War II with the creation of the Bretton Woods system that the US dollar became the number one reserve currency of the world. Today, the US dollar is undoubtedly the most well-known currency worldwide and the only currency that is readily accepted even in the remotest parts of the world. There was approximately $1,559 trillion in circulation as of 15 November 2017, of which $1.55 trillion was in Federal Reserve notes.273 From a historical perspective, it is safe to say that the Civil War destroyed the South’s economy, while the North’s economy flourished. President Abraham Lincoln composed and communicated the final Emancipation Proclamation on 1 January in 1863. In the same year, Congress passed the National Bank Act, which was extended in 1864–1865 and followed by a second act in 1964. This made possible the construction of a dual banking system and the national currency was created. The National Currency Act of 1863 became known as the National Banking Act in 1864. This act established a national currency: the dollar. The act also established national banks, which composed the dual banking system with 273

h ttps://www.federalreserve.gov/faqs/currency_12773.htm; https://www. federalreserve.gov/paymentsystems/coin_data.htm

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national and state-chartered banks – the only such system in the world. The Act of 1864 initiated a system of bank examinations. The Bank Act of 1865 intended on getting rid of banknotes, and levied a tax on state currency. The tax went from 2 per cent to 10 per cent, resulting in the extended use of checks. For example, in 1865 there were 349 state banks and 1,294 national banks. In the meantime there were considerable developments in the 1870s in the extension of the railroad network. The two railroads to connect the East and West coast met on 10 May 1869: the Golden Spike was placed to commemorate the event. It was here, in the area of Promontory Summit, the northern part of Utah that the western and eastern parts of the United States were finally connected – the first transcontinental railway in the world eliminated the western border. Until the completion of the railway the options to reach the other part of the country were limited to stagecoaches, horseback riding or sailing around South America. A large number of factors blocked railroad building efforts. In 1862 Congress commissioned Central Pacific Railroad and Union Pacific Railroad to build a railroad in order to connect Sacramento, California and Omaha, Nebraska. However, until the end of the Civil War progress of the work was very limited, but with the end of hostilities both companies continued the project with renewed energy. On the one hand, Union Railroad had an abundant workforce, but most workers were adventurers and alcoholics. On the other hand, Central Pacific Railroad had to deal with the numerous natural obstacles of the Sierra Nevada that slowed down construction considerably. Severe labour shortages made the situation worse, so much so that the company was forced to employ Chinese migrants to do the work – this is commemorated by the Chinese Arch. The two railroads were finally connected on 10 May 1869 (Chart 5-31). The symbolic act of this was when Union Pacific engine 119 and Central Pacific engine Jupiter met. The road was now open for settlers to reach bigger cities and Native Americans lost the battle to keep their lands and to stop the disappearance of the frontier. Today, the event is celebrated annually at the point where the two railroads were connected, at the Golden Spike National Historic Site created in 1957.274 274

https://www.nps.gov/nr/travel/cultural_diversity/Golden_Spike_National_ Historic_Site.html

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Chart 5-31: Completion of the first American transcontinental railway275

Source: www.stgeorgeutah.com

In the 1870s, entrepreneurs began to turn to local banks, while through the cooperation of wealthy individual businessmen and New York City banks an alternative financing possibility appeared: venture capital. Due to its nature, venture capital had different requirement towards portfolio companies compared to bank loan-based financing. John D. Rockefeller, William Rockefeller, and partners created Standard Oil which gradually became the largest oil refining business worldwide. Standard Oil was the first great US trust corporation. The founding partners borrowed much of their capital from the leading New York bankers. Exxon Mobil is the largest joint-stock company in the oil industry. It was created in 1999 with the merger of Exxon and Mobil Oil. As such Exxon Mobil is a direct descendant of Standard Oil.

275

I n the photo Samuel S. Montague (representative of Central Pacific Railroad, centre left) shakes hand with Grenville M. Dodgettel (Union Pacific Railroad representative, centre right). The celebration at the meeting of the two locomotives at the Golden Spike at Promontory, Utah on 10 May 1869.

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During and immediately after the Civil War the economy of the United States boomed. This kind of prosperity was accompanied by reckless financial expansion and speculation. Between 1867 and 1873, more than 30,000 miles of new railroads were constructed at an enormous capital cost. Recession started in Europe and spread to the US by the autumn of 1873. The first sign was that Jay Cooke and Company declared bankruptcy. The failure of Cooke resulted in a series of events that affected the entire economy of the United States. The New York Stock Exchange was closed for 10 days. Credits dried up, foreclosures were common, and several banks failed. Factories closed their doors, costing thousands of worker’s jobs. Poverty was so severe that charity organisations were unable to finance soup kitchens and shelters. Most major railroads stopped operation for a time. President Grant and Congress came in for much public criticism. Nevertheless, there were numerous reasons for the devastating crisis. The period following the Civil War was characterised by very fast, uncontrolled growth and the government did nothing to stop market abuses. It is a fact that the main reason for the panic and the following economic recession was the overcapacity of the railroad network of the country. Following this, economic instability lasted for more than 20 years and the complex situation only stabilised around 1878. In addition to the ruined fortunes of thousands of Americans there developed from the panic of 1873 a bitter antagonism between workers and the leaders of banking and manufacturing. This tension would erupt in the labour unrest that marked the following decades. Chase Manhattan Corporation originated in the final days of the 18th century. On 2 April 1799, at the urging of such civic leaders as Aaron Burr and Alexander Hamilton (later noted rivals), the New York state legislature chartered the Manhattan Company to build a water supply system for New York City. The original capital (USD 2 million) was so large that the directors quickly voted to use surplus funds to open an ‘office of discount and deposit,’ and on 1 September 1799, the Bank of the Manhattan Company was opened at 40 Wall Street. In 1808, the company sold its waterworks to the city and turned completely to banking business. Although growth was steady, the bank’s real expansion began after the start of the 20th century. In 1918, it merged with the Bank of the Metropolis and thus acquired the first of many branch offices.

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In 1920, it merged with the Merchants’ National Bank of the City of New York (founded 1803, with Hamilton’s promotion), and in 1929 it acquired the International Acceptance Bank, Inc. (founded 1921), thus venturing into foreign trade financing. The Chase National Bank was organised 12 September 1877, by John Thompson (1802–91), who named the bank in honour of the late US Treasury secretary Salmon P. Chase. Thompson had earlier helped found the First National Bank, a predecessor of Citibank and later CitiGroup. Chase’s growth was phenomenal, and by 1921 it had become the second largest national bank in the United States, without the benefit of mergers. Then there followed a long series of mergers: Metropolitan National Bank (1921), Mechanics and Metals National Bank (1926), Mutual Bank (1927), Garfield National Bank (1929), National Park Bank (1929), Equitable Trust Company, including Seaboard National Bank (1929), and Interstate Trust Company (1930). Such mergers resulted in a proliferation of branches and extensive foreign affiliations. On 31 March 1955, Chase National Bank (then the nation’s 3rd largest bank) and the Bank of the Manhattan Company (the 15th largest) merged. The new bank was named The Chase Manhattan Bank. In 1996, the Chase Manhattan Corporation merged with the nation’s second largest bank, the New York-based Chemical Banking Corporation, to form what was then the largest bank in the United States. The merged bank kept the name The Chase Manhattan Corporation. Chase Manhattan’s December 2000 merger with investment bank J.P. Morgan created a diverse financial firm, J.P. Morgan Chase & Co., with leadership in retail banking, investment banking, and financial services. The examples below are a good illustration of the traditions and historical evolution of certain US financial institutions that still have an effect on global economy in some cases. Around 1885 there were 1,015 state banks and 2,689 national banks in the United States. Starting in 1886 and continuing until 1933, Congress considered 150 proposals to create deposit insurance plans. The panic of 1893 was again connected to the railroad industry. During the late 1880s and early 1890s, severe weaknesses began to appear in the economy, especially in the overbuilt, debt-ridden railroad industry, which had become the major sector of the US economy. The increase in income tax rates was the decisive moment that started the panic of 1893. This panic is sometimes referred to as a part of the

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long depression that started with the 1873 panic and similar to the previous collapses it was caused by the overcapacity of the country’s railroad network and the uncertain financing of large scale railroad building projects. The national economic crisis was set off by the collapse of two of the country’s largest employers, the Philadelphia and Reading Railroad and the National Cordage Company. Following of the failure of these two companies, a panic erupted on the stock market. Hundreds of businesses had overextended themselves, borrowing money to expand their operations. When the financial crisis struck, banks and other investment firms began calling in loans, causing thousands of business bankruptcies across the United States. Banks, railroads, and steel mills especially fell into bankruptcy. Over 15,000 businesses closed during the Panic of 1893. Homelessness skyrocketed, as workers were laid off and could not pay their rent or mortgages. The unemployed also had difficulty due to the lack of income. In the meantime, the economy slowed down considerably, as manufacturing and agricultural sectors were operating at a fraction of their capacities and foreign investment suddenly sunk. The result was a financial and banking panic. For the first time, bank runs occurred outside of New York City, in Kansas City, Louisville, Milwaukee, Denver, and Portland. Ohioans also suffered through the economic depression. At different points, the unemployment rates in Ohio reached fifty per cent among industrial workers. Buckeye Mower and Reaper Company’s owners sold the firm to a business in Chicago (Illinois). In 1894, Jacob Sechler Coxey, an Ohio businessman, organised a protest march of workers from Ohio to Washington, DC. Coxey hoped that this march would force the federal government to provide assistance to workers during the Panic of 1893. ‘Coxey’s Army’, as it eventually became known, reached the nation’s capital with only six hundred marchers. Local police arrested Coxey and the march’s other main leaders. The rest of the marchers quickly dispersed. The government refused to intervene in the happenings. Fortunately for the United States populace, the panic of 1893 finished by the end of 1897. The panic of 1893 caused a massive economic decline. Contemporaries primarily blamed the shortfall of gold. Standard Oil became financially self-sufficient. It had more cash than any corporation in history and no longer needed Wall Street as financial backer. The Standard Oil Trust had become a huge bank within an industry. It financed

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itself against competition and provided venture capital to other entrepreneurs on high-class collateral. The ‘bank’ of Standard Oil Trust became a natural, spontaneous offshoot of successful commerce. US railroads desperately needed capital. British investors responded, lending massive amounts of money. President William McKinley launched the trust-busting era. He appointed several senators to the US Industrial Commission. The Commission’s report laid the groundwork for President Theodore Roosevelt’s later attacks on the trusts’ industrial titans. Industry generated surplus capital. New York banks, however, developed from foreign dependence on capital. New York City emerged as an international banking centre. Financial panics and bank runs were common in the period. The US economy did not have stabilisers to provide sufficient liquidity by such means as a central bank and deposit insurance. In 1890 there were 2,250 state banks and 3,484 national banks in the US. Two years later there were 3,733 state banks and 3,759 national banks. Deposits at First National City Bank (Citibank) reached USD 31 million – a 158 per cent increase from $12 million in 1893. The Dow Jones Industrial Average of 1896 became a universal yardstick by which investors judged the stock market’s performance. The same year 11,500 commercial banks operated in the United States. The Spanish-American War started in 1898. The US gained control of the former colonies of Spain in primarily the Caribbean and Pacific. Much of the Caribbean’s economy had already been in US hands, and most of its trade was with the United States. The war improved the business and earnings of US railroads, increased the output of US factories, and stimulated industry and commerce.

5.3.8. The Third Central Bank (Federal Reserve) The bank panics of 1873, 1893, and 1907 made it clear that there was an exceptional urgency to create a central bank system, but this challenging idea was evidently unpopular in the USA. Opponents were reluctant to put their trust in a single, strong, central agency with the financial action scope of the entire monetary system.

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The Federal Reserve (Fed) system was created on 23 December 1913 by the Federal Reserve Act. The Federal Reserve is the third central banking federation of the United States. Federal Reserve Banks started operation on 16 November 1914, and the Act enabled the system to issue its own currency (Chart 5-32). Banknotes were issued by Reserve Banks and money entered into circulation through the intra-system of financial institutions. The Federal Reserve arrangement system was not initially thought of as a strong central bank. Chart 5-32: First 100-dollar banknote of the Federal Reserve (1914)

Source: www.worldbanknotescoins.com

Indeed, much of the legislative debate in 1913 about establishing the Fed was about whether the Federal Reserve would be a powerful central bank or rather a looser collection of several leading Reserve Banks. Eventually, the Federal Reserve Act was passed as a result of the persistence of newly elected Democrat President Thomas Woodrow Wilson and the Democrat majority in both Houses. However, Wilson insisted that the initial design should contain a smart control mechanism in practice, i.e. a supervisory entity appointed by the government; in line with this, the Board of Governors should be at the top of the new central banking system. Nevertheless, strong opposition from some Democrat representatives nearly prevented passage of the bill by Congress. Wilson convinced the opponents by making a promise to these representatives to submit an anti-trust bill to Congress. The final version of the Act that was

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passed at the end of 1913 predominantly with the votes of Democrats indeed had more similarities with the Aldrich Plan than the two previous Democrat versions. Nelson W. Aldrich, a Republican Senate leader and financial expert, had proposed to create a strong, privately owned central bank with the least possible state influence. As for a compromise, he was ready to give some seats to the government in the intern board of directors. The plan was supported by most Republican representatives and by Wall Street, but the lack of necessary majority in Congress prevented it from being passed in this form. As the bill was submitted by Aldrich himself (who was the father-in-law of Rockefeller) and as he was considered to represent the ‘interests of the East’, it was categorically rejected by those in the Southern and Western part of the country who were already convinced that rich banking families and large enterprises were controlling the finances of the United States. The Aldrich Plan was also opposed by those banks of the countryside that thought that it would give too much power to their East coast competitors. Progressive Democrats would much rather have had a reserve system owned and managed by the state, which is out of the reach of the Wall Street trusts who dominated US money supply. The strong influence of Wall Street was also opposed by Conservative Democrats who argued for a privately owned and expressly decentralised reserve system. There were even Republicans who criticised the power of monetary trusts and on this ground strongly opposed the Aldrich Plan.276 Finally, Paul Warburg was appointed as the first Chairman of the Fed, and the new Federal bank played a key role in financing both the Allied and the US war effort during World War I. Initially, the Fed operated as a system of Reserve Banks, with a substantial amount of decentralised decision-making. In the 1920s, for instance, some Reserve Banks sold Treasury securities at times when other Reserve Banks were buying Treasury securities. To improve the coordination of such open market purchases and sales of securities, the Reserve Banks eventually formed the Open Market Committee in the 1920s. The Federal Open Market Committee, FOMC currently has 12 members: the Board of Governors of the 276

https://www.federalreservehistory.org/people/nelson_w_aldrich

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Federal Reserve System has 7 members, besides the Chairman of the New York Federal Reserve Bank (permanent member) 4 out of the 11 Reserve Bank rotate as members, each for a year (for the current structure of Fed see Charts 5-33 and 5-34). The FOMC is one of the most important organisational entities of the Fed system, second only in importance to the Washington-based Board of Governors. The next organisational entity of the system is the 12 Federal Reserve Banks in the largest cities of the United States, each with a 9-member Board of Directors. The fourth organisational entity of Fed are the numerous private member banks spread out everywhere in the US that bought nontradable stock in the Federal Reserve Bank and are financially responsible for their own regions. The last important entities within the Federal Reserve system are the numerous different advisory bodies.277 Chart 5-33: Three key entities influencing the functioning of the Federal Reserve278 Congress oversees the Federal Reserve System and its entities

Federal Open Market Committee Consists of the members of the Board of Governors and Reserve Bank presidents. The chair of the Board is the FOMC chair

Board of Governors is an independent agency of the federal government

Federal Reserve Banks are the operating arms of the Federal Reserve System and are supervised by the Board of Governors

Source: www.federalreserve.gov

https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system. htm 278 The authors of Federal Reserve Act developed a central banking system fully reflecting the public interest. 277

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Chart 5-34: Structural and organisational structure of the decentralised Federal Reserve system U. S. Central Bank

Key Entities

Key Functions

The Federal Reserve System

Federal Reserve Board of Governors

Conducting the nation’s monetary policy

12 Federal Reserve Banks

Helping maintain the stability of the financial system

Supervising and regulating financial institutions

Federal Open Market Committee Fostering payment and settlement system safety and efficiency

Promoting consumer protection and community development

Source: www.federalreserve.gov

The FOMC (Federal Open Market Committee) was established by congressional action in the Banking Act of 1933. The FOMC conducts monetary policy as we know it today. In 1935, Congress put all seven members of the Federal Reserve Board of Governors on the FOMC and limited the Reserve Banks to only five voting members at any one time. Unlike the First and Second Banks, the Federal Reserve was not designed to make business loans or accept deposits from the general public. Instead it is a ‘bankers’ bank’ holding key deposits and making loans to depository financial institutions. Like the First and Second Banks, however, the Fed issues notes that circulate as currency in the national economy and around the world. Just as its predecessors’ main branches, the Fed also has 12 Reserve Banks plus several subdivisions throughout the country. Like the nation’s two previous central banks, the Fed is the federal government’s fiscal agent, receiving its revenues, holding its deposits, and managing its payments. Originally, the third central bank also had only a 20-year charter from Congress, but the McFadden Act of 1927 gave it permanence. Thus, unlike its precursors in finance, the Fed has lasted beyond its initial charter period of two decades.

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5. The Second Industrial Revolution (1870—1914)

National banks and those state-chartered banks that choose to be members of the Federal Reserve System receive non-tradable stock in their District Reserve Bank, in contrast to the publicly owned and traded stock of the First or Second Bank. By law, the stock earns a fixed 6 per cent dividend. Stockholders elect six of the nine members of a Reserve Bank’s board of directors, while the remaining three (including the chairman of each board) are appointed by the Federal Reserve’s Board of Governors. Box 5-12 Origins and development of clearing houses

Central clearing houses processing different payment and securities transactions play an extremely important role in today’s financial system. From the historical perspective of the development of banking systems, it is evident that there was a need for such services from the beginning, practically from the moment the first banks formed. The need became more and more pressing with the development of the institutional system and implementation of high technology. The first banks of Europe, i.e. the money changers of the late middle ages, were created partially to keep money safe, such as the mints of 17th century England (Quinn, 1997, 411–432), but it was also important (for example, for the Venetian money changers) that the banks performed a clearing function if there were multiple currencies in use. Banks soon found it necessary to offer various payment services for their clients. As a part of this, amongst other things, banks in Genoa in the 15th century enabled their clients to settle the payment obligations towards each other by transfers performed on their banks accounts (Fratianni – Spinelli, 2006, 23). Other banks issued receipts of the deposits made at them and later these were used for payment services. There were some banks that allowed certain clients to send a written payment statement to the bank to allow the redemption of good or services purchased. As these financial solutions became widespread another innovative instrument emerged: if the buyer and the seller had accounts at different

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Banks in history: innovations and crises

banks, these banks cleared between each other. This was convenient both for the clients as it made payment easier and the banks as it enabled them to issue liabilities without interest. It also facilitated the acceptance (circulation) of non-interest-bearing banknotes, making it an expanding instrument to use for financing interest-bearing assets. However, there was a risk of failure of performance between banks as well. To mitigate this risk, banks cleared their claims from time to time. Initially this was only a local practice, such as the inter-bank agreements in 17th century England and Scotland, or those in the 19th century between US and Canadian banks. This was a completely new task and cost element for banks – banks had to calculate the liquidity needed for clearing, a part of their liquidity had to be set aside to back clearing, and as a part of the procedure money had to be transferred physically from one bank to the other. For cost efficiency reasons new techniques were developed from the 18th century. For example, netting was used for claims (first bilaterally then multilaterally) (Kohn, 2001, 4). Clearing was initially performed in gold or banknotes, but later banks issued notes for clearing purposes. This complex practice has led to the practice of inter-bank clearing using central bank money. The system of cash correspondent banks was created to perform clearing for commercial transactions between geographically remote territories. The increasingly effective centralisation led to the formation of clearing houses managing the accounts of banks and later to the formation of strong or less strong central banks. For example, bilateral clearing was performed daily in 1775 London managed by Bankers’ Clearing House. In the interests of further cost cutting, multilateral clearing was introduced in 1841 (Norman et al., 2011, 12). For example, at the end of the 19th century regional clearing houses were also operating in Canada. The four most important performed netting every fourth day and also cleared the transactions of lower-level clearing houses. Then, in 1927 a central clearing house was established (Bank of Canada, 1997, 3).

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5.4. Development of the Hungarian banking system after the Austro-Hungarian Compromise 5.4.1. Historical background 5.4.1.1 The Bach Era and the events leading to the Austro-Hungarian Compromise The goals of Hungarian civil progression were defined in the Period of Reforms (approximately 1830–1848). The movement to achieve the political goals culminated in the Revolution and War of Independence of 1848. However, the changes came to an abrupt end (particularly regarding independence) when the war was lost particularly due to the massive intervention of the Russian army. Several political strategies were devised for Hungary following the War of Independence. Finally, a system of neo-absolutism was established under Minister Alexander Bach. A large number of Austrian officials were transferred to Hungary, whom Hungarians referred to with the sobriquet ‘Bach hussars’. In the meantime, an effective network of intelligence agents was established. The historical evaluation of the Bach Era (1850–1859) is a subject of debate in Hungary to this day, but it is clear that the period was not beneficial for the development of the domestic banking sector, partially due to the fact that mortgage-based credits were strongly limited and discouraged by the Monarchy. The ultimate goal was to create a uniform empire based on the absolute rule of the emperor. Hungary was divided to districts and a central public administration was introduced (also known as semi-constitutional imperial centralism). However, it is also true that several pragmatic legal changes took place that later facilitated the operation of local credit institutions. Based on Austrian examples and with the involvement of foreign capital, different modernisation experiments were conducted: the railroad network was developed, internal customs borders were abolished and a unified interior market was created. In the meantime, despite the strict neo-absolutistic system, civil progression mainly accelerated, as well. Civil transformation was mainly facilitated by the following actions: public burden-sharing (1850), abolition of ius aviticum (1852), and the elimination of serfdom (1853).

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In this complex situation, a part of the Hungarian nobility chose some forms of resistance: the ways of active resistance included attacks, plots and different guerrilla operations; the movement of passive resistance was led by Ferenc Deák and his followers who fought Austrian tyranny with political passivity, civil disobedience and the withdrawal of taxes. Finally, there were the 1848 political emigrants lead by political personalities such as Kossuth and Klapka. Austria lost the war of Italian independence in 1859. The defeat at Solferino against the Franco-Sardinian Alliance lead to a severe financial crisis that manifested itself in an increase in inflation and state debt. Bach who was responsible for Hungary before was now dismissed by Emperor Franz Joseph and the ruler promised the implementation of certain reforms for the nations of the empire. In the meantime, Hungarian emigrants started largescale plotting. On 6 May 1859 in Paris Kossuth, Teleki, and Klapka formed the Hungarian National Directorate that was to function as the emigrant government until the new Parliament was elected. There were plans to extend the Directorate with a Croatian and a Transylvanian member. Then they set out to solve political and military tasks. Previously, the emigration was completely divided, but by then the majority was united behind the Hungarian National Directorate. Emigration leaders sent a message to Hungary to ask the nation to refrain from rebellion until the Directorate gave the sign. They also warned Hungarian society about the importance of reconciliation with the neighbouring nationalities. This was based on Kossuth’s constitution proposal that was proclaimed as the programme of domestic policy by the emigration. On 18 May 1862, Ignác Helfy published Kossuth’s plan for the Danube Confederacy in L’Alleanza of Milan that promoted the idea of HungarianItalian collaboration. The complex political proposal was drafted in 1850 and later modified in three points.279

279

http://mek.niif.hu/04800/04881/html/szabadkpp0010.html

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Box 5-13 Parties and party systems before and after the Compromise

The first stage of the history of the Hungarian party systems starts in 1867 and ends in autumn 1918; in other words, it begins with the negotiation and implementation of the Compromise and ends with the collapse of Austria-Hungary. In the period preceding the Compromise, modern political parties had not existed in Hungary in the legal and politological sense of the word. The legal framework for the establishment and contextual operation of parties was missing, and the necessary modern party-political framework was also missing until the Compromise. The Address Party (Felirati Párt) and the Resolution Party (Határozati Párt) were the names that started to be used for the two main political groups of the National Assembly of 1861. The names stuck by the time of the 1865 National Assembly – the Address Party (Felirati Párt, later Deák Party) and the Resolution Party (Határozati Párt, the party led by László Teleki and later Kálmán Tisza). The path to the Compromise started with Ferenc Deák’s eastern article published on 16 April 1865. The two parties within the National Assembly started as ‘parties of representatives’ and lived on as such following the Compromise of 1867. However, the two parties did not form or represent an exact political and ideological organisational line, and individual representatives selected their party optionally by each question under debate. Thus, they formed certain ad hoc interest blocks and gathered around strong leaders in crucial debates. Following the complex politico-economic changes of the era, splits, mergers and name changes at the end of the developmental process the two aforementioned great parties became the basis of key parties of the Dualism era (see also Chart 5-35). In spite of that, it is a fact that these leading parties initially did not and later only partially exhibited the characteristics of modern parties and party systems.

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Banks in history: innovations and crises

5.4.1.2 The road to the Austro-Hungarian Compromise The relationships of the major European powers mainly changed during the 1850–1860s. Austria gradually lost the support of its former traditional allies, including Russia. Italian and German unification movements made the court in Vienna reconsider its own position of power. Prussia was increasingly gaining economic and industrial influence vis-à-vis other competitors as Otto von Bismarck made successful political unification efforts within the German Confederation. Thus, Austria gradually lost the possible initiatives and scopes of action in foreign policy. As a result of the limited foreign policy options, the next step was for the Habsburgs to try to stabilise their own empire by implementing cohesion policy measures in domestic politics. They were perfectly aware of the aspect that the ‘Hungarian question’ remained unsolved and that continuous attempts to gain independence could destabilise their empire any time. Franz Joseph made two attempts to reach a compromise, in 1860 and in 1861 but both failed. The first attempt was made in October 1860 (October Diploma), which in many respects attempted to restore the pre1848 political status. One important part of the October Diploma concerning Hungarians was the restoration of the political unity of the country, that is, the districts and the Serbian Vojvodina were dissolved. However, the power of the proposed National Assembly would have been more limited than ever before – taxation and military recruitment would have been out of its scope. For these most inconvenient reasons, the Diploma was rejected by the entire Hungarian nobility. The Austrian emperor failed to convince even the most conservative noblemen. Franz Joseph’s second attempt to seek a compromise was the February Patent. It replaced the imperial council of the October Diploma with a bicameral imperatorial parliament with restricted, but constitutional rights and placed above the diets of the provinces. Ministers were still personally and directly responsible to the emperor. Nevertheless, compared to the population number, the Hungarians were vastly underrepresented within the system established by the Patent. In 1861, the Hungarian National Assembly categorically rejected the Patent due to an address majority (Felirati Párt).

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5. The Second Industrial Revolution (1870—1914)

As far as the Hungarian issue was concerned, as the failure of the Revolution of 1848–1849 became a vivid memory, it was also becoming increasingly evident that what the country and the nation needed was a period of consistent development that was also acceptable for Vienna. From 1861 onwards, the Address Party did not reject the idea of a compromise with the Habsburgs in principle. By contrast, the Resolution Party categorically rejected this idea and was not ready to make any compromise, so much so that it saw a real possibility for an armed uprising to restart the war of independence (for the party relations in the era of dualism, see Chart 5-35). From a foreign policy perspective, 1859 was a decisive year, because the Habsburg Empire has lost an important war and from that moment the Address Party felt that its position was stronger. What were the facts in favour of the Address Party? Big landowners and especially the intelligentsia were depleted and unable to continue with the strategy of passive resistance against the emperor. Another fact was that the unfavourable international position of Austria was not changing very rapidly and the isolation of Vienna in terms of foreign policy continued to gradually deepen (additionally Austrian provinces were dropped out of the German Customs Union, which was now supported by a strong Prussia). Moreover, there was a risk that an increasing number of aristocrats would make their own personal compromise with the Habsburgs and this scenario would have drastically weakened the actual negotiating position of popular leaders in the interests of obtaining a larger compromise with Vienna. Another decisive argument was that the nobility felt that they had already made enough sacrifices during the struggles of 1848–1949 and they were not ready to make more concessions just to gain the support of the masses.

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Banks in history: innovations and crises

Chart 5-35: Development of Hungarian party relations in the era of dualism Address Party Deák Party

Right Opposition (Conservative Party)

1875

Resolution Party

1861

Left Centre

1865−68

Extreme Left

1865−68

General Workers' Association 1868

Party of '48

Liberal Party

1868

Party of Independence

Independent Liberal Party

1874

Party of Independence and '48

1876

United Opposition (Moderate Opposition)

1884

1876

General Workers Party of Hungary 1880

1890

National Party

Ugron Faction 1892

1904

Catholic People's Party

National Party

1895

Catholic People's Party

1905

Coalition 1905−1909

Liberal Party

National Constitution Party

Social Democratic Party of Hungary 1890

Independent Socialist Party

1905

1897

Independent Socialist Peasant Party of Hungary

Party of Independence

National Agrarian Party of Independence and '48

1908

1909

Kossuth Faction

National Party of Work 1910

1909

Justh Faction

United Party of Independence and '48 1913

merged and split dissolved

Civic Radical Party 1914

Source: Magyarország története (The History of Hungary), Volume II. Edited by: Erik Molnár, Ervin Pamlényi, György Székely (1964, 154)

The two parties mentioned above and their developing ideologies reflected the split that was characteristic of the Hungarian political elite of that era. It can be summarised in two points: passive resistance depleted them financially and kept the leaders from taking part in public life; moreover, the ideas of the

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5. The Second Industrial Revolution (1870—1914)

war for independence and the memory of the brutal retaliation made it very hard and complicated emotionally to seek a real political compromise. In the clarification of the opposing positions and the creation of the new leadership of the empire, the role of the Austrian-German upper-middle class was imperative along with that of conservative Hungarian aristocrats (for example György Apponyi, Antal Szécsen). A series of failures in foreign policy and the deepening financial crisis of the 1860s forced Franz Joseph to seek a serious compromise with Hungarians and the year 1867 brought the historical turning point for the parties to officially settle the tense Austrian-Hungarian relationships.280 It is important to note that this complex negotiation process involved debates on various special policy issues among the involved parties –the related financial issues are discussed in the following.

5.4.2. Economic developments 5.4.2.1 The position of the Hungarian economy in the 1850s and during the global crisis of 1857 By the end of the 1850s, the crisis was felt but only temporarily in the Hungarian economy, primarily in the field of the flow of capital and investments. Poor implementation of the changes in public law led to a large number of difficulties in the agricultural sector. Nevertheless, between 1850 and 1860 (and even before) the constant development of the public administration based on the Austrian example and the slow influx of foreign capital resulted in significant economic development in Hungary (along with some slower periods due to the effects of the global stock exchange and commercial crisis of 1857–1858). The oppressive Austrian public administration operated in an autocratic system, which generated several damaging features, but it also concentrated on strong capital imports and implemented job-creating measures as an integral part of its own imperial, centralist economic agenda. This lead to recognisable economic growth for the people of Hungary as well. Accordingly, the strong centralist economic policy of Bach also resulted in positive economic

280

Unger–Szabolcs 1979, 213, 217.

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Banks in history: innovations and crises

effects. Investigating cause and effects, it is evident that after Bach was dismissed it was possible to build on his development results. The internal customs borders of 1754 were already abolished by Austria in 1851 creating a unified market where Hungarian products had an advantage locally. In the meantime, railroads were built, there was an industrial upturn and demand for grain increased sharply. Domestic trader and bourgeoisie groups grew stronger primarily due to trade in agricultural goods, mining, railroad construction, and the establishment of credit institutions. Precisely this developing economic elite constituted one of the most influential groups of society of Austria-Hungary, especially from 1867. For example, during the Crimean War alone, which was fought between 1853 and 1856, Austrian investors established 14 sugar refineries in Hungary; following the War for Independence Austrian ‘capital export’281 to Hungary began to flow in. Another sign of development was the opening of the Pest grain hall in 1845, and in 1856 the first Hungarian steam engine was manufactured in the Röck factory. Box 5-14 Foundation of the First Hungarian General Insurance Company (Első Magyar Általános Biztosító Társaság) in the year of the crisis

Széchenyi and ten other members of the aristocracy had already made an attempt to establish a Hungarian insurance company in 1827. They raised the capital together, but the implementation of the plan failed. Thus, in the 1850s only some foreign insurance companies were active in Hungary. Although some mutual insurance societies existed previously, for example the ‘mutual society to insure against ice damage’ established in 1843, these did not develop further and ceased to exist shortly after their opening. Finally, the First Hungarian General Insurance Company (Első Magyar Általános Biztosító Társaság) was founded on 15 July 1857. The official establishment time was the date of the general meeting (16 January 281

Austrians were allowed to export capital to Hungary practically without limits – following 1848–1849 coal mining increased tenfold and 80% of the investments came from predominantly Austrian investors.

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5. The Second Industrial Revolution (1870—1914)

1858) where prestigious persons of the society of the day were present (for example Count Antal Szécsen, László Szögyény, József Ürményi, Count Ferenc Zichy, and Count Henrik Zichy); a year later the factory reinsurance agreement was established with the leadership of Generali.282 While previously even the most significant insurance companies were hardly able to recruit more than 300-400 agents, the First Hungarian General Insurance Company surprisingly attracted such prestigious individuals that their involvement in itself guaranteed public success. The first CEO of the patriotic company was the well-known financial professional Henrik Lévay who managed to attract such famous persons to become founders as Count György Apponyi, Ferenc Deák, Count Emil Dessewffy, Baron József Eötvös, József Havas, Baron Sámuel Jósika, László Karácsonyi, Count György Károlyi, András Kiss, István Nádossy, Baron Pál Sennyei, and Pál Somssich. After three years of operation the company created a pension fund for employees from 4 per cent of profits with some additional funds from the basis for dividends. Some 50 years later an analysis of the pension fund showed that the standard of living of pensioned officials had not suffered significantly following their retirement. In 1858, more than 600 employed agents were waiting for the start of the new company, and the number of representatives doubled by the end of the year. By 1860, the number of insurance agents in the countryside working for a fixed fee rose to 7,000. In 1860, the company extended its activities to the life insurance sector. In the following 40 years, the financial activities of the company covered all of the relevant insurance services of the period and its prestige steadily grew. By the end of the 1893 accounting year, the reserve base of the company in business since 1858 had risen to 30 million forints. As for the general figures of the sector: in 1860, there were 8 active insurance companies in Hungary; in 1895 this number rose to 12; and in 1900 to 18. By 1913 the number of active insurance companies increased to 114.283

ttp://budapest-anno.blog.hu/2011/07/17/az_elso_magyar_altalanos_biztosito_ h tarsasag_szekhaza_a_vigado_teren_a_szazadelon 283 http://www.biztoshely.hu/magyar-biztositas-tortenete.html 282

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Banks in history: innovations and crises

After 91 years of successful operation the First Hungarian General Insurance Company was nationalised in 1948. Then, on 20 July 1949, the State Insurance National Company (Állami Biztosító Nemzeti Vállalat) was established. As a result of the global crisis of 1857 the official date of establishment was moved to 16 January 1858 by the general meeting of the company that had already been founded in 1857. Furthermore, from the founding capital of 3 million forints ‘[…] only 30 per cent was deposited directly. 70 per cent was provided in the form of promissory notes. By 1879, reserves covered the total issue value of stocks and these were returned to the founding shareholders.’284 5.4.2.2 Economic situation of the Dual Monarchy in general The Compromise of 1867 designated the economy of the dual monarchy as an area that is managed together, but not as a common policy area. A key element was the economic compromise that had to be renewed and re-established every 10 years. The main features of this were the following: common repayment of debts, establishment of a common bank and currency, and the renewal of the common customs area every 10 years. ‘This rate of contribution shall be in effect for 10 years, as per the agreement between the Lands of the Crown of Saint Stephen and His Majesty’s other countries, which is from 1 January 1868 to 31 December 1877.’285 As per Act XVI of 1867 a ‘customs and commercial union is established and the Monarchy is enclosed within a common customs border.’ This meant back then that the countries of the Monarchy created a mutual commercial and customs union, which worked as a common market. The customs union of Hungary and Austria had already been created on 1 October 1850 as customs were no longer paid between the provinces of the empire. The Compromise of 1867 did not bring about any particular changes in this respect. The customs free zone of Austria-Hungary was maintained for 51 years, until the end of the existence of the dual Monarchy. The only occasion when renewal was not h ttps://www.arcanum.hu/en/online-kiadvanyok/Lexikonok-a-pallasnagylexikona-2/e-e-7C62/elso-magyar-altalanos-biztosito-tarsasag-8453/ 285 https://net.jogtar.hu/ezer-ev-torveny?docid=86700014.TV&searchUrl=/ezer-evtorvenyei%3Fkeyword%3D1867%2BXIV.%2B 284

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swift was the crisis of 1899. Finances continued to be common, and a conjoint system of metrics was introduced as well. Chart 5-36: Common finances of Austria-Hungary

Source: mek.oszk.hu

The state debt of the empire was repaid together based on separate legislation. This was carried out based on the ratio defined by the quota committee selected by the two separate parliaments. At the time of the Compromise, Hungary was required to pay 30 per cent of the debt payments. This ratio was changed to 32 per cent in 1897, and later to 34 per cent. The task of financing the budget of the two Ministries was performed by the joint Ministry of Finance (Chart 5-36). In line with Ferenc Deák’s conditions, Dualism included three common areas: finance, foreign policy, and the military. The leaders of the respective ministries came from both countries, and traditionally the majority were Austrian. Out of the three Ministries, it was usually the Ministry of Foreign

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Banks in history: innovations and crises

Policy that was led by a Hungarian politician. Ministers were appointed by Franz Joseph I, and the work of ministers was controlled by delegations selected by the parliaments of Hungary and Austria. This meant that the control of the actual common government (that operated besides the national executive bodies and consisted of the common ministers) was performed by two delegations, 60 men each, selected from the two national parliaments. Both delegations had 20 representatives selected from the upper chamber and 40 representatives selected from the lower chamber of the respective parliaments. As Deák put it: these delegations did not pass laws and did not have authority to act in any other issues. Their mandate primarily was to make decisions regarding the distribution of assets, which concerned the common budget. The delegations held a meeting once a year alternating between Vienna and Pest as the location. The delegations held a hearing for the proposals of the common ministers and voted on the budget of the common ministries. It is an interesting fact that communication between the two delegations occurred exclusively in letters. The only exceptions were longer conflicts. If there was a long-standing disagreement among involved parts, there was the possibility to hold a joint meeting and decide on the outstanding issues with a simple majority. The monarch also had the right to decide in the case of a disagreement. The real economic advantage of this political/economic scheme was that it made possible the free movement of capital and workers. After the Compromise, the newly created huge internal market of the empire offered great and real possibilities for Hungarian agriculture and food industry. Moreover, as Hungary was rich in mineral resources dynamic development started in mining and the related heavy industry, including machine manufacturing. Based on the common areas, Hungary initially contributed to 30 per cent of the common budget. This figure rose to 40 per cent by the end of the Austria-Hungary era. This change confirms that there was strong economic growth in the period (Unger–Szabolcs, 1976, 221–224 and 243– 244). Modernisation and civil progress was also intensive. In approximately four decades the population grew from 15 million to 21 million. The rapid development of the economy was based on strong pillars as the growth

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5. The Second Industrial Revolution (1870—1914)

of agricultural export, the industrialisation and modern infrastructural developments. Even the year of the Compromise was a good start as the harvest was exceptionally large in 1867–1868 in Hungary, but very poor in Western Europe. This resulted in a steep increase in international grain prices. Therefore, the country managed to make a significant export income and profit (Hanák, 1972, 170–172). The prosperity period in the grain sector continued until 1873. Then a temporary financial crisis followed due to the collapse of the stock exchange of Vienna and Budapest. In 1884, another short crisis occurred when cheap US grain and Australian wool pushed down prices. Chart 5-37: The Hungarian economy in the era of Dualism, 1867—1918

Source: slideplayer.hu

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Banks in history: innovations and crises

5.4.2.3 Key features of the Hungarian economy during the era of Dualism Instead of the continental division of labour, Hungary became part of a local system of labour division: Austria specialised primarily in industry and Hungary in agriculture. However, following the Compromise the other sectors of Hungarian industry started to develop as well (Chart 5-37). As for agriculture, modern methods started to spread (for example crop rotation, the use of artificial fertilisers and combine harvesters). Livestock breeding was also modernised (stables, introduction of new breeds).286 Another trend was the intensive use of different fertilisation methods. Technical improvements were gradually introduced, such as the use of iron ploughs and modern scythes. Due to the stable and secure demand, producers worked to increase production and applied considerable investments. Higher production required increased storage capacities. This facilitated the development of the food processing industry. This in turn enabled producers to sell goods at higher prices. At the time of the Compromise, approximately 60 per cent of Hungary’s national income came from agriculture. As a result of the development of industry and services, this figure fell to 40 per cent by the time of World War I. Although the development of Hungarian agriculture was relatively slow, it remained the key sector in the economy from the perspective of both the number of employees and national income. The use of machines in the agricultural sector was most widespread in threshing. First, horse-driven threshing machines were used, then in the 1860s steam engines appeared gradually. By 1900, threshing was generally mechanised. In connection with agricultural equipment manufacturing, it is important to mention the factory of Ede Kühne and the sowing machine it

286

evelopment trends in stock farming were as follows: livestock in stables, modern D dairy farming in manors, new cattle types (in 1880 80% of cattle stock is Hungarian grey cattle, by 1910 their rate had dropped below 30%) became more widespread. Stock farming, especially the import of selectively bred livestock, was statesubsidised. As regards animal health, a modern veterinary network was created.

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5. The Second Industrial Revolution (1870—1914)

manufactured.287 The modernisation of agriculture and the use of tools such as plough-hacks, sowing machines and harvesters lowered the time requirements of labour. The first steam powered plough was used from 1861. The meat processing industry was also important: the famous salami factories of Herz and Pick were established back then. The most important sectors of food industry were canning and sugar production. The structure of domestic food consumption changed dramatically during this period – meat consumption decreased while the importance of bread and pasta grew significantly. As for root crops, Hungary was second to the USA in corn production. This was the period when the most important areas of vegetable and fruit production were formed. By contrast, wine production went through a serious crisis as a result of the ‘phylloxera plague’ of the 1880s. Continuing with industry, it should be pointed out that Hungarian industrialisation had a delay of 100–150 years compared primarily to Western Europe. Also, there were significant shifts in the balance of the industrial sectors resulting in an unbalanced domestic structure. Apart from temporary changes, small crafts played a very limited role. Foreign capital inflows (its presence or the lack thereof) had a strong impact on the Hungarian economy (Chart 5-38). All of this also impacted the structure of society, employment and the various developments in the industrial sectors.

287

Further examples: Röck, Vidacs, Schlick, Hoffherr & Scrantz.

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Banks in history: innovations and crises

Chart 5-38: Change in the distribution of industrial capital stock between 1900 and 1913 100

Per cent

Per cent 7.1

18.2

90 80

28.9

100 90 80 70

70 41.9

60 50

40 64

30 20

39.9

10 0

1900

1913

Joint ventures of foreign and Hungarian capital Companies with foreign capital Companies with Hungarian capital Source: slideplayer.hu

During the Dual Monarchy and following the abolishment of traditional guilds (1872), there were basically three industrial sectors where Hungary showed exceptional performance that reached European levels. One of these was the aforementioned food industry, and the other two were the milling industry and railroad construction. In connection with business types, it is important to note that guilds were replaced by Craftmen’s Corporations beginning from 1884.288 These had a positive effect on the development of free private businesses and the free movement of workers, but small crafts could never reach the level of anything beyond underdeveloped cottage industry. Craftmen’s Corporations normally did not enjoy customs protection and accordingly manufacturers were very vulnerable to market forces.

288

lthough guilds were abolished in 1872, several ‘grace periods’ were offered until A 1884.

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5. The Second Industrial Revolution (1870—1914)

Box 5-15 Guilds and chambers

Guilds were essentially associations that protected the interests of craftsmen and merchants. The history of guilds goes back to the middle ages and they existed in Hungary until the second half of the 19th century. The birth of guilds was facilitated by the different privileges of city dwellers. The structure of guilds, however, was extremely hierarchic. The members of it included masters, apprentices, and journeymen; the guild was led by the guild master, with the help of some other masters and optionally one or two senior journeymen. Craft guilds limited the freedom to pursue a trade for their own benefit: for example, certain trades could only be practiced by the members of the guild (compulsory membership). Furthermore, the number of masters within a guild was strictly limited. A guild could only be joined by masters or merchants of impeccable reputation who proved their skills by producing a masterpiece. The system of apprentice and master training was based on strict rules: to become a master, the candidate had to present an own masterpiece to the head of the craft guild. In effect, the rules devised by guilds during the centuries formed the basis of the operation of chambers of commerce and industry later. The use of trademarks and the protection of patents also originates from craft guilds. These initially played an important role in maintaining a healthy balance of production. However, later certain families managed to acquire private control over craft or trade guilds and this lead to a crisis in the structure of that traditional system. These families wished to claim all the benefits of the controlled system for themselves, but in doing so they damaged the business structure and in the end themselves. The internal struggle between masters and journeymen (who felt exploited), due to contrasting financial interests reached a climax in the 17th century. These struggles destroyed the moral basis on which craft guilds had been built upon. In the meantime, new branches of industry were appearing, original inventions were spreading and ever more capital was invested in industry. These issues all had a negative effect on the financial interests that still held guilds together. However, the

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red line was crossed when certain families (in secret) started selling the right to become a master. This undermined the strict authority and power guilds had previously had. The level of training had declined, and under the new circumstances guilds were unable to compete with industrial circles. Their only method to fight factories and manufacturing was trying to limit the number of journeymen. In doing so, the guilds were fighting the interests of industrial production. Thus, the medieval system of guilds built on the principle of limiting the individual activities of members became obsolete within the framework of modern industry and economy. Guilds were no longer entities suited for the industrial market. In the meantime, chambers were born. The idea was based on the German example. Chambers defined themselves as organisations created by law that had autonomy to manage their affairs and represent their members, taking over certain tasks and the related powers from public administration with respect to their area.289 Chambers did not perceive their role as the extension of the power of the state to control the independent operation of the affected sector. By their official definition, chambers limited the power of the state by the privatisation process of the related sectors and created an intermediary level of power. Chambers as a form of institution were established throughout Europe following the French example. This system was different from its British counterpart that developed in parallel, but was built on free associations. In the Habsburg Empire, the first chamber was established as a result of the Napoleonic Wars. Lombardy and Venice were under French rule in 1811, and this was where chambers of commerce were established based on the French pattern. These continued to operate even after the fall of Napoleon. The first chamber of commerce and industry of Hungary was founded in Fiume in November 1811. However, it terminated its activities when the French troops were withdrawn (from October 1814). Hungarian Reformers after the Revolution of 1848 were convinced that guilds were 289

system of views on local government based on Lorenz von Stein’s philosophy. A See Stein, Lorenz von (1887): Lehrbuch der Nationalökonomie. Manz, Wien.

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an institution of the past and modernisation was needed in commerce and industry, but the chaos of war prevented the government from working out the system of chambers. In the meantime, a decision was made in Vienna to create a chamber of commerce with compulsory membership. Based on the new Austrian legislation only one chamber was established. This was a subordinate to the Ministry of Commerce as an advisory body and operated through the headquarters in Vienna. On 26 March 1850, Minister of Commerce Baron Karl Ludwig Bruck issued the emperor’s patent to establish the system of chambers in Hungary. Also, these chambers were subordinated to the Ministry of Commerce in Vienna and strict rules applied to keeping books and minutes of meetings. At this time, Hungary had 11 chambers with the following headquarters: Pest-Buda, Debrecen, Kassa, Temesvár, Kolozsvár, Brassó, Eszék, Zagreb, and Fiume. These chamber offices were partly official, partly autonomous bodies. Chambers dealt with issues such as the devaluation of Kossuth banknotes without compensation, finding a solution to the bank question, raising the allocation of the Austrian National Bank’s branch, the risk of the monopolisation of steam shipping on the Danube, the development of public roads, the improvement of the railway network, compete implementation of free competition and with this the free practice of trade, the establishment of a temporary warehouse and a secondary school of commerce based on foreign examples, the establishment of a winter port in Pest, and additionally, the establishment of a commodities and stock exchange. The Act on Chambers of 1868 provided considerably more freedom and autonomy to these organisations compared to the 1850 Patent of the emperor. Act VI of 1868 defined the development of chambers for a longer period. It is safe to claim that the quality of the act was in many respects close to that of the act on chambers passed approximately three decades later in Prussia. Based on the implementing regulation of the Act, the Croatian-Hungarian public law measures and the restructuring performed later290 a total of 20 chambers of commerce and industry were established in the territory of Dualism in Hungary. In connection with the autonomous activities of the chambers, it

290

Primarily the reorganisation under minister Gábor Baross.

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is important to draw attention to the fact that chambers of commerce and industry played a major role in drafting the 1872 Act on industry.291 This was the law that definitively eliminated all the guilds in Hungary. As per Section 83, all existing guilds were disbanded approximately 3 months after the act came into force. Nevertheless, there was a possibility to form a craftsmen’s association. If the majority of guild members decided to do so within 9 months, the assets of the disbanded guild were transferred to this newly established association. If not, the assets of the guild were to be donated for public-benefit industrial purposes by the assembly of the guild. If the guild assembly did not wish to make such a decision, authorities had the right to decide on the industrial use of the guild’s assets.292 Chart 5-39: Roller mill, the world-famous invention of András Mechwart293

Source: www.mozaweb.com

ct No. VIII. of 1872 on Industry. A http://real.mtak.hu/64279/1/Zachar_Gazdas%C3%A1g%20-%20politika.pdf 293 András Mechwart’s world famous invention, the roller mill facilitated the development of the milling industry. Roller mills offered a grind much finer than that of traditional grindstones. 291 292

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Chart 5-40: Contemporary steam mill stock

Source: www.mozaweb.com

The emergence of the world-famous milling industry was largely thanks to András Mechwart’s invention, the roller mill (Chart 5-39) which effectively revolutionised the sector. The first steam mill was founded during the Period of Reforms in 1839 under the name ‘Pesti Hengermalom Rt’ (Gr. Sz. I.). By 1867, 14 large steam mills were already in operation in Pest, and several milling joint-stock companies were established (Pannónia, Concordia) – for the photo of a stock of ‘Blum-féle Gőzmalom Rt.’ see Chart 5-40. As a result of main innovations, the quality of wheat, and the mobility of capital by the 1870s Budapest became one of the centres of the milling industry of the world – 60 per cent all steam engines in operation were used in milling; for example, 57 per cent of the wheat produced in 1880 in Hungary was milled using these modern steam mills (Chart 5-41).

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Chart 5-41: The distribution of steam engines in different sectors of industry 100

Per cent

100

1863 Food industry Iron industry Timber industry Chemical Industry

1884

Mechanical Engineering Textile industry Others

Source: slideplayer.hu

Initially, the development of the processing industry was limited to the food industry, but this development in turn had a positive effect on machine manufacturing as demand for machines and equipment increased (Ganz Machine Factory, Shipyard of Óbuda, MÁVAG, the Weiss Manfréd Machine Factory in Csepel). The first sectors of industry to develop were the segments related to railroad building, that is ironworks and coal mining, with the milling industry joining them from the 1860s (for the photo of a roller mill in Budapest, see Chart 5-42). Then, the development of the machine industry and transport facilitated the growth of heavy industry (iron and steel production, mining, for example in Ózd, Miskolc/Diósgyőr and Salgótarján). Machine manufacturing was the number one sector within heavy industry. Machine manufacturing was strategically important as it produced vital equipment. Heavy industry was

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mechanised following the German model. The Second Industrial Revolution was underway by the 1880s, but Czech and Austrian competition was very strong. By 1910, the share294 of heavy industry was significantly greater than that of the food industry. The number of large enterprises was 11 in 1890. 20 years later there were 36 factories with more than 1,000 workers. Most of these were joint-stock companies or owned by the state. It is important to note that foreign capital played a major role in the development of large industries after 1867 and the domestic accumulation of capital was very low. One original success story of the iron and metal industry295 was the Manfréd Weiss Works which was originally founded in 1884 as a canning factory. Coal and iron ore are the traditional resources of heavy industry, but Hungary did not have particular advantages in this respect because the available resources were scarce and mining costs were quite high. Although coal production grew more than 20-fold between 1860 and 1913 and nearly doubled between 1900 and 1913, high quality black coal that was best for coke production had to be imported.

here were three main centres of heavy industry: in Northern Hungary in T the Gömör-Szepes Mountains; in Hunyad and Krassó-Szörény counties in south east; and in Budapest and its surrounding region. 295 For example, the ironworks of Rimamurány was established in 1852 and by 1865 it produced 100,000 tons of raw iron. The technical development in casting of iron resulted in better quality coal and coke. Ironworks were also perfected. Metallurgy industry started to use the technical inventions coming from Western Europe (for example mixing, roll forming). The first Bessemer furnace was built in 1868; the first Martin furnace in 1876. 294

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Chart 5-42: Roller mill in Budapest

Source: mandiner.blog.hu

Box 5-16 1873 — the second global crisis

The second global crisis started in Berlin and reached the rest of Europe by 1873. Previously, in the same year in September, Jay Cooke & Co. failed in New York, resulting in a huge bank panic. In Germany, Heinrich Quistorp introduced 29 joint-stock companies to the stock exchange and offered loans for these for constructing new buildings. Quistorp was primarily dealing in investments (stocks) to create new industrial facilities. In parallel, he was building luxury apartments and a water tower (Germaniaturm) in the western part of Berlin (in the suburb Neuener). However, in 1873 stock prices fell from April to October at the Berlin stock exchange and the value

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of Quistorp’s securities went down to 1/8 of their original price. Thus, the banker’s investment business went bankrupt. Vereinsbank Quistorp & Co. founded in 1870 was the first German bank that became insolvent during the ‘Gründerkrise’ (business founding fever) period. The bank collapsed on 15 October 1873. News spread very quickly, causing turmoil in the German financial market and then turned into a global panic. Prices fell in Budapest, Vienna (Chart 5-43), and in Philadelphia (USA). Although the avalanche was started by German Vereinsbank Quistorp & Co. in Europe, in the global world economy (or at least in an economy that had started on the road towards globalisation) the collapse of the Berlin Stock Exchange and with it the ‘Gründerkrise’ period was not an isolated event. The panic in September in New York and in October in Berlin abruptly ended the rapid growth of world economy. ‘Business founding fever’ was a global phenomenon that ended at this point. Chart 5-43: 9 May 1873, Black Friday at the Vienna Stock Exchange (panic)

Source: de.wikipedia.org

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Indexes of the affected stock exchanges fell by 44 per cent on average due to the collapse. Approximately 18,000 businesses went bankrupt in the USA in a short period. Railway building suffered the heaviest losses. The 1873 crash of the stock exchanges lead to the worst economic crisis of the 19th century. Economic stagnation went on for a decade. The crisis also marked the beginning of a new era – this was the first time as the depression was not caused by agriculture but by industrial overproduction. New technologies revolutionised the production of raw iron and steel, and this quickly lead to a surplus of supply. This situation was worsened by the large number of risky deals at the stock exchange. This was due to the fact that enormous amounts of capital had to be raised in order to be able to finance railroad building and the development of the heavy industry, which both had enormous cost requirements. The crisis hit the USA and Germany worst, as both of these countries were on the fast track to industrialisation. In the USA, the crisis marked the end of the industrial/economic boom that had started with the end of the civil war. In Germany, the crisis ended the company foundation boom that had been underway since 1871. Prussian chancellor Bismarck demanded huge war compensation after the victory against France in the GermanFrench war of 1870–1871. These payments financed the constantly rising prices at the Berlin stock exchange for two years. During these two years 2.5 billion marks arrived in the German capital market and more than 900 new companies were founded. However, when the bubble burst in 1873, this short period ended very abruptly. Debates started about safeguard duties that were called for predominantly by German industry. Social peace was at risk as a result of a series of worker’s strikes and riots. It is not a coincidence that the system of general health, accident and pension insurance promoted by Bismarck was created in this period – it was a pioneering attempt to maintain social peace in Germany. The crash of the stock exchanges of Vienna and Budapest in May 1873 was just the tip of the iceberg – these events partly had a different cause (credit bubble) and marked only the beginning of a chain reaction of negative events in this part of Europe. By this time, Budapest had become an

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important economic centre following the Compromise of 1867. The Budapest Stock Exchange opened in 1864, before the Compromise, more precisely during the weakening of Austrian oppression. The financial crisis had a different effect on Hungary compared to other European countries. Also, economic history previously failed to interpret the events correctly. However, the real cause of the economic and financial crisis cannot be only sought in overproduction (industry was still in a developing phase), but in the various effects of international recession. Banking was the first sector that was hit badly (liquidity problems, loss of value of money and several credit losses). Then, the global crisis hit the most dynamic sector of industry: railroad building slowed down or stopped completely. However, the effect of the crisis was also felt in numerous other industries.296 The period between 1867 and the 1873 economic crisis was marked by significant development in Hungary, especially compared to the Bach era.297 However, the industrial structure remained unbalanced. As an example, Hungarian textile industry developed slower than the (already more developed) Austrian and Czech competition that also enjoyed the benefits of the common customs area. Growth was stopped by the crisis of 1873 and only accelerated again at the turn of the century as a result of the state support provided for industry. As a consequence of the crisis and its aftermath, several bills were passed in the 1880s and 1890s to develop and support the economy. In general, though the momentum of the economy was lost for years. The aim of the laws supporting the economy was to create missing prerequisites and to compensate for the lack of independent customs policy. Further goals Unsold stocks slowly piled up in domestic iron factories. Moreover, iron production fell by 25% between 1873 and 1879 compared to 1872. This was caused by the slowdown in the railroad building segment. Coal mining fell by 15% and only reached the pre-crisis level by 1879. As for the construction industry, it was primarily the brick factories that were forced to close. In the food industry the crisis stopped the development of the then world-class and developed milling industry. The industry never fully recovered this shock. Before the crisis Budapest was the number one milling industry centre of Europe, and the second in the world. Then and there Hungary was a winner of world trade. 297 Furthermore, leather and glass industries were modernised in the 1880s. The same period saw a boost in the following fields: cellulose manufacturing, plastic industry and oil refineries. Existing industries gave a new boost to brick production, machine manufacturing, beer production and coke production. 296

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included boosting the amount of incoming foreign capital and stimulating and locally incentivising the development of the key industrial sectors. The following are examples for industrial development and support: tax exemption for 15 years in 1881 (for companies that used the latest technology to manufacture products that had not been manufactured in Hungary); 236 new factories were built, 187 were refurbished and modernised; an extension of the benefits available in 1890 (interest-free loans, state subsidies); extension of subsidies in 1899 (textile industry, chemical industry, machine manufacturing); all products were eligible for subsidies that had not been manufactured before in Hungary in 1907 (a possibility to extend the tax exemption for another 15 years). The effect of laws introduced to subsidise industry was generally indirect. These were not devised to found state-owned companies, the goal was to provide some incentive benefits. The laws were usually favourable for both foreign capital and domestic accumulation of wealth. Foreign capital import resulted in concentration trends in some industrial sectors.298 At the end of the 19th century and the beginning of the 20th century, new sectors started to grow, such as the electrotechnology industry. Hungarian investors contributed to the development with some very important new concepts.299 Egyesült Izzólámpa Rt. and Ganz Villamossági Gyár (electric plant) were important businesses. However, there were significant distortions within the individual sectors – while machine tool manufacturing could hardly meet 25 per cent of domestic demand, Hungarian engine manufacturing was among the most developed in Europe. Another distortion was evident in the number of industrial enterprises (concentration) – in the first decade of the 20th century y this time the majority of the sector’s production was covered by a few industrial B enterprises: in the mining industry Salgótarjáni Kőszénbánya Rt., Magyar Általános Kőszénbánya Rt. and Észak-Magyarországi Egyesített Kőszénbánya Rt.; ironworks: Rimamurányi-Salgótarjáni Vasmű. 299 Some examples: transformer developed by Bláthy-Zipernowsky-Déri, ammeter, the invention of Bláthy, the electric engine of Kálmán Kandó, and the krypton-filled fluorescent lamp invented by Imre Bródy. Egyesült Izzólámpa és Villamossági Rt. exported lamp bulbs. The carburetor invented by János Csonka improved internal combustion engines. France and Germany used Bánki turbines. Láng factory specialised in steam engines and by the 1910s it had already constructed 10,000-horse power steam turbines. 298

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5 coal mines, 3 ironworks and 3 big industrial companies (Ganz, MÁV, and Csepel) employed 60 per cent of Hungarian industrial workers and accounted for 75 per cent of overall production. Cartels were formed – by 1914 80 cartels were established that practically completely dominated some of their own industrial sectors. Developments were financed using loans and in some cases the fact that some large-scale credit deals were managed with the involvement of Austrian agents resulted in a significant extra cost. In the period of Dualism, per capita national income grew by 250 per cent. The proportion of the population employed in industry and commerce grew from 20 per cent to 40 per cent, while the same figure for agriculture decreased from 75 per cent to 60 per cent. By 1914, one third of national income was provided by industry. 5.4.2.4 Transport, railroad network, infrastructure Railways played an increasingly significant role in transport as after the Compromise the largest investments were focused on railroad building, with regard to both domestic and foreign capital. The reason for that can be explained in a secure and profitable investment. The key importance of railroads was a well-known fact as early as the Period of Reforms300 (Chart 5-44), and railroad building was supported even during neo-absolutism, although to a much more limited extent. The state gave concessions to build and operate railway lines to private enterprises. Consequently, the Hungarian railway network was built by private businesses with the state providing appropriate financing and a guarantee on returns. This means that a certain profit percentage was guaranteed to incentivise investors. If the actual profit was lower than the guaranteed value, the state stepped in and paid the missing sums. This system was a magnet for corruption. Several railway companies went bankrupt and the government was forced to buy these in order to ensure the continuation of service. As a result of this situation Gábor Baross (state secretary and later minister of transport) fought for the nationalisation 300

he first important railway line connecting Pest and Vác was opened as early as T 1846.

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Banks in history: innovations and crises

of railway companies. To reach this goal Baross founded Magyar Királyi Államvasút (Hungarian Royal Railway, the predecessor of MÁV). By the end of the century all major railway lines were owned by this company (the state had a 62 per cent stake in the company).301 By this time, the railway network had become a powerful engine of the Hungarian economy and Baross made it a key tool in the improvement of the economy. In the meantime, MÁV became a profitable business. Baross introduced a tariff system that helped to establish a unified market while the system of zones made personnel and goods transport for larger distances more economic. Chart 5-44: Opening ceremony of the Pest—Vác railway line in 1846

Source: Fekete Sándor: Haza és haladás. (Homeland and progress). Képes Történelem. (History in pictures.) Móra Ferenc Könyvkiadó, Budapest (1974, 137).

301

he majority of Hungarian railways were privately founded until 1873. At this T point, the share of state railways was 16%. Between 1880 and 1891 virtually all major lines were bought and transferred to the state railway company, MÁV.

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5. The Second Industrial Revolution (1870—1914)

The railroad network gradually covered the most important towns and commercial nodes of the country. By the turn of the century, the density of the railway network of Hungary was similar to that of Western Europe (see Chart 5-45 for the spectacular development; Chart 5-46 shows a MÁV express train engine). The Ganz workshop was manufacturing internal combustion engines in 1888 and soon became internationally recognised: the electric engine of Kálmán Kandó made it possible to use electricity in transport. Chart 5-45: Development of the Hungarian railway network between 1867 and 1914

Source: slideplayer.hu

The development of public roads was not a priority in this period. One reason for this was that the responsibility of road maintenance was shared by the state, the counties and the municipalities. By 1914, Hungary had a public road network of 74,000 kms. 11,000 kms of this network was maintained by the state, but only 200 kms were asphalt or paved roads. As for shipping, the ports

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Banks in history: innovations and crises

of the Adriatic Sea made it possible for Hungary to have sea trade connections with Europe and the rest of the world. In the beginning development was slow in this sector. The large enterprise Dunagőzhajózási Társaság (DGT), established on the initiative of Széchenyi, managed to push out of business all domestic lines. Consequently, Baross supported the idea of the establishment of a state-owned Hungarian shipping company. The boats of Magyar Folyamés Tengerhajózási Részvénytársaság (MEFTER) appeared on the Danube and Tisza from 1894. Tickets were sold earlier for the Vienna line compared to the Austrian competitor. Passenger boats, towboats, and barges were built in the Újpest shipyard. Fiume (today Rijeka) had been a part of Hungary since 1807. Kossuth had already made a proposal to develop the small fishing port, but it had to wait until the Compromise. Construction was started in 1872 and in a few short years Fiume became one of the most important ports on the Adriatic. The port had direct lines to America and Australia. Chart 5-46: MÁV (Hungarian State Railway) express train engine from 1874

Source: www.innoteka.hu

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5. The Second Industrial Revolution (1870—1914)

5.4.2.5 Demographics and migration Dualism brought the change in demographics that is characteristic of the initial stages of civil progression – the slightly decreasing and parallel trend of births and deaths fell rapidly, with a sharper fall in the case of deaths.302 In the four decades following the Compromise the population of Hungary grew from 13.6 million to 18.3 million – including Croatia from 15.5 million to 20.9 million. As such actual growth was 5.4 million, with average annual growth of 0.74 per cent. While demographic growth started considerably earlier in the industrialising countries of Europe, the trend only became detectable in Hungary in the 1880s. However, this was not exclusively due to the fact that Hungary was economically underdeveloped compared to Austria and the Czechs. Other factors contributed to it as well, including the epidemics between 1830 and 1873. As a result of the last large cholera epidemic of the 1870s the trend changed only in the 1880 when the demographics change characteristic of the initial stages of civil progression reached Hungary.303 Actual population growth was diverse depending on region and nationality. For example, the growth of urban population was 300 per cent of the national average, and population growth in the cities of the new industrial areas was more than 50 per cent.304 In the second half of the 19th century, there was a strong migration trend from Europe to America. Masses were leaving Germany and also the Monarchy. The migration trend was especially strong among the nationalities of Austria-

he birth ratio fell from 42.5 per mille to 34.3 per mille, and deaths from 34.5 per T mille to 22.7 per mille between 1869 and 1910. In the decade before World War I natural growth was 11 per mille. During the whole period natural growth was 5.8 million, with Croatia 6.7 million (http://konyvtar.ksh.hu/index.php?s=kb_statisztika). 303 In a European comparison, the actual growth rate of Hungary was rather low as Austria (0.82%), Germany, England or Russia produced much higher rates. It is also true however that Italy, France, and Spain had lower rates than Hungary (http:// mek.oszk.hu/02100/02185/html/171.html). 304 http://venus.arts.u-szeged.hu/pub/torteneti/legujabbkori_egyetemes/tomka/ Tomka_k01_Mo_penzintezetek.pdf 302

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Hungary, and as a result the ratio of Hungarians within the population grew.305 This was an integral part of the universal migration trends of the 19th century, the movement of the population among countries and also (inter) regions – these processes significantly changed the composition of population within some urban and rural areas of the Kingdom of Hungary. The most important reasons for migration were unemployment, low standards of living, in general the extreme poverty of peasantry that had neither work nor land.306 ‘The actual loss, which comes from the migration surplus, can be estimated at 1.7–1.8 million. However, this is more than the 1.4 million difference of natural and actual growth. The reason for this is the significant migration to Hungary that mitigated the effect of immigration, although it could not counterbalance it. Statistics are not available for the number of such migration results, but the number could be around 300,000-400,000. Approximately 75 per cent moved to Hungary from the other parts of the Monarchy.’307

5.4.3. Development of the Hungarian banking system in the period of Dualism 5.4.3.1 Hungarian banking system from the Compromise until 1873 The financial background of the development of the economy was provided by the growing number of credit institutions, banks and savings banks. While in Western Europe large-scale industrialisation drove changes, in Central Europe the bank system and the establishment of modern infrastructure were the most dynamic branches of the capitalist transformation. The quick expansion of the system of credit institutions during Dualism also resulted in a spatial, geographical extension: besides the increase in the number of banks the innovation of credit institutions and new facilities spread from the centre http://multunk.com/index.php?title=N%C3%A9pess%C3%A9gn%C3%B6veked%C3%A9s,_v%C3%A1ndorl%C3%A1s,_v%C3%A1rosiasod%C3%A1s 306 http://multunk.com/index.php?title=N%C3%A9pess%C3%A9gn%C3%B6veked%C3%A9s,_v%C3%A1ndorl%C3%A1s,_v%C3%A1rosiasod%C3%A1s&oldid=118319 307 http://multunk.com/index.php?title=N%C3%A9pess%C3%A9gn%C3%B6veked%C3%A9s,_v%C3%A1ndorl%C3%A1s,_v%C3%A1rosiasod%C3%A1s&oldid=118319 305

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towards the periphery with a spectacular shift. After the Compromise, the increasingly dynamic diffusion of banking innovation with the integration of domestic capital resources created the financial prerequisites of development even in the smaller adaptation nodes, that is in an increasing number of towns in the countryside. Development was unstoppable. By the beginning of the 1870s it was evident that Pest and Buda would be the number one financial centre of Hungary, a perfect adaptation centre for foreign capital. As such, following unification in 1873, the capital city became the most important growth and innovation centre of Hungary. This was the diffusion stage of the development of the system of credit institutions. Nevertheless, besides the virtuous circle of regional economic and social modernisation and the spread of capital and banking innovations outside of the capital, a deliberately directed diffusion of the inventions of Budapest was needed to create viable networks in and among the new centres of growth. Zoltán Gál describes this form of spreading capital diffusion using the hierarchic diffusion model. In this, innovation spreads along the hierarchic chains of credit institutions and municipalities.308 The modern banking system was built after the Compromise, as the previous period with its less benign political climate (revolution, tyranny, federalism, semi-constitutional centralist) was not favourable for the flow of capital and the establishment of strong banks. The credit systems of 17–18th century Hungary were strictly limited and restricted geographically and socially, operating on a local basis: loans were given to each other by people who were personal acquaintances and belonged to the same social group (for example, the loans of Széchenyi). ‘Institutional’ credit was mainly provided in the very limited circle of church foundations, orphan funds and towns. These loans were random, unpredictable, and short term, with high interest rates. Moreover, the capital was generally less than needed by the person who took out the loan. Although credit institutions had existed before the Compromise (for example, Pesti Magyar Kereskedelmi Bank established in the Period of Reforms, several savings banks, Első Magyar Iparbank and Budai Takarékpénztár established in 1864, or Budai Kereskedelmi és Iparbank 308

http://vikek.eu/wp-content/uploads/2014/02/KEK-9.pdf

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established in 1865), the type of dynamic development that would have been evident also in the financial system (the type of development that had already been seen in the more developed countries of Europe) and which the country was in great need of only started after 1867, that is after the Compromise. At the time of the Compromise, there were only 84 credit institutions in operation in Hungary: 4 banks, 1 land credit institution, 57 savings banks and 22 credit cooperatives. These were joined by the 6 branches of the Austrian National Bank and the Pest branch of Creditanstalt. There were only three large-scale Hungarian credit institutions similar to the latter – Pesti Magyar Kereskedelmi Bank and Pesti Hazai Első Takarékpénztár established in the Period of Reforms, and Magyar Földhitelintézet established in 1862. There was only one significant similar institute in the countryside, Pozsonyi Első Takarékpénztár (1842). The total equity capital of all Hungarian credit institutions did not exceed 7 million forints, with all assets amounting to 85 million forints. The following years seemed to confirm the optimism of those who were expecting very quick convergence (Table 5-7). The number of credit institutions providing the basis of the credit system multiplied in the first years of Dualism: the number of banks, credit institution, land credit institutions and savings banks grew from 84 in the year of the Compromise to 632 in 1873 with a capitalisation of more than 500 million forints (Berend – Ránki, 1972, 24–39). The five most important banks created in this period are as follows: Magyar Általános Hitelbank (Creditanstalt, founded by the Rothschilds, jointstock company format); Angol–Magyar Bank; Franko–Magyar Bank; Magyar Általános Földhitel Rt.; and Municipális Hitelintézet.

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Table 5-7: Number of credit institutions in Hungary between 1866 and 1895 1866

1873

1880

1890

1895

Banks

122

107

170

264

Savings banks

298

316

455

583

Land credit institution

Credit unions

208

249

591

968

Total

632

677

1,221

1,822

Source: Magyar Statisztikai Évkönyv (Statistical Yearbook of Hungary). 1895. Budapest (1896, 294— 295); Magyar Statisztikai Évkönyv (Statistical Yearbook of Hungary). 1896. Budapest (1897, 316)

Besides the political stability ensured by the Compromise, several other factors contributed to the development of the banking system (and the Hungarian economy). The period of prosperity that was general in Europe between 1850 and 1873 reached its climax in 1866–1867. European industrialisation resulted in a permanently higher level of demand for foodstuff and raw materials, and this had a positive effect on the development of Hungarian agriculture. By the end the 1860s, Hungary’s grain exports 500 per cent higher compared to the exports of an average year before the revolution. It seemed that Hungary could start the much-desired attempt at convergence amidst predominantly positive external circumstances in the years following the Compromise. Free trade principles were prevalent in the decades around the middle of the 19th century in international trade, so customs duties or restrictions did not hinder the flow of goods. The inflation connected to the Prussian-Austrian war of 1866 also had positive short-term effects as it resulted in a large quantity of state securities and banknotes being issued.

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Table 5-8: Issue of securities and investments in Hungary between 1860 and 1873 (increase in capital stock in million forints) 1860—1866

1867—1873

Railroads

68.7

377.0

Other transport companies

2.1

15.1

Industrial joint-stock companies

4.6

97.1

Equity capital of credit institutions

1.6

92.1

Equity capital of insurance companies

2.5

5.0

Portfolio of mortgage loans

31.6

89.8

Total

111.1

676.1

Source: László Katus: A tőkés gazdaság fejlődése a kiegyezés után (Capitalist economic development after the Compromise) (1979, 928).

Demand seemed to be unlimited and consequently a large number of jointstock companies were established. Between 1867 and 1873, approximately 676 million forints was invested in the Hungarian economy. This amount is extraordinary compared to the previous seven years (Table 5-8, for the data of several decades, see Table 5-9). In the period of 1867–1873, nearly 550 credit institutions and 170 industrial firms were established in a joint-stock company format. During these seven years, 4,000 kms of railroad track was built, twice as many as in the previous two decades. However, the majority of the newly created enterprises did not have any real economic output. The only reason was to gain profit on the stocks. In the years of the mass foundations (Gründerzeit) this was a worldwide phenomenon. The sector of credit institutions was especially infected by phantom corporations. Banks were very eager to provide loans for buying stocks. The temporary abundance of money and the eagerness to found businesses created a climate that was perfect for the creation of credit institutions: 22 new credit institutions were established in 1867, 49 in 1868, 91 in 1869, and 80 in 1870. On average 7 million forints was invested annually in establishing credit institutions (Botos, 2002, 17-37, 42–78). The amount of capital collected and distributed by the credit institutions grew by 35–40 million forints each year. The temporary credit crisis of 1869 and the Prussian-French war slowed down the reckless foundation of credit institutions in Hungary, but the boom was back in 1872–1873. For example, — 440 —

5. The Second Industrial Revolution (1870—1914)

203 new banks and savings banks were established between January 1872 and May 1873.309 The period of prosperity went on for six years and ended in May 1873 with the crash of the Vienna Stock Exchange. A decade of crisis and recession then started for the Monarchy. Table 5-9: Capital investments in Hungary between 1867 and 1900 (annual average, million forints) 1867— 1873

1874— 1880

1881— 1885

1886— 1890

1891— 1895

1896— 1900

Public investment by the state

20.4

8.1

25.4

17.9

25.2

46.5

Increase in railway capital

53.8

21.1

15.8

23.5

41.5

52.5

Industrial / share capital growth

10.0

4.0

7.9

6.5

16.0

17.0

Mortgage loans

12.3

11.1

18.7

41.5

61.0

61.5

Constructions carried out in Budapest

12.3

7.0

13.2

15.5

23.0

40.0

Machinery imports

9.1

5.5

12.5

7.4

15.0

17.5

Source: László Katus: A tőkés gazdaság fejlődése a kiegyezés után (Capitalist economic development after the Compromise) (1979, 92).

It is to remark that in the first phase, which is up to 1873, most new banks were large banks founded using foreign capital (top down with external assistance) and as a result of this the structure of the bank system was incomplete. A large amount of foreign capital (English, French, Austrian) entered the Hungarian economy through the credit institutions. Primarily foreign banks and capital investment groups created financial institutions in Budapest which were considered huge in this period. Creditanstalt of Vienna, the bank group of the Austrian Rothschilds founded the aforementioned Magyar Általános Hitelbank in 1867 with the assistance of Hungarian aristocrats and capitalists. This was the period when the new type of mixed banks became widespread in Hungary. Besides traditional banking services, these banks founded industrial and trade companies, built railroads and traded in real estate. 309

http://multunk.com/index.php?title=A_t%C5%91k%C3%A9s_hitelszervezet_ kialakul%C3%A1sa#cite_ref-5

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Magyar Általános Hitelbank concentrated its capital primarily on railroad building, but it also created a gas factory and a machine factory. With its stable international background and excellent connections, this bank even performed state banking functions. Angol–Magyar Bank was established in 1868 using British capital. Erlangen Bankház and Franko–Osztrák Bank jointly established Franko–Magyar Bank in 1869. It was also the Erlangen Bankház that founded Magyar Általános Földhitel Rt. in 1871 and Általános Municipális Hitelintézet in 1872 (with the involvement of Franko–Magyar Bank). New banks were generally established with strong capitalisation in a concentrated manner. The 5 big banks referred to above were established using foreign capital. Capitalisation was 47 million forints, 58 per cent of the capitalisation of all 500 Hungarian monetary institutions that existed at the end of 1872. (For the development of big banks, see Table 5-10.) Besides the 5 big banks, Magyar Leszámítoló és Pénzváltóbank started operation in 1869 under somewhat more humble circumstances. This institution was founded by Niederösterreichische Escompte-Gesellschaft. In the same year, Magyar Jelzálog-Hitelbank was founded using Hungarian capital (Vargha, 1896, 271–289). These Budapest based big banks soon established a series of smaller banks in the countryside. Table 5-10: The banks of Budapest on the path of becoming ‘big banks’ between 1869 and 1904 Bank Magyar Általános Hitelbank

Shareholders’ capital (HUF million)

Total capital (HUF million)

1869

1880

1890

1880

1904

6.0

10.0

32.6

72.0

Pesti Magyar Kereskedelmi Bank

1.5

2.5

8.0

19.4

151.0

Leszámítoló Bank

0.5

2.0

10.0

5.0

45.0

Magyar Jelzálog-Hitelbank

0.6

0.7

10.3

2.6

160.0

Pesti Hazai Első Takarékpénztár

1.0

2.4

4.0

68.0

169.0

Magyar Földhitelintézet

n.a.

80.0

149.0

Total

9.6

17.6

42.3

207.6

746.0

All credit institutions by percentage

36.0

23.0

37.0

40.0

45.0

Source: multunk.com

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5. The Second Industrial Revolution (1870—1914)

The new big banks primarily concentrated on serving the credit needs of local industry and commerce. This was especially true for German and Austrian banks. Modern mixed banks operating in the joint-stock company format largely depended on their own capital and on loans taken from big foreign banks. At the same time, besides offering conventional, traditional banking services, they were involved in all kinds of capitalist economic activities. Examples include the trade of securities, stock exchange deals, issuing debenture bonds and bonds, offering loans for the state and to villages, establishment of credit institutions, industrial, commercial or railway companies, providing financing for these companies through short- and long-term loans, trade of real estate and even trade with goods. At the same time, the low levels of low-risk deposit deals in the financial environment of the period was a weakness as these were precisely the deals that could have counterbalanced at least to some extent the high-risk, crédit mobilier type of extensive monetary trade deals. Early on, the profit could be deemed low as it exceeded 10 per cent of equity capital, and this surplus did not come from traditional bank transactions but from risky financial/stock etc. deals. In the meantime, banks were unable to collect and inject enough foreign capital into the economy. The amount of deposits collected mainly by issuing cash vouchers was continuously growing, but in parallel the growth of the promissory notes stock was not following the modern pattern and did not satisfy the high expectations based on Western European results (Kövér, 1984, 486-511). Although continuously growing and extremely high, sometimes 50 per cent profit margins may have suggested that the economic situation was stable and the founding fever would continue for a while, these were all just a prelude to the oncoming financial crash. By that time, the first signs of the 1873 crisis were visible in Pest. The market slowly became saturated and it became harder to sell new securities to the banks. However, such disruptions could lead to serious disturbances on the stock exchange. By then some banks were buying the

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stocks of their own companies. The stock exchange was somewhat nervous during the spring of 1873 and finally in May 1873 panic struck the stock exchange of Pest closely following the events in Vienna. Significant price fluctuations were experienced first on 5 May 1873 when Franko–Magyar Bank of Pest, one of the stars of the Vienna Stock Exchange, submitted the claims for the payment backlog of its still available nominal capital. Two weeks earlier the bank had promised a one-time 12.5 per cent dividend raise for stock holders. The discrepancy of the bank’s promises and its stock exchange behaviour lead to a crisis of trust and the investors found themselves in a difficult situation. On 9 May 1873, only one week after the opening of the Vienna World Exhibition 120 bankruptcies were reported, including that of the banking house Bankhaus Mayerberg & Russow.310 This resulted in a dramatic price drop of stock prices and the building of the Vienna Stock Exchange was unexpectedly closed down by the police at 1:00 PM. The history of the Vienna Stock Exchange remembers this day as ‘Black Friday’. The severe crash quickly reached all sector of the economy – the crisis now affected the entire Empire. Another factor that deepened the crisis in Hungary was the heavy public deficit – its value was more than 55 million forints in 1873.311 The situation was serious, and the poor harvest and the cholera epidemic worsened it. Heavy losses in the case of mixed banks were predominantly caused by risky stock exchange and real estate deals, and unsafe, unsubstantiated company establishments. Consequently, a twin crisis hit Hungary – a modern stock exchange crisis and a traditional crisis (Katus, 1979, 913–930). Stocks alone suffered a loss of 55 million forints. 44 million of this came from bank stocks. Capital of the banks decreased from 56 million in 1873 to 27 million in 1879. Approximately 50 banks went bankrupt. By 1879 there were only 12 joint-stock companies in Budapest, and the majority suffered heavy capital losses (Jirkovsky, 1940, 170–206). The swift loss of value of shares had a serious effect on all bigger banks and other financial institutions investing in this sector, but the extent of the damage was different. This difference was made by the extent to which company 310 311

http://library.fes.de/spdpdalt/19310716.pdf http://real-j.mtak.hu/51/1/AkademiaiErtesito_1873.pdf

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5. The Second Industrial Revolution (1870—1914)

founding efforts were part of the business activities of the affected bank. Out of the newly founded big banks only Magyar Általános Hitelbank survived the crisis partly with some luck, but mainly because it had better foundations. Nevertheless, due to the losses suffered it was forced to decrease its capital from 12 million forints to 10 million forints. On the other hand, the two big banks with primarily foreign investors, Franko–Magyar Bank and Angol–Magyar Bank, suffered very heavy losses. For example, in 1873 these banks suffered a loss of 2.49 million and 1.22 million respectively. The biggest problem was the defaulted exposures that were considerably larger than the sum mentioned above, and only grew during the following years. Nevertheless, in the end Angol–Magyar Bank failed not because of risky stock exchange deals but the wrong business decision regarding forest deals in the Military Frontier area and wood deals in Besztercebánya. As for Franko– Magyar Bank the fatal loss was suffered due to the risky pre-crisis stock and real estate deals and due to the companies founded to make a big profit. These did not have real business output and only increased the losses of the bank. Management did everything to hide the losses by tampering with the balance, but this was futile as the bank lost the trust of investors. The assembly decided to destroy a part of the toxic shares and deposit further capital to save the non-toxic ones, but payment difficulties went on for decades and in the end the bank decided to liquidate.312 Similarly to these banks other banks also refrained from declaring bankruptcy right away. Owners made significant consolidation efforts for years, and the banks stopped operations once these proved to be ineffective. 5.4.3.2 Lessons from the crisis of 1873 and developments in the Hungarian banking sector in the 1870s The period of the founding fever was followed by calm years in the banking sector. The remainder of the 1870s was characterised by the liquidation of several banks and companies, and also by slow consolidation. Consolidation was supported by laws such as Act XXXVII of 1875 on commerce that enforced an extremely liberal credit policy. This law also considered the important lessons learned from the crisis. For example, joint-stock companies were 312

http://library.fes.de/spdpdalt/19310716.pdf

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banned from acquiring and pledging their own stocks. This is also the reason why the act on commerce of Hungary became considerably detailed and more enhanced regarding joint-stock companies. The legislation did not concern the legal entity of the companies and the task of company registration was assigned to courts from the very beginning (Sárközy, 2005, 2–25). Nevertheless, special emphasis was put on the regulation of joint-stock companies. The act protected the interest of shareholders and creditors, and specified the responsibility of management and ordered their supervision. A reporting obligation of the more important business activities was imposed. As it was considerably easier for joint-stock companies to raise capital compared to other companies and it enabled them to keep pace with the development of technology, Hungary was at the forefront of progress in Europe regarding joint-stock company numbers and capital.313 The majority of banks concentrated in Pest-Buda (from 1873 on Budapest).314 The leading role of the city was already evident in the 1870s. This was the result of a longer trend: Pest and Buda (especially Pest) continuously strengthened their role in the credit activities in Hungary. Until 1867 this was the only city where banks operated. Also, it is no coincidence that the new Austrian big bank, Creditanstalt opened its branch in Pest in 1857. Although the Austrian National Bank had several branches in Hungary from 1854 onwards, the funding of the Pest branch radically exceeded that of the others – in 1854 for example it was 12-fold (Kövér, 1993, 186; Jirkovsky, 1944, 81–116). It is a revealing fact that the share of Pesti Hazai Takarékpénztár and Budai Takarékpénztár of all savings bank mortgages and discounting of bills grew from 33 per cent in 1852 to 40 per cent in 1862 (Vörös, 1978, 158). Budapest became the centre of credit activities in Hungary in the decade following the Compromise and despite the negative effects of the crisis it h ttps://www.penzugyiszemle.hu/documents/borbelyk-2017-1-mpdf_ 20170406160439_46.pdf 314 It is important to note that 1873, the year of the global crisis, opened a new period in the history of the Hungarian capital – on 17 November Pest, the quickly developing city of commerce was unified with Buda and Óbuda, the cities with the treasures of historical past. The city was unified as capital Buda-Pest in line with Act XXXVI of 1872. http://hogyantortent.com/pest_buda_es_obuda_fovarossa_egyesitese/ 313

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managed to retain this role after 1873 as well. For example, in 1877 the banks of Budapest held promissory notes with a value of 27.5 million forints: this was 66 per cent of the value of all promissory notes held by all Hungarian banks (Vargha, 1896, 597–599). Furthermore, in 1872 the equity capital of the banks of Pest-Buda (that is stocks and reserve capital plus profits) amounted to 41.7 per cent of all capital assets, a disproportionately high ratio (Pólya, 1895, 48–50). 5.4.3.3 Extending bank activities: universal banks during the Dualism era Box 5-17 Birth and spread of universal banks

In the most general sense, mixed banks or universal banks315 are financial institutions that combine commercial banking (short-term loans) and investment bank (long-term investment) activities. By the definition of modern banking: ‘Universal banks [...] do not limit their activities with regard to quantity, locality, client types, industrial sectors, or quality’ (Büschgen, 1989, 30). Another definition by the same author: mixed banks ‘are active in all banking activities except for issuing banknotes and mortgage bonds’ (Büschgen, 1970, 6). As these definitions are extremely broad and as such less operative, let us quote Georg Solmssen’s definition from 1930: a mixed bank is a ‘credit institution that combines credit deals and monetary trade with issuing activities and the establishment of business’ (Solmssen, 1930, 12). Historians and contemporaries used the term for banks that issued securities and founded companies. This version of modern industrial banks originated from the philosophy of Saint-Simonianism. Saint-Simonians claimed that bankers are the real leaders of modern economic life. A characteristic example of the new bank type was Crédit Mobilier established by the Péreire brothers in 1852 in Paris. In the 1850s, this bank type became popular in Germany and Austria. 315

To describe universal banks words were not used in a consistent way. The following names appear: mixed bank, settlement bank, mobile bank. Based on the English term ‘mixed banking’ and the German ‘gemischte Banken’ the two phrases are used, that were mentioned initially in addition to the German original.

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(Vargha, 1896, 362–365). Crédit Mobilier specialised in short- and longterm loans and its clients typically combined loans of movables and real estate. The bank had liquidity problems after 1866 and abandoned or radically limited its activities. It was only revived in the period between the two world wars. Mixed banks were the backbone of the system of credit institutions not only in Germany, but also in other Central European countries such as Austria,316 Switzerland, Italy, Hungary,317 and Scandinavia. By contrast, British credit institutions refrained from this business as – according to the financial philosophy of the age – it was deemed risky and not ‘banking compatible’.318 In reality this was a sign of the specialisation of banks: the majority of credit institutions were active in short-term credit and deposit deals (‘commercial bank’, ‘deposit bank’), while others specialised in issuing securities and securities trade exclusively (‘investment bank’, ‘broker’). The system of credit institutions of Belgium and France was halfway between the British and German types. Although these countries were the pioneers of long-term industry financing (Société Générale, Banque Belgique, Crédit Mobilier) the banks of these two countries largely abandoned these business areas after a few failures (Bom, 1977, 151–172). Pesti Magyar Kereskedelmi Bank was a traditional type of bank that only pursued deals concerning the following activities based on its 1866 charter: discounting, advance payments, deposits, mortgage for city real estate, account deposits and short-term securities deposit. Magyar Iparbank and Budai n Austrian example is Österreichische Credit-Anstalt für Handel und Gewerbe, A 1855 (Vienna), which also had a Pest branch. 317 Before World War I, the banking system of Hungary was not only tightly integrated with the bank systems of other Central European countries (primarily with that of Austria), but in many respects these systems were similar. For a comparison of pre-war banking systems, see Béla Tomka: A magyar bankrendszer fejlődésének sajátosságai nemzetközi összehasonlításban, 1880–1931. 318 C onsidering the contrast, see also Adolf Weber: Depositenbanken und Spekulationsbanken. Ein Vergleich deutschen und englischen Bankwesens. Leipzig 1902. 316

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5. The Second Industrial Revolution (1870—1914)

Kereskedelmi és Iparbank, the other two banks of Pest-Buda established before 1867, had a more limited scope of business activities (except for accepting saving deposits): for example mortgages were excluded (Pólya, 1895, 19). Compared to this scope of activities that was very similar to that of savings banks, the profile of the newly established banks was significantly more diverse. For example, Magyar Általános Hitelbank, Angol–Magyar Bank, and Franko–Magyar Bank were open to almost all kinds of business activities (at least based on their charters) with the exception of issuing banknotes and mortgage bonds. Moreover, Angol–Magyar Bank reserved the right to be active in the latter field. Among others these banks were certified to be active in the following field: establishment of industrial and commercial companies, involvement in the establishment of such companies; providing support for these companies in any form, including advance payments or loans; building railroads or waterways; providing advance payment for all kinds of goods and agricultural products; real estate deals; discounting; deposit collection (account or securities deposits); and finally all types of stock exchange transactions (Jirkovsky, 1940, 174). This business philosophy (also called the ‘crédit mobilier’ type) appeared in Hungary in a very short time, based directly on foreign effect and following foreign patterns. A good example is the most famous bank established in the period, Magyar Általános Hitelbank, founded at the end of 1867. The bank was backed by the Rothschild group (Anselm Rothschild was one of the vice presidents) and this provided extremely valuable connections. This is the reason why Hitelbank operated the Pest branch of Vienna-based Creditanstalt (another Rothschild company) together with Creditanstalt. The two banks continued to be tightly connected until the turn of the century. Both agreed not to open a branch in the country of the other’s head office and at the same time to represent each other there. Furthermore, Creditanstalt provided a significant credit line for Hitelbank. The establishment of Creditanstalt was the answer of the Rothschilds to the challenge posed by the crédit mobilier type of banks (März, 1968, 29–38). Hitelbank followed the same path. This is an account of the first business year: ‘We provided support for the establishment of several factories and companies destined for success. Some of these were established directly by us. However, our attention is focused on numerous

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Banks in history: innovations and crises

railroads either in the process of building or planning, approved by the government’ (Mihók, 1868, 4). One of these railroads was one of the longest lines (Barcs–Pécs) of the Alföld–Fiumei Vasút. Industrial companies included Szegedi Légszeszgyár and Magyar–Belga Gép- és Hajógyár Társulat. The excellent business background and connections practically predestined Hitelbank to act as a state bank. Indeed, its services were soon needed when the chaotic finances of the state rendered it necessary to apply for foreign loans (Sándor-Kolossá, 1950, 353–379). Although from Hungarian perspective, the role of Magyar Általános Hitelbank (1867) that formed a cartel with Credit-Anstalt (1870) to serve the Pest-based banking and trading class has the highest visibility, this was not the only Hungarian universal bank. Similarly to Germany, the domestic big banks of Hungary in the period were mixed banks.319 The French ‘banque d’affaire’ example reflected among others in Franko-Magyar Bank, but the German pattern was also present. These two patterns were combined in a special way in Hungary, and as such the banks of this type performed the roles of mixed and credit banks – sometimes in turns and sometimes in parallel developments. Hungarian cooperations established with the participation of international banks belong in this category: Angol–Magyar Bank (1868) and Franko–Magyar Bank (1869), which was later liquidated in Pest due to the crisis of 1873. Further examples for the transformation to become a universal bank: Boden-CreditAnstalt: Wiener Bankverein (1869); Pesti Kereskedelmi Bank: 1881 the ‘new bank style’ of Leó Lánczy; the successful merger of Pesti Kereskedelmi Bank and Magyar Általános Földhitel Rt. in 1881; sales of the mortgage bonds of Magyar Földhivatal by Magyar Általános Hitelbank as a part of a contract.

319

his also means that an examination of the German example poses several T interesting question for Hungarian economic history. The most important of these are undoubtedly connected to the role of banks in industrial development and the support of development. The formation of the system of mixed banks (Universalbankensystem) is the most characteristic feature of the development of German banks in this period, one that is dealt with in great depth in the literature.

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5. The Second Industrial Revolution (1870—1914)

5.4.3.4 Was the development of Hungarian banking system market or bank oriented? Although with phase delays and structural differences, the development phases of the Hungarian banking system reflected international trends. A fully independent Hungarian banking sector did not exist in this period – it was integrated into the banking market of the Monarchy, and the centre of activities was outside of Hungary. Nonetheless, the financial markets within the customs and monetary union of the Monarchy predominantly sourced the capital resources from the common market. Due to the low or slowly progressing income of the Hungarian state (taxes, etc.) and the fact that domestic capital accumulation was inadequate to finance the required developments, even more foreign capital was needed to implement substantial changes. In fact, the Compromise also created a legal basis that enabled Hungary to receive Austrian capital. As actual borders were not crossed and complicated exchange processes were not involved, foreign capital started to flow to Hungary starting from 1867 – general direction was from west to east. The majority of capital came from Austria, but this cannot be considered as proper capital export as the transfer happened within the Monarchy. Capital owners seized the investment possibilities opened up by the Empire, acting also as capital brokers. By the beginning of the 20th century, Austria had invested a total of 5.5 million crowns abroad, with 4.7 million of this invested in Hungary. Government bonds were an important form of foreign capital influx. 50 per cent of these were conducted as foreign credit deals, and by the end of the 19th century total value reached 5 billion crowns (the main brokers were the Rothschild). Further capital influx types: Hungarian mortgage bonds and village bonds and mortgages. Hungarian railway bonds were also a form of capital influx. 70 per cent were held by foreign owners. It is evident that foreign capital found an adequate market, and the ensuing demand controlled the flow of the required capital. Within the financial system, this manifested most clearly in the credit sector. Initially, Austrian capital amounted to 60 per cent, while capital generated within Hungary was partly in Hungarian ownership (see Table 5-11). By this time, the capital influx and railway investments had become the engine of the Hungarian economy.

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Banks in history: innovations and crises

Table 5-11: Percentage of foreign and domestic capital concerning investments in Hungary Period

Austrian and foreign capital

Domestic capital

1867—1873

60%

40%

1874—1900

45%

55%

1901—1913

25%

75%

Source: docplayer.hu

It is strikingly clear that – besides the uneven distribution of capital concentration – it was the conditions of the international economic environment that defined the structural characteristics of the credit institution sector in the Monarchy. The Compromise was followed by the company establishment fever, and the vibrant business spirit of this era strongly stimulated the foundation of credit institutions in the countryside. This started the diffusion phase of the establishment of the network of credit institutions. While the big banks of Budapest (especially in the first parts of Dualism) were founded using significant foreign capital investment, the increase of the number of banks and savings banks in the countryside was a sign of the acceleration of the domestic accumulation of capital, and also of the growing wealth of the countryside. As we have seen earlier, the capital required for modernisation was acquired from the internal market. As both Austria and Hungary were characterised by a stable political climate, it was profitable to make investments in the region. The Compromise resulted in economic growth, and the economy of the Monarchy started to expand towards the Balkans. A series of banks, bank-founded companies and savings banks were established outside of the major urban areas, especially in the least developed, undercapitalised regions (for example, Transtisza, Bánát, and Transylvania). More and more newly established credit institutions were competing for financial resources that opened the way for further investment possibilities. The majority of these resources landed in the most important commercial centres of the east. In a region that was underdeveloped previously regarding the infrastructure of credit institutions. The new geographical pattern was a direct consequence of the fact that capital was following the strict logic of

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5. The Second Industrial Revolution (1870—1914)

profit maximisation. Arbitrary capital influx initiated major changes in the traditional development trends of towns. Some of the slowly progressing town of the past era were left behind. New regional and economic centres of the countryside initially formed in the more developed corridors, along the lines of the railway network and the connected flow of innovation and capital (the nodes of the bank system) and later extended through the linear network of transport, communication, and the financial sphere. In this period the structure of the bank network was dominated primarily by locally embedded credit institutions. 5.4.3.5 Geographic development of the Hungarian credit system after 1890 Compared to the previous period, the influx of foreign capital gradually decreased starting from 1890. Nevertheless, the period between 1890 and World War I was the golden age of credit institutions in Hungary. By the 1890s, with the continuous expansion of the more important innovation channels (for example, the railway network and the credit institution system of the countryside) a balance was reached between the bigger towns of the countryside working on strengthening their position and the capital that had aspirations of centralisation. In this period, the regional centres of the eastern territories of Hungary at that time became the most important centres of growth in the countryside. Development was incredibly fast compared to previous periods due to the enormous demand for credit and the fact that capital concentration took place in a relatively underdeveloped region. This is shown by the large number of banks established in the region and the deposit interest rates that were higher than usual due to the lack of capital. As for the developing and initially natural geographical concentration of the banking system of Dualism, Budapest was in a dominant role. This was reflected in the geographical distribution of collecting deposits and offering credit: the conditions for local capital concentration were rather unfavourable in the less developed regions. Nevertheless, both the classic broker role of banks and the locally established credit institutions had a major role in the financing of the economy. Based on the considerations listed earlier it is safe to claim that the centralisation of financial services was only partially caused by the legacy situation – the fact that the key sectors of the economy were

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Banks in history: innovations and crises

traditionally Budapest centred. Although Hungarian banking system managed to become a high-level sector in a European comparison, the entire period was characterised by a lack of capital, although this was mainly felt in the regional nodes. Consequently, although the centres of the banking market of the eastern regions (the Szeged–Szabadka axis, the Arad–Temesvár axis, and the Debrecen– Nagyvárad axis) were geographically close to each other, they did not have a negative effect on each other’s development. This situation was a result of the fact that these nodes initially formed in relatively underdeveloped regions and the large demand for loans could only be met by multiple bank market players offering a monetary supply tailored to local preferences. Compared to the eastern regions, the Transdanubia area had a denser network, but progress was slower in this period (after 1893), and opposite trends were indeed seen. For example, the stronger position of Szombathely limited the financial and economic role of nearby Kőszeg also regarding credits (due to the competition on the market). As a result of the rapid growth, the Hungarian monetary and capital market finally managed to reach the level of development that was required by the modern capitalist economy. In parallel and gradually it also became independent. Contemporary expert Károly Mandello was able to draw the following conclusion already in 1894: ‘Budapest is not what it used to be. Not a town in the countryside dependent on the banks of Vienna, but the centre of Hungarian finance and commerce’ (Mandello, 1894, 51). Nevertheless, the credit system of Hungary remained tightly integrated with the credit activities in the other part of the Monarchy, primarily with the big banks of Vienna. However, the connection was not characterised by one-sided dependence and strong vulnerability as before. It transformed into a cooperation based on the mutual interests of the two partners. The banks of Vienna were not the only access point of Hungarian big banks to the monetary and capital markets of Western Europe any more. Strong independent international connections were built. Hungarian big banks also played an increasingly important role on the credit market of the Balkan countries – state and public loans were issued with their assistance and they were also involved in the establishment of banks, transport, industrial and commercial companies. The geographical extension of the network of Hungarian credit institutions was characterised by two trends in the period between the 1890s and World

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War I. On the one hand, the rapid growth of the number of savings banks, smaller banks and credit cooperatives in the countryside established with the use of local capital resulted in the development of a coordinated system of credit institutions and consequently a more balanced scheme of local banking markets (even though the creation of these credit institutions seemed to be unsubstantiated in some cases). By the turn of the century, regional centres started to export capital. This is indicated by the fact that the number of savings banks and other institutions grew in the smaller municipalities in their surrounding area. Austro-Hungarian National Bank and its branches (see Chart 5-47) were also significant financial and contact points, primarily for companies – besides numerous other activities the bank was very active in credit deals and also in the discounting of bills. Chart 5-47: Branches and personal loan districts of the Austro-Hungarian National Bank (1886)

Personal loan districts of the Austro-Hungarian National Bank 1. Vienna 15. Plzeň 30. Rzeszów 45. Košice 2. Linz 16. Prague 31. Stanislaw 46. Cluj-Napoca 3. Salzburg 17. Liberec 32. Ternopil 47. Brașov 4. Graz 18. Saaz 33. Tarnów 48. Miskolc 5. Klagenfurt 19. Teplice 34. Czernowitz 49. Sopron 6. Ljubljana 20. Děčín 35. Split 50. Bratislava 7. Trieste 21. Varnsdorf 36. Budapest 51. Győr 8. Bolzano 22. Brno 37. Arad 52. Subotica 9. Bregenz 23. Olomouc 38. Debrecen 53. Szatmár 10. Innsbruck 24. Bielsko-Biała 39. Rijeka 54. Szeged 11. České 25. Krnov 40. Pécs 55. Timișoara Budějovice 26. Opava 41. Zrenjanin 56. Zagreb 12. Cheb 27. Cracow 42. Nagykanizsa 57. Osijek 13. Hradec Králové 28. Lwiw 43. Oradea 14. Kolín 29. Premysl 44. Sibiu

Source: Authors’ own compilation based on www.oenb.at.

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Box 5-18 Mortgage loans in the period of the Compromise

The number of mortgage loans was low during the 1850s: Pesti Magyar Kereskedelmi Bank refrained from providing such loans, and contemporary savings banks were first trying to decrease the sum of real estate backed loans and then kept such loans at a low level for years. Indeed, the growth in mortgage loans stock was slow compared to the usual figures of the age (see Table 5-12). Table 5-12: Mortgage loans and mortgage bond transactions (year’s end data, in million Austrian forints) Year

Amount of credit

Of which Of which Hungary Hereditary Lands

Mortgage bonds

1856

1.7

1.6

0.1

0.5

1858

38.7

14.9

23.8

26.6

1859

53.0

19.0

34.0

40.1

1860

55.7

18.3

37.4

41.8

1862

58.7

22.9

35.8

36.1

1864

58.5

25.1

33.4

44.1

1867

68.9

29.4

39.5

59.4

1868

68.4

29.6

38.8

60.5

1869

65.3

28.7

36.6

59.2

1870

63.4

27.2

36.2

59.0

1871

63.0

27.3

35.7

59.9

1872

60.5

27.1

33.4

58.7

1873

73.8

37.2

36.6

73.1

1874

87.4

42.7

44.7

86.9

1877

103.1

43.4

59.7

102.5

Source: slideplayer.hu

Based on the proposals of Dessewffy and the consequences drawn from the example of the Landschafts, work was started on the draft proposal for a Hungarian land credit institution office. This was approved by the

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emperor in 1862, and Magyar Földhitelintézet initiated operation on 1 July. Magyar Földhitelintézet operated in a cooperative format: borrowers were also owners. Mortgage bond owners were secured by the collective guarantee of borrowers. The initial leverage ratio of the land credit institution was low, and the Austrian National Bank gradually showed less resistance. Consequently, the mortgage market was able to show some progress as early as the 1860s. Similarly to Prussia and France, after the Compromise the ruling dynasty of Austria-Hungary introduced incentives to support the mortgage market. Act XXXIV of 1871 provided benefits for Magyar Földhitelintézet.320 This energised the activity of the institution: the interest rate of mortgage bonds sunk to 3.5 per cent from the initial 5.5 per cent, and by the turn of century the placement rate had risen to nearly nominal value (99.5 per cent) from the initial 80–90 per cent. Mortgage bonds were sold in numerous stock exchanges: first in Pest and Vienna, later in Prague, Trieste, Berlin, Frankfurt, Hamburg, and Amsterdam. Pesti Magyar Kereskedelmi Bank, the first Hungarian bank with its 1840 establishment, gradually extended its activities to offering loans by issuing mortgage bonds. Moreover, the first regulation on solvency margin was introduced in 1876; to be able to issue, mortgage bonds credit institutions had to set up a separate fund with a minimum value of 200,000 forints. Mortgage bonds could be issued in the value up to 20 times of the value of this fund. Following the principles of liberal monetary policy, issuing mortgage bond was not subject to the government’s special permission. The right to issue mortgage bonds was granted for all joint-stock companies and cooperatives. The joint-stock company Magyar Jelzálogbank was established in 1869. This financial institution specialised exclusively in mortgage bond deals. To finance crown-denominated mortgage loans, the bank issued a large number of mortgage bonds denominated in francs, 320

hese benefits were as follows: its instruments were recognised as authentic T instruments, and the part of annual income transferred to the reserve base was granted an exemption.

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Swiss francs and pound sterling. This resulted in serious financial problems and complications due to the currency crisis of World War I. In the highly competitive situation of the age, the goal of supporting mortgage loans was the same everywhere: to facilitate and accelerate industrialisation. As such it helped to develop Vienna, Paris and Berlin. Huge construction projects were underway in the capitals. As the host of the world exhibition (from 1 May to 2 November 1873), Vienna was the first city in the German-speaking world to welcome visitors from all parts of the globe. Money was constantly flowing from the banks to the economy, i.e. to different large-scale development programmes. Cheap credit resulted in a considerable price increase of construction plots and real estate, and the fact that new mortgages were taken out to profit from rising prices formed a real estate bubble. After the recession, demand for mortgage bonds increased in Hungary. One relevant question is whether the operation of Hungarian mortgage market was closer to the US or the German model (for the current mortgage models, see Table 5-13). An important fact about Hungarian mortgage institutions is that Galizische Landständische CA (1841) was established following the example of the Prussian Landschafts. Magyar Földhitelintézet (1863), originally established as an association, belonged to this type of banks. Moreover, the Austrian National Bank’s mortgage department (1856) and its operation was unique in Europe at this time. Another direction was the French ‘crédit foncier’ type of mortgage financing based on French capital. Allgemeine Österreichsiche Boden-Credit-Anstalt (1864) and Magyar Jelzáloghitelbank (1870) were typical representatives of the model. In 1870, the leaders of the mortgage market of Hungary were the following: Austrian National Bank (market leader, 27.6 per cent share), Boden-Credit-Anstalt (21.5 per cent market share) and Magyar Földhitelintézet (21.5 per cent market share). By 1910, there was a significant increase in the number of institutions offering mortgages. At that point, the following enterprises were the key players of the market: Magyar Földhitelintézet, Magyar Jelzáloghitelbank, Pesti

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Magyar Kereskedelmi Bank, Osztrák-Magyar Bank, Boden-Credit-Anstalt, and from 1892 Magyar Takarékpénztárak Központi Jelzálogbankja. Table 5-13: Models concerning mortgage banks Characteristics Regulation Issuers of mortgage bonds Control Supervision Demand Branch office network Entering and leaving the market Valuation of real estate Safety Maximum outstanding volume of securities

US model

German model

no specific separate law

special law

any capital company

mortgage bank

by the market

by law

does not exercise control over the issuer

strict supervision

on two levels

on one level

it is necessary in order to operate in different regions

simple, fast

bound to supervisory license

from the maximum possible value

70 to 80% of the turnover value

government guarantee

owners of mortgage lend are responsible by their entire assets to the creditors; property inspection is compulsory

not limited

is up to 60 times of the own funds

Source: slideplayer.hu

5.4.3.6 Establishment and operation of the Austro-Hungarian National Bank The Austrian National Bank, as the predecessor of Austro-Hungarian National Bank, was founded with a patent on 1 June 1816 to perform central bank activities when managing depreciation based on specie provided by the financial government, and to issue banknotes, perform the discounting of bills, provide mortgage loans, and for the repayment of state debt resulting from the conversion of paper money/coins. Miksa Havas, an influential businessman of the era evaluated this event as follows: ‘It was born from the failure of the state. Its aim was to console those who lost their wealth, cover the incapacity of the government and to open a new source of credit for the

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Banks in history: innovations and crises

Treasury.’321 Of the early 12 branches opened in the first decade following the establishment of the Austrian central bank, three were in Hungary: in Buda, Temesvár, and Nagyszeben. However, the Pest branch was discounted in 1851 (collateral deal). Austrian National Bank was granted political, legal and economic independence vis-à-vis the state in 1862. In 1866 Austrian state debt was fixed at 80 million forints as a part of the negotiations of the Compromise, and the Hungarian party did not have any legal obligations in this respect. In return, however, Hungary was granted by Austria the right of the monopoly of savings banks note issuing. The Hungarian monetary policy of the Austrian National Bank received harsh criticism during/as a result of the ‘small crisis’ of 1869. It was mainly Hungary that attacked the Austrian bank claiming that it generated the crisis on purpose to destroy the financial sector of Pest that started to develop in this period. However, this criticism was not valid.322 The Austrian National Bank was chartered for a pre-set period, and the charter was extended on several occasions (for example in 1841). At the time of the Compromise, the charter of the Austrian National Bank was valid until 1877. Consequently, the Austrian party did not consider it an issue to be included in the negotiations. As such the issue was designated to the category common interests within common policy, and the two ministries of finance received the task of solving the central bank issue after the Compromise. The establishment of the new bank was subject to a long and complicated political struggle. It is clear that after the Compromise of 1867 Hungary prevented the Austrian central bank from being re-chartered in 1877 under unmodified terms. The reason for this was that contemporary legislators followed the logic of Dualism regarding the issue. Their idea was to implement their requirements based on the principle of full parity. Already in the first years following the Compromise, Hungarians demanded the right to Havas Miksa: Az Osztrák–Magyar Bank és a pénzpiac (The Austro-Hungarian Bank and monetary market) (73 l.) 1902. 322 These claims can be rejected based on the fact that the bank was eager to considerably develop its Hungarian branches and financial toolset in the following years. 321

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5. The Second Industrial Revolution (1870—1914)

establish an independent Hungarian central bank submitting various versions. However, negotiations to update the economic Compromise started only on 2 January 1876. Establishment of an independent Hungarian central bank was among the most important points of the Hungarians. In the spring of 1876 an agreement in principle was reached claiming that a central bank would be established in Hungary and both the Hungarian and the Austrian central bank would be under common supervision. This supervisory office would have had both Austrian and Hungarian members, delegated based on the principle of parity. However, on 23 November 1876 the Austrian National Bank rejected the proposal for the establishment of independent national banks, supervised by a body, set up based on the principle of parity. The Austrian government refused these Hungarian demands stiffly. While seeking a compromise, different concepts were drawn up. Complex negotiations were underway for years (‘bank conflict’). In the meantime, there was still only one central bank in the Monarchy and Hungary was forced to give up its original goal, the establishment of an independent central bank for Hungary.323 On 8 February 1877, Minister for Internal Affairs Kálmán Tisza resigned due to the conflict connected to the common Austrian-Hungarian central bank. Finally, a compromise was reached on 25 February 1877. Based on the deal, the structure of the Austrian central bank was changed, and a new, binational bank was set up under the name Austro-Hungarian National Bank.324 It was established officially in 1878 (Act XXV of 1878 on the establishment and charter of the Austro-Hungarian National Bank). Thus, the Austrian National Bank was restructured to become the Austro-Hungarian National Bank and it became the central bank of the Monarchy and Hungary. I t is a fact that Hungary temporarily gave up on the possibility of creating an independent central bank and approved the banknotes and the forced exchange rate of the Austrian National Bank. In return, the Austrian bank accepted the obligation to extend its branch network in Hungary and provide it with the necessary assets. However, Austrian National Bank was not included in the negotiations and this situation soon lead to serious debates. The central bank was independent of the government in monetary policy, and refused to align itself with the expectations of the government. 324 h ttp://www.oenb.at/de/ueber_die_oenb/bankh_archiv/geschichte_der_ oenb/1878_bis_1922/18781922.jsp 323

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Banks in history: innovations and crises

The main issues regarding the establishment of the bank arose from the different economic and financial structures of the two parts of the Empire, and this lead to constant debates later. The constituent general meeting of the new bank was held on 30 September 1878 where high council members were elected. The central bank was directed by a governor (Alois Moser) and a high council comprising both Austrian and Hungarian members. The bank had separate directorates and head offices in Pest and Vienna. The high council performed general supervision tasks, and the government commissioners and heads of directorates also participated in its meetings. The emperor nominated Frigyes Köffinger to become the government commissioner head of the Budapest head office. The high council had separate sub-committees to deal with the professional questions of mortgage, administration, execution and currency. Two vice-governors headed the Budapest and the Vienna directorates. They were appointed by the government. In Vienna, a general secretary was the head of bank operations, and central services performed the central cashier and court of auditors’ tasks. Similarly, the foreign currency and deposits departments were under central services along with the banknote printing and (on a temporary basis) mortgage department. This was later taken over by the office of the governor. In the head offices, a secretary was responsible for operative tasks both in Vienna and Budapest (see also Kálniczky, 2009, 7–8). On 19 November 1878, the emperor appointed Imre Fest as vice-governor. Directors were appointed by the high council. The constituent meeting of the Budapest directorate was held on 9 January 1879. At this meeting, the director acknowledged that the high council appointed Gyula Koppay as rapporteur to the Budapest directorate. Koppay had previously worked as head of the Budapest head office. Mór Strauss was appointed as the president of the head office. Lajos Herzberg became vice-president. Frigyes Flittner was appointed as head office legal counsel. The selection of promissory note reviewers was regulated by law (Act XXV of 1878), but the number of censors was not limited and in Pest they belonged to the commission that previously had 16 members. Censors had a 3-year mandate. Censors were selected so that all sectors of commerce and city industry would be represented. Moreover, professional continuity was an important aspect: former branch directors of the Austrian

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5. The Second Industrial Revolution (1870—1914)

National Bank were welcome to join the inner commission. Professionals gaining censor experience generally continued as members of the directorate. A strictly observed rule was that no family or company was allowed to send a directorate member and a censor at the same time. The censorship committee had 4 members each year, and special attention was paid to involving each branch of commerce. A member of the directorate served as the head of this committee on a rotational basis, and the head had veto rights. The process of selecting promissory note reviewers remained unchanged during the existence of the bank. There was but a minor change in 1899 regarding the process of nomination – in the case of censors, besides the personal recommendations of chambers of commerce and industry, from 1899 on the opinion of Országos Magyar Gazdasági Egyesület had to be requested. Censor appointments were for life, and at re-election the new censor normally came from the same family. The stock capital of Austro-Hungarian National Bank was 90 million forints. This was divided to 150,000 stocks, each of a 600-forint denomination. In the name of all stockholders, the general assembly had a right to decide on the rights of the stock holders of the bank. The general assembly met annually in Vienna, but in case of extraordinary issues it was possible to hold multiple meetings. Discharge was approved by the general assembly and composed by the invoice reviewers. Invoice reviewers were selected by the general assembly from its members. Mortgage loans were not part of the responsibility of the two head offices (the directorate). This area was controlled solely by the high council and its subordinate professional committees. This branch of business was supervised by government commissioners. A total of 50 million forints was allocated for discounting and loan deals in Hungary with the option the extend this by another 50 million if required by large-scale loan deals. However, the extension was only temporary.325 At the same time, as a result of the 1852 bank privileges (independence from the state), the bank was not allowed to open new loan deals with the state. It was only possible as a part of commission deals.

325

www.mnl.gov.hu/download/file/fid/36621

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Banks in history: innovations and crises

As already been mentioned, some branches of Austro-Hungarian National Bank operated as significant regional financial centres. Let us take an example: as a result of active monetary policy and capitalist development, Kaposvár (as an external site of the Nagykanizsa branch) was able to become involved in the activities of the central bank, the Austro-Hungarian National Bank that migrated to the gold standard base in 1892 (Chart 5-48 and 5-49). Then, at the turn of the century, the central bank opened a separate branch in the rapidly developing town. The establishment of this branch was very important for the town. Let us quote Zádor: ‘It was the first of the ten towns of the country where a branch was opened. It called the attention of businessmen showing them that this is a town where it is a good idea to invest’ (Zádor, 1964, 220). Chart 5-48: The Kaposvár branch of the Austro-Hungarian National Bank326

Source: www.mvkkvar.hu

326

The Kaposvár branch opened on 17 September 1900 on the first floor of the city hall.

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5. The Second Industrial Revolution (1870—1914)

Chart 5-49: Services of the Kaposvár branch of Austro-Hungarian National Bank327

Source: www.mvkkvar.hu

5.4.3.7 Austro-Hungarian National Bank – money issuance At the time of the Compromise the official currency of the country was the Austrian forint, that replaced the Conventionsthaler after more than 100 years. The new silver forint was introduced based on the German Customs Union’s 1857 minting convention of Vienna. It defined standard gold and silver coins. Despite Austrian plans, Germans did not approve the transfer to gold standard base. The background of the German decision was that they were worried 327

These services were advertised by the bank in the contemporary newspaper.

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Banks in history: innovations and crises

about the large quantities of specie flowing in from US deposits. The priority of the introduction of the Austrian forint was based on three main goals: first it meant a switch from middle age mark weights to metric weights. The weight of the coins was defined using the following formula: ‘45 coins may be minted using 500 grams of pure silver’. The old change rate 1 forint / 60 kreutzer was modified to 1 forint / 100 kreutzer. This considerably simplified everyday payments (use of the decimal numeral system). The state wanted to get rid of the Anticipationsschein that had been in circulation since 1811 and practically meant that the country had a dual currency system for half a century. Box 5-19 Latin Monetary Union (LMU)

The Latin Monetary Union was a sustainable monetary agreement with the largest geographical extension in the age. It harmonised the monetary systems of several countries by defining gold and silver coins of standard weight and fineness. The need to join the Latin Monetary Union is expressed in Section 12 of the act on the Compromise – this is what the term ‘Paris monetary meeting’ refers to. Originally, the LMU also standardised silver coins compared to gold coins based on an exchange ratio of 1:15.5. However, as the price of silver fell considerably the free exchange of silver and gold was limited from 1873 onwards, and the countries effectively moved to a gold-based monetary system. Silver coins were effectively degraded to change money, and only gold was accepted as currency money. Vienna started negotiations with the founding states (France, Belgium, Switzerland, Italy). However, as the LMU rejected bimetallism Austria declared its refusal to join on 24 December 1867. However, from a professional point of view joining the LMU would have been a valid decision – in 1866 Austria lost the battle of Königgrätz and was forced to leave the 1857 minting convention of Vienna (thus the agreement effectively ceased to exist). The only actual action based on cooperation with the LMU was that the Monarchy minted 10and 20-franc gold coins with 4- and 8-forint denominations for commercial

— 466 —

5. The Second Industrial Revolution (1870—1914)

purposes starting from 1870. The value of this gold forint however was expressed with a 1.23 ratio of the Austrian one, i.e. its value was equal to the value of a silver forint. For this reason, trade agreements had to clarify if the parties wished to settle in gold or silver forints. The modification was implemented because the exchange ratio of gold to silver was originally set at 1:15.5, but later gold became more expensive and 1 gram of gold cost approximately 20 times the price of 1 gram of silver. These gold coins were important not only for being accepted as currency in the countries of the Latin Monetary Union. The coins were unique because this was the first time that a double denomination was used on the same coin (forint and francs). However, the rejection to join LMU as a full member was a decision based on political rather than economic reasons. Austria hoped to lead the road to the unification of Germany until 1866, but after Napoleon III attached Prussia and lost the war, Vienna did not wish to face the fresh alliance of the German states in open conflict. Instead, it sought a natural alliance. Minting gold coins in line with the monetary union served its economic interests well. With the establishment of the Austro-Hungarian National Bank, new banknotes were issued. As we saw earlier Hungarians were delegated to the management of the Austro-Hungarian National Bank, but in line with the level of domestic monetary development (weakness) participation was based on the principle of ‘partial parity’ and not equality. In the meantime, it was an important economic achievement that the bank was able to supply the Hungarian monetary market with banknotes. One side of the banknote had German, the other Hungarian text. Bilingual banknotes were only introduced in 1880 (Chart 5-50, 5-51).

— 467 —

Banks in history: innovations and crises

Chart 5-50: Hungarian side of a 5-forint banknote

Source: Móra Ferenc Museum, Szeged, Numismatic Collection.

Chart 5-51: Austrian side of the same banknote from 1881

Source: Móra Ferenc Museum, Szeged, Numismatic Collection.

— 468 —

5. The Second Industrial Revolution (1870—1914)

Hungarian language only banknotes were not issued. This is strongly connected to the struggle around the central bank question that was referred to before – it is a lesser-known fact that as a part of the Compromise negotiations, the agreement concluded in Vöslau on 12 September 1867 had a secret point on the national bank. The agreement was concluded between Hungarian Minister for Finance Menyhért Lónyay and Austrian Minister for Finance Baron Franz Becke. Point 10 of the agreement stated that until the two parts of the Monarchy conclude a new agreement on finances and make a legal decision on banknotes, the royal ministry of Hungary agreed that it would not establish an independent central bank. As the Austrian National Bank at that time was a joint-stock company officially, and it received a charter from the state that stated that the bank had a monopoly on issuing banknotes until 1877, the Austrian party did not wish to enter into negotiations about the issue of an independent central bank. The Hungarian party agreed to take the question off the table and to keep the banknotes issued by the Austrian National Bank in circulation until the end of the charter as official state currency. All public cashiers were obliged to accept these banknotes as before. The agreement also included that the Austrian National Bank takes the obligation to establish as many branches as the Hungarian ministry requires. Furthermore, it was agreed that Austrian National Bank will have the mandate to issue securities in both parts of the Monarchy. It would also be enabled to offer loans depending on the stocks and securities registered at the stock exchange. Although based on this agreement Hungarian politicians were not allowed to submit a request for an independent Hungarian central bank, they indicated as early as autumn 1866 that instead of the existing bank monopoly there is pressing need for a central bank system that meets the requirements of the Monarchy and the demand for credit better (Kövér, 1993, 197–212). Consequently, the concept of an independent Hungarian central bank appeared only in 1872 as a viable option. Accordingly, legal measures to confirm the monopoly of Austrian National Bank in Hungary are missing from the documents of the Compromise. Researchers András Cieger and György Kövér draw attention to the fact that the authentic and full text of the secret agreement has not been published to this date (Cieger, 2008, 155–159;

— 469 —

Banks in history: innovations and crises

Kövér, 1993, 197–212). Pál Danyi also investigates this topic and concludes that Point 10 of the Vöslau agreement was deleted from the draft sent to the Hungarian delegation and as such it was not debated in the parliament. Consequently, this topic became part of the Compromise only in an informal manner, and this led to conflicts later.328 Thus, in the beginning the common currency was the bilingual HungarianAustrian forint. This was replaced by the bilingual gold crown in 1892. The Austro-Hungarian National Bank was given the monopoly to issue this currency (the charter was renewed several times). The new common currency was introduced based on Acts XVII, XVIII, and XIX of 1892 and was in circulation from 2 August 1892. Starting from the switch to the gold-based currency, the Austro-Hungarian National Bank had the new task to protect the exchange rate of forint against the other gold-based currencies. At the turn of the century, a new phase started in the banking history of the Empire. By then the Austro-Hungarian National Bank was operating based on the principle of full parity and the profits were more favourable for Hungary. Moreover, the renewed charter (1900) provided more favourable conditions for the Budapest head office. From 1900 onwards, the gold crown was the only official currency of the Monarchy (Charts 5-52 and 5-53). Similarly to previously issued banknotes the common currency was a symbol of one of the strong foundations of the economic unity of the Empire. The common currency facilitated the flow of Austrian capital to Hungary, with its positive and negative consequences. However, as a drawback of the common currency in some cases Austrian big businesses were preferred to Hungarian credit stocks by the Austro-Hungarian National Bank. This disadvantage was generally perceptible in crisis situations when capital was scarce.

328

h ttps://www.artortenet.hu/index.php/arak/item/195-kiegyezes-apenzpolitikaban#_ednref12

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5. The Second Industrial Revolution (1870—1914)

Chart 5-52: Austro-Hungarian 100-crown coin from 1908

Source: www.fokusz.info

Chart 5-53: 100-crown banknote

Source: hu.wikipedia.org

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Banks in history: innovations and crises

During World War I, the bank was under considerable pressure to use the tool of monetary extension to finance the war. Although the bank was privately owned, its charter had to be renewed every 10th year. Thus, the government was able to get what it wanted and by the end of the war the amount of currency in circulation was 10 times more than the amount in circulation in the last year of peace. Based on an agreement concluded with Austria during the war, the currency circulation of Hungary was managed by the Austro-Hungarian National Bank even after the war, until 1919. During the last months of 1918 the Monarchy disintegrated and the management of the bank started negotiations with the governments of the new countries about upholding the monopoly of issuing common coins and banknotes. The new states of the former Monarchy, however, identified the Austro-Hungarian National Bank as a remainder of the oppressive Empire. The states also refused to pay back the securities issued by the bank to finance the war. For this reason, the Kingdom of Serbs, Croats and Slovenes started to stamp the crown banknotes in January 1919 and refused to accept banknotes that had not been stamped. This started a chain reaction in the other states of the former Empire. In order to escape inflation, all states started to stamp the banknotes. Meanwhile occupying forces obliged Austria and Hungary to accept unstamped banknotes. Occupying Romanian forces put banknotes stamped by them in circulation in the occupied territories of Hungary. The Austro-Hungarian National Bank first declared that stamped banknotes and banknotes issued by the states are counterfeit, and tried to reject them, but the governments of the new countries ignored this step. The winners of the war soon gained control over the bank that by the end of 1919 voluntarily limited its activities to the territory of the new Austrian Republic. The Peace Treaties of Germain-en-Laye (1919) and Trianon (1920) ruled that the bank should be put under Entente supervision and liquidated. Austria and Hungary were banned from issuing a common currency. Austria and Hungary were forced to stamp every banknote in circulation and replace them with their own currency. The general assembly of the bank met the last time on 14 July 1921. The directorate met the last time on 15 December 1922 with the participation of governor Alexander Spitzmüller.

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During the period of the Hungarian Soviet Republic, banknotes were issued by Posta Takarékpénztár. Following this the banknotes issued by Posta Takarékpénztár and Austro-Hungarian National Bank remained in circulation until 1921. Then a transitional period followed from 1921 to 1924 with the operation of Magyar Királyi Jegyintézet (established in 1921). The act that established this institution clearly reflects that it was established to manage the transition. Its task was to issue the paper money (state notes) created by the state. Finally, the independent Magyar Nemzeti Bank (Hungarian National Bank) started operation in May 1924. The act establishing the bank ‘clarified that the state gives exclusive rights to Magyar Nemzeti Bank to issue state banknotes. Magyar Királyi Jegyintézet was liquidated. Its state note circulation and giro account debt was taken over by the bank, and this would become state debt owed to Magyar Nemzeti Bank’ (Kálniczkyné, 2009, 11).

5.4.4. Economic evaluation of the period of Dualism Austria-Hungary was more than a simple customs union. It operated as a dynamically developing common market with complete monetary integration and a partial tax union. Furthermore, the implementation of the Compromise in the field of business ensured the complete and free movement of production factors, capital and labour between the two units of the Monarchy. From a monetary perspective, Austria-Hungary was a fully integrated area with a common currency, but from the perspective of the budget it was only a partial tax union. Although the agreement of the two parties recognised that –besides a simple common customs – there is a need for the coordination of taxes (consumption taxes) no attempts were made to harmonise common expenditures. This failure had the strongest (and negative) effect on the flow of capital. The framework of the operation and the actual results of the bureaucratic state within the empire regarding finance is a field that has not been studied yet. Furthermore, it is not surprising that at the birth of the Dual Empire the two most debated points of the negotiations that led to the ‘economic compromise’, the commercial and customs alliance of the two states of Austria-Hungary were the following: how to split the considerable debt and how to contribute to common areas (the ‘quota’ question). One of the

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provisions of the agreements on the economy put a direct limit on the amount of loans that could be taken out from the Austrian National Bank and clearly defined the limits of creating money. Consequently, both governments had to observe the rules of capital markets and budgetary deficits could only be increased up to the point where depositors would still be willing to finance it. Hungary followed the Austrian example in offering a guarantee on returns for railway building private enterprises. However, this was soon replaced by nationalisation and a comprehensive programme to create an extensive state-owned railway network. One third of the loans taken out were spent on investments that developed the economy. Thus, the government was not forced to impose heavy taxes. Consequently, the state pursued an active monetary policy that was designed not to limit the business dynamics of the private sector. Actually this was also evident in the fact that by selling state bonds (primarily to the Austrians) a fundamental goal of the financial policy of the government was to secure the constant influx of capital. Hungarian government continued the policy of actively facilitating economic and financial development even after the slowdown of capital influx in the 1890s, although with less spectacular results. At the same time the central government of Austria, following the extension of suffrage (1907), put an increasing emphasis on the harmonisation of the significant differences in the standard of living of the nations that are living in the Empire (for example large-scale public works, construction of channels and other infrastructure development programmes). The considerations of nationalities became increasingly important. This investment strategy was visible even in railway developments: taxes collected in the richer provinces and regions populated by Germans, Czechs, and Italians were directed to the more underdeveloped eastern and southern Slavic regions. Galicia and the support of the ‘Polish club’ is a vivid example. Based on this we can draw the conclusion that the central and primary goal of the Hungarian budget was to maximise growth; at the same time Austria followed an economic policy that used its budgetary surplus to invest in the lesser developed regions for convergence reasons. The period showed an exceptional performance in building a system of cultural institutions and an effective system of education and in achieving a significant improvement in the literacy and education of the population.

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Attempts to reform the system of Dualism that survived both economic crises and upturns generally failed because of the bureaucracy that also included the aristocracy. The ‘years of happy, common peace’ were ended by the realignment of power relations and World War I. The question if the economic compromise laid the foundations of the economic growth of the Monarchy and Hungary, the ‘merry times of peace’ is still a subject of intense debate. It is a fact that Bohemia was a simple, subordinated province of the Empire, yet its development matched that of Hungary. Nevertheless, Bohemia failed to reach a political compromise with Vienna. It is also true that the second half the 19th century was a period of industrial revolution, a period of the boom of the banking system and credits everywhere in Europe.

Key terms Austro-Hungarian Compromise Bank operating as a joint-stock company (Aktienbank) Big bank (Großbank) Bank of issue (Notenbank) Clearing house Common finances Credit cooperative (Kreditgenossenschaft)

Federal Reserve (Fed) Mortgage bank (Hypothekenbank) Paper money People’s bank (Volksbank) Private bank (Privatbank) Savings bank (Sparkasse) Second Industrial Revolution Universal bank

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Internet sources of charts and tables Chart 5-2: Source: https://www.allaboutlean.com/industrial-espionage-and-revolution/ Chart 5-3: Source: https://upload.wikimedia.org/wikipedia/commons/thumb/e/e9/Deutscher_Bund.svg/1014px-Deutscher_Bund.svg.png Chart 5-4: Source: https://www.metzler.com/en/metzler-en/bank/history Chart 5-5: Source: http://www.wikiwand.com/de/A._Schaaffhausen%E2%80%99sches_Bankpalais Chart 5-6: Source: https://commons.wikimedia.org/wiki/File:Atlantes_Franz%C3%B6sische_ Stra%C3%9Fe_Berlin.JPG Chart 5-7: Source: https://upload.wikimedia.org/wikipedia/commons/thumb/d/d5/Deutsches_Reich_%281871-1918%29-de.svg/2000px-Deutsches_Reich_%281871-1918%29-de.svg.png Chart 5-8: Source: https://upload.wikimedia.org/wikipedia/commons/5/50/Borsig_1847.jpg Chart 5-11: Source: https://www.dsgv.de/de/fakten-und-positionen/sparkassenzeitung/170412_sz_200_Jahre.html Chart 5-13: Source: https://upload.wikimedia.org/wikipedia/commons/2/21/Hermann_Schulze_%28Delitzsch%29.JPG Chart 5-14: Source: https://upload.wikimedia.org/wikipedia/commons/c/c7/FW_Raiffeisen. jpg Chart 5-15: Source: https://upload.wikimedia.org/wikipedia/commons/thumb/1/13/Giebelschmuck_Mecklenburg-Vorpommern_Pferdek%C3%B6pfe.JPG/800px-Giebelschmuck_Mecklenburg-Vorpommern_Pferdek%C3%B6pfe.JPG Chart 5-16: Source: https://commons.wikimedia.org/wiki/File:Reichsbank_berlin_jaegerstr.jpg Chart 5-17: Source: https://upload.wikimedia.org/wikipedia/commons/e/e0/100_Mark_1908_ front_01_09.jpg https://commons.wikimedia.org/wiki/File:100_Mark_1908_front_01_09.jpg#/media/File:100_ Mark_1908_back_01_09.jpg Chart 5-18: Source: https://de.wikipedia.org/wiki/Province_of_Massachusetts_Bay Chart 5-19: Source: https://en.wikipedia.org/wiki/King_William%27s_War#/media/File:King_williams_war.svg Chart 5-20: Source: http://www.worldbanknotescoins.com/2014/10/ Chart 5-21: Source: https://www.bellevuerarecoins.com/wp-content/uploads/2016/04/ franklin-bill-1739.jpg Chart 5-22: Source: https://en.wikipedia.org/wiki/United_States_dollar#/media/File:Continental_Currency_One-Third-Dollar_17-Feb-76_obv.jpg

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5. The Second Industrial Revolution (1870—1914) Chart 5-23: Source: https://upload.wikimedia.org/wikipedia/commons/d/d1/First_Bank_of_ the_United_States.jpg Chart 5-24: Source: http://thesaltysailor.com/rhodeisland-philatelic/rhodeisland/commercial/ Farmers-Bank-1808.jpg Chart 5-25: Source: http://thesaltysailor.com/rhodeisland-philatelic/rhodeisland/commercial/ Tiverton-Bank-1857.jpg Chart 5-26: Source: https://upload.wikimedia.org/wikipedia/commons/0/07/Second_Bank_ of_the_United_States_front.jpg Chart 5-27: Source: http://www.us-coin-values-advisor.com/the-mint-branches-out.html Chart 5-28: https://hu.wikipedia.org/wiki/F%C3%A1jl:Panning_on_the_Mokelumne.jpg Chart 5-29: Source: https://hu.wikipedia.org/wiki/Kaliforniai_aranyl%C3%A1z#/media/File:Gold_seeking_river_operations_California.jpg Chart 5-30: Source: https://hu.wikipedia.org/wiki/Kaliforniai_aranyl%C3%A1z#/media/File:Quartz_Stamp_Mill.jpg Chart 5-31: Source: (The photo had to undergo restoration. Andrew J. Russell, Public Domain, with the use of Wikimedia Commons, St. George News): https://www.stgeorgeutah.com/ wp-content/uploads/2017/04/2048px-East_and_West_Shaking_hands_at_the_laying_of_last_rail_Union_Pacific_Railroad_-_Restoration.jpg Chart 5-32: Source: http://www.worldbanknotescoins.com/2014/10/1914-one-hundred-dollarfederal-reserve-note-blue-seal.html Chart 5-33: Source: https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm Chart 5-34: Source: https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm Chart 5-36: http://mek.oszk.hu/01900/01905/html/index137.html Chart 5-37: Source: http://slideplayer.hu/slide/11362108/ Chart 5-38: Source: http://slideplayer.hu/slide/2039557/ Chart 5-39: Source: http://www.mozaweb.com/Lecke-TOR-Tortenelem_7-Gyorsan_fejlodo_iparagak-101984 Chart 5-40: Source: http://www.mozaweb.com/Lecke-TOR-Tortenelem_7-Gyorsan_fejlodo_iparagak-101984 Chart 5-41: Source: http://slideplayer.hu/slide/2039557/ Chart 5-42: Source: http://mandiner.blog.hu/2008/05/09/miert_jo_a_globalizacio_magyarorszagnak

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Banks in history: innovations and crises Chart 5-43: Source: https://de.wikipedia.org/wiki/Gr%C3%BCnderkrach#/media/File:Schwarzer_Freitag_Wien_1873.jpg Chart 5-45: Source: http://slideplayer.hu/slide/11177179/ Chart 5-46: Source: http://www.innoteka.hu/cikk/innovaciok_a_magyar_vasut_torteneteben.1410.html Table 5-10: Source: http://multunk.com/index.php?title=A_t%C5%91k%C3%A9s_hitelszervezet_kialakul%C3%A1sa Table 5-11: Source: http://docplayer.hu/2315148-Gazdasagi-eredmenyek-a-dualista-magyarorszagon-tetel-10-05.html Table 5-12: Source: http://slideplayer.hu/slide/2106860/ Chart 5-47: Source: https://www.oenb.at/Ueber-Uns/unternehmensgeschichte/200-jahr-jubilaeum/historische-zahl/289-bankplaetze.html Table 5-13: http://slideplayer.hu/slide/2106860/ Chart 5-48: Source: http://www.mvkkvar.hu/kiallitas/szecesszio/04jegyek/magyarallamkincstar.php Chart 5-49: Source: http://www.mvkkvar.hu/kiallitas/szecesszio/04jegyek/magyarallamkincstar/19000916.html Chart 5-50: Source: http://monetarium.hu/100-forint-1880-pap%C3%ADrp%C3%A9nz-ferencj%C3%B3zsef Chart 5-51: Source: https://www.the-saleroom.com/ Chart 5-52: Source: http://www.fokusz.info/index.php?cid=1285654298&aid=1230243413 Chart 5-53: Source: https://hu.wikipedia.org/wiki/Osztr%C3%A1k%E2%80%93magyar_korona

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The Third Industrial Revolution (1918—1939), the era of delayed and interrupted development István Papp – Beáta Szabó – Ákos Urbán – Bence Varga329

World War I shook the leading European countries, which then struggled with all their power to get their economies back on their feet in the years following the war. Implementation of the Dawes Plan played a key role in restoring Germany’s solvency and was able to place the German economy on an upward path. Meanwhile, robust economic growth was occurring overseas: in the United States production was steadily increasing and stock markets were flourishing. The economy was connected to the stock market in innumerable ways, so when the stock market crash hit, it dragged down the entire economy, and trust in financial institutions was fundamentally shaken. In the USA, the Great Depression led to high unemployment and a major decline in incomes. The new president, Roosevelt, saw the solution in strengthening state involvement in free market mechanisms. Through large-scale infrastructure investments, the economy got moving again and the purchasing power of the population also started to increase. The strategy, known as the New Deal, set the US economy on an upward path, lowered unemployment and significantly boosted consumption. In addition to economic policy, major developments in bank regulation were taking place during this period. At the beginning of the 20th century, the US central bank – the Federal Reserve (Fed) – was set up, which by virtue of its central bank mandate provided the lender of last resort function, with a positive effect on The authors here express their thanks to Dr Gábor Izsák for preparing the subchapter on the development of the deposit insurance system of the United States of America, and to Zoltán Bögöthy for preparing the box entitled ‘State assistance during the pre-World War II banking crises’.

329

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growth in lending; furthermore the Federal Deposit Insurance Corporation Act entered into force on 1 January 1934, which insured 98 per cent of depositors. Successful crisis management generated spectacular economic results in the United States, which helped the USA to strengthen its position in the world. The great improvement in economic performance also had a major impact on the development of the US banking sector. After World War I, US banks secured a foothold in Europe, Latin America and the Far East as well. They played a key role in financing European reconstruction and the internationalisation of the New York Stock Exchange. The events of the early 20th century disrupted the system of the gold standard, and the emergence of nationalism and protectionist economic policy disorganised the forms of international economic co-operation. During the years of the Great Depression, the role of government intervention in terms of mitigating market economy failures became more significant. With the devaluation of US dollar and the revaluation of gold, in 1934 government intervention helped to stabilise the dollar’s exchange rate. As a result, significant amounts of capital started flowing to the USA, and foreign trade thrived again. A few years later, the USA played a key role in restoring the gold standard, the framework of which was set out at the 1944 Bretton Woods Conference. The impact of the Great Depression was less felt by the British economy and banking system, but the strengthening nationalism and protectionism dramatically reduced foreign trade, which negatively impacted the country’s export performance and broke the centuries-old hegemony of British banks. Between the two world wars, the British economy and banking system performed much better than continental European countries and their banks, but even England could not stop the rise of the United States. During these years, the USA continued to reinforce its economic and financial position in the world, which led to the suppression of British positions in many cases. After the First World War, Germany’s economy plunged into a deep crisis, and under the burdens of the defeat, it collapsed within a few years. German banks also had to contend with the effects of hyperinflation, which significantly depreciated their capital. The merger of large banks and the acquisition of small banks resulted in the consolidation of the credit institution sector. Struggling with serious financial problems, Germany tried to fight the crisis using a number of instruments, but

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as foreign loans dried up it was only able to access new resources through gold sales. However, the country’s gold stock had decreased sharply, due to the massive reparations. As to the USA, after a few years of persistent efforts, it was able to overcome the crisis, but Germany took a markedly different path. Finally, Europe’s major emerging power came out from the crisis by executing a war-money policy. After 1933, both economic policy and financial policy served the cause of war preparations. The capital of Hungarian credit institutions also fell significantly in the wake of World War I. In addition, the redrawing of the borders under the Treaty of Trianon significantly transformed the financial system, as some 60 per cent of the credit cooperatives then belonged to neighbouring countries. Thus, a significant portion of the deposits and loans were concentrated in Budapest. The National Bank of Hungary was established in 1924, which set the primary objective of achieving and maintaining price stability. The central bank played an important role in the Hungarian economy during the crisis, one result of which was the stabilisation of the purchasing power of the pengő.

6.1 Changes in the world economy after the war World War I was an important milestone in history as it fundamentally changed the economic development of leading countries. Until the turn of the century, the dominance of Great Britain was indisputable, mainly because of its strong economic influence, its extensive colonial system and its prominent role in culture. The war, however, changed the previously established power relations in Europe. Significant expansion of armaments and military capabilities caused an economic shock to the warring countries. Depletion of reserves and the large number of war casualties caused serious damage to the dynamics of production and hampered further economic growth. At the same time, the United States became a major economic power overseas. The USA not only played a key role in winning World War I, it also was a major force in the peace talks. As the war had not affected the territory of the United States, the American economy started to develop dynamically, the

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main sectors of which were telecommunications, the construction industry and automobile manufacturing. As a result of wartime military shipments, the arms industry grew as well, which also had a positive impact on the country’s economic growth. The number of casualties in World War I and the material and physical damage was enormous around the world. While the economic consequences were mainly concentrated in Europe and primarily in Germany, these events significantly influenced the course of economic developments in the USA as well. Huge military expenditures in Europe led to massive debt accumulation. In turn, the weight of high indebtedness and reparation measures pushed the major loser of the war, Germany, towards the direction of short-term loans provided by the USA, which further increased the amount of US loans extended during the war. After the war, the victorious powers obliged Germany to pay reparations. During the military struggle, Great Britain and France had suffered significant financial damage which they wanted to settle through German reparations. However, German reparation payments faltered because Germany was economically exhausted by the war: its reserves had run out and the country had suffered a significant loss of population, so the reorganisation of the economy was difficult (Costigliola, 1976). The shaky solvency of Germany, however, hindered not only European reconstruction, but also significantly affected the performance of loan repayments to the USA (Chart 6-1). To solve the problem the Reparation Commission developed the Dawes Plan,330 which was approved by the German Government. With the help of the plan, German solvency was restored and the economy started to grow.

330

harles G. Dawes (1865–1951), American banker, politician. In 1925, he received C a Nobel Peace Prize for promoting European economic reconstruction. Between 1925 and 1929, he was Vice President of the United States.

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Chart 6-1: Financial dependencies after the World War I

USA

credit repayment

lending

reparation transfer France, Great Britain

Germany

Source: Authors’ own compilation.

After the easing of tensions involving reconstruction in Europe and reparation payments, rapid economic development began in Europe as well as in the USA, which was the main lender of the Continent. Industrial and agricultural production expanded significantly, but this was not followed by an expansion of demand, which soon led to the accumulation of unsold supplies and overproduction. Due to the extremely fast-paced growth unfolding in the USA, the world was drifting towards an economic crisis.

6.2 The Great Depression — In the trap of overproduction and overlending After World War I, the map of Europe changed considerably: old empires (the Austro-Hungarian Monarchy, the Ottoman Empire, the Russian Empire) were dissolved and new sovereign states (Czechoslovakia, Estonia, Finland, Latvia, Lithuania, Poland and Yugoslavia, among others) were created. Due to World War I and the Treaty of Trianon, Hungary lost one-third of its population

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and two-thirds of its territory. The division of labour within the Monarchy collapsed, and almost every successor state inherited a unilateral economic structure. With the rise of nationalism and the emergence of ideas of economic isolation, more and more countries introduced protective tariffs. This era was characterised by intensifying war fears and the spread of isolationist policies, which strongly hindered the exploitation of the potential arising from the strengthening of international economic relations. The origin of the 1929 crisis was mainly overproduction and overlending. On the one hand, economic growth was only observed in certain sectors (construction industry, telecommunications, automobile manufacturing); on the other, the unequal distribution of purchasing power was continuing to widen. Due to the war, as a serious consequence of the large price drop, the level of indebtedness had been rising continually in agriculture, especially among grain producers. Agro-industrial producers wanted to compensate for the price decrease with volume increases, but to increase production they had to raise large amounts of mortgage loans. At the same time, due to further decline in sales prices and the accumulation of unsold supplies, the proportion of non-performing loans increased sharply. The 1929 economic crisis was caused in part by the unfavourable developments in agricultural production, and it was here that the first foreboding signs appeared.331 In addition, the interest rate policy of the Fed also played a part in the escalation of the crisis, as in the 1920s it kept interest rates low against inflation, which further strengthened the decline in prices, i.e. deflation (Polányi, 2004). As a result of the rapid economic growth and overlending, the stock market took off on the New York Stock Exchange. During this period, 4 million out of 331

hanks to modern technology, world grain production was growing rapidly. In T the USA, more and more land was placed under cultivation where they produced more and more grain. With the construction of railways, Canada, Argentina and Australia also offered their grain surplus for sale on the world market. Moreover, the Soviet Union also tried to acquire foreign currency through grain sales. All of this resulted in too much grain entering the market compared to demand, and subsequently prices began to fall.

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120 million American citizens had share investments. The banking sector was closely linked to the stock market through the financing of equity purchases and through the financing of industrial developments (Kaposi, 2004). The Dow Jones stock index332 reached its peak in 1929 and then dropped by 90 per cent in the next three years (Chart 6-2) (White, 1990). In 1929, to restrict lending the Fed tightened its monetary policy and raised the base rate, as a result of which stock prices stopped rising and then plunged. Monetary policy intervention therefore had a significant impact on asset price volatility, resulting in serious consequences (Bernanke-Gertler, 2000). Due to the plunge in stock prices, investors on the stock market panicked, followed by massive sales. In turn, the rising sales led to further stock price declines. On ‘Black Thursday’, the stock market collapsed, resulting in a great deal of distrust for the financial sector. Chart 6-2: Development of the Dow Jones stock index 400

Points

400

1945

1943

1941

1939

1937

50 1935

50 1933

100

1931

100

1929

150

1927

150

1925

200

1923

200

1921

250

1919

250

1917

300

1915

300

1913

350

1911

350

Development of the Dow Jones stock index Source: Yahoo Finance. 332

he index, indicating the average stock market prices of the top 30 publicly owned T US companies, is linked to the names of the American journalist Charles Henry Dow and the statistician Edward Davis Jones. Dow and Jones initially dealt with issuing handwritten newsletters in a news agency, and later they averaged stock prices, from which the Dow Jones Industrial Average Index was born in 1896.

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Within a few days the stock market crash paralysed the banking sector, as thousands of American banks became insolvent. Bank crises erupted throughout the United States: between 1929 and 1933, roughly 11,000 out of 25,000 banks became insolvent. In the event of a banking crisis or looming insolvency, credit institutions suspend the performance of their existing obligations. The collapse of the stock market also had a negative impact on the credit market, where a credit crunch occurred, which was immediately felt by economic actors. Trade and investments declined, the unemployment rate rose from 2 per cent to 24 per cent, and confidence in the financial sector fell to an all-time low. The troubled American banks tried to get their money as quickly as possible by early termination of loans, and this had an impact on Europe as well, because Great Britain, and Germany in particular, were heavily indebted. By now, the consequences of the crisis were felt not only in the USA but throughout the world. World trade shrank by almost one half,333 industrial production declined by 50 per cent in North and South America, by 35 per cent in Europe and by 10 per cent in Asia. The aftershocks of the crisis were felt even until the 1940s. At the same time, the crisis had a major impact on the development of economics as it revealed fundamental macroeconomic relations. It became evident that monetary policy tools significantly influence the real economy even in a dramatically changed macroeconomic environment. It was also recognised that central banks play an important and very active role in dealing with crises (Bernanke, 2000). Until the start of the Great Depression, the state stayed away from influencing market mechanisms, but the above events necessitated government intervention and changes in laws regulating the operation of banks (Bánfi, 2016). Thus, the state entered the field of banking regulation. 333

etween 1929 and 1934, Chile’s export performance fell the most (more than 80 per B cent), compared to which the decline in Chinese exports was somewhat milder (7580 per cent). The exports of Argentina, Mexico and Brazil also fell significantly (6075 per cent). The rate of decline in exports also exceeded 60 per cent in Hungary, Poland and Yugoslavia.

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6.3 The New Deal: the government enters the scene –in the banking sector as well! In 1933, when the new President of the USA took office, he faced a complex problem that could not be solved by conventional means. During the years of crisis, a large part of the American population was impoverished, even though the economy was characterised by overproduction. At the worst point of the crisis, almost 12 million people (i.e. 24.1 per cent of all economically active persons) were unemployed in the USA (Table 6-1). In addition, half of the employees were part-time workers, which meant a significant loss of income. Three-quarters of the businesses had become unprofitable, which is well illustrated by the fact that in 1929, Ford employed 120,000 workers at the Detroit factory, in the centre of automotive industry, but by 1931 it was only 37,000. Construction industry performance contracted by 82 per cent, and industrial production fell by 42 per cent in this period. Most financial sector actors faced operational difficulties in the absence of public confidence. As a result of this and the nearly 40 per cent devaluation of the US dollar’s value, many moved their savings abroad. Table 6-1: Selected indicators of the US economic crisis 1929

1932

Gross national product (USD billions)

103.0

58.0

Farmers’ cash income (USD billions)

11.3

4.7

Unemployment rate (%)

3.2

24.1

Number of unemployed (millions)

1.5

12.0

Source: Kaposi (2004).

Democrat Franklin Delano Roosevelt came to the US presidency in the depths of the recession, and after his inauguration he approached the problems in a completely new way. His idea was based on the following: people are buying less because they do not have enough income, so entrepreneurs cannot sell their products, consequently they have to reduce production, which requires a smaller workforce. The income of laid-off or part-time workers is reduced,

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and thus they were able to buy less. Market actors were unable to break out of this vicious circle on their own. Overall, the decline in aggregate demand was mainly due to the worldwide contraction of the money supply (Bernanke, 2000). At the beginning of 1933, Roosevelt gathered the professors of Columbia University who advised the president that the government should assist market mechanisms. The state could artificially maintain sufficient demand by means of fiscal instruments, such as infrastructure investments, as a result of which the economy would approach the equilibrium and unemployment would also decline. It is worthwhile to do this even if uncovered expenses result in a budget deficit: this can be counterbalanced by cutting public spending during the recovery period. British economist John Maynard Keynes – one of the greatest economic thinkers of the 20th century – had just been working on the book that proved the effectiveness of government intervention also on a theoretical basis. His student, Baron Kahn, conveyed Keynes’ professional advice to the president. Roosevelt understood Keynes’ proposal because he had outlined a real alternative for finding a solution. According to the proposal: with the rapid development of technology, the American economy could produce far more products than customers could buy, so the solution was not to reduce production but to increase the purchasing power of the population. Therefore, it was not the big business men and banks who could pull the economy out of the crisis, but the ‘ordinary people’ of America. As part of Roosevelt’s electoral platform, the New Deal economic programme contributed greatly to the recovery from the recession. In the first hundred days of his presidency, Roosevelt took emergency measures to stabilise and jump-start the economy. One of the most important measures among the more comprehensive ones was the National Industrial Recovery Act. In 1933, as a first step, the new president called a nation-wide four-day banking holiday, during which he had the Emergency Banking Act adopted specifically for crisis management. This made it possible to prevent the mass withdrawal of bank deposits and prevent gold from being exported from the country. As to

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the reopening of the banks, the Act made this subject to prior authorisation by the Secretary of the Treasury, thus preventing weak banks from being reopened (Chart 6-3). Chart 6-3: Number of bank suspensions between 1921 and 1933 3,000

Number of suspensions

Number of suspensions 5,190

3,000

2,500

2,000

1,500

1,000

500

1933

1932

1931

1930

1929

1928

1927

1926

1925

1924

1923

1922

1921

500 0

National Banks All banks

Source: Bremer (1935).

The key to recovery was adjusting agriculture and industry and increasing infrastructure investments. On the basis of the Agricultural Adjustment Act, they ordered the reduction of cultivated areas and livestock, which aimed to restore crop prices to an acceptable level. The farmers affected were compensated for loss of income. The sown area of wheat thus declined from 23.4 million hectares in 1932 to 19.8 million hectares in 1936. Due to this and the poor yields of 1935–1936, wheat production fell by about 20 percent. Farmers were granted a moratorium on payment of their debts. With government intervention, new investments were needed that could create new jobs but without their products being placed on the already overcrowded market (roads, highways, airports, services). One of Roosevelt’s reform ideas was the establishment of the Civilian Conservation Corps.

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Unemployed young people could apply to this organisation and were provided with free meals, accommodation, a uniform and one-dollar of spending money per day. They lived in camps led by army reserve officers. They planted forests, built roads and bridges, created parks and did soil amelioration work. An attempt was made to eliminate unemployment by launching a public work programme, with one of the most significant investments being the Tennessee Valley Authority Act, a complex utilisation plan for the Tennessee River Valley. The measure created a prosperous economy throughout the valley with the construction of hydroelectric power plants and irrigation canals. Until the outbreak of World War II, about 3 million young people worked in the Civilian Conservation Corps. The National Labor Relations Act (Wagner Act), which came into force in 1935, provided labour unions with the right of establishment, regulated minimum wages and the upper limit of working hours as well as made provisions for pensions and unemployment benefits. These allowances helped to stabilise the purchasing power of the population. Although a significant portion of the New Deal was classified as unconstitutional in 1935, President Roosevelt managed to lead the USA out of one of the most serious economic crises in history. In the 1930s it was not the policy based on the wealth of the few, but a strategy built on mass consumption that saved the world from the serious economic collapse and the turmoil of democracy in the USA. Following the US pattern, most countries recovered from the crisis through state intervention. This was a shift in the world economy as well: government interventions in market economies became permanent. In most European countries, it was also only the state which could solve the banking crises. For this reason, many large banks in France, Germany, Austria and Italy became government-owned. In Europe, Great Britain was the first to leave the gold standard system (1931), and then by devaluing the British pound it restored the international competitiveness of its industry, which had a positive impact on the economy. With a slight delay, Scandinavian countries followed the example of England. The recipe also worked for them, and thus economic rejuvenation in these countries started much sooner and the consequences of the crisis were milder than where a different policy was

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chosen, since the worldwide deflation in the late 1920s and early 1930s was caused by poor management of international economic problems within the gold standard system (Bernanke, 2000).

6.4 Regulatory consequences of the Great Depression: bank regulation in the USA Modern banking regulation started in the USA, where banks were already obliged to meet certain capital requirements in the 19th century. In terms of the functioning of the banking system, one of the most important steps was taken in the early 20th century, after the banking panic of 1907, since at this time the Federal Reserve (Fed) was set up. Originally, the Fed was to provide the lender of last resort function for banks, to prevent contagion within the banking system. The ‘lender of last resort’ role of the central banks can be interpreted as an institutionalised form for restoring confidence in the banking system using state resources. In the event of liquidity crises and bank runs, central banks came to the aid of troubled financial institutions. With the emergence of the lender of last resort function, credit institutions could be more confident in lending, and the creation of bank credit could, to some extent, deviate from the reserve constraints. However, central banks later gained substantial influence in the area of lending by regulating the compulsory reserve ratio. From the point of view of the development of banking systems, the answers to the consequences of the Great Depression of 1929–1933 are also to be considered an important milestone, especially in the USA. Following the outbreak of the Great Depression, in 1933 the new Banking Act – bearing the names of Carter Glass and Henry Steagall – was adopted, which separated commercial and investment banks: with this change, they wanted to avoid the creation of excessively large financial conglomerates. As a result, commercial banks had to sell or dismantle their investment and securities trading companies (Botos, 1996). The primary purpose of the Act was to restore confidence in the banking system and therefore it dealt with the possibilities

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of managing a potential banking crisis. Despite the provisions of the law, however, financial actors could circumvent the barrier between investment and commercial banking in several ways. Nevertheless, the Glass-Steagall Act remained in force until 1999 (see Chapter 10 for details) when as a result of the financial deregulation sweeping through the world, US financial sector actors also were able to attain the legislative power to ease the rigors of financial regulation (Biedermann, 2012).

6.5 Early development of the US deposit insurance system The origin of deposit insurance is frequently linked to the establishment of the US Federal Deposit Insurance Corporation (FDIC) in 1933. A less known fact is that much earlier, several state governments had already introduced a variety of deposit insurance systems, so when the federal government decided to introduce reforms covering all state banks in the United States, the legislators had a good basis to work with.

6.5.1 Roots of the deposit insurance system In the years following the founding of the USA in 1789, it seemed unthinkable for citizens using banking services that a credit institution could become insolvent, until in 1809, when customers of the Gloucester Farmers’ Exchange Bank experienced that such things do happen. The collapse of Farmers’ Exchange Bank was followed by several other bank failures in the coming years, prompting legislators to find a novel solution to protect customers and restore confidence in the financial sector. In 1829, New York was the first state to introduce an early form of a deposit insurance system, but it would be incorrect to say that this innovation appeared out of nowhere. Development and promotion of the programme was linked to the name of Joshua Forman, a businessman who through his business transactions learned about the contemporary regulation of Hong

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merchants of Canton. The essence of this was that Hong merchants, in order to do business with foreigners, were obliged to apply for a type of trading license from the government. On the one hand, the license monopolised their business, as they had exclusive right of entering into transactions with foreign traders, but on the other hand it obliged them to be jointly and severally liable for the obligations of a trader in distress if any trader became insolvent. In line with this regulation, Forman’s plan contained the following main elements: 1. an insurance fund must be established to which each credit institution must pay a contribution; 2. the fund must have professionals supervising the activities and business process of banks; 3. it is necessary to determine the types of investment in which banks can hold their capital. New York State Governor and later President Martin van Buren embraced Forman’s idea, realising that maintaining trust in the financial sector required consistent government regulation, and he was even convinced that the fact that money held in New York banks would be protected from market turbulences and would give them a competitive advantage over credit institutions in other states. In fact, the New York Safety Fund was established that year as an independent institution with an adequate organisation. Regular contributions for provisioning the fund were to be settled by the banks in six annual instalments until this contribution reached 3 per cent of their capital. If the resources of the fund were exhausted, it was also possible to decree payment of an extraordinary contribution. All credit institutions renewing their operating licenses and institutions obtaining new banking licenses were required to contribute to financing the fund, and in return, their clients were fully protected for both their deposits and the banknotes issued by the bank if a credit institution was placed under liquidation. Administration of the fund was placed in the hands of three commissioners, who conducted a quarterly inspection of banks and were given powers to turn to court if any violation of statutory standards was detected. The New York system was promising, but failed in its first run. In 1837, a banking panic broke out once again, resulting in the failure of eleven credit institutions. The fund should have paid $2.5 million for full compensation, but

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even with the full provision level it had only $150,000 at its disposal. Following the failure of the system, state legislators amended the legislation to allow banks to withdraw from the fund, which, after the last bank left it, ceased to exist in 1866. Despite the failure, several other member states adopted the New York model, and thus Vermont, Indiana, Michigan, Ohio and Iowa introduced the key elements of the regulation, but after the Civil War all of the insurance systems disappeared (Grant Jr., 2012).

6.5.2 The first deposit insurance systems After 1866, the individual states stopped implementing large-scale plans to reform the security of the banking system operation independently, basically because they believed that previous bank crises were mainly due to banknotes issued by the credit institutions. However, after the Civil War, only newly established national banks were allowed to issue banknotes and a tax was imposed on previously emitted banknotes. Coverage of new banknotes was no longer dependent on the solvency of a bank or its reliability, as all banknotes were covered by government bonds and in addition the Treasury of the United States provided a direct guarantee for payment. As a result of the reforms, customers turned to bank deposits, the stock of which was rising rapidly because of the new regulations. However, the dispute surrounding deposit protection systems did not calm down; as early as 1886 draft legislation came before the US Congress on the introduction of a national deposit insurance system, but it was not adopted. However, the 1907 banking crisis once again drew attention to the protection of bank customers’ money, and as a consequence several individual states came up with their own deposit insurance plans. After the Civil War, Oklahoma was the first state which tried to find an answer to the challenges stemming from banking crises: in December 1907, the state legislature decided to establish a deposit insurance fund to help in case of bankruptcy of state banks. On the basis of the initial plans, credit institutions

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

were required to pay in an amount equivalent to 1 per cent of the deposits, but later this obligation was increased by a supplement to 2 per cent. The Oklahoma model also had followers, and in ten years, seven other states had adopted similar regulations. It is unfortunate that, like the systems introduced before the Civil War, this system did not stand the test of time. The agricultural difficulties of the 1920s triggered more and more banking crises, and by 1933 all of the deposit insurance systems presented before became insolvent or ceased for other reasons (FDIC, 1998).

6.5.3 Establishment of the FDIC Between 1921 and 1929 more than 600 credit institutions collapsed, i.e. nearly ten times more than in the previous decade. The overwhelming majority of the collapsed banks were small, local credit institutions whose failure was due to poor management. However, the massive failure of credit institutions made it even more difficult to establish a national deposit insurance system because many in Congress believed that the closure of unviable banks would only strengthen the banking system. At the same time, customers reacted sensitively to the failure of small banks and they exchanged an increasingly significant part of their bank deposits for cash, which further deepened the crisis, and even the Federal Reserve could not provide sufficient liquidity to the banking system. In April 1932, with Representative Henry Steagall’s encouragement, the process of enacting the concept of modern deposit insurance was completed but as before, the way to achieve the goal was not easy. Since as early as 1886, it had been a recurrent question as to whether the protection of depositors should be raised to the federal level. Due to political deals, however, these initiatives failed over and over again. By the time that the final draft bill came to President Roosevelt’s table, Congress had already rejected 150 proposals. This resistance was contributed to strongly by the fact that states where the banking system was less regulated and assumed high risks may have profited significantly from the federal system, but at the same time the low-risk states did not want to cover the burden of regulatory deficiencies in other states.

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In Congress, opponents of deposit insurance were still in the majority. For the representatives, it was unimaginable that such a system could work, since previous ones had failed after one another and they found it very costly to maintain the system. Moreover, President Roosevelt also found it dangerous to set up a guarantee fund. He believed that such a plan may carry an immeasurable moral hazard, encouraging weak banks to have a careless attitude, which therefore could jeopardise the viability of strong credit institutions. Actors in the private sector also raised their voice against the possible introduction of a guarantee fund, and the President of the American Banking Association even called the idea scientifically unjustified and dangerous. At the same time, Representative Henry Steagall fought tirelessly for it. The existence of modern deposit insurance is due in no small part to the fact that he was able to singlehandedly convince the overwhelming majority of the House of Representatives of the undisputed benefits of the system. Carter Glass, Chairman of the Senate’s Banking and Currency Committee, however, still did not consider the proposal viable, largely because of the inefficiency of past attempts. Nevertheless, he himself noted that social pressure was in favour of setting up a deposit insurance system and admitted that no bill would be appropriate for both the Congress and the electorate at the same time. In his view, the legislature might have never been so divided in a dispute (FDIC, 1998). In mid-May 1933, Glass and Steagall presented their bank reform package to the Senate and the House of Representatives, which already included the establishment of a deposit insurance system. The proposal also included the Roosevelt Administration’s demand for providing adequate time to set up and operate the system. The Congress, with minor arguments and proposed amendments, finally adopted the submitted proposal, which was signed by the President on 16 June 1933. Roosevelt referred to the 1933 Banking Act as the second most important legislation in the country (FDIC, 1998). With its entry into force on 1 January 1934 the new Act established the Federal Deposit Insurance Corporation, and defined its responsibilities, function and organisational structure. The FDIC’s initial capital was secured by the US Treasury and the 12 Federal Reserve Banks. The Board of Directors consisted of three members, one of whom was ex officio the Chairman of the Office of the

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

Comptroller of the Currency (OCC), while the other two were nominated by the President for 6 years with the Senate’s proposal and consent. Establishment and adaptation of the deposit insurance system, however, occurred in two phases. The first, temporary phase started on 1 January 1934 and lasted for six months. During this period, every depositor was insured for up to $2,500, while credit institutions had to make an amount equivalent to 0.5 per cent of the insured deposits available to the FDIC in a one-off sum, and they had to pay in the same amount of money to the deposit insurance corporation in a scheduled manner in equal proportions. All Federal Reserve Banks had to join federal deposit insurance, while other credit institutions were given the opportunity to become members of the deposit insurance system after the approval and preliminary examination of the FDIC. On 1 January 1934, deposits of 13,201 banks became insured. The second phase of the launch began on 1 July 1934, which provided protection to depositors for even up to $5,000, and thus 98 per cent of bank customers were insured (Kroszner–Melick, 2008).

6.6 Collapse of the gold standard system and the isolation of national economies Economic difficulties (crises, inflation) following the end of World War I and the rearrangement of gold reserves during the war, made the gold standard system impossible to maintain.334 After the war, nationalism intensified, national economies became increasingly isolationist, and as a result, protectionist economic policy became the general characteristic of the era. Due to the generalisation of the new economic policy, previously capital-exporting countries were no longer looking for foreign investment opportunities but invested their liquid funds primarily in the domestic economy. Therefore, countries that before the outbreak of the war were in need of capital inflows, now faced a shortage of resources because their former 334

he gold standard made it difficult to finance the costs of the war, so when the war T broke out, governments restricted the free flow of gold and then more and more countries (USA, France, Germany, Belgium and Italy) left the gold standard system and started issuing paper money. Officially, the gold-based financial system was not suspended but after the exit of the main actors it could not work in practice.

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Banks in history: innovations and crises

external resources had dried up.335 Free cash flows stopped between states, and the role of private capital was taken over by state loans and development loans. After the end of the war, attempts were made to restore the gold standard, and the success of these efforts is well illustrated by the fact that the number of countries joining increased sharply for several years (Chart 6-4). The consequences of the Great Depression, however, quickly destroyed these results, and due to the crisis, international financial integration deteriorated more and more. Consequently, nations were forced to do without the established systems of the world economy (gold standard, exchange rate obligations). Chart 6-4: Number of countries using the gold standard 50

Number of countries

1937

5 1936

1935

1934

1933

1932

1931

1930

1929

1928

1927

1926

1925

1924

1923

1922

1921

Number of countries on the Gold Standard

Source: Palyi (1972).

335

Before World War I, Argentina financed half of its overall capital demand from foreign sources. The largest investor was Great Britain, investing around half of its financial assets abroad.

â&#x20AC;&#x201D; 506 â&#x20AC;&#x201D;

6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

In the spirit of Keynesian economic policy, the state sought to reduce the malfunctions and deficiencies of the market economy through stronger regulation and stricter control. Between the two world wars, especially after the Great Depression, government intervention became increasingly intensive in the banking sector as well. Banks with liquidity difficulties can be stabilised through state intervention, and as a result, liquidity problems do not spread or intensify in the banking system. The emergence of mature capitalism brought about a growing organisational and territorial centralisation of banks in Europe. At that time, in continental Europe, a number of single-branch banks were abolished and they were replaced by a banking system with a national branch network. A large number of local financial institutions merged into commercial banks with a national branch network and the previously regional capital markets became part of the more and more unified national capital market. In addition, some of the stronger national financial institutions became global financial actors over the years. In the USA, however, the McFadden Act, adopted in 1927, permanently preserved the strong segmentation of the banking sector. The Act made it possible for banks to raise the ceiling for loans to private individuals, deal with mortgage lending, trade with securities and establish branches. The legislative change resulted in geographical restrictions on the operation of banks, since under the Act a commercial bank registered and based in a given US state was not allowed to open a branch in the territory of another state. This phrase significantly influenced the development of the US banking sector; the number of small banks in the USA is still high. Box 6-1 State assistance during the pre-World War II banking crises

The practice of recovering from banking crises through government intervention started with individual cases in the second half of the 19th century. The state’s economic engagement was limited, and accordingly, assistance was mostly a single measure. The form of this assistance was versatile, starting from the negotiation-based intervention in the process

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Banks in history: innovations and crises

of solving the liquidity problem (Brazil, 1897; Sweden, 1907; Denmark, 1908), through the easing of the banking system regulation (USA, 1893) even to the official closure or merger of troubled banks (Argentina, 1890; Brazil, 1890; Italy, 1891) (Bordo–Eichengreen, 1999). The most common tool for government intervention was the temporary suspension of banks’ operation and the introduction of an official moratorium on payment obligations. In 1893, the Government of New South Wales, Australia, ordered a 5-day suspension following the collapse of three local banks to contain the mounting banking crisis. In 1898, the Chilean government provided assistance in curbing a local banking crisis by declaring a 30-day moratorium, while the Portuguese government granted a general suspension of payment to two troubled banks in 1891 (Bordo– Eichengreen, 1999). The application of temporary suspension of operations was maintained even during the Great Depression of 1929–1933. In March 1933, US President Franklin Delano Roosevelt signed Proclamation 2039, suspending the operation of 3,460 banks in the country for four days. During the same period, another instrument of government assistance was provided: intervention through a state asset management institution. The Reconstruction Finance Corporation (RFC), founded in 1932, played a major role in managing the 1929–33 US crisis, providing financial assistance to banks and business corporations as an independent institution of the US federal government. In addition to lending, the RFC also helped the troubled banking sector with capital injections through the purchase of banks’ preferred stock; by the spring of 1934, the federal institution had purchased preferred stock in nearly half of the commercial banks. By June 1935, the capital stock owned by the RFC comprised one third of the total banking sector’s capital stock (Calomiris–Mason, 2003). Little information on the fiscal costs of crisis management before WW II is available in the literature. Calomiris–Mason (2003) states that the cost of bailing out all of the insolvent American banks would have been 3 per cent of GDP. It is important to note, however, that the number of banks that completely suspended their operation between 1929 and 1933 is estimated at several thousand. — 508 —

6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

6.7 The evolution of banking systems and the emergence of innovations in selected regions: USA, Europe and Hungary 6.7.1 United States of America 6.7.1.1 The US economy between the two world wars By the end of World War I, the industry of the USA was superior to the industry of the European Great Powers. Already in the years preceding World War I, the US economy was the largest in the world, but at that time it was evolving in isolation. However, outbreak of the war accelerated the internationalisation of the economy and the financial sector. At the start of the war, the USA was the country with the highest debt, but its investors – primarily England – began to withdraw their investments from America to cover war expenses. The USA was able to make up for the outflow of foreign capital with domestic resources, and consequently disinvestment eventually did not cause economic turbulence, but much rather opened new opportunities.336 European war needs created huge demand for US goods. However, to be able to finance the costs of the war, US allies first withdrew their investments from the USA. For commercial supplies they paid from the reserves they had thus accumulated, and finally they obtained goods in return for military loans. During the war years, US foreign trade expanded steadily, and the volume of exports increasingly surpassed that of imports. Due to the export surplus, US banks could provide loans for the purchase of goods to foreigners, as a result of which new export markets opened up for US companies. The growing demand and the widening application of technological achievements provided a decent profit for the USA. Stock markets were vibrant and stock quotes rose. The boom was ended by the 1929 crisis which shook the US banking system and economy to its foundations. Due to the rapid, dramatic deterioration of the

336

ntil 1913, most of the USA’s imports came to the country on board foreign ships, U and most shiploads were insured by foreign insurers. Starting in 1914, however, the USA took the place of foreigners in these areas as well.

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Banks in history: innovations and crises

financial and economic situation, the US government decided to consolidate banks. The official measures proved to be effective, and the government was able to stabilise the financial sector. The US dollar exchange rate stabilised in 1934 with the adoption of the Gold Reserve Act. According to the law, the dollar was depreciated by 40.9 per cent and an ounce of gold was fixed at USD 35. A USD 2 billion Exchange Stabilisation Fund was generated from the gold reserve revaluation gains (USD 2.8 billion). The success of stabilisation measures is well shown by the fact that in 1935 the previously repatriated capital started to flow back to the USA. Following stabilisation of the USD exchange rate, the protectionist customs law was eased, and as a result US foreign trade started to grow again. The Great Depression began in the USA and also ended there earlier than in any other developed country. The key to successful crisis management was the New Deal strategy, according to which the predominant factor behind restoring the economy was to increase domestic purchasing power. Because of its size, its financial position and its role in the world war, the US economy was in a better position than the European countries, but this alone was not a guarantee for successful crisis management. A new approach was needed in which the banking system played a substantial role. Nevertheless, the US also paid a very high price for its role in the emergence of the crisis: its GDP dropped significantly, its banking system had to be consolidated and its debt stock jumped sharply. 6.7.1.2 The international role of US banks in the interwar period At the beginning of the 20th century, British multinational banks dominated international banking operations. Despite all their efforts, French and German banks lagged far behind their UK competitors, both in terms of trade finance and investment banking. US banks were focused particularly on domestic activities, leaving international banking operations almost entirely to European banks. At that time, the international banking activities of American banks were merely limited to intermediating European capital to the USA. The European funds collected mainly in London were used for financing American railway construction and purchases of shares.

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

Until 1913, commercial banks with a national banking license (national banks) could not open a branch abroad. After changes to the law (Federal Reserve Act) New York-based banks (Chase Manhattan, National City Bank) first tried to get a foothold in Europe. In order to strengthen their presence, they bought up the former capital intermediary companies. The European activities of banks were initially restricted only to serve the demands of American customers. World War I brought about a radical change in the international activities of American banks. At the end of the war, European countries faced significant inflation and the devaluation of their currencies, which made their banks’ international involvement difficult. More and more money was moved from Berlin and Paris to London or New York. The environment that had previously effectively promoted the growth and international expansion of British banks, significantly deteriorated between the two world wars. At the same time, the international role of US banks and the US dollar was increasing strongly.337 American banks not only established a foothold in Europe, they were also expanding in Latin America338 and the Far East as well. They tried to take advantage of their favourable post-war position as winners and embarked on spectacular international expansion. They financed not only American customers, but also helped European governments in post-war economic recovery and assisted in restoring the gold standard. The US banks also paid attention that the New York Stock Exchange, which had previously a very strong domestic orientation, should be opened up to foreign investors. In the 1920s, despite the earlier expectations, the return to the gold standard did not lead to a breakthrough in banks’ international activities as there was a lack of cooperation between the leading powers, which could have stabilised the operation of the international financial system. As the comparative value of national currencies in the gold standard system was fixed, they were exposed to speculative attacks. This is because, according to the gold parity, he international role of the US dollar was significantly strengthened by its T convertibility to gold, which, albeit with minor interruptions, existed until 1971. 338 By 1930, National City Bank had established 100 branches abroad, two-thirds of which operated in Latin America. 337

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Banks in history: innovations and crises

each country had to maintain the gold-fixed exchange rate of its currency (Bernanke, 2004). After the Great Depression, with the repeated collapse of the gold standard system, more and more countries introduced exchange rate and capital restrictions, which facilitated neither international trade nor the internationalisation of banks. Among other things, these developments led to the Bretton Woods Conference in 1944 held at the proposal of the USA, where the foundations of the post-World War II international monetary system were laid. 6.7.1.3 A popular financial innovation The Great Depression, which started in 1929, caused a temporary set-back in the spectacular expansion of the US banks. At the same time, due to the post-crisis economic development the use of banking services increasingly became part of everyday life. Following stabilisation of the banking sector, financial products and services reached ever wider strata of US society. In this context, the spread of a financial innovation and the introduction of the deposit insurance system played a significant role, which later served as a model for a number of countries. In the 1930s, the use of mortgage-backed securities (MBS) was extended to financing residential real estate as well, which soon became very popular in the US. Thanks to mortgage-backed securities, the public could obtain residential properties relatively cheaply and predictably (fixed instalments), which was an important part of fulfilling the American dream. This is why the spread of using mortgage-backed securities enjoyed considerable political support. Due to the rise in mortgage lending, housing construction increased significantly, as a result of which construction industry became a leading sector. To ensure the efficient functioning of the mortgage market, an institution was needed to buy up and mediate mortgage papers to investors. In 1934, the National Housing Act was adopted, and in 1938 the Federal Mortgage Association was formed, establishing the institutional framework for the secondary mortgage market.

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

6.7.2 Great Britain 6.7.2.1 The British economy between the two world wars The dominance of the British economy was undermined by World War I, and although Great Britain was one of the victorious powers, by the end of the war it was heavily indebted to the United States. By the end of the 1920s growth was achieved in the economy, but the Great Depression of 1929 quickly put an end to the growth, and during the years of the crisis (1929– 1933), foreign trade fell sharply and heavy industry production declined by one third. The decline in exports was mainly due to the fact that the crisis had strengthened protectionism everywhere, which dramatically reduced the demand for English goods. As a result of the economic decline, unemployment in Great Britain increased considerably. In the summer of 1932, 3.5 million unemployed were recorded at the peak of the crisis, and many of those who had a job were employed only part-time (Billings–Capie, 2011). Mostly Northern England, Scotland, Northern Ireland and Wales were affected. Coal mining and heavy industry in these regions were in crisis and therefore in some areas the unemployment rate reached 70 per cent. The best coal deposits began to be exhausted, which resulted in an increase in costs. In addition, crude oil increasingly took on the role of the most widely-used fuel, and thus demand for coal fell even more. The English government responded to the worsening employment indicators by reducing unemployment benefits and government officials’ salaries. The symptoms of the crisis in England were similar to those in America, but the two governments chose radically different approaches to dealing with the crisis. The English government was cautious and conservative, and therefore rejected the Keynesian proposal to launch large-scale public work projects and sought to restore the balance of the budget through austerity measures. This approach exacerbated the problems of the crisis sectors, and by 1939, coal and steel exports fell to half of the pre-crisis level. As the crisis eased, the English government changed its original strategy and, instead of austerity, it began to support measures to stimulate domestic

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Banks in history: innovations and crises

demand. In April 1934, it restored the previous amount of unemployment benefits, helping to boost domestic demand. The rise in housing construction also bolstered domestic demand: in the 1930s, as a result of the housing programmes of local governments, houses were constructed in which there was already an indoor toilet, bathroom and electricity. In that decade, nearly 3 million homes were built in the United Kingdom. In addition to stimulating domestic demand, the emergence and strengthening of new industries also helped the recovery of the economy. At that time, the electrical industry started to develop dynamically, and machine manufacture also expanded rapidly. The spread of electricity contributed to the development of energy-intensive metallurgy, which gave a new boost to mechanical engineering. Automobiles and radios were made on the assembly lines, the two best-selling products of the era, which at that time shifted from being a luxury to being mass-produced items. The development of the automotive industry acted as a driving force for rubber manufacturing and glass-making, the production and use of petroleum products, the development of mechanical electronics and the construction industry, as the spread of motor traffic required new roads, bridges and other infrastructure. Over time, technological progress gave impetus to the development of aircrafts, and by the beginning of World War II, aircraft manufacturing was already an important sector of the military industry. The widespread use of plastics started between the two world wars. Mechanisation also spread in agriculture, which greatly increased labour productivity in the agrarian sector. Crop yield averages were also raised by increasing use of chemical fertilisers. The government helped to develop this sector as well. In 1931, the Agricultural Marketing Act was adopted, which guaranteed state purchase for basic foods (milk, potatoes, etc.). In the 1930s, the food industry also increased its capacities significantly. At the beginning of 1925, it was not clear yet when Great Britain wanted to join the gold standard again. England had suspended its participation in the gold standard system due to the outbreak of war, which was maintained throughout the war and even in subsequent years. Regarding the date of return, there was

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

a tense conflict between fiscal and monetary policy considerations. However, Chancellor of the Exchequer, Winston Churchill decided in April 1925 to restore the gold standard. As a result, the pre-war exchange rate took effect, i.e. £1 was $4.86. Churchill’s decision was later debated by many, especially by those who thought that the pound exchange rate was overvalued; in their view the gold standard was the reason for the weak performance of the economy. Because of the overvaluation of the pound, the balance of payments deteriorated and the Bank of England was under pressure to keep the base rate high. By 1931, the price of gold rose to such an extent that Great Britain finally had to retreat again from the gold standard, and as a result the pound/dollar exchange rate fell from $4.86 to $3.40. Due to the depreciation of the pound, British exports became more competitive, which helped economic growth. At the end of the 1930s, war preparations were another boost to economic rise. 6.7.2.2 Change in the behaviour of British banks in the interwar period At the end of World War I, the British banking sector was dominated by five large banks (the Big Five: Barclays, Lloyds, Midland, National Provincial and Westminster). The big banks were headquartered in London and operated with highly centralised, bureaucratic organisations. The five large banks had nearly 10,000 branches in the early 1920s and held about 80 per cent of the total stock of deposits (Billings–Capie, 2011). At this time, the big banks no longer had close contact with local business communities as in the previous century. Decision-making became formalised, decisions were made at the central level about loan applications, banks preferred to provide short-term loans and enhanced the role of collateral in credit assessment. Because of the changes in the behaviour of the large banks, confidence in these institutions weakened. In the 1920s and 1930s, due to the economic recession, banks had limited growth opportunities. Their situation was further aggravated by the fact that they had to compete for customers not only with each other, but also with the savings cooperatives, building societies, insurance companies and, in the case of fund raising by large corporate customers, even with the stock market. At the same time, even during the recession the big banks did not want to reduce margins or ease their lending terms. Although banks dominated the

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Banks in history: innovations and crises

financial sector, their market share eroded year after year as a result of intense competition with their rivals. The big banks did not even ease their lending terms when Great Britain withdrew from the gold standard system and the pound depreciated significantly. British banks followed a conservative lending policy, and their market share declined, but by lending only to the most trusted customers they still were able to realise enough profit and performed far better than their American or European counterparts, where – due to the consequences of the Great Depression – many banks went bankrupt. The British big banks, having hit a strong barrier with respect to expanding corporate lending (recession, drastic drop in foreign trade and industrial output) began to search for new customers and opened up to serving the general public, primarily the middle class. Between the two world wars, it became commonplace among members of the middle class to have a bank account; they generally opened two accounts: one for business and the other for personal use. At that time, among working class, few people had bank accounts but the expansion of services to meet the needs of the middle class led to a significant increase in the number of branches across the country (Table 6-2). Due to rising real wages, in the second half of the 1930s, more and more workers had a bank account, but they did not choose the big banks, opting instead for savings banks, building societies and post offices. Table 6-2: Midland Bank: Numbers of branches and sub-branches between 1910 and 1940 Year

Numbers of branches and sub-branches

1910

689

1915

1,087

1920

1,497

1925

1,850

1930

2,100

1935

2,140

1940

2,031

Source: Holmes–Green (1986).

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

In the years following World War I, the big banks first turned to brandbuilding and marketing, due to the erosion of customer confidence. With the expansion of retail banking and stronger competition among banks, the banks’ brand-building efforts continued to increase and, in order to acquire new customers, they began to develop new products and started marketing and advertising these (Newton, 2008). A number of new banking products were created with the aim of including lower income individuals in the group of bank users; for example, from the end of the 1920s at Midland Bank one could even open an interest-bearing deposit account with 1 pound. These accounts did not yield large profits, but helped banking services to reach the widest possible range of society, as more and more people came into contact with credit institutions and banking habit became part of their everyday life. When establishing new branches, banks took special care to ensure that their branches’ physical appearance inspired customers’ trust. British banks were able to provide their customers with more personal service through the development of their branch network; in 1928, the number of customers per branch in Great Britain was 4,600, while in the United States this number was 9,799. Due to the change in the behaviour and business model of British banks between the two world wars, the general public came to hold the view that these banks were stable and secure, and this continued to be the case even until the end of the 20th century.

6.7.3 Germany 6.7.3.1 The German economy after defeat in World War I Of the participants in World War I, Germany was hit the hardest by the consequences of defeat. Even before the war, the German economy was dependent on foreign funding but during the war these sources dried up. Moreover, the victorious powers imposed massive reparations on the country. Due to the lost war, Germany’s economic performance dropped significantly, inflation skyrocketed and unemployment soared. Tensions, however, were not only accumulating in the economy, but also in society at large. Germany was not a stable country either economically or politically after the end of

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Banks in history: innovations and crises

World War I. The situation was further deteriorated by the fact that – due to the poor performance of the economy – Germany was unable to meet its reparation obligations. The German government played a decisive role in reorganizing the economy. The government strictly regulated food imports, helped indebted landowners with loans, and maintained the right to take control of the factories in difficulty. Despite its efforts, the German government was unable to foster the economic performance that could have ensured the scheduled execution of reparation payments. The measures implemented through the Dawes Plan made substantial progress in economic stabilisation and reparation payments. After adoption of the plan, the USA provided a loan of 800 million gold marks to Germany. According to the plan, within seven years a total of 33 billion marks flowed in Germany, mainly in the form of American loans. As a result, the economy was normalised, the export performance of the country began to rise and consequently German reparation payments were executed more smoothly. Most US loans came to the country through the German banks. The US dollar’s interest rate was lower than that of the European currencies, which increased the attractiveness of USD loans. German banks borrowed short-term loans, but domestic borrowers needed long-term resources for industrial investments. The German banks therefore extended more and more long-term loans, backed by short-term US dollar funding. This type of double transformation (maturity and currency), however, is very risky. In order to reduce their risks, German banks allocated a part of the short-term loans in the United States at short maturities. This business was not too lucrative, but it was thought that through such deals they would have enough liquidity to pay in case creditors should demand their money back ahead of time. The assumption behind the idea was that creditors would not immediately demand back more than one-third of the loans. If they should raise demands above that amount, they could meet their obligations with the help of the central bank (Reichsbank) and commercial bills.

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While this type of risk management policy might have been appropriate in an equilibrium state, the consequences of the Great Depression that started in 1929 surpassed all imagination. American creditors in trouble needed as much money as possible and as soon as possible, and therefore they demanded back the full amount of loans to German banks, moreover a part of it in gold. However, these demands could not be met by the German banks, not even with the help of the central bank because even the Reichsbank did not have as much gold and foreign currency reserves as demanded by US creditors. As a result of the unfavourable news, depositors ran on banks in Germany, and as an immediate response a bank holiday was imposed on 14 and 15 July 1931; foreign currency restrictions were introduced and reparation payments were suspended. Due to the measures taken, the extent of capital flight increased in Germany. The German banking crisis affected Europe as a whole: England and France also reacted fiercely. At the news of the measures taken in Germany, France withdrew its liquid capital from Great Britain. From 1925 the pound sterling was again gold-based, hence there was a concern that other European countries (the Netherlands, Belgium, Switzerland) would also convert their claims to gold and take gold from England. As a result, mutual distrust intensified throughout Europe. Struggling with serious financial problems, Germany tried to fight the crisis with a number of instruments, but after the drying-up of foreign loans, it would only have been able to tap into new resources through gold sales, but the gold stock of the country had sharply decreased due to massive reparations. As to the USA, after a few years of persistent struggle, it was able to overcome the crisis, but Germany took a markedly different path. The country finally emerged from the crisis through the realisation of a wartime financial policy after Adolf Hitler came to power. After 1933, both economic and financial policy served the cause of war preparations. 6.7.3.2 The operation of German banks between the two world wars In the interwar period, German commercial banks faced two fundamental challenges. On the one hand, they had to struggle with the restoration of their size (balance sheet total), which had become inflated due to hyperinflation

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following the world war, and on the other hand they had to stand their ground in the increasingly fierce competition with rivals. The German banks’ market share was jeopardised by foreign banks and, from the 1930s onwards, savings cooperatives as well. After defeat in the war, German inflation reached extreme highs. The country’s official currency devalued from day to day because it was not backed by sufficient volume of commodities (Chart 6-5). Chart 6-5: Monthly average price of gold expressed in paper mark 1,000,000,000,000

Paper mark

1,000,000,000

1,000,000

1,000

Jul. 1923

Jan. 1923

Jul. 1922

Jan. 1922

Jul. 1921

Jan. 1921

Jul. 1920

Jan. 1920

Jul. 1919

Jan. 1919

Jul. 1918

1,000

Jan. 1918

1,000,000,000,000

Escalation of inflation Source: Bresciani–Turroni (1937).

The reorganisation of production was sluggish, and moreover part of the produced stock was eaten up by the reparation obligations. The capital of the German large banks was thoroughly eroded by inflation. In real terms, the capital of the banks was about one third of the 1913 value by 1924. Not only

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capital was dwindling as big depositors withdrew their money from banks, some of them also outsourced their savings abroad. The big banks sought to buy up as many small banks as possible to restore their balance sheet total. In particular, between 1919 and 1923, a very large number of banks were bought up in Germany, and among the fusions there were mergers of big banks as well (e.g. Danat Bank was created by the merger of the Bank für Handel und Industrie, Darmstadt and the Nationalbank). In 1923–1924, the government sought to stabilise the financial system by introducing the gold mark. Despite the fact that the balance sheet total of the banking sector remained lower than in previous years, large banks were able to enter an upward path. Between 1924 and 1929 a considerable amount of foreign funds flowed into Germany through domestic banks, but cross-border direct lending also became increasingly popular.339 Intensifying competition among banks pushed margins down, which reduced the profitability of banks. In order to achieve higher profits, therefore, German banks were increasingly engaged in high yielding, but risky transactions. The economic recovery starting from 1924 then came to an end with the significant withdrawal of deposits in 1929, which led to a banking crisis in 1931 (Table 6-3). Deposit withdrawals initially affected only the domestic currency (Reichsmark), but later also foreign currency denominated deposits. This shows that in 1931 the depositors were worried not only because of the exchange rate risk.

339

German banks often had board membership in the companies they financed. However, if a German company borrowed directly from abroad, the foreign lender did not claim membership of the board, which increased the popularity of these loans.

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Table 6-3: Percentage reduction of aggregated value of various classes of liquid assets of the Berlin big banks during three episodes of deposit loss Between ends of months

Cash, deposit at banks of issue, commercial bills

Balances at other banks

March–May 1929*

-18

-5

Sept.–Oct. 1930**

-13

-10

April–May 1931**

-4

-13

May–June 1931**

-21

-20

June–July 1931**

-24

-20

Note: *Deutsche Bank, Diskonto-Gesellschaft, Dresdner, Danat, Compri, RKG. **De-Di, Dresdner, Danat, Compri, RKG, BHG. Source: Balderstone (1994).

On 13 July 1931, the previously rapidly expanding Danat Bank, the second largest bank in Germany at the time, became insolvent. In order to prevent the banking crisis from spreading, on 14 July, the authorities imposed a bank holiday, which lasted as long as until 5 August. Meanwhile, they tried to transfer capital directly or through the Reichsbank340 to the big banks to avoid further bank collapses. Danat Bank merged with Dresdner Bank, and the German government had a 91 per cent ownership share in the new bank. In the other two major banks, the state also had a significant interest: 69 per cent in the Commerz- und Privat-Bank and 35 per cent in the Deutsche BankDisconto Gesellschaft (De-Di). In the years following the banking crisis, the German large banks stagnated; until as late as 1936 there was hardly any major industrial investment. Banks’ more active operation was also hampered by the foreign currency restrictions imposed at the time of the outbreak of the crisis.

340

he Reichsbank was founded in 1875 as the central bank of the German Empire. T Initially, it had the responsibility of maintaining the gold standard system, and later on it carried out more and more tasks of a monetary authority.

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After Hitler came to power, the banks’ economic role declined. After the launch of the armament programme, the Reichsbank broke with its previous policy and became one of the tools for financing government spending. The implementation of armament programmes required close cooperation between the government and the industry, hence the role of commercial banks became devalued (Hardach, 1995). The government of Nazi Germany placed the sector under strict government supervision and restricted competition among banks. A new institution could only be founded with the permission of the government and the government was entitled to set interest rates. The strong liquidity and reserve requirements governed the operation of banks until as late as the end of the 1950s. During the period between the two world wars, savings banks and savings cooperatives (Sparkassen/Spargenossenschaften) expanded their product range and boosted their market positions. Regarding the operation of savings cooperatives, the Deutsche Girozentrale, founded in Berlin in 1918, is considered a milestone. It linked the institutions operating in the country and operated as a clearing system for savings cooperatives. The 1931 crisis negatively impacted the operation of savings banks and savings cooperatives as well. The repayment of loans for local governments was mainly jeopardised and local credit institutions turned to the Reichsbank for help. In exchange for support, the authorities arranged it that savings banks that previously belonged to local governments would become independent. This was necessary to ensure that in the future local governments in trouble would not be able to use local credit institutions as their own banks. The changes had a beneficial effect on the operation of the savings banks and savings cooperatives, and their ability to attract deposits significantly increased. Between 1933 and 1938, the deposit stock of German big banks grew by 39 per cent; on the other hand, in the case of savings banks the growth amounted to 68 per cent, while savings cooperatives’ deposit stock grew by 62 per cent. Local credit institutions played a key role mainly in financing the local economy.

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6.7.4 Hungary 6.7.4.1 The Hungarian economy between the two world wars The consequences of World War I and the Treaty of Trianon had a significant impact on the economic situation in Hungary. One example was the state of industry, since before World War I Hungarian industry was considered moderately developed in relation to the Monarchy, but after the temporary war boom period the pace of development slowed down and already in 1917 there were signs of decline as a result of general raw material and capital shortages. After the Treaty of Trianon, unfavourable tendencies intensified as Hungary lost 56 per cent of its manufacturing industry, and its main sources of raw materials remained abroad, and – in all sectors of the economy – both the country’s external and internal markets became tight (Csath, 2014). In addition to industry, the development of other economic sectors also moved in a very unfavourable direction, which was due to the adverse changes in population number, settlement patterns and infrastructure, as well as the opening up of foreign trade and the loss of the earlier customs-protected markets. These negative shocks also had an adverse impact on the key sector of Hungary’s economy, agriculture (Kaposi, 2010). Although reconstruction and consolidation already began in 1920, economic results only appeared years later. 6.7.4.2 The impact of World War I on credit institutions Due to the unfavourable economic conditions, the emerging crisis, the transition to civilian management as well as accelerated inflation, World War I also had a significant impact on credit institutions. As a consequence of these factors, credit institutions’ equity decreased considerably: while it was equivalent to 2.8 billion pengős in 1914, the stock was only worth 0.4 billion pengős by 1924. The Hungarian banking sector was both fragmented and oversized. In the 1920s the number of credit institutions increased as a general trend; at the peak in 1924 their number was 962 (Botos, 1994). The reason for this is, on one hand, that Act XIV of 1916 prohibited the establishment of new credit institutions until 1 January 1919, and after that time there were

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no more restrictions. On the other hand, the rising inflation also encouraged the establishment of banks primarily for speculative purposes, which was certified by the utilisation of the inflation ‘economy’ to the greatest possible extent. Inflation, however, had an impact on credit institutions in other ways as well: their equity fell from 60 million (1921) to 14 million (1923) koronas (Tomka, 2000). As to the number of credit institutions, the Treaty of Trianon mainly affected credit cooperatives – in their case more than 60 per cent of them remained outside the borders (Schandl, 1938). Following the Treaty, the concentration in the capital city, which had already been taking place, was naturally strengthened further, and so by 1930 78 per cent of deposits and 92 per cent of loans were related to the capital (Varga, 1928). Some subsidiaries of credit institutions continued to operate beyond the borders, and the reason, among other things, was that capital mediation and the continuity of previous financial relationships had to be maintained (Varga, 2017). Liquidity risks inherent in the operation of credit institutions were considerably increased by the fact that the maturity structure of credit institutions’ outstanding loans became significantly shorter. While in 1915 65 per cent of the available credit lines were long term, by 1924 this ratio had dropped to 5 per cent and by 1929 it had only risen back to 30 per cent (Incze, 1955). This circumstance also had a major impact on the financial supervision of credit institutions, as the Pénzintézeti Központ (Central Corporation of Banking Companies), founded in 1916, placed greater emphasis on liquidity testing than before. The definition of different liquidity levels also dates back to that era (Walder, 1939). World War I also had a significant impact on the business activity of credit institutions. Before the war, mortgage business was the dominant activity of banks, whereas by 1923–1924 overdraft and bills receivable already dominated, and currency and foreign exchange operations started to increase as a result of the expansion of foreign relations. It was particularly important to finance railway construction, which yielded one of the greatest benefits for the credit institutions.

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Between the two world wars the role of Magyar Jelzáloghitelbank (Hungarian Mortgage Bank) and Egyesült Budapesti Fővárosi Takarékpénztár (United Budapest Municipal Savings Bank) declined, whereas Magyar Általános Hitelbank (Hungarian General Credit Bank), Magyar Általános Ingatlanbank (Hungarian General Real Estate Bank) and Földhitelbank (Land Credit Bank) showed significant progress. The change, to mention another aspect, was also shown by the fact that besides credit institutions performing traditional functions, credit institutions carrying out special tasks (mainly cooperatives) also emerged, such as Iparosok Országos Központi Hitelszövetkezete (Craftsmen’s National Central Credit Cooperative) (1920) or Földbirtokrendezés Pénzügyi Lebonyolítására Alakult Szövetkezet (Cooperative for Financial Management of Land Reallocation) (1929). In addition, the emergence of housing cooperatives – e.g. Országos Lakásépítési Hitelszövetkezet (National Housing Credit Cooperative) – also dates back to the era between the two world wars. It should also be remembered that OKH, i.e. Országos Központi Hitelszövetkezet (National Central Credit Union), founded in 1898, had grouped over a thousand Hungarian credit cooperatives together in an organisation since 1920. The activity of OKH is also to be emphasised in terms of financial innovation as the institution was considered to be the centre of the Hungarian cooperative movement as well as the ‘stronghold’ of Hungarian cooperative life (Schandl, 1938). Moreover, OKH played a significant role in ensuring that the more and more popular, so-called ‘korona cooperatives’ – which were only ‘cooperatives’ in name, but their activity was basically dominated by usury – would decline significantly and usury loans would decrease substantially (Sugár, 1899). Credit institutions were also negatively impacted by the decline in foreign capital inflows after the world war, as foreign investors saw previously significant investment patterns (e.g. mortgage-bond) as being risky due to inflation, the state of government budget and the unsettled reparation payments. Capital inflows only improved in 1924 when progress was made on the negotiations on the League of Nations loan. As an advance, the Bank of England granted a loan of £4 million to Hungary, which also had a positive

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impact on currency stabilisation. In the same year, the League of Nations loan was disbursed, which amounted to 307 million koronas ($69 million) (Tomka, 2000). 6.7.4.2.1 Establishment of an independent Hungarian central bank In Hungary, the autonomous, independent central bank was established in 1924, when the Magyar Nemzeti Bank (MNB) – the National Bank of Hungary – was founded. The establishment of the MNB was a significant achievement, as the idea of establishing an independent central bank had been on the agenda for several decades and many proposals had been made in connection with the foundation. One aspect to be highlighted is the idea of creating a so-called ‘cartel bank’ – later a central bank association – born in the second half of the 19th century, which, however, like the other proposals, provoked opposition from the Austrian National Bank (Pethő, 1925). A few years before the founding of the MNB, in 1921, there were also similar proposals; it was then that the legal predecessor of the MNB, the Magyar Királyi Állami Jegyintézet (Royal Hungarian State Note Institute) was established on a transitional basis for the temporary provision of central bank functions. The main task of the MNB was to protect the new and genuinely Hungarian currency, the korona’s stability and to provide the appropriate bullion reserves for commencement of payments as well as to regulate cash flow. Compared to the State Note Institute the MNB was more independent. The government could exercise influence over its activities only in specific cases (Botos, 1999). On the other hand, the independence of the State Note Institute was substantially limited by the fact that the Reparation Committee exercised a pledge over the banknotes. At this time, however, it was not possible to speak about the full independence of the government and the central bank. The Hungarian currency was stabilised in 1924, in course of which the price of the korona was tied to the British pound (Varga, 1929). The stabilisation was largely contributed to the loan provided by the Bank of England, which was in no small measure due to the personal relations and widely recognised professional expertise of the MNB’s first President, Sándor Popovics.

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The MNB also played a significant role during the global economic crisis of 1929–1933. The restriction of foreign exchange transactions, which was suspended in 1925, once again came into effect in 1931, on the basis of which MNB made foreign operations with currency and the borrowing and disbursement of credits on the international money market subject to a special permit. It was part of the measures that outstanding debts to a foreign bank, exceeding a certain level, had to be reported to the MNB. All these contributed significantly to the fact that the pengő did not lose its value, traditional and mortgage lending was able to revive (Kovács, 2006) and the price level began to rise at a slow pace only in the middle of the 1930s (Botos, 1999). 6.7.4.3 Impact of the Great Depression on credit institutions In Hungary, the economic crisis began in 1931, when Creditanstalt in Vienna, which played a substantial role in financing the Hungarian banking sector, announced its insolvency (Clavin, 2000). During this period there was also a high level of concentration regarding credit institutions; 40 per cent of the total domestic share capital was owned by two Hungarian banks: Pesti Magyar Kereskedelmi Bank (Hungarian Commercial Bank of Pest) and Magyar Általános Hitelbank (Hungarian General Credit Bank) (Incze, 1955). As a consequence of the crisis, mergers also occurred: for example, in 1938, Magyar Általános Takarékpénztár (Hungarian General Savings Bank) merged into Magyar Általános Hitelbank (Hungarian General Credit Bank). As a consequence of the crisis, the number of credit institutions gradually decreased; from 962 (in 1924) to 426 (in 1935) and in the last year of peace, in 1938, the number fell to 396 (Holbesz, 1939). The deposits of credit institutions also contracted: during the crisis, 1930 showed the highest value regarding both current accounts (1,758 million pengős) and savings deposits (1,075 million pengős). The next year deposits fell by 21 per cent and 26 per cent. A level close to the 1930 deposit level was only restored in 1938 (Table 6-4).

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

Table 6-4: Main balance sheet items of the Hungarian credit institutions between 1925 and 1938 (in million pengős) Year

Bills

Current account credit

Mortgage loan

Savings deposit

Current account deposit

1925

726

635

309

845

224

1,870

1929

2,089

1,178

1,005

1,022

1,738

700

6,064

1930

2,216

1,203

775

1,075

1,758

748

6,703

1933

2,387

894

643

753

1,445

1,186

6,478

1938

2,413

877

538

866

1,721

1,003

5,703

Rediscounted Balance bills sheet total

Source: Authors’ own compilation based on Tomka (2000).

The crisis also had a major impact on financial supervision. Approximately 30 per cent of the financial institutions operating in the form of a jointstock company and 10 per cent of the credit cooperatives were liquidated (Schandl, 1938). Consequently, the tasks of the Central Corporation of Banking Companies related to liquidation and reconstruction increased; on-site investigations became more pronounced, and due to the increased liquidity risks in the operation of credit institutions, liquidity aspects also came to the fore. Another measure was that from 1932 credit institutions were required to send monthly data to the MNB and the Central Corporation of Banking Companies (Tomka, 2000; Walder, 1939). During the economic crisis, the anti-cooperative attacks were intensified, which expressed the view that state subsidies and tax incentives to cooperatives – considered to be excessive – had contributed to the deepening of the crisis. The background to these attacks might have been that at that time there was no uniform credit policy for the state promotion of cooperatives, and so due to the non-transparent allocation of resources, criticism became prevalent. On the other hand, however, according to some opinions, without the ‘cooperative movement’ there was no way to escape the crisis (Wanke, 1930), and therefore the resources allocated to these institutions cannot be judged excessive.

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Because of the deteriorating situation in the domestic economy, foreign creditors tried to rescue their funds from Hungary. To this end, concessions were even granted; due to this circumstance and the transfer moratorium, the credit institutions managed to become partially ‘reconstructed’ (Varga, 1964). On the one hand, the stabilisation process of the banking system was promoted by the fact that Magyar Szavatossági Bank (Hungarian Guarantee Bank), founded in 1931, was able to provide bill of exchange loans for the payment of credit institutions’ deposits, as the purpose of its operation was to maintain the solvency of credit institutions. On the other hand, stability was reinforced by the reconstruction function of the Central Corporation of Banking Companies as well, since based on Act XIV of 1916, it was able to provide temporary liquidity to credit institutions rated as distressed but viable (Jakab et al., 1941). All of this contributed to the fact that only one major domestic bank, Földhitelbank (Land Credit Bank) was close to insolvency between the two world wars (Tomka, 2000). Box 6-2 History of bank robberies

An international example Ever since banks have existed, many have been tempted by the thought of getting rich quickly by stealing money and valuables from banks. For most people, however, the thoughts end here, as banks do indeed take great care of the values assigned to their custody. However, in every era, there have always been individuals, who cannot withstand temptation, and despite the high risks, attempt to acquire values stored in the bank (Chart 6-6). Banks have built a strong defence system during their century-long operation, which is not easy to break or circumvent, and therefore many attempts at bank robbery end in failure. However, even those who might be able to rob a bank cannot be calm, because bank robbers are chased by large police forces. Moreover, many thieves commit a fatal error when using the stolen money, which can also cause their being caught. One of the largest bank robberies in the world was committed on 12 July 1987, when cash and valuables of £60 million (equivalent to £160 million

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

in 2017) were taken from a deposit centre in London. The robbery was led by Valerio Viccei, who fled to London in 1986 from his native Italy, where he was wanted for 50 armed robberies. Viccei liked the luxury financed by the money from robberies. He wanted to finance his luxurious lifestyle in London in a similar way, so he masterminded the looting of the Knightsbridge Safe Deposit Centre. Viccei also had inside help in the person of the managing director, Parvez Latif, a cocaine user, who was heavily in debt. On the day of the robbery, Viccei and one associate walked into the Knightsbridge Safe Deposit Centre, saying that they would like to rent a safety deposit box. After being shown into the vault, they drew handguns and subdued the bank employee and security guards. Then they hung a sign on the street-level door explaining that the safe deposit centre was temporarily closed. Meanwhile further gang members came and with their help they broke open many safe deposit boxes. Finally, the bank robbers left with a hoard estimated to be worth £60 million. Only one hour after the robbers left the scene, at a change of shift, the staff discovered the looting of the safes and alerted the police. At the robbery site, investigators recovered a bloody fingerprint that was traced to Valerio Viccei. After several days of surveillance, several members of the robbery gang were arrested during a series of coordinated raids on 12 August 1987, but Viccei managed to flee to Latin America. Later, however, he returned secretly to England to take his Ferrari to Latin America. However, the police learned of this, blocked the road Viccei was driving and he was captured. At the end of the trial, he was sentenced to 22 years in prison. Viccei spent 5 years in Parkhurst Prison on the Isle of Wight, and then, in 1992, he was transferred to Italy to serve the rest of his prison sentence in his home country. In Pescara he was incarcerated in a prison where he was allowed to live the luxurious lifestyle he was already accustomed to, as well as to run a translation office. During his detention, he wrote two very popular books on his bank robberies. On 19 April 2000, while on day release, he got into a gunfight and was killed.

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Chart 6-6: Number of bank robberies in the USA 12,000

Number of robberies

12,000

10,000

8,000

6,000

4,000

2,000

0 2016

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

Number of robberies

Note: The total number of bank robberies includes those of commercial banks, mutual savings banks, savings and loan associations and credit unions. Source: FBI Bank Crime Statistics.

A Hungarian incident In Hungary too, it has happened several times that this easier, but more risky form of money-making was chosen. One of the most memorable events in the history of bank robberies in Hungary was the famed New Year’s Eve bank robbery. On Monday, 31 December 1934, a bank robbery attempt escalated into a bloody tragedy in Szabadság tér (Liberty Square), Budapest (Chart 6-7). The armed attack took 3 lives. As a result of this bank robbery with fatalities, domestic banking security changed significantly, and several innovations were introduced to prevent similar cases.

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

Chart 6-7: View of Szabadság tér (Liberty Square)

Source: hu.wikipedia.org

On the day of New Year’s Eve, the branch of the Hungarian Commercial Bank of Pest (Adria Palace) – which had significant cash turnover due to the proximity of the Stock Exchange – was open in the usual opening hours at Liberty Square 16., at the corner of Vécsey Street. At about ten o’clock in the morning, two men with guns in their hands burst into the cash hall and immediately started shooting. One shot at the employee in the cashier cabin and his partner fired at the other officials and clients in the bank. Having been wounded, the cashier with his remaining strength dragged himself out of his cabin and breaking out the floor-length glass window fell to the Liberty Square, where he died. A trainee working in the branch was also shot.

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The customer closest to the cash cabin, who had just withdrawn money to pay employees, took out his revolver from his back pocket and fired at the robbers. At this the attackers were so terrified that they began to flee, but at the bank exit they shot dead an errand-boy who had just come to the door. The robbers jumped into their stolen car parked in Vécsey Street and sped away toward Honvéd Street. While escaping, they shot at the park-keeper rushing toward them, but fortunately he was not hit. A car mechanic who had come to the bank just when the robbers were running out from there, later shot at the fleeing attackers in the square and wounded one of the two men on his arm. Within a matter of minutes large police forces came to the scene and started to interrogate the eyewitnesses. In that very afternoon of New Year’s Eve, the stolen car was found near the Kelenföld railway station. The two attackers and their accomplice, who was waiting in the car during the robbery, were taken to the police station that same night for questioning, where the wounded robber made a detailed confession. The gang had already attempted to loot several financial institutions in Budapest, but not one of their efforts was successful: – On 15 May 1931, they attacked the branch of Hungarian Discount and Exchange Bank (Magyar Leszámítoló és Pénzváltó Bank) in Klauzál Square. There, they also started shooting, but the cash-keeper slammed the door of the strong-box, so the robbers left empty handed; – On 4 December 1931, they attacked the Post Office on Mária Street in Újpest, but the postmaster shot back, so once again they had to leave without any booty; On 17 May 1932, the branch of County Savings Bank (Községi – Takarékpénztár) in Lipót Boulevard was attacked, but the cash-keeper hurled a hole punch at the bank robber, who dropped his weapon and fled.

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development

On the basis of the court’s judgment, all three robbers were hanged. The cashier was buried on 3 January 1935; that day mourning flags were displayed at the headquarters of every bank in Budapest. As to the trainee who was shot, he died from his injuries on the day of the funeral. The evening papers reported on the bloody attack in Liberty Square on the very same day when it occurred. Senior managers of Budapest-based banks met on 2 January to consult on increased protection of the branch banks. The police were requested to ensure that in the future vehicles would not be allowed to park at the bank branches for a longer time. They also agreed that they would introduce the use of alarm devices everywhere, strengthen the existing physical guarding, carrying it out with redoubled vigilance and by having an increased number of guards.

Key terms banking crisis deposit insurance economic crisis Glass-Steagall Act Great Depression hyperinflation Keynesian economic policy

League of Nations loan lender of last resort Magyar Nemzeti Bank (National Bank of Hungary) New Deal reparation World War I

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Banks in history: innovations and crises

References Balderstone, T. (1994): The banks and the gold standard in the German financial crisis of 1931. Financial History Review, Cambridge University Press, pp. 43–68. Bánfi, T. (2016): A pénz forradalma. A pénzteremtés elmélete és gyakorlata (The Revolution of Money. The Theory and Practice of Money Creation). Cenzus Kiadó, Budapest. Bernanke, B. S. (2000): Essays on the Great Depression. Princeton University Press, New Jersey. Bernanke, B. S. (2004): Money, Gold and the Great Depression, lecture, Lee University, Lexington, Virginia. Bernanke, B. S. (1994): The Macroeconomics of the Great Depression: A Comparative Approach. NBER Working Paper No. 4814, Cambridge. Bernanke, B. S. – Gertler, M. (2000): Monetary Policy and Asset Price Volatility. NBER Working Paper No. 7559. Cambridge. Billings, M. – Capie, F. (2011): Financial crisis, contagion, and the British banking system between the world wars. Business History, Volume 53. Bordo, M. – Eichengreen, B. (1999): Is our current international economic environment unusually crisis prone? Capital flows and the international financial system, pp. 18–74. Botos, J. (1994): A magyarországi pénzintézetek együttműködésének formái és keretei (Forms and Frameworks of the Hungarian Financial Institutions’ Cooperation). Közgazdasági és Jogi Könyvkiadó, Budapest. Botos, J. (1999): A Magyar Nemzeti Bank története II. Az önálló jegybank 1924–1948 (History of the National Bank of Hungary II. The Autonomous Central Bank 1924–1948). Presscon Kiadó, Budapest. Botos, K. (1996): Elvesz(t)ett illúziók. A magyar bankrendszer helyzete és távlatai (Lost Illusions. The Situation and Prospects of the Hungarian Banking System). Közgazdasági és Jogi Könyvkiadó, Budapest. Bresciani-Turroni, C. (1937): The Economics of Inflation. George Allen & Unwin Ltd., London. Calomiris, C. – Mason, J. R. (2003): How to Restructure Failed Banking Systems: Lessons from the US in the 1930’s and Japan in the 1990’s (No. w9624). National Bureau of Economic Research. Clavin, P. (2000): The Great Depression in Europe, 1929–1939. St. Martin’s Press, United States of America. Costigliola, F. (1976): The United States and the Reconstruction of Germany in the 1920s. The Business History Review. 50, 4, pp. 477–502. Csath, M. (2014): A múlt hatásai és a jövő lehetőségei a gazdaság területén (The Effects of the Past and Future Opportunities in the Economy). Hitel (Credit), No. 2/2014: pp. 22–37. Detzer, D. – Dodig, N. – Evans, T. – Hein, E. – Herr, H. – Prante, F. J. (2017): The German Financial System and the Economic Crisis. Springer

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6. The Third Industrial Revolution (1918—1939),the era of delayed and interrupted development FDIC (1998): A Brief History of Deposit Insurance in the United States. FDIC, Washington D.C. Grant, F. D. Jr (2012): The Chinese cornerstone of modern banking: the Canton guaranty system and the origins of bank deposit insurance 1780–1933. Universiteit Leiden, Leiden. Hardach, G. (1995): Banking in Germany, 1918–1939. In: Banking, Currency, and Finance in Europe Between the Wars, ed.: Charles H. Feinstein, Clarendon Press, Oxford. Holbesz, A. (1939): A magyar hitelszervezet története (The History of the Hungarian System of Lending). May János Nyomdai Műintézet, Budapest. Holmes, A. R. – Green, E. (1986): Midland. 150 years of banking business. B.T. Batsford Ltd, London. Incze, M. (ed.) (1955): Az 1929–1933. évi világgazdasági válság hatása Magyarországon (The Impact of the 1929–1933 Economic World Crisis in Hungary). Akadémiai Kiadó, Budapest. Jakabb, O. – Reményi-Schneller, L. – Szabó, I. (1941): A Pénzintézeti Központ első huszonöt éve (1916–1941) (The First Twenty-Five Years of the Financial Institution Center [1916–1941]). Királyi Magyar Egyetemi Nyomda, Budapest. Kaposi, Z. (2004): A 20. század gazdaságtörténete (Economic History of the 20th Century). Dialóg Campus Kiadó, Budapest–Pécs. Kaposi, Z. (2010): A trianoni békeszerződés hosszú távú gazdasági következményei (The Long-Run Economic Consequences of the Peace Treaty of Trianon). Közép-Európai Közlemények, Szeged, Vol. 3, No. 4: pp. 44–55. Kovács, Gy. (2006): A bankrendszer és stakeholderei történeti megközelítésben, avagy az állam szerepvállalása az ipar banki finanszírozása előmozdításában a magyar gazdaságtörténetben (The Banking System and Its Stakeholders in a Historic Approach, or the Role of the State in the Facilitation of the Financing of the Industry by the Banks in the Hungarian History of Economics). Published in: Katalin Botos (ed.): A bankrendszer és stakeholderei (The Banking System and Its Stakeholders). Szegedi Tudományegyetem, Gazdaságtudományi Kar Közleményei, Generál Nyomda, Szeged: pp. 54–109. Kroszner, R. S. – Melick, W. R. (2008): Lessons from the U.S. Experience with Deposit Insurance. In: Deposit Insurance around the World: Issues of Design and Implementation, eds.: Demirguc-Kunt, Asli; Kane, Edward J.; Laeven, Luc, MIT Press. Newton, L. (2008): Branding, marketing and product innovation: the attempts of British banks to reach consumers in the interwar period. Henley Business School University of Reading, 055. Palyi, M. (1972): The Twilight of Gold, 1914–1936: Myths and Realities. Henry Regnary Company. Chicago. Pethő, S. (1925): Világostól Trianonig. A mai Magyarország kialakulásának története (From Világos to Trianon. The History of the Development of Today’s Hungary). Enciklopédia Rt. kiadása, Budapest. Polányi, K. (2004): A nagy átalakulás – Korunk gazdasági és politikai gyökerei (The Great Transformation – The Economic and Political Origins of Our Time). Napvilág Kiadó, Budapest.

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Banks in history: innovations and crises Schandl, K. (ed.) (1938): A magyar szövetkezés negyven éve (Az Országos Központi Hitelszövetkezet munkája és eredményei) (Forty Years of the Hungarian Cooperatives [The Work and Achievements of the National Central Credit Union]). „Pátria’ Irodalmi Vállalat és Nyomdai Rt., Budapest. Sugár, I. (1899): Pénzintézetek reformja (Reform of Financial Institutions). Közgazdasági Szemle, Vol. XXIII: pp. 403–425. Tomka, B. (2000): A magyarországi pénzintézetek rövid története (1836–1947) (A Short History of Financial Institutions in Hungary [1836–1947]). Aula Kiadó Kft., Budapest. Varga, B. (2017): Pénzügyi felügyelés a két világháború közötti Magyarországon (Financial Supervision in Hungary between the Two World Wars). Hitelintézeti Szemle, Budapest, Vol. XVI, No. 1: pp. 143–161. Varga, I. (1928): A jelentősebb budapesti pénzintézetek helyzete az 1927. évi mérlegek adatainak tükrében (The Situation of the Major Financial Institutions in Budapest in Light of the Figures from the 1927 Balance Sheets). Közgazdasági Szemle, Budapest, Vol. LII: pp. 444–485. Varga, I. (1929): A Magyar Nemzeti Bank és az Osztrák–Magyar Bank bankjegyforgalmi, váltótárca- és érckészletadatainak magyarázata (An Explanation of the Banknote Circulation, Bills Receivable and Ore Stock Data of the National Bank of Hungary and the Austro-Hungarian Bank). Special publication No. 2 of the Hungarian Economic Research Institute. Budapest: Magyar Gazdaságkutató Intézet. Varga, I. (1964): Az újabb magyar pénztörténet és egyes elméleti tanulságai (The New Hungarian History of Money and Certain Theoretical Lessons). Közgazdasági és Jogi Könyvkiadó, Budapest. Walder, Gy. (1939): Bankellenőrzés és bankpolitika (Bank Control and Bank Policy). Közgazdasági Szemle, Budapest, Vol. LXIII: pp. 443–476. White, N. E. (1990): The Stock Market Boom and Crash of 1929 Revisited. The Journal of Economic Perspectives, 4, 2, 67–83. p. Wanke, G. (1930): Szövetkezeti problémák és szövetkezetellenes támadások (Problems with and Attacks on Cooperatives). „Pátria’ Irodalmi Vállalat és Nyomdai Részvénytársaság, Budapest.

Internet source of the chart Chart 6-7: Source: https://hu.wikipedia.org/wiki/F%C3%A1jl:Szabads%C3%A1g_t%C3%A 9r,_1940.jpg

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Banking systems after WWII Ádám Banai–István Papp341

Thanks to its dominant position in the global economy, the US became the world’s leading financial power after the end of WWII and played a major role in determining the evolution of the global financial system in the second half of the 20th century. Apart from its role in WWII’s military operations, the US also played an active role in the reconstruction following the war, through its aid programmes. These activities were instrumental for the US in retaining its economic influence and dominant financial position for decades to come. In the 1950s and 1960s, most banks operated under strict regulations. These years were devoted to post-war reconstruction, for which all internal funds were needed. Local governments sought to channel the largest possible amount of resources into key industries. Financial authorities imposed strict regulations on the operations of financial institutions, while the sector was characterised by strong segmentation, and most interest rates were anchored at artificially low levels. International capital flows were limited, and banks’ overseas operations were restricted in scope and strongly confined in geographical terms. The 1960s witnessed a spectacular deterioration in the US balance of payments, which led the US government to introduce new regulations on capital investment and taxation. To circumvent the domestic financial regulations that became increasingly disadvantageous for US banks, thus they established the Eurocurrency markets in London, the growth of which was also encouraged by international distrust in the US. However, that impressive growth would 341

The authors wish to thank Zoltán Bögöthy for compiling the boxes presenting the fiscal costs of banking crises, Bertalan Vajda for authoring the box on money laundering, and Zoltán Andrási for collecting and processing information on the development of bank information technology in Hungary.

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not have been possible without a series of product and process innovations, some of which were rapid European adaptations of financial processes and products that had already been tried and tested in the US. The biggest appeal of the Eurocurrency markets was the fast, cheap access they offered to large amounts of credit, mostly at variable interest rates. The volatility of interest and exchange rates became a major driver of financial innovations because the high uncertainty about the future course of interest and exchange rates has a negative impact on economic actors in their business decisions. Financial innovations linked to mitigating interest and exchange rate risks (forwards, options, swaps) spread rapidly in these years. The wide range of risk management products and the deepening of these markets made a significant contribution to mitigating and hedging interest and exchange rate risks. The 1960s and 1970s were characterised by rapid adjustment in Western Europe and in particular Japan, accompanied by the achievement of independence by former colonies, as another major effect on the development of the global financial system. In the 1970s, the collapse of the Bretton Woods Agreement and the stronger financial position of oil producing countries had a major impact on developments in international finance. Another key driver behind the internationalisation of finances was leveraging the benefits offered by regulatory arbitrage, as regulations on international banking operations were not standardised at the time. In the 1980s and 1990s, China and the newly industrialising countries in East Asia (the Little Tigers) strengthened their positions spectacularly, primarily at the expense of Japan, which – starting from the early 1990s – had been struggling for years with the consequences of its burst real estate bubble and anaemic economic growth. However, the onset of the Asian currency crisis in 1997 temporarily arrested the financial and economic development of the emerging countries, with Japan and China successfully weathering the wave of crises which swept the region. In Latin American countries, it was the mid1990s that brought about a strategic change in the interests of increasing the competitiveness and crisis resilience of local financial sectors through reliance on a more active participation by foreign banks. — 540 —

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In the early 2000s, the introduction of the euro and the expansion of the single market helped the European banks to compete in global finance. However, the global financial crisis which erupted in 2007 reshuffled power relations again, temporarily weakening both the US and the EU. Owing to its faster and more determined crisis management, the US recovered from the crisis ahead of the European Union. As regards financial innovations, the Japanese banking system lagged behind its US and Western European rivals, which is why during the global financial crisis the less sophisticated Japanese financial system suffered more moderate losses compared to its competitors. The European and US banks which withdrew from Asia in the years after the crisis were mostly replaced by Chinese and Japanese banks. As the banking sector is an information-intensive industry, the development of information technology in the second half of the 20th century revolutionised banking. The deregulation and globalisation of the financial sector contributed significantly to the rapid spread of financial innovations. Banking services were radically reshaped by the expansion of financial innovation, the dynamic internationalisation of the sector, a high degree of automation, increased sales capacity, strong customer orientation and a series of information technology innovations. Nevertheless, the evolution of consumer needs and technology today is faster than what banking systems can keep pace with, due to the obligation to comply with an increasingly extensive body of regulations, as a result of which FinTech companies may be given a first-mover advantage in serving consumers and may possibly even emerge as alternatives to banks. The spread of mobile communication devices is causing the conventional branch network to lose its importance, providing access to financial services for social groups that have previously been prevented from using such services. Participants entering from outside the financial sector may become major financial service providers in the years to come, potentially making active contributions to shaping the future of the financial sector. Over the past decades, the development of financial institutions and financial markets has been interrupted by periodic crises, which have affected the — 541 —

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functioning of the sector and continuously shaped its future. The banking sector itself has suffered a number of shocks and currently faces a myriad of challenges. Nevertheless, it remains a key segment of the economy, which is why its state of affairs has attracted special attention. While there is no generally accepted, proven method to assess the performance of banking systems, we consider that the role in financial intermediation, effective fund-raising and stable operations that are immune from crises could be the criteria against which the performance of individual financial systems should be assessed.

7.1. The geopolitical situation after WWII The US emerged from WWII as the strongest military, economic and financial power, reinforcing its economic and financial hegemony. While its territory was spared from the devastations of the war, the US earned substantial revenues from the sale of weapons and loans to the belligerent countries. During the years of the war, the US saw a significant increase in its industrial capacities, which spectacularly strengthened its global economic and financial position by the end of WWII. In 1944, at the initiative of the US, a conference was held in Bretton Woods at which the foundations of the post-WWII international financial system were laid. A key element in that arrangement was a guarantee to governments for the convertibility of the US dollar to gold at a fixed rate, while the exchange rates of the rest of the currencies were pegged to the dollar. To aid the operation of the new financial system, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) were established. In the years following WWII, international capital flows were limited, and the US also played a dominant role in that regard, given that the war had depleted the reserves of most countries and destroyed a considerable part of their industrial production capacities, while reconstruction required major financial resources.

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Bretton Woods Agreement: Throughout the history of European (western) banking, money with ‘intrinsic value’ was used from the beginnings, with the subsequent introduction of bank notes that could be redeemed for precious metals at a fixed rate of exchange. Although money with ‘no intrinsic value’ was one of the most prominent innovations of the 20th century, in 1944 Bretton Woods sought to establish a modified form of the classical gold standard. At the Bretton Woods Conference, the exchange rate of the US dollar was pegged to gold. The exchange rate of the rest of the currencies participating in the system was in turn pegged to the US dollar. This put the US dollar in a dominant position within the system. To encourage international trade, the parties attending the conference established stable rates of exchange. In the early 1970s, however, the exchange rate of the US dollar came under pressure due to the Vietnam War and the mounting US trade deficit. The US government responded by increasing the supply of money, which resulted in a sharp fall in its gold reserves, leading President Nixon to suspend the convertibility of the US dollar to gold in 1971 (Nixon shock). Since the announcement of the ‘suspension’ for an indefinite period, the exchange rates of currencies have been determined in market trading.

Demand for US products and capital also remained strong after WWII, as a result of which US manufacturing companies and financial institutions both appeared on the international scene. While there had been examples of banks and bankers moving overseas, the expansion of US banks introduced a new quality, heralding the internationalisation of financial sectors. In the case of the US banks, manufacturing companies and banks were established in foreign countries simultaneously. The steady increase in the flow of goods between Europe and the US made it reasonable to relocate certain production units closer to customers and consumers. Manufacturing companies were followed overseas by the banks, which had in-depth knowledge of their customers and preferred not to share the valuable business information they had accumulated about them. Later, banks successfully attracted other companies to follow them overseas owing to their good understanding of both their customers and the foreign economic environment. Regardless of — 543 —

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whether a bank led or followed its customer, in this period the increase in foreign direct investment (FDI) and trade strongly correlated with banks’ expansion overseas. Banks moving overseas primarily served their corporate customers incorporated in the home country. Following the end of WWII, most developing countries also had scarce development resources. Due to the enormous costs of postwar reconstruction, the European states themselves (the previous colonial powers) lacked disposable funds and were indeed in need of financial assistance from the US. Established under the Bretton Woods Agreement, the World Bank was initially assigned the primary task of providing assistance with reconstruction in Europe. From the late 1950s, however, an increasing volume of World Bank funds were allocated to developing countries. Moreover, once reconstruction was complete, some European countries were already able to provide funds to developing countries. Nevertheless, as World Bank credit and foreign aid was only available to governments, financing local companies remained a responsibility of local banks, the operations of which were subject to strict regulations by local governments and financial authorities. The oil crises of 1973 and 1979 brought about fundamental changes in the situation of international finance, as the OPEC countries managed to achieve a major (i.e. three-fold) increase in the price of petroleum. As a result, petroleum-exporting countries generated significantly higher revenues, which could not be absorbed by their local economies and financial systems. These liquid financial assets (‘petrodollars’) were deposited with US and European banks, providing these institutions with substantial amounts of foreign funds. These deposits were primarily lent in the form of syndicated loans to developing countries to promote their economic development or by way of compensation for the effects of deteriorating terms of trade resulting from increasing fuel prices. There was particularly strong demand for US dollar loans tied

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to the LIBOR,342 with the governments of Mexico and Brazil among the first customers. Over the years, as an increasing number of countries applied for loans of this type, the debt of developing countries grew at a faster rate than their repayment capacity. In the late 1970s the US Federal Reserve (Fed) was given a mandate to curb the steadily rising inflation. The resulting monetary tightening also affected LIBOR rates and variable-rate dollar loans were quickly re-priced, causing a major increase in repayment burdens. Moreover, monetary tightening plunged the US and most developed countries into recession, reducing their demand for imports from developing countries. Consequently, developing countries were stripped of a key source of hard currency revenue. As a result, in August 1982 Mexico announced its inability to repay its outstanding debt. Other countries (Philippines, Nigeria and Yugoslavia) were also soon faced with the fact that they were no longer able to meet their obligations to repay their international loans. A series of payment difficulties led to a global debt crisis in the 1980s. Discouraged by repayment problems, foreign banks abandoned Latin America, and only resumed lending to the region starting from the mid-1990s.

7.2. Funding post-war reconstruction in Europe At the end of WWII, the economy in most European countries was in ruins, with a major part of the industrial capacities destroyed. Europe was unable to provide its population with food and consumer goods. To eliminate the shortages, continued imports from the US were required for several years. However, imports required US dollars, but given the negligible volume of European exports to the US, there was a shortage of US dollars across Europe. The way out of this difficult situation was shown by the announcement of the Marshall Plan, officially called the European Recovery Program (Komp, 1999). To help the recovery 342

LIBOR: London Inter-bank Offered Rate.

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of European countries, the US government provided aid, primarily in the form of grants, and a minor part in loans. The objective of the Marshall Plan was to ensure that between 1948– 1952, industrial production and the level of infrastructure in Western European countries reached pre-war levels. In those years, the 17 European countries participating in the plan received a total of over USD 13 billion343 in aid, primarily in the form of US goods. In practice, the European Recovery Program was limited to Western Europe, as the eastern part of Europe, having fallen into the sphere of interest of the Soviet Union, declined participation in the aid program under Soviet pressure. In Asia, although the US aid program was not given a separate name, US aid in the total amount of USD 5.9 billion was granted to Japan, China (Taiwan), South Korea, India, Indonesia and the Philippines from the end of the war until the end of 1953 to help the recovery of these Asian countries. The beneficiaries of US aid were primarily the largest economies of Western Europe, the rationale being that the successful recovery of larger economies would also drive smaller economies (Komp, 1999). After the United Kingdom (26 per cent), France (22 per cent) and Italy (11 per cent), the largest share of aid was granted to West Germany (10.5 per cent), but even that amount was far short of what was needed to restore the country. For that reason, in West Germany, as part of the Marshall Plan a public development bank was established by the name of Kreditanstalt für Wiederaufbau (KfW), with the US contributing DEM 3.7 billion to funding this institution. Following its establishment, the KfW primarily financed large-scale projects which were not undertaken by commercial banks. These included developments in the coal and gas industry, investments in transport, and projects related to the supply of water and electricity. In special cases, the KfW was also mandated to grant short-term loans, subject to prior consultation with the German central bank. 343

Equivalent to USD 130 billion in 2017.

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In consultation with the German Ministry of Economy, the KfW drew up a list of priorities that included the schedule of reconstruction (Komp, 1999). The list was topped by starting up the exploitation and production of industrial raw materials (primarily coal and steel), followed by housing, agriculture (machinery and fertilisers), and the construction of local infrastructure (roads, electricity and water supply). Next on the list were incentives for exports and job creation. Rather than reaching pre-war levels of production, the key criterion for drawing up the list of priorities was to ensure that investments were implemented whereby a strong and productive economy was created that was capable of sustainable operations and could stand its ground in the world.

7.3. Technological development in the financial sector after WWII Although banks’ reliance on achievements in communication technology (telephone, telex, telegram) became increasingly widespread from the second half of the 20th century, 24-hour (‘follow the sun’) trading only emerged in the 1980s. The decades following the end of WWII saw rapid developments in computing, which had a major impact on the financial sector. Owing to advancements in telecommunications and data processing, new products and services were added to banks’ range of products,344 while banking operations were rendered more cost efficient through the increasingly extensive use of technological developments. As computing capacities increased, and statistical software applications became widespread, banks’ analytical tools underwent significant development, and the assessment of financial risks was also put on a firm footing. By eliminating geographical distances, technological development contributed strongly to the globalisation of the industry. 344

hile the development of technology also enabled a number of innovations in W the banking sector, some financial innovations are not technological in nature but are based on some economic consideration, and are often by-products of financial regulation.

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Chart 7-1: Functions of financial innovations

Investment function Financing function Pricing function

Financial innovation

Financial system

Payment function

Risk management function Source: Błach (2011).

The development of the financial sector was also profoundly influenced by financial innovations (Chart 7-1). The achievements of technology simplified the origination of credit transfers, investments, and borrowing, allowing increasingly widespread, convenient access to the products and services offered by banks, the range of which was continuously broadened by financial innovations. The precursors of retail credit cards, called Charg-It cards, were first introduced in the US in 1946. Although the first Automated Teller Machines (ATMs) appeared in the late 1960s (Hayashi et al., 2003), it took this landmark innovation, which subsequently had a strong impact on the lives of both banks and consumers, decades to be incorporated into everyday life (Chart 7-2). By means of ATMs, customers gained constant access to their current accounts and could withdraw cash at any time. Likewise, it is much simpler and cheaper for banks to operate an ATM than to open and operate new branches. Although the first ATMs were only capable of dispensing money, over time multifunctional machines were introduced that also enabled money transfers and top-ups. In parallel with the development of convenience functions, the customer identification and security functions of ATMs also became more robust.

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Chart 7-2: ATM machines in the USA 450,000

Number of ATMs

450,000

400,000

350,000

300,000

250,000

200,000

150,000

100,000

50,000

1985

1990

1995

2000

2005

2009

Source: IMF, Fed.

Payment systems also developed rapidly, as a result of which electronic credit transfer systems were born in the 1970s. SWIFT (Society for Worldwide Interbank Financial Telecommunication), a payment system that handles international money transfers and is widely used to this day, became operational in 1973. Deposit and credit cards linked to current accounts were also important financial innovations as they enabled purchases to be made without cash, which took financial services to a higher level of convenience and gave consumers more freedom. Together with their credit cards, customers were also granted credit lines that could be used free of charge, another function that met the needs of broad masses by making purchases more convenient. It was not until the 1990s that internet banking was introduced, enabling customers to access information on their finances and initiate transactions online, anywhere and at any time. While the new

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innovation gave consumers even more freedom, it also enabled banks to reduce the number of customer visits to banks, providing significant cost savings over the longer term. By the turn of the millennium, the use of the internet had become common in the world, accompanied by a stronger online presence of commercial banks. The first bank websites were launched in 1995, and today practically all banks provide customer access through the internet. The financial revolution at the turn of the century also brought about a new institutional model, giving rise to financial institutions that are operated exclusively as online banks.345 The operational structure of these banks is radically different from the bank organisations that have been in place for centuries, as online banks do not have physical branches and can only be contacted through their web interfaces. Online banks: In the CEE region, ZUNO Bank, established in 2010 by Raiffeisen Bank International, ran for a few years as a bank without a branch network, with plans for a Hungarian launch following Slovakia and the Czech Republic. The Hungarian launch was finally abandoned following the closure of the bank in 2017. By contrast, founded as an independent online bank in 2000, The Japan Net Bank is up and running to this day. It owes its success to its solid financial and information technology background (60 per cent of its shares are held by the Sumitomo Mitsui banking group), and its partnership agreements have enabled it to access and acquire a wide range of internet users. By cutting operating costs, it has been able to offer customers higher deposit and lower lending 345

t the time of their launch, online banks appeared very promising as they offered A an alternative to replace conventional bank transactions. During the dotcom boom of the late 1990s, a large number of online banks were established worldwide, but a great majority of them disappeared within a few years. Established in 1999, Wingspan was closed down and merged into J. P. Morgan in 2000 when the dotcom bubble burst, and Citi f/i, a Citigroup company, also merged into its parent in 2000. Established as an independent online bank in 1996, NetBank survived longer, but its owners were forced to close it down in 2007. In a short time following its establishment, British online bank Egg acquired 2 million customers in 2000, but disappeared within a few years, and had its customers transferred to ‘conventional’ banks.

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rates, as well as more favourable charges on banking services (e.g. money transfers) compared to its competitors. Through its contracted partners (Sumitomo Banking Group, Seven Bank, AM/PM convenience store chain, etc.), it serves its customers with a network of over 10,000 ATMs.

In Hungary, the first wave of major developments in financial information technology (IT) came in the second half of the 1980s with the entry of commercial banks spinning off from the central bank. Having become independent, these banks were required to put their own IT systems into place to provide the functions previously carried out by the MNB and to achieve the targets set by their managers. The most important tasks included the optimisation of human resources by streamlining certain business processes, achieving higher standards in customer service, and support for top management decision-making. However, the development of IT at the time was severely hindered by the insufficient number of experts with considerable professional knowledge and experience. The security aspects of financial transactions were already addressed in the 1980s, but in retrospect it appears that in that period these aspects did not receive the amount of attention that they do today. As technology advanced over time, IT grew to proportions which made it indispensable to manage the risks resulting from its operation. As part of that process, IT and IT security essentially evolved into two separate fields. This separation provided the opportunity for IT security as a separate professional domain to define standards, procedures, requirements and guidelines along which IT should operate (ISMS) or can be controlled efficiently and measurably through the application of methodologies (COBOL, ISO). The tasks of IT security have significantly gained in importance, given that today the purchase price of IT assets is negligible compared to the value of the information stored in those assets. At present, the value of the information stored in a company’s IT systems accounts for a major part of the company’s worth. This is particularly true in — 551 —

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fields such as the financial sector, because even a partial damage to the information stored in a central account servicing system could have incalculable consequences. IT is undergoing continuous changes, as a result of which needs may be met and solutions verified only through continuous learning and development. Due to the key importance of IT, during the establishment, operation and control of financial institutions’ IT systems it is particularly important to ensure legal compliance, to identify and manage the risks inherent in the governance, operation and business activities of financial institutions, to assess the impact of existing and potential risks on institutions, and to provide the basis for enforcement measures. Over the past decades, information and telecommunications technology has revolutionised banking services and the functioning of financial markets. Nevertheless, at the dawn of the 21st century information technology is seen as more of a challenge. As financial deregulation and globalisation reach full scale, the banking system – now with advanced IT infrastructure at its disposal – seeks to serve all economic actors. But today the evolution of consumer needs and technology is faster than what banking systems can keep pace with under the obligation to comply with an increasingly extensive body of regulations. As a result, FinTech companies, which are not subject to the regulations applicable to the banking sector, may be given a first mover advantage in serving consumers in a number of segments and might even emerge as alternatives to banks over time. The spread of mobile communication is providing access to financial services for social groups that have previously been prevented from using such services, and participants entering from outside the financial sector (e.g. mobile carriers) could become major financial service providers in the future.

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7.4. Evolution of the banking systems in developing countries, notably Asia and Latin America, and the risks involved After WWII, a number of colonies gained independence and these new sovereign states were faced with new opportunities and challenges in economic terms as well. In order to reduce their economic deficits, developing countries sought early opportunities to establish and strengthen institutions in their local financial sectors and to raise external funds. In most developing countries, financial authorities imposed extremely strict regulations on bank operations, focusing on the protection of their domestic markets. The banking systems of some developing and emerging countries were able to provide effective support for the process of economic convergence, while other countries have remained unable to cope with this crucial but highly complex task.346 The literature analysing the lessons from the paths taken by successful countries tends to highlight the important role of the following factors in the catch-up process: macroeconomic stability, human capital, entrepreneurship, product and process innovations, stable investment finance, the efficient mobilisation of savings, active participation in the world economy, the control of inflation, rule of law, adequate rules for accounting and disclosure, and the availability of efficient decisionmaking mechanisms. While the literature to date has failed to provide empirical evidence for the proposition that a more developed financial system results in higher economic growth,347 over the past decades numerous examples he reasons for a weak banking system may vary by country. In the literature, the T most frequently cited reasons include low levels of financial literacy, lack of capital, high loan losses, weak banking regulations and weak legal systems. 347 At the onset of their economic upturn, both Japan and China had strict regulations in place for their financial sectors; subsequently, however, the needs of economic development required that the financial systems become more flexible and sophisticated. 346

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Banks in history: innovations and crises

have illustrated that weaknesses in the financial system and the materialisation of accumulated risks can cause severe losses (Table 7-1) and may result in major setbacks to a country’s development. This explains the close attention paid around the world to issues concerning the development, efficiency and stability of financial systems. Table 7-1: Banking crises dates and costs in Asian and Latin American countries between 1970 and 2011 Country

Timeframe

Output loss Fiscal cost (percentage of GDP) (percentage of GDP)

Asia Indonesia

1997-2001

69.0

56.8

Malaysia

1997-2001

31.4

16.4

1983-1986

91.7

3.0

1997-2001

0.0

13.2

1997-2002

57.6

31.2

1983

24.8

0.7

1997-2000

109.3

43.8

1980-1982

52.8

55.1

1989-1990

12.6

6.0

Philippines South Korea Thailand Latin America

Argentina

Brazil Chile Mexico Venezuela

1995

0.0

2.0

2001-2003

71.0

9.6

1990-1994

62.3

0.0

1994-1998

0.0

13.2

1976

19.9

…

1981-1985

8.6

42.9

1981-1991

26.6

…

1994-1996

13.7

19.3

1994-1998

1.2

15.0

Note: Output losses are computed as the cumulative sum of the differences between actual and trend real GDP over the period of the crisis [T, T+3], expressed as a percentage of trend real GDP, with T as the starting year of the crisis. Fiscal costs include fiscal costs associated with bank recapitalisation, but exclude asset purchases and direct liquidity assistance from the treasury. Source: Authors’ own compilation based on Laeven–Valencia (2012).

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7. Banking systems after WWII

The economic reconstruction following WWII strengthened local economies, with a strong emphasis on efforts to achieve economic selfreliance and import substitution in contemporary industrial policies. However, the oil crises of the 1970s triggered major changes in the world economy. To adjust more effectively to changes in the world economy, more and more countries abandoned their earlier policies favouring import substitution and adopted export-oriented economic policies. However, the new industrial policy required a new type of financial system, which increasingly led developing countries to make their strictly regulated financial systems more flexible.

7.4.1. Asia

In most Asian countries, financial authorities imposed strict regulations on bank operations, focusing on the protection of their domestic financial sectors. Despite this, there was no single banking model for Asia, or even East Asia. South Korean banks show a number of similarities to the operations of Japanese banks (relationship banking348), while state-owned banks were dominant in Malaysia and Indonesia, with strong government influence over their lending policies. By contrast, the banking systems of Thailand and the Philippines were dominated by privately-owned banks. As regards common features, the practice of interest rate control was followed for decades, yet in most countries across the region positive 348

I n Japan, long-term customer relationships have a particularly important role in corporate lending. A company and its ‘main bank’ will enter into a close and longterm relationship, and switches are very rare in such ongoing commitments. The company will not only receive funds from the bank, but may also rely on consulting support as required. This mutual and ongoing commitment has the advantage that the company has a secure source of funding, whereas in addition to interest income the bank will also collect other revenues from consulting services. The institution of the main bank has helped to reduce the cost of bank finance, while corporate restructuring is easier and less costly in times of difficulty, as the bank continuously monitors the activities of the company, which reduces information asymmetry between the company and the bank (Hidasi–Papp, 2015).

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Banks in history: innovations and crises

real interest was paid on bank deposits, i.e. financial repression did not reach extreme proportions. Across the region, all countries shared the characteristic that their governments played a historically significant role in shaping the lending processes of their economies. In each country, the government sought to enforce its own will in lending (and elsewhere), which was done directly (through state-owned banks) in some places, and through politicians’ influence on the decisions of privately-owned banks in others. In the countries of the region, family businesses played a prominent role and lending on grounds of family relationships was also common. The oil crises brought about fundamental changes in the terms of trade, as a result of which starting from the 1980s an increasing number of East Asian countries opted for export-driven industrialisation policies. In order to promote such policies, deregulation started in the strictly regulated banking sectors across the region. Financial deregulation started in the 1980s in the ASEAN countries (Association of Southeast Asian Nations), and then in the early 1990s both the breadth of the measures and the number of countries entering the path of deregulation increased, as a result of which comprehensive financial liberalisation was accomplished in a number of developing countries in Asia. The wide range of financial deregulation measures (Table 7-2) sought to intensify competition among financial institutions, ensure a more efficient distribution of funds, mobilise savings more effectively, broaden the scope of banks’ activities, and promote the internationalisation of local banks (Bank of Thailand, 1993; Vichyanond, 2000). As part of the measures, a number of earlier restrictions were relaxed or removed, accompanied by the reinforcement of standards on safe and sound operations, and the introduction of new prudential regulations. On the one hand, through the measures adopted, financial authorities sought to ensure that competition among banks resulted in a more efficient distribution of funds in the new

— 556 —

7. Banking systems after WWII

and more liberal financial environment, that institutions widened the scope of their activities, and that all of this had a positive impact on the performance of the financial sector and on economic development. On the other hand, they wanted to raise the highest possible amount of foreign funds, at the lowest cost attainable, to accelerate economic development. In the countries of the region, in addition to local banks, foreign credit institutions were also present, but these strictly regulated foreign banks349 (subject to stringent rules for entry and a prohibition on the opening of new branches) had no adequate means to meet the demand created for foreign capital by the Asian countries, which had accelerated their pace of economic growth. However, to help their economies raise foreign funds, rather than relaxing the legal regulations restricting the entry and operations of foreign banks, governments opted for the establishment of off-shore financial centres (Bangkok International Banking Facilities (BIBF) (Thailand), Labuan International Business and Financial Centre (IBFC) (Malaysia)). Through the establishment of the BIBF (1993), Thai financial authorities wanted to channel more foreign funds to the economy, while seeking to ensure that Bangkok would emerge as the financial centre of Indo-China.

349

efore the crisis, the entry of foreign banks had been restricted in a number of Asian B countries and specifically prohibited in some of these countries. For some 20 years before the Asian currency crisis, Thailand had not granted a single banking license to commercial banks. As a result of this protectionist policy, domestic banks were not seriously required to reckon and deal with foreign competitors.

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Banks in history: innovations and crises

Table 7-2: Chronology of major financial liberalisation measures in Thailand Abolition of interest rate control March 1990

Abolishing interest rate ceiling on commercial banks’ time deposits of less than 1 year

January 1992

Abolishing interest rate ceiling on commercial banks’ saving deposits

June 1992

Abolishing ceiling on commercial banks’ lending rates (liberalisation of commercial banks’ interest rates completed)

Foreign exchange liberalisation May 1990

Thailand formally accepts obligations under Article VIII of the IMF’s Articles of Agreement (complete liberalisation of current account transactions)

April 1991

Allowing more free outflows of capital for overseas investment, repatriation of dividends and proceeds from sale of stocks by foreigners; resident individuals or legal entities were allowed to open foreign currency accounts

May 1992

Further liberalisation of exchange controls (allowing exporters to be paid in baht from non-resident baht accounts without prior approval from the Bank of Thailand (BOT); allowing exporters to use foreign currencies from exports to repay foreign debts without prior approval from the BOT, etc.)

Expanding the scope of activities of commercial banks March 1992

Allowing commercial banks to operate as selling agents for debt instruments issued by the government and state-owned enterprises; information service; financial consulting service

June 1992

Allowing commercial banks to operate the following (fee-based) businesses: arranging, underwriting, and dealing in debt instruments; representative of secured debenture holder; trustee of mutual funds; securities registrar; selling agent for investment units

Strengthening prudential regulations January 1993

Imposing the BIS capital adequacy standard on commercial banks (minimum capital-to-risk-asset ratio for domestic banks 7 per cent and 6 per cent for foreign banks)

June 1993

Commercial banks with BIBF (Bangkok International Banking Facilities) licenses were required to increase their provisions for possible loan losses (50 per cent to 75 per cent); Thai Rating and Information Service (TRIS) was established

December 1993 Increasing the minimum capital-to-risk-asset ratio from 7 per cent to 7.5 per cent for domestic banks and 6 per cent to 6.5 per cent for foreign banks March 1995

Commercial banks have to submit the details of risk and their management on the trading of foreign currencies and related derivatives

December 1995 Commercial banks with BIBF licenses were required to increase their provisions for possible loan losses (75 per cent to 100 per cent) Deregulation of asset management November 1990 Branch-opening requirement for commercial banks to hold government bonds as a minimum proportion of total deposits was reduced from 16 per cent to 9.5 per cent May 1991

Increasing the minimum amount of assets that each foreign bank branch must maintain in Thailand from 5 million baht to 125 million baht

— 558 —

7. Banking systems after WWII September 1991

Branch-opening requirement for commercial banks to hold eligible securities as a minimum proportion of total deposits was reduced from 9.5 per cent to 8 per cent

January 1992

Relaxing rural credit requirements (broadening the definition of targeted rural credits, etc.)

May 1993

Abolishing branch-opening requirement for commercial banks to hold eligible securities as a minimum proportion of total deposits

Deregulation of entry March 1993

Establishing the BIBF (47 units)

November 1996 7 foreign BIBF units were upgraded into full bank branches December 1996 BIBF licenses were granted to 7 new foreign commercial banks November 1997 Allowing foreign investors to take majority stakes and management control for up to 10 years in locally incorporated financial institutions Source: Bank of Thailand (1998).

In 1994, the Thai government announced that legal regulations prohibiting the entry of banks to the market would be relaxed, and 5 to 7 BIBF members would be granted domestic operating licenses by 1997. The announcement gave rise to fierce competition among the 20 foreign banks that had recently joined the BIBF, generating an extraordinary increase in the inflow of short-term foreign currency loans to Thailand. However, as the steadily rising volume of credit could not be absorbed by the economy, some of it was used for real estate and equity purchases, as a result of which significant financial and credit risks accumulated in the country in the space of a few years. Due to repeated postponements in licensing the entry of new banks, countries across the region accessed most of the funds required for the development of their economies in the form of cross-border lending.350 350

anks and companies across the region often used short-term foreign currency loans B to finance long-term local investments and capital expenditures. Due to double mismatch, the accumulated debt proved particularly devastating in the course of the crisis. In mid-1997, the exposures of domestic residents in the three countries hardest hit by the crisis (Thailand, Indonesia and South Korea) to foreign banks amounted to USD 232 billion, including USD 151 billion worth of short-term debt. Within total foreign debt, the share of short-term debt was 20 per cent in Indonesia, 30 per cent in Thailand, and 50 per cent in South Korea. The outstanding amount of shortterm liabilities exceeded the stock of international reserves in the three countries.

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Banks in history: innovations and crises

However, international experience shows that while the stock of such loans is quick to build up, funds may also rapidly run dry when the confidence of foreign creditors is undermined. The culmination of the Asian currency crisis was no exception; from 1997 onwards foreign creditors systematically refused to renew the expiring debt of countries in the region351 (Palmer, 2000). The increase in the volume of shortterm foreign borrowing in the countries concerned led to a build-up of significant exchange rate risk as well as of high maturity (rollover) risk, which materialised following the onset of the crisis. As the US dollar had appreciated for a considerable period, by 1997 the currencies of a number of Asian countries, which were pegged to the dollar, had become overvalued. Triggered by the devaluation of the Thai baht, the crisis spilled over to other countries in the region, primarily Indonesia and South Korea but also affected the other countries in the region (Malaysia, the Philippines, Singapore and Hong Kong). Countries in the region took turns in devaluing their currencies, which significantly increased the amount of repayments on debt accumulated in US dollars and resulted in massive capital flight from the countries concerned. Plummeting asset prices pushed several countries to the verge of insolvency, when Thailand, Indonesia and South Korea applied to the IMF for financial assistance. Although the crisis was successfully contained within a few years through the contribution of the IMF, the financial meltdown was a major setback to the economic development of the countries in the region, and the remedy applied had a number of side effects. Foreign funds can be raised in forms other than cross-border (off shore) loans, and international experience demonstrates that the stocks of loans granted in local currencies by foreign banks with local branches tend to be much more stable than cross-border foreign currency 351

etween June 1997 and June 1999, outstanding amount of cross-border loans to B Asian countries dropped by 36 per cent.

— 560 —

7. Banking systems after WWII

lending (Montgomery, 2003). In other words, foreign banks with a direct presence in local banking sectors are more committed to local economies at times of crisis than foreign financial institutions that have no physical presence locally. Moreover, while cross-border loans only involve the flow of funds, foreign banks with a direct local presence supply the country concerned with both funds and new technologies and up-to-date financial and risk management knowledge. Brick-and-mortar foreign banks are not only more committed to the local economies, the participation of such banks is also more diverse, with a much stronger network of ties to local customers compared to other banks in financial centres. While placing too much emphasis on facilitating foreign borrowing, the authorities of Asian countries failed to give proper weight to promoting various forms of fund-raising in the course of financial liberalisation measures,352 which led to a major build-up of vulnerability in countries throughout the region. That risk materialised during the Asian currency crisis, leaving local banking systems with a hefty price to pay, as the currency crisis triggered a widespread banking crisis, which set back the performance of the economy for years, partly because banks cut back on their lending and bank bailouts consumed massive amounts of money.

352

In the course of financial liberalisation, the proper sequence of measures is of key importance. Liberalisation of domestic financial markets must primarily be accompanied by the reinforcement of the prudential operation and supervision of institutions, followed by liberalisation of foreign direct investments in the sector, and then liberalisation of the debt and capital markets, and finally the licensing of off-shore banking (Leightner, 2007). However, failing to follow this order (Bank of Thailand, 1993, p. 26), Thai authorities were too early to offer scope for off-shore banking, which significantly influenced the impact of deregulation measures. The introduction of new financial products was not fully aligned with taxation issues (e.g. negotiable certificates of deposits (NCD)), which limited the spread of such products (Bank of Thailand 1993, p. 33).

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Banks in history: innovations and crises

In the light of the foregoing, it can be argued that a more effective policy choice would have been for financial authorities to pay more attention to the consistency of their deregulation measures (e.g. by avoiding the early licensing of off-shore banking), place more emphasis to the development of capital markets (e.g. by facilitating corporate bond issues) and offer more space for foreign banks during the deregulation of the sector. There would have been several options for the latter, e.g. foreign banks could have acquired the shares of domestic banks or licenses could also have been granted for the establishment of new joint banks. It would have been appropriate for financial authorities to find a balanced solution whereby – apart from gaining access to cheaper foreign funds – domestic banks would also be interested in the acquisition of state-of-the-art financial techniques. This would have required the establishment of an operating environment that would have provided domestic banks with a strong incentive to upgrade their financial know-how, diversify their operations and market new products and services on a continuous basis (Papp, 2001). The example of the countries under review, and of Thailand in particular, shows that where liberalisation is carried out following a limited and biased concept (restricting the role of foreign banks to the supply of cheap funds), the original objectives will not be accomplished, banks will not diversify, and their operations will not be upgraded in any meaningful way. In other words, in an environment where cheap foreign funds are abundant and domestic banks hardly face any competition at all, rather than focusing on financial innovation and the development of products and services, local banks will primarily optimise their operations for the exploitation of profit opportunities provided by the reduced cost of funds. In general, it can be argued that the need for financial services will increase in parallel with economic development and the improvement in customers’ financial circumstances. In the first half of the 1990s, while the growth of Asian economies was considerable even by international

— 562 —

7. Banking systems after WWII

standards, local banks failed to exploit this exceptionally favourable period of growth to transform into crisis-resilient, modern banks with a diversified structure of funds and products. Sweeping across the region in 1997, the Asian currency crisis pushed a number of local banks to the verge of bankruptcy, paralysed the functioning of financial systems in the region and set back the dynamics of the economy for years. Eliminating the consequences of the crisis cost enormous amounts of money. The governments of the countries in the region changed their previous behaviour only when they were faced with the dire consequences: only then did they understand the importance of borrowing in a diversified and healthy structure. In subsequent years, policymakers paid more attention to reducing the vulnerability of the economy and increasing the shock-resilience of the financial sector, which involved the development of local bond markets353 (Chart 7-3), and the improvement of local banks’ competitiveness. These developments played a key role in helping the countries in the region avoid a systemic banking crisis in the aftermath of the global financial crisis, and made it possible for Asian countries to resume dynamic growth, and contribute to the expansion of the world economy today.

353

he development of local bond markets offered multiple benefits to the countries T in the region. On the one hand, economic actors were indebted in local currency rather than foreign currencies, while maturities also became significantly longer. The establishment of bond markets enabled a higher level of diversification in borrowing, which reduced banks’ dominance in finance. From investors’ perspective, the increasingly wide range of bonds on offer broadened the scope of investment opportunities.

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Banks in history: innovations and crises

Chart 7-3: Historical growth of Asian local bond markets 3,000

US Billions

3,000

2,500

2,000

1,500

1,000

1,000 500

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Q2

500

Corporate bonds Government bonds

Note: Aggregates of Indonesia, Malaysia, Philippines, Singapore, South Korea and Thailand. Source: Asian Bonds Online.

7.4.2. Latin America

For decades, commercial banks in the Latin American countries focused on traditional products (loans), with less attention to the development of financial services and the capital market. These countries share the key characteristic that their loan-to-GDP ratios remained low for decades, despite the predominance of banks in financial intermediation (Chart 7-4). Most countries in the region tend to have high levels of bank concentration, often accompanied by aÂ low intensity of competition among banks. In the majority of the financial systems in Latin American countries, an important role was played by state-owned banks, which granted most long-term development loans. Privately-owned commercial banks primarily granted short-term loans.

â&#x20AC;&#x201D; 564 â&#x20AC;&#x201D;

7. Banking systems after WWII

Chart 7-4: Credit provided by the banking sector, percentage of GDP 180

Per cent

180

Brazil

Mexico

100

Argentina

100

Indonesia

120

Philippines

120

Singapore

140

Malaysia

140

South Korea

160

Thailand

160

1975 1995 2015 Source: World Bank data.

For decades, the financial systems of Latin American banks were characterised by a low level of penetration, a limited choice of financial products, the low mobilisation of savings, the prominent role of stateowned banks and the limited presence of foreign banks. As most banks applied high interest rate margins, only a narrow group of companies (predominantly large corporations) could have access to credit. A major part of lending was comprised of short-term loans. Government intervention in the operations of the financial sector was frequent, partly in order to channel bank lending into sectors to which the government had given priority. While domestic savings as a percentage of GDP increased spectacularly for decades in most of the Asian countries under consideration, this was not common at all in the case of Latin American countries (Chart 7-5).

— 565 —

Banks in history: innovations and crises

Chart 7-5: Gross domestic savings, percentage of GDP 60

Per cent

Brazil

Mexico

Argentina

Indonesia

Philippines

Singapore

Malaysia

South Korea

Thailand

1975 1995 2015 Source: World Bank data.

In the 1970s and 1980s, competition among banks in most developed countries exerted downward pressure on lending margins, forcing banks to diversify their operations. By contrast, in most Latin American countries the deregulation of the financial sector was completed only later, and consequently margins remained high for decades, while the share of interest income was approximately 90 per cent in the leading countries of the region. However, these high margins were only affordable for large corporations, and lending to the SME sector remained weak. The other main source of income for banks was the purchase and holding of government securities.

â&#x20AC;&#x201D; 566 â&#x20AC;&#x201D;

7. Banking systems after WWII

Dollarisation354 was also a characteristic of the countries in the region, especially in periods of high inflation. Savers were not saving in the local currencies, but purchased US dollars to be deposited with banks. In turn, these funds were lent by local banks in dollars. At the same time, where dollarisation was only partial, the currency mismatches made the balance sheets of both corporations and banks more vulnerable. In the case of full dollarisation, the country concerned essentially abandoned its autonomous monetary policy. Dollarisation: Dollarisation is the phenomenon where one country uses the currency of another for monetary functions. This may be a result of a central policy or economic actors’ individual decisions. Dollarisation was named after the arbitrary adoption of the US dollar by Latin American countries.

In Latin America, measures to relax strict regulations on bank operations (interest rate control, etc.) were spearheaded by Chile and Uruguay, which were the first countries to abandon interest rate control in 1974. By contrast, Brazil, Mexico and Venezuela waited for years and only liberalised their interest rates at the end of the 1980s. In Costa Rica, interest rates were not liberalised until 1995 (Table 7-3).

354

ollowing the establishment of Argentina’s currency board in 1991, the peso was F exchanged to US dollars at a fixed rate, which gave the US currency increasing prominence in financial intermediation. The system remained in place until its collapse in 2002, which led to sharp depreciation of the peso. In some countries in the region the extent of dollarisation exceeded 90 per cent (e.g. in Bolivia), and some countries (such as Ecuador and El Salvador) in fact opted for the full introduction of the US dollar as the legal tender. On the other hand, Brazil and Mexico were able to avoid dollarisation through legislation prohibiting economic actors from holding foreign currency for accumulation purposes (i.e. not linked to transactions).

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Banks in history: innovations and crises

Table 7-3: Latin America — First-generation reforms of the financial system

Country

Argentina

Liberalisation of the interest rates

1989

Start of an Adoption of intensive capital period of adequacy privatization requirements 1995

1991

Bank reserves (%)

Tension (1) or systematic crises following reform (2)

1990

2000

1995 (2)

Bolivia

1985

1992

1995

1985 (1)

Brazil

1989

1997

1995

1994 (1)

Chile

1974; 1985

1947-1987

1989

1982 (2)

Colombia

1979

1993

1992

1998 (2)

Costa Rica

1995

1984

1995

1994 (1)

Mexico

1988

1992

1994

1994 (2)

Paraguay

1990

1984

1991

1995 (1)

Peru

1991

1993

1995 (1)

Uruguay

1974

1992

1982 (2)

Venezuela

1989

1996

1993

1994 (2)

Source: Moguillansky et al. (2004).

Financial reforms in Latin America were introduced in two waves. In the first wave, efforts were made to improve banks’ operating environment e.g. through the liberalisation of interest rates, the free allocation of financial assets, the reduction of barriers to entry and the establishment of a more sophisticated supervisory system. The second wave of reforms responded to the 1994 ‘Tequila crisis’, which had destabilised the banking systems of several countries in the region. These measures aimed to strengthen the supervisory system, and in particular to ensure that banks’ risk assessment improved and that their reporting to supervisory authorities became more reliable and transparent. From the mid-1990s, Mexico, Brazil and Argentina introduced farreaching measures that radically transformed their local banking systems and economies. This was the period in which the new exportled growth model started to gain higher priority (Bulmer–Thomas, — 568 —

7. Banking systems after WWII

1994, 366), progressively replacing the previous economic regime, which had a preference for strong government participation and import substitution. To promote the new growth model, a new economic policy was adopted, according to which trade and the functioning of the financial sector was liberalised and some state-owned enterprises (SOEs) were also privatised. Before the 1990s, few banks (most of them North American) were present in Latin American countries. Following the Tequila crisis, however, an increasing number of foreign banks entered the Mexican market, and in the second half of the decade, the presence of foreign financial institutions also grew rapidly in other countries throughout the region. Latin American countries witnessed a number of financial crises over the course of their history, yet it was only in the aftermath of the Tequila crisis that distressed local banks were offered to foreign investors. Previously, the governments of the countries in the region had nationalised failed banks from time to time. Around the turn of the millennium, strong interest in Latin American expansion, which also involved the acquisition of banks on the verge of bankruptcy, was shown particularly by Spanish banks. While entering the market of a crisis-hit country involves a large number of hazards, the new markets also offered plenty of benefits to expanding foreign banks (Papp, 2005). One such non-recurring opportunity was the opening up of previously closed markets to foreign investors in the aftermath of the crisis. Apart from the time factor, the significant reduction in the costs of foreign expansion is also a potential advantage, given that at times of crisis, particularly when a banking crisis is accompanied by a currency crisis, foreign buyers may acquire distressed local banks at a bargain price. At the same time, the entry of foreign banks also offers a number of potential benefits to the host countries. First, foreign participation accelerates the restoration of the local financial sector, while it also reduces its burdens. Second, the presence of foreign banks as safe — 569 —

Banks in history: innovations and crises

havens provides security for depositors, allowing the capital flight to be curbed. Third, foreign banks can continue lending to creditworthy local borrowers even in times of financial distress, since unlike local banks, multinational banks have diversified operations and rely upon a far greater number of pillars compared to local competitors, as a result of which their presence mitigates the effect of a credit crunch. Fourth, brick-and-mortar foreign banks with local branch networks have stronger ties to the local economy than foreign financial institutions whose operations are limited to cross-border lending. Finally, entering foreign banks prompt local competitors to innovate by means of the state-of-the-art business models and management methods they bring with them, and the new banking products and services they introduce to the market (Papp, 2005). From the second half of the 1990s, there was a spectacular acceleration in the expansion of foreign banks in Latin American countries (Table 7-4). As foreign banks appeared on the scene, new financial products and services were introduced to the market, and competition among banks intensified. Banks moving in from developed countries had lower operating costs and followed more advanced and sophisticated risk management practices. The establishment of foreign banks as well as the new banking business models and risk management methods they brought with them required that banking supervision be modernised and that its quality be improved (Peek–Rosengren, 2000; Crystal et al., 2002). As the prudential operations of banks were strengthened, the shock-resilience of local banking systems improved, while intensifying competition in the market made local banks more cost-sensitive and profit-oriented.

— 570 —

7. Banking systems after WWII

Table 7-4: Foreign bank ownership in selected emerging markets Total assets (1994) (billion $)

Foreign control (1994) (%)*

Total assets (1999) (billion $)

Foreign control (1999) (%)*

Latin America Argentina

73.2

17.9

157.0

48.6

Brazil

487.0

8.4

732.3

16.8

Chile

41.4

16.3

112.3

53.6

Colombia

28.3

6.2

45.3

17.8

210.2

1.0

204.5

18.8

Peru

12.3

6.7

26.3

33.4

Venezuela

16.3

0.3

24.7

41.9

Malaysia

149.7

6.8

220.6

11.5

South Korea

638.0

0.8

642.4

4.3

Thailand

192.8

0.5

198.8

5.6

Czech Republic

46.6

5.8

63.4

49.3

Hungary

26.8

19.8

32.6

56.6

Poland

39.4

2.1

91.1

52.8

Mexico

Asia

Central Europe

Note: *Ratio of assets of banks where foreigners own more than 50 percent of total equity to total bank assets. Source: Authorsâ&#x20AC;&#x2122; own compilation based on IMF (2000).

However, the results of improving cost efficiency provided only limited benefits for bank customers, as the results were retained by banks. Accordingly, interest rate margins remained high in most Latin American countries. Favourable developments in macroeconomic indicators, and most prominently the control of inflation facilitated the upsurge in lending, which in turn deepened financial intermediation. The establishment of the system of financial supervisory institutions resulted in more efficient risk management and more stable institutions, but by no means did that prevent the build-up of new risks and vulnerabilities in the financial sectors.

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Banks in history: innovations and crises

Following the Tequila crisis the entry of foreign (US) banks had a stabilising effect on Mexico’s economy as it shortened the crisis and reduced its burdens. Over the following decade foreign banks gained significantly in terms of market share in Latin American countries, which was accompanied by an increase in the number of home countries. In this period, the expansion of Spanish banks in particular was extremely dynamic in the countries in the region. However, during the global financial crisis it became obvious that foreign banks behaved differently in crisis situations, i.e. that they did not always act as stabilising forces.355 Pre-2008 literature only studied host-grown crises such as the Tequila crisis and the Asian currency crisis, and – on the grounds of the observed behaviour of foreign banks – it considered their local subsidiary banks as stabilising forces, which provided a safe haven for depositors at times of market turbulence, and remained capable of lending when local financial markets were affected by liquidity shortages. However, the events following the global financial crisis highlighted the fact that the behaviour of foreign banks (i.e. their commitment to the local economies) was substantially influenced by the financial strength of their parent banks. The global financial crisis provided a number of examples356 demonstrating that foreign banks with weak (vulnerable) parent banks could have a destabilising effect on the banking systems and economies of their host countries (De Haas–Van Lelyveld, 2014; BIS, 2015, 35). In order to reduce contagion, more efficient coordination and closer cooperation is required between the banking supervisory authorities in home countries ultinational banks operate in several countries, which gives them the ability to M reallocate capital and liquidity, while due to their geographical diversification they have easier access to funds at times of market turbulence, which is why they were regarded as stabilising forces. 356 There are also a number of examples to show that following the onset of the crisis, lending was cut back the most by banks that had expanded the most aggressively in the years leading up to the crisis. Parent banks that had financed their foreign subsidiary banks from the interbank markets reduced the funding of their foreign operations more substantially compared to banks whose funding models were based on bank deposits. 355

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7. Banking systems after WWII

and host countries, while the framework of international cooperation also needs to be strengthened. On balance, it can be argued that financial reforms, improvements in the quality of banking supervision and the stronger presence of foreign banks has created a more cost-efficient and shock-resilient banking system in the Latin American countries. The effect of foreign banks’ presence on financial stability is nevertheless complex, given that – despite the initial expectations – their stabilising effect was not consistently felt throughout the global financial crisis. In many cases, foreign banks with weak parent banks had a negative effect on the stability of the local banking systems, as they transmitted home-country shocks357 to host countries, imposing the burden of an unprecedented type of vulnerability on Latin American banking sectors. The consequences of the global financial and economic crisis highlighted the extremely rapid rate of contagion and the need to reduce the channels of contagion. Due to the unfolding financial globalisation, the interdependence of participants in the financial system became extremely strong. Due to the interdependence of financial markets, spillover effects may transform local problems and crises into geographically widespread or even global problems. Contagion can be reduced by the diversity of home countries, as well as by more efficient cooperation between the supervisory authorities of the countries concerned. While the internationalisation of the financial system of Latin American countries placed the burden of new risks on local banking sectors, the countries in the region have experienced a far lower number of bank

357

he crises of home countries varied in depth, and due to its faster and more T determined crisis management, the US recovered from the crisis ahead of the European Union. The economic crisis and the European sovereign debt crisis created a remarkable setback to the lending activity and profitability of European banks. The operations of Spanish banks were hit hard by the unfavourable developments, accompanied by a reduction of their international role and presence.

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Banks in history: innovations and crises

runs and systemic banking crises over the past one and a half decades compared to earlier decades (Chart 7-6). Chart 7-6: Number of systemic banking crises starting in a given year 25

Crises

Global financial crisis

Tequila crisis

Asian currency crisis

Transition economies

Latin American debt crisis

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1990

1992

1988

1986

1984

1980

1982

1978

1976

0 1974

0 1970

1972

Latin American countries Transition economies East Asian countries Other countries Source: Authors’ own compilation based on Laeven–Valencia (2012).

Box 7-1 Fiscal costs of banking crises after WWII

Following WWII, as government participation in the economy increased, the fiscal management of banking crises also became more complex. In relation to crisis management, a variety of government objectives were introduced, to minimise fiscal costs and strengthen the fiscal position through assistance or transparency in the implementation of crisis management (Alexander et al., 1997). These objectives were associated

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7. Banking systems after WWII

with a variety of instruments, which policy makers applied in combination in their efforts to aid the recovery of the financial sector. In the context of the fiscal costs of banking crises, a distinction is made in the literature between direct and indirect channels (Amaglobeli et al., 2015; Chart 7-7). Direct fiscal costs are incurred as part of bank bailouts in the application of instruments such as bank recapitalisation, the transfer of bank assets, government guarantees on deposits, and the restructuring of financial institutions (through nationalisation, closure or merger). Indirect fiscal costs arise in connection with the macroeconomic consequences of a banking crisis such as the increment resulting from the revaluation of foreign currency debt, or tax revenues lost due to a decline in GDP. Cottarelli et al. (2014) argue that in the period up to 2007 recapitalisation, restructuring (excluding nationalisation) and the transfer of bank assets were the most frequently used instruments to help recovery. Chart 7-7: Channels of the fiscal impacts of banking crises

Macroeconomic developments

Indirect channel

Resolution

Direct channel

Containment

Central bank channel

Banking crisis

Central bank involvement

Direct fiscal costs

Indirect fiscal costs

Source: Authors’ own compilation based on Amaglobeli et al. (2015).

In the second half of the 20th century, the direct fiscal costs of banking crises were substantial. In connection with the pre-2007 banking crises

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Banks in history: innovations and crises

included in the database of Laeven–Valencia (2013), countries incurred an average gross fiscal cost amounting to 14 per cent of GDP (net of asset transfers). Although some of that cost was recovered in the course of recovery from the crisis, according to the IMF (2010) in the G20 countries even the net fiscal costs calculated with a haircut for recoveries amounted to 8 per cent of GDP. Most of the costs were related to the recapitalisation of financial institutions (Laeven–Valencia, 2008). The crises in Argentina (1980) and Indonesia (1997) were overcome at the expense of extremely heavy fiscal burdens, as the gross cost of bank bailouts exceeded 50 per cent of GDP in both countries. In 1980, the Argentine government assisted with the bailout of three banks that had suffered severe losses during the crisis. In 1997, Indonesia provided assistance for the recovery of seven state-owned banks, whereby four government-owned banks were merged, and all of the remaining banks were recapitalised.

7.5. Global standardisation of banking regulation – Basel I The banking systems of the 1950s were rather isolated and operated under extremely strict regulations. The use of computers was rudimentary, and international channels of communication were severely limited. The banking sector primarily provided the funds required for the development of the national economy, subject to extensive government participation. National financial authorities imposed extremely strict regulations on the operations of local financial institutions, including restrictions on the activities of foreign banks. Following the completion of post-WWII reconstruction, trade among developed countries started to grow dynamically, accompanied by an intensification in other forms of economic cooperation (e.g. FDI), the effects of which were felt in the development of international finances. Commercial banks followed manufacturing companies as they expanded abroad; however, initially banks entering foreign markets were only allowed to serve corporate customers headquartered in their home countries (Papp, 2015).

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7. Banking systems after WWII

The deregulation of financial products and services started as part of the international economic cooperation among developed countries, which continuously increased in both breadth and depth. The deregulation of standards that fundamentally influenced the functioning of the financial sector started in the 1960s and 1970s, gradually leading to the internationalisation and globalisation of the sector. Thanks to the unfolding process of financial deregulation funds available grew, the number of financial innovations increased, and the spread of data transfer and data processing technologies developed. All this gave new impetus for banks’ more flexible operations and international expansion. Organisational innovations: Due to floating exchange rates and capital market liberalisation, from the late 1970s there was a rapid development in wholesale commercial banking services. One of the outcomes of that development was the establishment of the first commercial banking treasuries within large banks, which offered services related to the financial, currency and capital markets. Treasuries serve the needs of institutional and corporate investors. It was also around this time that Asset and Liability Management (ALM) was separated in organisational terms within banks, and was tasked with minimising interest rate and liquidity risks and maximising interest incomes. On the technology side, the emergence of treasuries was enabled by the development of telecommunications and computing, given that efficient treasury operations require real-time exchange rates as well as fast information processing and computing capacities for pricing buy and sell offers, and for the quantification of the risks underlying the products. Once those requirements were met, treasuries could offer customers an increasingly wide range of increasingly complex products for investments and hedging risks. Treasury operations have been developing continuously, and at present transactions are carried out on electronic platforms without human intervention, which has led to a rapid growth in trading volumes. Today, both treasury and ALM are core components of commercial banking operations worldwide.

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Banks in history: innovations and crises

International experience shows that banks’ foreign expansion is influenced by a number of factors. Many banks have sought to gain a competitive advantage and acquire new customers by relocating all or part of their operations to countries where regulations are more favourable (i.e. less stringent). Given the high number of rules imposed on the activities of financial institutions, the effort to leverage regulatory arbitrage has been one of the drivers of the internationalisation of banks from the beginning.358 Authorities started to look for an effective response to that phenomenon in the 1970s due to banks’ intensifying international operations. In the 1970s, banks’ capital adequacy started to deteriorate, which was not met with approval by banking supervisory authorities. Moreover, the increasingly active participation of banks in international lending led to a significant increase in their risks. As regulatory arbitrage affects several countries by nature, work on possible responses was also carried out on an international scale from the onset. By this time, regulatory experts had realised that the increasingly international banking system could be reasonably regulated by means of consistent international standards. Established in 1975, the Basel Committee on Banking Supervision (BCBS) was tasked with the 358

lthough the favourable geographical location and multilingualism of Luxembourg A were advantageous for the provision of international financial services, the financial sector of the country was not seen as significant before the 1970s. A major impetus for becoming a financial centre was provided by the introduction of changes in the fields of banking regulation and taxation in neighbouring Germany, Belgium and France that led economic actors in the region to transfer their investments and savings to Luxembourg. In the late 1960s, West Germany increased the reserve requirement ratio for banks, to which several German banks responded by deciding to establish branches in Luxembourg, because financial institutions operating there were not subject to the new German regulations. In the emergence of Luxembourg as an international financial centre, an important role was played by the deliberate measures of its leaders in shaping the financial regulations and taxation regime of the country so as to benefit the flows of international capital, and seeking to remain in the lead at all times in that regard. Encouraged by the successes of Luxembourg, other countries made their own efforts to exploit the benefits offered by the asymmetry arising in the field of taxation and banking regulations. On the other hand, the countries negatively affected by ‘creative regulations’ sought to prevent regulatory arbitrage with the help of international forums.

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7. Banking systems after WWII

creation of a regulatory environment for banking that was competitively neutral. Countries worldwide applied a wide variety of methods to regulate capital requirements for banks, as a result of which the liberalisation of capital flows enabled credit institutions to take advantage of the regulatory differences between countries (regulatory arbitrage). Adopted in 1988, the first Basel regulatory package (Basel I) had two key objectives. The first was that through the harmonisation of capital requirements, authorities should strengthen the stability of the international financial system, and limit the opportunity for banks that operate in several countries to use the same capital to undertake higher risk in other countries. The second objective was that the consistent application of a coordinated set of requirements should create a level playing field, i.e. reduce opportunities for regulatory arbitrage (the Basel regulations are discussed in detail in Chapter 10). Balance sheet innovations: When the first Basel regulatory package was adopted, banking supervisory authorities expected that in order to improve their capital adequacy, banks would increase their own funds at a faster rate compared to their lending. However, in order to ensure faster and easier adjustment to the more stringent standards, banks introduced products that were not recognised in their balance sheets and were consequently not subject to standards on capital adequacy. Rearrangements in the structure of bank balance sheets resulted in a number of innovations.

7.6. The evolution of banking systems in selected regions 7.6.1. Establishment of the Eurodollar market

In the 1950s and 1960s interest rates were higher in Western Europe than in the US, prompting a large number of European corporations to issue bonds overseas. However, the 1960s witnessed a spectacular deterioration in the US balance of payments, which led the US — 579 —

Banks in history: innovations and crises

government to introduce new regulations on capital investment and taxation. In 1963, the US government introduced a new type of tax (Interest Equalisation Tax) to tap (i.e. equalise) income from foreign bonds. However, as many investors did not want to pay the new tax, its introduction contributed strongly to the expansion of the Eurobond359 market in Europe, as the bonds issued there were exempt from equalisation tax. The Eurodollar market was established by US banks in the 1960s to circumvent the domestic financial regulations that became increasingly disadvantageous for them. Initially headquartered in London360 and conducting market transactions in dollars, the interbank Eurodollar market developed into a global Eurocurrency market in the space of a few years. The emergence of Eurocurrency markets was also helped by Cold War opposition, and in particular distrust of the US. However, the spectacular growth would not have been possible without a series of product and process innovations, some of which were rapid adaptations of the financial processes and products that had already been tried and tested in the US (Battilossi, 2000). The appeal of the Eurocurrency markets was the fast and cheap access they offered to large amounts of funds, mostly at variable rates. Product innovations: The strong volatility of interest and exchange rates was a major driver of financial innovations because the high uncertainty around the future development of interest and exchange rates has a negative impact on market participants in their business decisions. This explains the rapid growth of financial innovations linked to mitigating interest and exchange rate risks (forwards, options, swaps) in the 1970s and 1980s. The diversity of risk management products and the increasing urobonds are not related in any way to the single European currency. In this E context, the Euro- prefix refers to a bond issued overseas in a currency other than that of the country of issue. 360 In an effort to restore London’s leading role in international finance, which had waned during WWII, British authorities did not raise obstacles to the entry of foreign banks; indeed, such banks were allowed to conduct business in foreign currencies without any restrictions (Battilossi, 2000). 359

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7. Banking systems after WWII

breadth and depth of these markets made a meaningful contribution to mitigating and hedging interest and exchange rate risks. The proliferation of financial innovations (Table 7-5) enabled the financing of complex, risky or high-volume transactions for which no funds could have been granted in conventional financing arrangements, i.e. without financial innovations technological and economic development would also be slower (Błach, 2011, 17). At the same time, not every innovation necessarily turns out to be useful and sustainable. Table 7-5: Classification of financial innovations Criteria Sources of innovations Factors of innovations

Classification of financial innovations Supply-driven innovations Demand-driven innovations External factors driven innovations Internal factors driven innovations Adaptive innovations Aggressive innovations

Motives of innovations

Defensive innovations Protective innovations Responsive innovations Financial market innovations

Elements of the financial system

Financial institution innovations Financial instruments innovations Financial regulations innovations Product innovations

Types of innovations

Process innovations Risk-shifting innovations

Effect of innovations Moment of creation Underlying assets

Sustainable innovations Harmful innovations Ex-ante innovations Ex-post innovations Debt-linked innovations Equity-linked innovations

Source: Błach (2011).

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Banks in history: innovations and crises

Although the significant increase in the importance of the Eurodollar market was due to European syndicated loans and oil, the risks building up on the back of the latter subsequently impacted US banks. US banks primarily expanded in developed countries,361 and London undeniably became their most popular European headquarter. US banks evolved into essential participants in the European markets, playing major roles primarily in granting syndicated loans and the subscription of Eurobonds. The oil crises caused a massive increase in fuel prices, prompting petroleum-exporting countries to channel some of their profits to Europe in the form of petrodollars. In a number of emerging and developing countries, the balance of payments showed a major deficit in the 1970s and 1980s specifically because of skyrocketing energy prices, which the governments concerned covered by borrowing. US banks were keen to lend to such countries. In 1982, however, the Mexican government announced that it was unable to repay its credit debt, which led to far-reaching changes in international lending. Mexico’s failure set off a chain reaction in the international credit market, as a result of which within a year some 30 countries (mostly in Latin America) were given default status. US banks incurred major losses, which significantly impacted their profitability and ultimately caused a decline in their international presence. The gap left by US banks withdrawing from international lending was filled by Japanese banks in the 1980s. The rise and fall of an enterprise based on scientific innovation: Based on an invention by Nobel-laureates Fischer Black and Myron S. Scholes, and enhancements by Robert C. Merton, in 1973 the Black–Scholes model was introduced as a mathematical formula for pricing stock exchange options, which greatly facilitated the development of the market for stock options. In 1994, Long-Term Capital Management (LTCM) was established, with

361

he expansion of US banks is aptly illustrated by the fact that while their presence T amounted to 139 foreign branches in 1960, some 80 banks operated 540 branches overseas in 1970, and 162 banks 900 branches and 758 branch offices in 1980.

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7. Banking systems after WWII

the Board of Directors also including Scholes and Merton. LTCM relied on scientific advancements in the field of option pricing for the design of its trading strategy, which essentially sought asset pairs in international markets that were similarly priced and whose prices correlated. When the correlation was broken and prices moved in opposite directions, LTCM purchased the cheaper asset (bonds), and waited for prices to equalise. However, after three years of successful operation, the high-leverage company incurred a massive loss of USD 4.6 billion due to the Asian currency crisis and the Russian financial crisis, sealing its destiny. For the calculation of price trends, developers of the strategy relied on historical data, disregarding the extreme price movements generated by crises. In 1998, the intervention of the Fed helped LTCM to avoid bankruptcy, but in 2000 the hedge fund was finally wound up.

7.6.2. The rise and fall of Japanese banks

Japan was the only non-Western economy that had grown into an advanced, industrialising power by the early 20th century. The insular country carried out its financial revolution in the 1880s, a century after the US. Finance minister Masayoshi Matsukata (松方正義) took over a financially unstable country from his predecessors, and 20 years later he handed over an emerging global power with a modern economy. The stabilisation of public finances, the adoption of the gold standard (1897), and the development of the banking system and capital markets were known and proven techniques in the West, but in the East they were only adopted by Japan by the early 20th century. The legacy of the feudal financial system was transformed into a modern, consolidated banking system within the framework of government regulations. While a key characteristic of Japanese modernisation was active government participation, financial modernisation heavily relied on the relatively advanced financial system of the feudal era, which had been based on savings by wealthy merchants and landowners. In 1882, Japan established its central bank (Bank of Japan, BoJ) patterned on the — 583 —

Banks in history: innovations and crises

model of European central banks. Its tasks included the management of reserves and the issue of banknotes. When Japan embarked the path of modernisation, over a thousand banks were established within a short time to channel savings into the economy (free banking). Most of the banks specialised in financing small family farms. However, the advance of modernisation and the growth of capital-intensive industries called for the consolidation of the Japanese banking system. In 1928, as a result of tightening under the Banking Act, about half of the 1,400 banks operating at the time were excluded from the market, leaving a mere 400 banks in the country by 1936. Japan’s defeat in WWII was followed by years of US occupation, which shaped the country’s post-war economic and financial development. After the war, under foreign pressure Japan adopted anti-monopoly laws, which heralded the break-up of all industrial and financial conglomerates (zaibatsu). At the end of WWII, there were four giant conglomerates in operation in Japan, comprising Mitsui, Mitsubishi, Sumitomo and Yasuda. US military authorities in occupation started reforms by breaking up industrial corporations, and indeed advanced further in that regard than in the break-up of large financial institutions. Dissolved business conglomerates were subsequently able to reorganise themselves, mostly around large banks. After reorganisation, corporate groups (keiretsu) were already more loosely linked, and most of them were no longer owned by families, which helped the general adoption of professional corporate governance. Following the country’s post-WWII reconstruction and modernisation, Japanese companies and banks started to enter the international scene in the 1970s, which was also facilitated by the deregulation of the country’s financial sector that had previously operated under strict regulation. The improvement in economic performance was accompanied by the increased international role of Tokyo and Japanese banks. Japanese banks applied lower margins compared to their competitors, which enabled them to gain a steadily increasing share within international lending. In 1989, 40 per cent of international loans were granted by — 584 —

7. Banking systems after WWII

Japanese banks. The internationalisation of the Japanese financial sector earned Tokyo a place among global financial centres, where customers received full-fledged service not only in lending but also in the field of derivative transactions. Tokyo’s increasingly prominent international role enabled 24-hour (‘follow the sun’) exchange trading. The establishment of Japanese multinational companies in the second half of the 20th century was accompanied by the globalisation of Japanese banks. Japanese companies established new production units primarily in Asia and the United States, to be serviced by Japanese banks. Subsequently, Japanese enterprises entered Europe, where they were also followed by home-country banks, which were already present at financial centres worldwide and were becoming increasingly active in international lending. As domestic financial deregulation was progressing and capital requirements for banks were being standardised internationally, Japanese banks were faced with a rise in the cost of funds, which broke the momentum of their international expansion. This prompted them to adjust their previous business models and to seek new, more profitable markets. Banks found property-related lending to be the most attractive, the volume of which grew rapidly (Chart 7-8), also fuelled by the central bank’s loose monetary policy. As a combined result of these effects, Japanese real estate prices skyrocketed in the space of a few years. As the Japanese asset price bubble burst, the country plunged into a prolonged recession, which was also acutely painful for credit institutions (Fuji–Kawai, 2010). The Japanese central bank watched the steady rise in property prices with growing concern and was prompted to raise its base rate in May 1989. The increase in the cost of funds brought an end to the years-long boom in stock and real estate prices; the bubble burst, the consequences of which could only be managed over many years at the expense of considerable sacrifices. The adjustment of stock and real estate prices continued for years, and the Japanese economy slipped into a prolonged recession. Credit institutions’ holdings of non-performing loans reached a historic high, — 585 —

Banks in history: innovations and crises

prompting banks to cut back on lending and reduce their international presence. 1997 saw the start of the Asian currency crisis, which caused stock prices to fall in Japan as well, further exacerbating the situation of the financial sector. In November 1997, several financial institutions went bankrupt, including the unprecedented failure of a large city bank (Hokkaido Takushoku Bank). Chart 7-8: Changes in outstanding loans by sector in Japan 900

Per cent

900

800

700

600

500

400

300

200

100

Construction Real estate Total

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

1983

1981

1979

1977

Manufacturing Wholesale and retail

Source: Bank of Japan.

The failure of Hokkaido Takushoku Bank called for urgent, firm action by Japanese authorities as confidence in the financial sector had been on the decline. Banks responded to the worsening situation with another wave of deleveraging, cutting back even further on their lending. The drastic reduction of lending resulted in a sharp fall in corporate investments, which exacerbated the economic crisis in Japan. The institutional and financial foundations for the resolution of problems in the banking system were laid by the late 1990s. Having — 586 —

7. Banking systems after WWII

recognised that in the absence of a durable solution to the problems of the financial sector no satisfactory economic growth was to be expected, policymakers abandoned the former policy of wait and see, and took a path of firm action after nearly a decade had been wasted. Patterned on the model of the US Resolution Trust Corporation, an asset management company was established in 1999 (Resolution and Collection Corporation, RCC), which started to acquire non-performing bank loans. Another important step was the announcement of the Programme for Financial Revival. The programme set itself the objective of reducing large banks’ NPL ratio by one half by 2005 from 8.7 per cent in March 2002. In order to meet that objective, the financial supervisory authority placed banks under an obligation to increase their capitalisation, and simultaneously restrictions were applied to banks’ asset valuation practices. At the initiative of the government, another asset management company was established in 2003 (Industrial Revitalisation Corporation of Japan, IRCJ362), which invested in corporations that were unable to repay their debts, but could have their viability restored by means of capital injections and restructuring. The government also made it clear that if needed, it was prepared to allocate public funding to stabilise the situation of banks. The large banks, playing a dominant role in the life of the country, were increasingly concerned that if no breakthrough was made in resolving the problem of non-performing loans, they could also be nationalised, which prompted them to carry out major capital increases (Mitsubishi Tokyo Financial Group: USD 2.63 billion, Sumitomo Mitsui Financial Group: USD 4.88 billion, Mizuho Financial Group: USD 9.76 billion). Only UFJ Holdings did not follow the example of the other banking groups, which subsequently proved to be a serious mistake, and rendered the Group’s independent operations impossible. The high procyclicality of the Japanese banking system resulted in a serious lag by the end of the 20th century. Eventually, Japanese banks 362

The operations of the IRCJ were discontinued as of 15 March 2007.

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Banks in history: innovations and crises

took around 15 years to drive down their NPL ratios that had reached extreme levels following the burst of the bubble. The difficulties in handling the large stock of non-performing loans were a major drag on the performance of Japanese banks and tied up the sector’s resources, as a result of which in the field of financial innovations Japanese banks increasingly fell behind their US and Western European rivals, which gradually eroded their international competitiveness. Although this had the unintended benefit that during the global financial crisis the less sophisticated Japanese financial system suffered more moderate losses relative to its foreign competitors, in the longer term this less sophisticated, less competitive banking system will have a negative effect on the customers of Japanese banks, in particular corporations exposed to international competition (Hidasi–Papp, 2015). Japanese banks responded to their deteriorating competitiveness with exploiting efficiency of scale, which benefited from full-scale financial deregulation. As a result, universal ‘megabanks’ were created (Chart 7-9). In Japan, institutions providing specific types of financial services had previously been strictly segregated. That regulation was progressively relaxed, laying the foundations for the formation of large financial holding companies. Today, the largest Japanese financial institutions (Bank of Tokyo-Mitsubishi UFJ, Sumitomo Bank, Mizuho Bank) operate as universal banks, carrying out both commercial banking operations and investment services. Consequently, the financial institutions operating in Japan today are more efficient, while they also carry significantly higher systemic risk. This is because the failure of a mega-banking group is capable of causing far more extensive damage to the financial system compared to the insolvency of a smaller credit institution. The failure of a mega-banking group may generate a severe liquidity shock in the banking system, while it would also be difficult for smaller banks to make up for the loss of large banks that have extensive branch networks and sophisticated business profiles, and are strongly embedded internationally. Finally, the bail-out of megabanks would also involve a significantly higher fiscal cost for the budget. While the emergence of megabanks offered a benefit in — 588 —

7. Banking systems after WWII

terms of closing the gaps in competitiveness, their formation placed the burden of a new systemic risk on the Japanese financial sector by amplifying the ‘too big to fail’ problem (Hidasi–Papp, 2015). Chart 7-9: Emergence of Japanese mega-banking groups Before 2000 Dai-Ichi Kangyo Bank

2000 September

2002 April

2003 March

2013 July

Mizuho Holdings

Mizuho Financial Group

Fuji Bank

Dai-Ichi Kangyo Bank

Industrial Bank of Japan

Mizuho Trust

Sakura Bank

Fuji Bank Mizuho Trust

Tokyo Trust Mitsubishi Trust Nippon Trust

Mizuho Corporate Bank

Mizuho Trust

2001 April

2002 December Sumitomo Mitsui Financial Group

2001 October

2005 October

Mitsubishi Tokyo Financial Group

Mitsubishi UFJ Financial Group

Mizuho Trust

Bank of Tokyo-Mitsubishi Tokyo Trust

Bank of Tokyo-Mitsubishi

Bank of Tokyo-Mitsubishi UFJ

Mitsubishi Trust

Mitsubishi UFJ Trust

Nippon Trust

UFJ Holdings

2002 January UFJ Holdings

Tokai Bank

Sanwa Bank

UFJ Bank

Tokai Bank

UFJ Trust

Tokai Trust

Toyo Trust

Mizuho Bank

Sumitomo Mitsui Banking Corp. 2001 April

2001 April Sanwa Bank

Mizuho Bank

Mizuho Corporate Bank

Sumitomo Mitsui Banking Corp.

Sumitomo Bank Bank of Tokyo-Mitsubishi

Mizuho Bank

Toyo Trust

Colours: city bank long-term credit bank trust bank

Source: Authors’ own compilation based on the data from Japanese Bankers Association.

After the Lehman shock, with a view to mitigating the consequences of the global financial crisis, the Japanese government again offered to use public funds to bail out banks that were prevented from lending due to deleveraging. The financial supervisory authority also eased its previous rigour in inspections, in exchange for which it requested banks to increase their lending to SMEs. The government also sought to stimulate the economy through an ultra-loose monetary policy. Although these efforts helped to avoid protracted deflation, their results fell significantly short of expectations. Japan is the third largest economy in the world, and while the economic achievements and successful modernisation of the country are facts — 589 —

Banks in history: innovations and crises

of common knowledge, its banks are less known, and opinions also differ as to the performance of its banking system. The local banking system was capable of providing effective support for post-war reconstruction, economic catch-up and modernisation; in the 1980s, however, it was also through the active participation of credit institutions that the bubble economy was formed, the consequences of which tied up the resources of the banking system for a decade and a half, and to date the sector has failed to provide adequate support for overcoming the difficulties facing the country (continued subdued economic growth, aging society, extremely high and growing government debt).

7.6.3. Emergence of Chinese banks as global players

After WWII, following the example of the Soviet Union, China implemented a one-tier banking system, and right up until 1970 the Chinese banking system essentially consisted of a single bank, the People’s Bank of China (PBOC). Modernisation of the banking system started with the establishment of three specialised banks in 1978 (Turner, 2012). The Agricultural Bank of China (ABC) was set up to grant credit for agro-industrial activities, the Bank of China (BOC) financed foreign trade and carried out foreign currency transactions, whereas the People’s Construction Bank of China (PCBC; subsequently China Construction Bank, CCB) was in charge of financing the construction industry. In 1984, in addition to these three state-owned large banks, a fourth bank was established with the name of Industrial and Commercial Bank of China (ICBC), which primarily financed large state-owned enterprises. Despite the introduction of the two-tier banking system, state-owned commercial banks still did not have genuine decision-making powers as they were not in a position to refuse to finance large state-owned enterprises. Moreover, the establishment of lending rates was also

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7. Banking systems after WWII

subject to restrictions.363 As a result of this practice, stocks of nonperforming loans kept building up on a regular basis. For this reason, another three policy-based banks were established in 1994: the China Development Bank, the Export and Import Bank, and the Agricultural Development Bank. These institutions gradually took lending for economic policy purposes from the four large state-owned banks, allowing the latter to become more commercially oriented. Since the 1980s, China’s two-tier banking system has become increasingly sophisticated, with a number of new participants entering the sector, rural banks, leasing companies and investment firms appearing, and foreign banks obtaining licenses364 over the past decades, yet state-owned banks have retained their predominance to this day. The global financial crisis also reshuffled the international financial system, opening the field to the international expansion of Chinese banks. This was because the financial crisis was a major setback to the performance of US universal banks, forcing most of these banks to deleverage, which in most cases involved the withdrawal of their presence overseas. This in turn offered a splendid opportunity for Chinese banks to increase their international presence (Chart 7-10). Owing to their domestic and foreign expansion, Chinese banks rose to the group of the largest financial institutions of the world over the past years;365 however, their development into global players differs from earlier patterns in several respects. hile restrictions on lending rates were relaxed gradually, they were not removed W completely until July 2013. 364 Opening up financial markets to foreign competitors was a prerequisite for accession to the World Trade Organization, which is why entry was granted to foreign banks. 365 Over the past decade, the total assets of Chinese banks increased fivefold, as compared to the 40 to 50 per cent growth rates of European, US and Japanese banks. The growth in Chinese banks’ total assets was attributable to an increase in domestic demand for credit only to a lesser extent, and was due for the most part to the dynamic expansion of the banks’ international operations. At the end of 2017, four out of the ten banks with the highest total assets in the world were Chinese (ICBC, CCB, ABC, BOC). 363

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Banks in history: innovations and crises

Chart 7-10: Chinese banks’ foreign claims 700

USD Billions

700

600

500

400

300

200

100

0 2015 Q2

2015 Q1

2014 Q4

2014 Q3

2014 Q2

2014 Q1

2013 Q4

2013 Q3

2013 Q2

2013 Q1

2012 Q4

2012 Q3

2012 Q2

2012 Q1

2011 Q4

2011 Q3

2011 Q2

2011 Q1

2010 Q4

2010 Q3

2010 Q2

2010 Q1

Source: IMF.

The evolution of Chinese banks is primarily driven by domestic economic interests and economic policy priorities, and these banks entered the group of the world’s largest banks through active government participation. Despite Chinese banks’ reliance on a vast and rapidly growing economy, their product range still falls short of the quality and sophistication of the services offered by US and European banks. The globalisation of Chinese banks is primarily driven by China’s economic interests. US and Japanese banks were established overseas in alignment with the internationalisation of manufacturers, whereas in China’s case the expansion of banks is also motivated by the need to secure the energy and commodities required to maintain the country’s economic development. Chinese banks have a preference for organic expansion, and primarily establish themselves in countries where key commodity sources are available, to be exploited through their own cooperation. China is — 592 —

7. Banking systems after WWII

investing an increasing amount of capital abroad, in which extractive industries have had a major share for years. China is the second largest user and third largest importer of petroleum in the world. The conscious promotion of the internationalisation of the renminbi is also an important driver of Chinese bank expansion, which is why a growing number of Chinese banks are being established in international financial centres. In 2016, the renminbi was added to the SDR (Special Drawing Rights) currency basket. According to SWIFT data for August 2017, the Chinese currency accounts for 1.94 per cent of all payments, which makes it the fifth most important currency in international payments. Over the past decades, China has made great progress in financial deepening, while its capital market has remained relatively underdeveloped. In the past decade, Chinese banks have increased their total assets fivefold due to a stable macroeconomic environment and the high propensity of Chinese households to save. In terms of financial depth (M2/GDP), China is outperforming most developed countries, which is partly attributable to its less developed securities markets. Within a short time, Chinese state-owned large banks transformed into modern commercial banks,366 and internationalised rapidly in line with the country’s interests. Apart from servicing customers abroad, one key motivation is for them to contribute to the supply of the commodities required for the development of the country by financing the exploitation of those commodities. Additionally, in recent years Chinese banks have secured strong positions in syndicated lending due to the international financial reshuffling following the global financial crisis. At the same time, in recent years concerns with Chinese growth have intensified, and the economic and financial risks associated with 366

I n 2005 and 2006 all four state-owned large banks were listed, and in 2015 all four banks (ICBC, CCB, ABC, BOC) were rated by the Financial Stability Board (FSB) as Global Systemically Important Financial Institutions (G-SIFIs).

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Banks in history: innovations and crises

China have increased, with the Chinese banking system playing a major role in this regard (Papp, 2016). To avoid further deceleration of the economy, Chinese banks flooded the economy with loans; in Q1 2016, the credit-to-GDP gap exceeded 30 per cent and then declined, but still remained above 22 per cent in Q1 2017, whereas even a 10 per cent ratio was considered risky by the BIS367 (Table 7-6). Apart from hitting China, the mounting risks associated with the Chinese economy and banking system may also impact a number of countries across the world, given China’s weight and embeddedness in the world economy, and the extensive international presence of its banks (Arslanalp, 2016). Table 7-6: Early warning indicators for stress in domestic banking systems Country, region

Credit-to-GDP gap

Debt service ratio DSR change if interest (DSR) rates rise by 250 bp

United States

–7.6

–1.3

1.3

United Kingdom

–19.0

–1.4

1.5

Germany

–3.4

–1.9

0.1

France

2.8

1.4

4.6

–14.5

–0.7

1.3

Japan

7.0

–1.8

0.9

China

22.1

5.4

8.7

Brazil

–4.9

2.0

3.5

Mexico

7.4

0.9

1.7

South Korea

–1.1

0.0

3.7

Malaysia

7.4

0.7

3.1

Thailand

9.0

–0.5

1.4

–11.2

–1.7

–0.4

Credit/GDP gap>10

DSR>6

2≤Credit/GDP gap≤10

4≤DSR≤6

Italy

Central-Eastern Europe Notes

Note: Data up to Q1 2017. Source: BIS.

367

The BIS is of the view that ratios above 10 per cent are unsustainable.

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7. Banking systems after WWII

The excessive pursuit of investments carries the risk of redundant capacities being created as a result of developments on which no recovery will ever be made (Liao, 2016). Investment-driven economic growth is accompanied by a boost in lending, and some of the intense demand for credit will be satisfied by shadow banking,368 rather than the conventional banking system. As a result of rising residential real estate prices, the property sector has become the segment of the Chinese economy to which most of the credit is granted. However, real estate developments are not only financed with bank funds, as growth in the property sector is also being fuelled by the shadow banking system. At the same time, the rapid expansion of the shadow banking system is one of the largest risks to the stability of the Chinese financial system today. The shadow banking system and commercial banks are very closely linked, as a major portion of non-banks are owned by commercial banks, which also sell the financial products of their subsidiaries. Additionally, banks supply funds to shadow banks either directly or indirectly. As a result of this high degree of interconnectedness, the problems of the shadow banking system may very quickly spill over to the banking system. For that reason, falling real estate prices may present a threat to both the shadow banking system and conventional banks, given that the balance sheets of banks may rapidly be contaminated by problems emerging in the shadow banking system. A negative feedback loop may be created between the shadow banking system, commercial banks and the property market. The operations of non-banks are returns driven and therefore involve a much higher level of risk-taking compared to commercial banks; moreover, the operations of such institutions are significantly less regulated and controlled, under non-transparent guarantee 368

hadow banks are non-bank financial intermediaries that provide services similar S to traditional commercial banks but they are not subject to the conventional rules of bank supervision and deposit insurance. Despite the benefits offered by the shadow banking system (by helping to overcome liquidity problems and reducing the dependency on banks), its existence may also be a source of major financial risks in the event of disruptions to its operations.

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Banks in history: innovations and crises

arrangements. As investment decisions are primarily dominated by promises of high returns, real risks are often not assessed, which has not been improved by the spread of IT assets; indeed, excessive risk-taking has become easier and more extensive. At the same time, as a result of the high degree of interconnectedness with commercial banks, the problems of the shadow banking system may very quickly spill over to the overall banking system. The exposure of commercial banks to the shadow banking system is rather heterogeneous; the four large banks have low levels of exposure (at 22 per cent of their capital buffers on average), whereas several smaller banks have significantly higher exposures (Chart 7-11), which puts them at higher risk. In securing funds, these banks increasingly rely on the interbank market, which makes them even more vulnerable. Finally, a strong shadow banking system may also pose an obstacle to efforts to cut back lending where such efforts are deemed appropriate by the authorities. Chart 7-11: Shadow assets as a percentage of capital buffers 600

Per cent

600

500

400

300

Average of small listed banks

200

100

100 0

0 Small listed banks

Big four

Note: Big four = Agricultural Bank of China, China Construction Bank, China Development Bank, and Industrial and Commercial Bank of China. Source: IMF (2016).

— 596 —

7. Banking systems after WWII

The deepening of the shadow banking system in China highlights the importance of financial regulation and the challenges of the 21st century. Compared to conventional banking system endogeneity, a higher level of moral hazard is carried by the shadow banking system (Chart 7-12) both between banks and investors, and between the government and investors. That is, the fund-raisers fail to exercise due diligence in the assessment of the returns on the projects to be financed, as the risks involved are borne by investors. In turn, investors expect to be indemnified by the government should problems arise, as a result of which they also fail to exercise due diligence in the assessment of risks. Consequently, the shadow banking system also provides access to finance for projects the returns on which carry a very high level of risk. Chart 7-12: Private sector credit as a percentage of GDP in China 250

Per cent

250 200

150

100

0 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

200

GDP proportionate credit stock of the private sector in the shadow banking system GDP proportionate credit stock of the private sector in the banking system Source: BIS.

— 597 —

Banks in history: innovations and crises

7.6.4. Financial integration in Central-Eastern Europe

Modern banking history shows a great number of similarities across the countries in the CEE region, given that after WWII all of the socialist countries introduced one-tier banking systems. This meant that central banks were in a quasi-direct relationship with economic agents, and companies kept their accounts with the central banks. The central bank had decision-making powers on granting loans, and also controlled their use. In practice, to meet the specific needs of households and corporations (similarly to the Soviet and Chinese banking systems) specialised banks were created. For example, in Hungary the National Savings Bank carried out retail banking operations, the Hungarian Foreign Trade Bank was in charge of financing foreign trade, and investments in the corporate sector were financed by the Hungarian Investment Bank (subsequently the State Development Bank). Given the absence of real competition for customers in the one-tier banking system, banks did not excel in the field of financial innovation. For that reason, regime change and the economic transformation also brought about considerable changes in the banking system, which was transformed into a two-tier system at the time. The process followed a similar course in all of the countries in the region, although it varied in terms of the timing. In the 1990s, each country faced at least one major banking crisis, primarily due to the legacy of the previous regime, but also to the absence of modern banking knowledge. To resolve the crises, fast bank privatisation was launched, as part of which primarily foreign strategic investors gained dominance in the banking systems of the region. The reason for this was the absence of a sufficient amount of internal savings for the recapitalisation of distressed banks without external funds. The absence of adequate expertise also called for the entry of foreign participants. Conversely, the newly opened market of the region was attractive for foreign investors. Underdeveloped financial intermediation and the promising growth potential of regional

— 598 —

7. Banking systems after WWII

economies both held out the prospects for high profitability for entering institutions. The transition was pioneered by Hungary and Estonia, whose banking systems were the first to take the path of transformation. In Hungary, the process started well before the regime change, marked by the establishment of the Central European International Bank (CIB) by the Magyar Nemzeti Bank and five western commercial banks in 1979, followed by the establishment of other jointly-owned banks before the regime change369 (Várhegyi, 2004). Then, at the time of the regime change, a number of foreign banks were established as part of greenfield investments. 1993 opened the next key chapter of transformation, by the end of which today’s banking structure had more or less been created. In 1993, the banking system was hit by a severe crisis. The aggregate banking sector ROE was –103 per cent, i.e. the banking system had lost all of its equity. In response to the crisis, bank privatisation was launched in 1994, as a result of which the Hungarian banking system was acquired by foreign majority shareholders by the mid-1990s. The final stage in foreign penetration, as it were, was the sale of Postabank in the early 2000s. Similarly to the situation in Hungary, Estonia’s bank transformation started very early on. The Estonian banking sector was already faced with a crisis in 1992, which was attributable to a number of other factors in addition to economic problems. Estonia gained independence at the time of the regime change, and for a while the framework of banking system supervision and regulation remained unclear. Former banks of the Soviet Union and the Estonian banking system developed in parallel. This problem was aggravated by the fact that it was rather easy 369

The MNB established Citibank Budapest with 80 per cent participation by Citibank Overseas, and Unicbank with 15 per cent of the shares held by each of IFC, the German DG Bank and the Austrian Raiffeisen Zentralbank (Várhegyi, 2004).

— 599 —

Banks in history: innovations and crises

to establish banks in Estonia due to the very low capital requirement. As a result, 30 new banks were established in 1991–1992. The crisis of 1992–1993 brought that to an end, and half of those banks went out of business (Korhonen, 1996). From 1994, Estonia licensed the entry of foreign investors to its banking system, and at the time of the Asian currency crisis, foreign banks accounted for half of the banking system. The shock of the Asian currency crisis represented the first serious trial for the Estonian banking system, which was handled successfully by most of the banks. The crisis nevertheless gave rise to further consolidation and acquisitions. Two major Scandinavian banks (Skandinaviska Enskilda Banken [SEB] and Swedbank) entered the Estonian market at this time, and have retained their dominant role until today (Temesváry–Banai, 2017). The other two Baltic states, Lithuania and Latvia followed a course similar to that of Estonia. In these countries as well, relaxed supervision and banking regulations triggered the establishment of a large number of banks in the 1990s. In 1995, both countries were hit by banking crises, which were aggravated by the Asian and Russian financial crises. Starting in the second half of the 1990s, consolidation brought results similar to those in Estonia, leading to the dominance of Scandinavian banks in both countries (Korhonen, 1996). Events took a similar course with the banking systems of the V4 countries, except that the foreign banks entering were mostly comprised of Austrian, German, Italian and French large multinational banks. In Poland, between 1993 and 1996 the government had to recapitalise several major credit institutions. These banks were ultimately recapitalised around the turn of the millennium. During the wave of privatisations, only Powszechna Kasa Oszczędności (PKO) was not acquired by foreign strategic investors. The bank was admitted for listing on the stock exchange, but the Polish government has retained approximately 30 per cent of its shares until today. In the Czech Republic and Slovakia, similarly to other sectors of the economy the privatisation of the banking system was a so-called coupon — 600 —

7. Banking systems after WWII

privatisation. However, that arrangement only delayed the banking system’s transformation such as that taking place in other countries. In the second half of the 1990s, large Czech and Slovakian banks were forced to rely on government subsidies, which warranted the entry of foreign strategic investors. Nevertheless, as in other countries, foreignowned banks also established their dominance in the Czech Republic and Slovakia by the turn of the millennium. In Romania and Bulgaria, the transformation of the banking system got off to a relatively late start, primarily due to persistent problems in the real economy. Privatisation only started at the very end of the 1990s, as a result of which the regime change of the banking system was already completed in the new millennium. In Bulgaria, the last major move was the sale of DSK Bank in 2003, which again led to foreign dominance. In Romania, the final step was made even later, in 2006, with the sale of Banca Comercială Română. Compared to most countries in the region, the successor states of former Yugoslavia also suffered delays in completing the transformation of their banking systems, primarily due to the Yugoslav Wars. Croatia was the first to start the transformation of its banking system between 1993 and 1995, as part of which four large banks were restructured and made viable. The risky lending that took off following the transformation and significant open FX positions triggered serious problems in the banking sector in the late 1990s. Some banks were forced out of business, and some were saved through mergers. As a result of consolidation starting in the early 2000s, most of the Croatian banking system was ultimately acquired by foreign investors. Serbia’s banking system only started its transformation at the very beginning of the 2000s, but was placed on completely new foundations rather quickly. In 2001, 19 small and a few large banks were also closed. Compensation was paid to depositors, and defaulted loans were cleaned up. This reduced the banking system to less than a third of its former size. The supervisory and regulatory authorities of the central bank were reinforced, which contributed to the stable operation of — 601 —

Banks in history: innovations and crises

the system. The remaining banks were acquired by foreign strategic investors (Barisitz, 2008). Among the successor states of the former Yugoslavia, Slovenia followed a unique course, because unlike the entire region, following the regime change a major part of its banking system remained in state ownership, and until the early 2000s sought to carry out its tasks primarily using internal funds. However, mainly in the aftermath of the country’s EU accession, the local economy started to grow dynamically, which was already financed through external funds. While the banking systems in the region were transformed in very similar ways, they were hit by the global economic crisis in different situations. The build-up of risks during the pre-crisis lending boom called for major adjustments following the crisis in several countries, including the Baltic states and Hungary. A special case of the buildup of risks was foreign currency lending, which caused problems primarily in Hungary, but also in Poland, Romania, Croatia and Serbia.370 Although the reasons for which households and companies choose to become indebted in foreign currencies vary by country, Chart 7-13 provides a good summary of the factors that facilitate the emergence and spread of foreign currency lending. Rapid economic growth and the strong ambition of banks for expansion had a positive impact on lending activity. High nominal interest rates due to high inflation, the global environment of ample liquidity, and the dominance of foreign banks contributed to ensuring that lending would take off in foreign currencies in all of the above countries. Additionally, a number of specific factors also pointed in that direction. For example, in former Yugoslav federal states distrust in the domestic currency made foreign currency savings popular. In turn that encouraged indebtedness in foreign currencies. In Hungary, expectations for the imminent introduction of the euro and the total absence of government intervention facilitated the upsurge of foreign currency lending. 370

While foreign currency lending was also significant in other countries across the region such as the Baltic states and Bulgaria, it was prevented from causing problems by the fixed exchange rate systems (currency boards) in place in those countries.

— 602 —

7. Banking systems after WWII

Chart 7-13: Flow chart for the expansion of foreign currency lending High government debt Relatively high risk premium

Loose fiscal policy

High inflation Substantial demand for funding related to convergence Expectations of joining the euro area Households' excessive income expectations Stable exchange rate

Globally loose monetary conditions and high risk appetite Dominance of foreign banks, easy access to foreign funds

Less funds for private sector lending in domestic currency

Rapid growth of FX debt

Increasing competition in risk-taking Risks related to FX lending was mainly borne by borrowers

High external indebtedness

High nominal interest rate

Regulatory environment

Source: Banai (2017).

During the global financial crisis, the resulting risks materialised. In Hungary, which had the largest stock of foreign currency loans, the ratio of non-performing loans reached 20 per cent in both the corporate and household segments, largely due to the significant increases in the instalments of foreign currency loans. This presented a serious problem both societally and in terms of financial stability. It was not by coincidence that all of the above countries took steps to address the difficulties facing foreign currency debtors. Hungary is also unique as regards the solution to the problems resulting from foreign currency lending. Following the crisis, a number of steps were taken to reduce debtors’ burdens and to address the problems of non-performing debtors. By 2014, the legal and economic environment (including in particular the interest rate level of the forint) had been provided for the forint conversion of household foreign — 603 —

Banks in history: innovations and crises

currency loans. In November 2014, as part of a joint action by the central bank, the government and the banking system, foreign currency loans had their exchange rates fixed, and were converted into forints in 2015. Consequently, Hungarian foreign currency debtors remained unaffected by the drastic appreciation of the Swiss franc in January 2015. As a result of forint conversion, the share of foreign currency loans within total household loans dropped to nearly 0 per cent (Kolozsi et al., 2015). Box 7-2 Fiscal cost of banking crises during the global financial crisis

Over the course of the crisis starting in 2008, the most frequently used bail-out instruments included the recapitalisation of distressed financial corporations, government guarantees on deposits, and the restructuring of financial corporations. Of the popular bail-out instruments of the previous period, the sale of the assets of distressed banks with government assistance was less significant in the management of the most recent crisis, whereas the transfer of losses, the temporary closure of banks and the freezing of assets almost completely disappeared from the bail-out toolkit (Cottarelli et al., 2014). The fiscal costs of managing the 2008 crisis fell short of the average expenditures in previous crises. According to IMF data, the direct costs of bank bail-outs (after recoveries) amounted to an average 2.7 per cent of GDP in G20 countries, which is far lower than the 8 per cent average of the previous period (IMF, 2010). Gross direct costs amounted to an average 7.4 per cent of GDP, of which 4.8 per cent was recovered by 2013–2014 (IMF, 2014). In the case of the crises included in the database of Laeven–Valencia (2013), the average is somewhat higher at 8.3 per cent. The list of the 10 costliest banking crises of the 2008 recession implies a similar tendency (Chart 7-14). The average 8.3 per cent of GDP was exceeded by the fiscal costs of only 6 banking crises, among which the collapse of Iceland’s and Ireland’s banking systems in 2008 are the most severe. In Iceland, the government nationalised the three largest banks

— 604 —

7. Banking systems after WWII

following their collapse, while in Ireland public finances were used for the recapitalisation and restructuring of two local large banks. In that light, it is not surprising that the gross costs to the budgets of Iceland and Ireland amounted respectively to 44 per cent and 41 per cent of GDP, ranking the two countries among those that have experienced the 10 costliest banking crises since 1970. Chart 7-14: Costliest banking crises during the recession of 2008 45

As a percentage of GDP

Austria

Latvia

Belgium

Luxembourg

United Kingdom

Nigeria

Netherlands

Greece

Ireland

Iceland

Source: Authors’ own compilation based on Laeven–Valencia (2013).

Box 7-3 Historical overview of money laundering and the fight against it

Apart from being instrumental in the more affordable and faster execution of legal economic transactions, the development of banks and full-scale financial innovations also facilitated the operations of those intending to exploit the banking system for illegal purposes. The growing complexity of the financial system and newly emerging products

— 605 —

Banks in history: innovations and crises

and services have offered these criminal groups a wide selection of perpetration methods over the past decades. According to an estimate by the United Nations Office on Drugs and Crime (UNODC),371 ‘laundered money’ accounts for 2 to 5 per cent the annual GDP of the world’s countries, corresponding to USD 800 to 2,000 billion each year. Money laundering is the concealment of the origin of illegally acquired money, typically through the involvement of banks or lawful businesses. It includes all procedures seeking to prevent the identification of the origin of the proceeds of criminal acts, and to make those proceeds appear to have come from a legitimate source. Peter Lilley (Lilley, 2000, 16) defines money laundering as ‘the method by which all proceeds of crime are integrated into the banking systems and business environments of the world: black money is washed so it ends up whiter than white (hence the French terminology blanchiment d’argent [...])’. Although the expression only came to be used in the 1900s, the activity of money laundering dates back much further. The emergence of wealth acquired through the violation of regulations was accompanied by the need to conceal such wealth. In his book Lords of the Rim, Sterling Seagrave describes how 3,000 years ago wealthy merchants in China hid their wealth, for fear that rulers would take the profits and assets they had accumulated through trade, primarily by expatriating funds, investing, often at inflated prices, and purchasing readily movable assets.372 Legend has it that the term money laundering dates back to the era of Al Capone in the 1920s, when the head of the Chicago criminal gang used coin-operated laundries, exploiting their high cash turnover, to ‘bleach’ the proceeds of his alcohol smuggling, prostitution, gambling and other rackets.

371 372

https://www.unodc.org/unodc/en/money-laundering/globalization.html https://www.globalpolicy.org/pmscs/30048.html

— 606 —

7. Banking systems after WWII

Research by Jeffrey Robinson (Robinson, 1996, 9) disproved Al Capone’s ‘laundry’ legend, arguing that the term money laundering was first used in 1973 in the context of the Watergate scandal, which ultimately led to the resignation of US President Richard Nixon. To illustrate and understand the process of money laundering, several models have been designed (e.g. Zünd’s circulatory model, the cyclical model, or Ackermann’s target model); however, of all models the most commonly used model is that of the ‘three stages’, under which the process of money laundering is broken down into three main stages (Matthews, 2003, 548), comprising placement, layering and integration (Chart 7-15). Chart 7-15: Stages of money laundering Stages of Money Laundering Placement

Layering

Integration

Source: MNB.

It is rare for all three stages to be realized in full, given that two money laundering processes are never completely identical; each stage tends to be realised only to the extent of specific elements, and are frequently combined. In general, the shorter the money laundering process, the easier it is to recognise the character of laundering. The first stage of money laundering is placement, which sets the laundry in motion. It is at this stage that the illegal proceeds are separated from the underlying criminal act, and are introduced into the financial system (e.g. by means of the deposit of cash with a bank). The first stage is of particular significance in the course of money laundering, because a high volume of cash may easily attract the attention of the authorities. Accordingly, for prospective money launderers the greatest challenge is to remove the

— 607 —

Banks in history: innovations and crises

‘dirty’ money from its initial place of origin, and transfer it to a place where its source is more easily concealed. Apparently, this stage is of critical relevance to the operations of financial institutions, because, provided that adequate regulations and control arrangements are in place, it is at this stage that money obtained from illegal sources may first be detected. Once the money to be laundered has been placed by the perpetrators, it is subdivided, then moved around, often across countries and continents. The second stage is layering, the primary aim of which is to ensure that the link between the origin of illegal proceeds and the perpetrator is increasingly impossible to disclose. As part of layering, money is transferred to the accounts of fictitious businesses, often through complex networks of shell and off-shore companies, and the operation is subsequently repeated a number of times. The aim is to carry out the greatest possible number of apparently legal transactions, possibly in amounts that attract the lowest level of attention practicable. Launderers seek to achieve this through a large number of intersecting and overlapping transactions, as part of which previously placed amounts are used recurrently, giving economic legitimacy to ‘laundered’ money, whereby these amounts are converted into legitimate parts of the economy. The third stage is integration, as part of which the illegal proceeds are returned to the legitimate economy, allowing launderers to provide a lawful explanation as to the origin of the money in their possession. To achieve that, the money is channelled to legitimately established companies and investments, where the originally illegal proceeds are returned to the legal economy by generating revenues through these companies, and paying the taxes due. It is important to note that money laundering is not meant to realise a profit: over the course of the full process, it is not uncommon for losses of up to 20 to 30 per cent to be incurred, depending on the size of the amount to be laundered, and the expected date of the result.

— 608 —

7. Banking systems after WWII

A true story In 1996, Harvard graduate economist Franklin Jurado admitted to his contribution to laundering the profits of the notorious Colombian drug baron Jose Santacruz-Londono, in the course of which, relying on his graduate-level knowledge of economics, he moved the proceeds of cocaine sales through the financial system. As a first step, he deposited significant amounts of cash with various Panamanian banks (placement). Then, from his Panamanian accounts, he transferred the amounts to over 100 bank accounts with 68 banks in 9 European countries, taking good care to keep each transaction below USD 10,000 so that they would not be flagged by the banks’ transaction screening systems (layering). According to the plan discovered by the investigators, these amounts would have been transferred back for the establishment of the legitimate businesses of Santacruz-Londono (integration). However, Jurado got caught because an investigation launched in connection with the failure of a Monacan bank discovered that a number of bank accounts were linked to Jurado, and that he had moved USD 36 million between various accounts. Jurado’s exposure was facilitated by a disturbance report filed against him by one of his neighbours in Luxembourg, as he had been operating his extremely noisy banknote counter for nights on end. Local authorities investigated the case, and Jurado was clearly found guilty of money laundering, for which he was sentenced to seven and a half years of imprisonment. History of anti-money laundering regulations It was in the second half of the 20th century that the world recognised the need for clear and strict regulations to counter money laundering. The US Bank Secrecy Act (BSA) was adopted in 1970 as the first antimoney laundering legislative package in the world. The package contained provisions for banks, primarily concerning the reporting of transactions over USD 10,000 (Currency Transaction Report – CTR), the identification of persons initiating transactions, and the obligation to retain transaction details. International anti-money laundering regulations date back to the 1980s, when the Committee of Ministers of the Council of Europe adopted its recommendation on measures against the transfer and the safekeeping of

— 609 —

Banks in history: innovations and crises

funds of criminal origin. The European Union, the United Nations, and other international organisations (most prominently the Financial Action Task Force [FATF] setting international anti-money laundering standards) have since adopted a variety of conventions and recommendations, and issued a number of publications on the prevention of money laundering. Among these, a key role is occupied by the directives issued by the European Union, which impose an obligation on all member states to transpose the European regulations into their own national laws. EU directives Relying on the findings of previous international conventions, on 10 June 1991 the Council of the European Union issued Directive 91/308/EEC on prevention of the use of the financial system for the purpose of money laundering.373 The First Anti-Money Laundering Directive covered the entire system of financial institutions already at this stage (without setting requirements for other industries, and defined money laundering primary as an activity following drug crimes. In response to the terrorist attacks of 11 September 2001 in the US (and those of 11 March 2004 in Madrid) the previous regulations were amended by the Second Anti-Money Laundering Directive (2001/97/EC), which applied to a broader group of undertakings, and widened the range of crimes seen as underlying money laundering (e.g. serious fraud, bribery, corruption, and any other offences punishable by a severe sentence of imprisonment). The June 2003 review of the FATF principles was followed up in 2005–2006 by the release of the Third Anti-Money Laundering Directive (Directive 2005/60/ EC of the European Parliament and of the Council, and Commission Directive 2006/70/EC), succeeded in 2015 by the Fourth Anti-Money Laundering Directive ((EU 2015/849). These latter set out more detailed requirements for customer identification and introduced risk-based measures for situations, where a greater risk of money laundering may warrant enhanced action, or respectively where a lower level of risk allows for less stringent controls. 373

he Directives are the most important elements of European anti-money laundering T regulations, given the obligation undertaken by Member States to transpose the provisions of the Directives into their own national law.

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7. Banking systems after WWII

Established as of 1 January 2011, the European Supervisory Authorities (ESAs), comprised of the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA), also play a major role in Europe’s fight against money laundering and terrorist financing. The joint committee of the three supervisory authorities release opinions on the risks of money laundering and terrorist financing to the EU financial sector, while it also develops and releases regulatory technical standards and other guidelines, based on which Member States’ national supervisory authorities specify their expectations for financial institutions and subsequently request proof of compliance. Hungarian regulations In former socialist countries of Central and Eastern Europe, including Hungary, as the financial sector developed and integrated progressively into the international financial system, given that the appropriate technical and legal means that were essential to detect criminal proceeds were generally absent in the region at the time, there was a significantly higher probability that the financial systems of these countries would be exploited for money laundering purposes to a substantially greater extent. The adoption of the first Hungarian act on money laundering dates back to 1994, when the country’s first anti-money laundering legislative package (Act XXIV of 1994 as amended) set out the core components of the fight against money laundering, and specified the scope of its application. The Act was applicable to a number of participants in the capital market the services of which could be exploited to launder criminal proceeds, including banks, insurance companies, security dealers and investment fund managers, as well as their customers, managers and employees. The Second Anti-Money Laundering Act (Act XV of 2003) widened the scope of the act and the group of crimes underlying money laundering, and followed up on the increasingly stringent international requirements responding to the terrorist attacks of September 2001. On 1 May 2004, Hungary, together with nine other countries, joined the European Union, which obviously also involved the obligation to comply with the legal

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requirements of the EU. Implementing the Third Anti-Money Laundering Directive, the Third Anti-Money Laundering Act (Act CXXXVI of 2007) entered into force as of 15 December 2007, and the Fourth Anti-Money Laundering Directive was transposed as of 26 July 2017 by the Fourth Anti-Money Laundering Act (Act LIII of 2017). The adoption of these latter acts are key milestones in Hungary’s fight against money laundering as they require service providers (e.g. credit institutions and financial institutions) to implement increasingly stringent measures. They do so in order to improve the effectiveness of service providers’ efforts to prevent money laundering, and to reduce criminal organisations’ capacity to integrate their illegal proceeds into the legitimate economy, including the financial system. The key tasks to be carried out by service providers are the following: – Designation of an internal employee (designated anti-money laundering officer), who is responsible for establishing the internal anti-money laundering system and internal regulatory environment, and for training; – Identification and assessment of money laundering risks to the service provider so that the latter is aware of its risks and allocates its resources accordingly; – Carrying out customer due diligence in the cases specified by the Act in order for service providers to know their customers, and be aware of what persons are behind their customers and on whose behalf their customers act (beneficial owners), or whether their customers are politically exposed;374 – Continuous control and screening of customer transactions in order to detect elements giving rise to the suspicion of money laundering;

374

politically exposed person is a natural person who is or has been entrusted with A important public functions within one year before the implementation of customer due diligence measures.

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7. Banking systems after WWII

– Reporting detected suspicious transactions to the authority acting as the national financial intelligence unit – currently the dedicated organisational unit of the National Tax and Customs Authority. In respect of financial institutions and credit institutions, compliance with the above is checked by the Magyar Nemzeti Bank in its capacity as supervisory authority, which, among other measures, may impose fines between HUF 400,000 and HUF 2 billion in the event of deficiencies being detected. Fines may also be rather heavy internationally. In 2012, following an investigation by US authorities, HSBC was required to pay a fine amounting to USD 1.92 billion upon acknowledgment of its liability for the violation of anti-money laundering regulations. Among other things, the bank had moved USD 881 million between the Mexican Sinola cartel and the Norte del Valle of Colombia.375

375

ttps://www.reuters.com/article/us-hsbc-probe/hsbc-to-pay-1-9-billion-u-s-fineh in-money-laundering-case-idUSBRE8BA05M20121211

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Key terms banking crisis deregulation dollarisation Eurocurrency financial repression internationalisation

money laundering Nixon shock regulatory arbitrage shadow bank systemic risk too big to fail

References Alexander, W. E. – Davis, J. M. – Ebrill, L. P. – Lindgren, C. J. (eds.) (1997): Systemic Bank Restructuring and Macroeconomic Policy. Washington: International Monetary Fund. Amaglobeli, M. D. – End, M. N. – Jarmuzek, M. – Palomba, M. G. (2015): From Systemic Banking Crises to Fiscal Costs: Risk Factors (No. 15–166), Washington: International Monetary Fund. Arslanalp, S – Liao, W. – Piao, S. – Seneviratne, D. (2016): China’s Growing Influence on Asian Financial Markets, IMF Working Paper No. 16/173. Banai, Á. (2017): Banki viselkedés a válság előtt és a válságban (Bank Behaviour before and during the Crisis), Doctoral thesis, Corvinus University of Budapest. Bank of Thailand (1993): Financial Innovation and Modernization of the Thai Financial Market, Quarterly bulletin, Bank of Thailand, December, pp. 21–46. Bank of Thailand (1998): Financial Institutions and Markets in Thailand. Battilossi, S. (2000): Financial innovation and the golden ages of international banking: 1890–1931 and 1958–81. Financial History Review, 7(2), pp. 141–175. Battilossi, S. – Cassis, Y. (2002): European Banks and the American Challenge. Competition and Cooperation in International Banking under Bretton Woods. Oxford University Press, New York. Barisitz, S. (2008): Banking in Central and Eastern Europe 1980–2006, Routledge, Abingdon. BIS Monetary and Economic Department (2015): Cross-border Financial Linkages: Challenges for Monetary Policy and Financial Stability, BIS Papers 82. Błach, J. (2011): Financial Innovations and Their Role in the Modern Financial System – Identification and Systematization of the Problem, e-Finance. Financial Internet Quarterly, ISSN 1734-039X, Vol. 7, Iss. 3., pp. 13–26. Bulmer-Thomas, V. (1994): The Economic History of Latin America Since Independence. Cambridge University Press. Cottarelli, C. – Gerson, P. – Senhadji, A. (eds.) (2014): Post-crisis fiscal policy. MIT Press.

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7. Banking systems after WWII Crystal, J. S. – Dages, B. G. – Goldberg, L. S. (2002): Has Foreign Bank Entry Led to Sounder Banks in Latin America? Federal Reserve Bank of New York, Current Issues in Economic and Finance, Vol. 8, No. 1, January. De Haas, R. – Van Lelyveld, I. (2014): Multinational Banks and the Global Financial Crisis: Weathering the Perfect Storm? Journal of Money, Credit and Banking, Supplement to Vol. 46, No. 1, February, pp. 333–364. Fuji, M. – Kawai, M. (2010): Lessons from Japan’s Banking Crisis, 1991–2005, Asian Bank Development Institute, ADBI Working Paper Series, June, No. 222. Hayashi, F. – Sullivan, R. – Weiner, S. E. (2003): A Guide to the ATM and Debit Card Industry, Federal Reserve Bank of Kansas City. Hidasi, B. – Papp, I. (2015): A japán bankrendszer átalakulásának főbb állomásai (Main Stages in the Transformation of the Japanese Banking System). Financial and Economic Review, Vol. 14., Special Edition, November, pp. 116–132. Honohan, P. – Laeven, L. (2005): Systemic Financial Crises: Containment and Resolution, Cambridge University Press, New York. International Monetary Fund (2010): Fiscal Monitor: Navigating the Fiscal Challenges Ahead. Fiscal Affairs Department, Washington. International Monetary Fund (2014): Fiscal Monitor: Back to Work – How Fiscal Policy Can Help, Washington. International Monetary Fund (2016): Global Financial Stability Report: Fostering Stability in a LowGrowth, Low-Rate Era. World Economic and Financial Surveys, October, Washington. International Monetary Fund (2000): International Capital Markets: Developments, Prospects, and Key Policy Issues, September, Washington. Kolozsi, P. P. – Banai, Á. – Vonnák, B. (2015): Phasing out of household foreign currency loans: schedule and framework. Financial and Economic Review, Vol. 14. Issue 3., pp. 60–87. Komp, L. (1999): How Germany financed its postwar reconstruction, EIR, Volume 26, Number 26, June 25. Korhonen, I. (1996): Banking Sectors in Baltic Countries. Review of Economies in Transition 3/96. Bank of Finland. Laeven, L. – Valencia, F. (2008): Systemic Banking Crises: A New Database. Journal Issue, 224. Laeven, L. – Valencia, F. (2012): Systemic Banking Crises Database: An Update. IMF Working Paper, WP/12/163. Laeven, L. – Valencia, F. (2013): Systemic Banking Crises Database. IMF Economic Review, 61(2), pp. 225–270. Liao, M. – Sun, T. – Zhang, J. (2016): China’s Financial Interlinkages and Implications for Inter-Agency Coordination. IMF Working Paper No. 16/181. https://ssrn.com/abstract=2882619

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Banks in history: innovations and crises Lilley, P. (2000): Piszkos Ügyletek – A pénzmosás világa (Dirty Deals – The World of Money Laundering). Perfekt Rt., Budapest. Leightner, J. E. (2007): Thailand’s Financial Crisis: Its Causes, Consequences, and Implications. Journal of Economic Issues, March. Matthews, K. (2003): International Banks and The Washing of Dirty Money: The Economics of Money Laundering In: Mullineux, A.W. – Murinde, V. (eds.): Handbook of International Banking, Edward Elgar, Cheltenham. Moguillansky, G. – Studart, R. – Marezco, S. V. (2004): Foreign banks in Latin America: a paradoxical result. CEPAL Review, April. Montgomery, H. (2003): The Role of Foreign Banks in Post-Crisis Asia: The Importance of Method of Entry. ADB Institute Research Paper Series No. 51. Palmer, D. E. (2000): U.S. Bank Exposure to Emerging-Market Countries During Recent Financial Crisis. Federal Reserve Bulletin, February, pp. 81–96. Papp, I. (2001): 「タイにおける金融自由化政策と現地銀行•外国銀行の効率性」その2, (The effect of financial liberalization on the efficiency of local and foreign banks operating in Thailand, II.), 一橋論叢 [Ikkyo Ronso], pp. 45–60. Papp, I. (2005): Do Banking Crises Attract Foreign Banks? Journal of Emerging Markets, Vol. 10, No. 1, pp. 42–50. Papp, I. (2015): A bankrendszerek nemzetköziesedése (Internationalisation of Banking Systems). Financial and Economic Review, Vol. 14., Special Edition, November, pp. 7–13. Papp, I. (2016): Stabilitási kockázatok a kínai bankrendszerben (Stability Risks in the Chinese Banking System). Manuscript. Peek, J. – Rosengren, E. (2000): Implications of the Globalization of the Banking Sector: The Latin American Experience. Federal Reserve Bank of Boston New England Economic Review (September– October), pp. 45–62. Robinson, J. (1996): A pénzmosoda (The Money Laundry). Park Kiadó, Budapest. Turner, G. – Tan, N. – Sadeghian, D. (2012): The Chinese Banking System, Reserve Bank of Australia Bulletin, September. Temesváry, J. – Banai, Á. (2017): The Drivers of Foreign Bank Lending in Central and Eastern Europe: The Roles of Parent, Subsidiary and Host Market Traits, Journal of International Money and Finance. December 2017, vol. 79, pp. 157–173. Várhegyi, É. (2004): A magyar bankrendszer átalakulása, működése és jellegzetes vonásai (Transformation, Operation and Characteristics of the Hungarian Banking System). Doctoral Thesis for the Hungarian Academy of Sciences. Vichyanond, P. (2000): Financial Reforms in Thailand. The Thailand Development Research Institute, Bangkok. Yao, S. – Han, Z. – Feng, G. (2008): Ownership reform, foreign competition, and efficiency of Chinese commercial banks: A non-parametric approach, Research paper/UNU-WIDER, No. 2008.38.

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The effect of digitalisation on the banking sector Dorottya Eszes–Péter Sajtos–János Szakács–Ágnes Tőrös

The banking system has undergone profound changes in the past roughly one century. After the strict regulations following the Second World War, the internationalisation of banks in the 1980s opened a whole new chapter in their history, as credit institutions significantly expanded their activities and incorporated many technological innovations into their range of products, for example electronic finance and cross-border transfers. The banking system’s development was uninterrupted for a long time, and by the turn of the millennium the digitalisation of financial services stood out among other industries. The global financial crisis and its impact marked a turning point in the development of the banking system. Banks’ profitability was influenced negatively by the deterioration of the loan portfolio as well as the low interest rate environment. Therefore, banks had fewer resources for financing and implementing innovations. In the early 21st century, the banking system lost its earlier innovative role. The latest stage in the innovation process in the financial sector is the appearance of FinTech innovators, whose emergence was fostered by widespread access to the Internet. Several technological innovations have occurred that can be used in the provision of financial services, and that reduce banks’ operating costs and improve customer experience. Most FinTech developments are incorporated into payment services, such as online payments, mobile payments and e-money. The innovations based on blockchain technology, for example the various altcoins, hold enormous potential. Several innovations, for instance

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the emergence of peer-to-peer lending, crowdfunding and robo-advisers, may disrupt traditional business models and pose huge challenges to incumbents. The innovations not only present tremendous opportunities, but also pose huge challenges to the financial system’s stability, as most of them are still unregulated. A balance between the two extremes should be found while laying down the new rules. An outright ban on implementing new ideas may hamper innovation, whereas ‘laissez faire’ regulation may provide an unfair competitive edge to FinTech firms, while also entailing consumer protection and financial stability risks. One possible tool for regulating and supporting FinTech innovations may be the Innovation Hub and the Regulatory Sandbox that have become increasingly widespread at the international level in the past 2–3 years. The Innovation Hub is a platform provided by the regulatory authority where the institutions developing FinTech solutions can receive guidance from each other and from all players in the FinTech ecosystem. On the other hand, the Regulatory Sandbox is a test environment offering temporary relief from regulatory requirements and an appropriate framework for testing innovative technologies with the involvement of real consumers while potential risks are managed. Over the longer term, the direction of FinTech development is difficult to project, but different market structures are expected to develop in the regions at various levels of development. In the areas where the new solutions have appeared as greenfield investments in the context of underdeveloped financial services and infrastructure, FinTech providers may be tough competitors or even substitutes for the traditional banking system. Overall, in the countries with a more advanced financial system, banks and innovators are expected to co-operate, however, some FinTech firms pose a real threat to incumbents in certain niche markets. These disruptive innovations may even crowd out traditional actors of the banking sector in specific segments.

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8. The effect of digitalisation on the banking sector

8.1 The 2008 global crisis and its impact on the banking system 8.1.1 The 2008 global crisis

The crisis originated from the real estate market bubble in the United States. In the 2000s, mortgage lending conditions were relaxed in the US, which – in parallel with the continuous rise in property prices – drastically increased banks’ outstanding mortgage credit. Rising house prices fuelled additional demand for loans, which banks satisfied through the securitisation of outstanding loans. Due to the fall in house prices from 2006, the lending policy became unsustainable, property prices dropped even further on account of the contraction in demand, and the banking system suffered substantial losses, leading to spillover effects in other segments of the economy and international developments, resulting in a global crisis (Allen–Carletti, 2010). The default of Lehman Brothers, an investment bank, and the erosion of market confidence highlighted the weaknesses of mortgagebacked securities. The crisis exerted global spillover effects through the interbank markets. These markets froze up almost completely, and financial institutions stopped lending to each other, which posed a major challenge for the banking system. The issues on the market made it very difficult and expensive for banks to raise funds, which they could only partly pass on to their customers, resulting in lower profitability. In times of crisis, due to the preceding credit boom or the unfavourable economic conditions, a large amount of non-performing loans may build up on banks’ balance sheets (Baudino–Yun, 2017). The rising NPL ratio considerably lowered banks’ profitability, which was also attributable to the global financial crisis (Chart 8-1). The NPL ratio and banks’ losses started increasing due to higher interest rates, unfavourable labour market conditions and falling property prices. As

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Banks in history: innovations and crises

a result, banks’ loan portfolio deteriorated significantly, dramatically reducing the profitability of credit instruments. However, NPLs grew most in the countries where banks engaged in excessive risk-taking on account of strong competition. Chart 8-1: Return on equity and assets in the USA and the eurozone 18

Per cent

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

0.0

Return on equity for banks in the US Return on equity for banks in the eurozone Return on assets for banks in the US (right-hand scale) Return on assets for banks in the eurozone (right-hand scale) Source: World Bank.

The large amount of NPLs hampered banks in lending to the economy. In addition to weak profitability, banks’ capital buffers were also reduced by large-scale loan loss provisioning, and therefore they could lend less. Moreover, NPLs have a greater risk weight in capital requirement calculations, which further constrained the credit supply through capital adequacy limits. A drop in credit supply leads to falling investment and output as well as rising unemployment. However, the resulting economic crisis also affects lending through the further increase of NPLs.

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8. The effect of digitalisation on the banking sector

8.1.2 Longer-term effects of the crisis

Deterioration of the loan portfolio had a substantial impact on banks’ profitability over the longer term as well. In the wake of the crisis, high level of NPLs appeared on banks’ balance sheets, which prevented banks from jump-starting lending and resulted in substantial revenue losses. Cleaning up the loan portfolio takes especially long in the countries that are indebted excessively and in an unhealthy structure (Chart 8-2). As a result of the crisis, consumer confidence in the banking system also diminished (Stevenson–Wolfers, 2011), which hindered the restoration of lending and banks’ profit generation. In a recession, companies seek to reduce their inventories, thereby reducing their short-term credit needs. They are forced to postpone investments due to surplus capacities and the uncertain economic prospects, which also reduces their demand for long-term loans. Chart 8-2: Proportion of non-performing loans as a percentage of the gross loan stock 40

Per cent

2008 Greece Italy

2012

2016 Spain France

Ireland Portugal

Source: World Bank.

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Germany

Banks in history: innovations and crises

Central banks responded to the economic challenges posed by the financial market crisis by introducing massive interest rate cuts, until the central bank policy rate dropped to zero or below in several countries. Therefore, from then on, the crisis had to be managed by introducing unconventional instruments: central banks provided liquidity to domestic financial institutions in their own currency through asset purchases, and in foreign currency through swaps (Borio–Distyatat, 2009). The low interest rate environment encourages investors to take greater risks in order to earn higher yields, and therefore the postcrisis risk-aversion was replaced by the search for yield (BIS, 2010). This phenomenon affected not only large investors but also became increasingly typical among retail investors. Smaller banks that depend more on deposits are more sensitive to this, choosing consolidation in several cases. Larger banks react to the profit pressure caused by low interest rates by raising fees (IMF, 2017). This strengthens the demand for the financial services outside the banking system, whereby the popularity of banking products declines. After the crisis, the regulation of the financial system was overhauled. The extent of the economic losses caused by the crisis showed that – in order to ensure financial stability and mitigate the fluctuations of procyclicality – regulators, including central banks, need to intervene in financial intermediation not only through microeconomic regulation and supervision, but also in accordance with systemic aspects. The newly introduced regulatory framework and the macroprudential policy instruments exert their effect through conscious, systematic regulatory processes aimed at systemic risks (Borio, 2014). In addition to the focus of the regulation, its complexity also changed: more comprehensive, detailed rules have been developed that have considerably increased banks’ regulatory burdens. All in all, the abovementioned factors substantially influenced banks’ operation, and required that the integration of banking innovations be strengthened (Chart 8-3).

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8. The effect of digitalisation on the banking sector

Chart 8-3: Impact of the economic crisis and subsequent developments on banks’ operation Financial service providers lost their leading role in digital solutions ▪ Significant stocks of NPL and loan loss provisions ▪ Economic growth challenges ▪ Moderate credit demand in certain regions

Need for increasing banks' cost efficiency

Increasing regulatory burdens Growing demand for digitalisation from consumers

▪ Low interest rate environment

It is necessary to strengthen the integration of innovations into banking operations Source: Authors’ own compilation.

8.2 The Fourth Industrial Revolution and the spread of FinTech innovations 8.2.1 The Fourth Industrial Revolution

Since 2000, technological progress has increasingly generated new services, the most important of which are social networks, mobile platforms and applications, the possibility of big data analysis, cloud services and artificial intelligence (AI). This process was facilitated by the spread of smart phones and cheap sensors, the development of batteries and the ever-smaller size of IT devices. The new technologies are transforming several sectors, improving efficiency, offering new business solutions and also contributing to economic development over the long run.

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Banks in history: innovations and crises

Development hinges on widespread access to the Internet. The latest phase in the development of the Internet started in 2010 (Sogeti VINT, 2014), and now the role of the World Wide Web has expanded, as it also contributes to linking the virtual and physical worlds (Chart 8-4). The Internet of Things (IoT) comprises uniquely identifiable physical devices, which communicate with each other to perform activities, sometimes even without human intervention. Together with the other technologies, this is paving the way for more widespread automation in manufacturing. Improving access to the Internet and artificial intelligence form a solid basis for expanding human capabilities, but this sort of utilisation is still in its infancy. Chart 8-4: Number of Internet users and connected devices 4,000

Million people

Million pcs

20,000

3,500

17,500

3,000

15,000

2,500

12,500

2,000

10,000

1,500

7,500

1,000

5,000

500

2,500

1995

2000

2005

2010

2011

2012

2013

2014

2015

Internet users Number of connected devices (Internet of Things−IoT) (right-hand scale) Source: World Bank, NCTA.

According to the empirical literature, Internet penetration and GDP are positively correlated (Choi–Hoon Yi, 2009). The rapid development and application of information and communication technologies has

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8. The effect of digitalisation on the banking sector

led a to whole array of innovations that may help economic growth. Although jobs may be lost due to automation, new, different jobs appear. Firms operate more efficiently, therefore new players find market entry easier, which is good for competition. Technological innovation also plays a pivotal role in maintaining competitiveness.

8.2.2 Innovation drivers in the financial sector

Since the 1960s, the banking system has relied heavily on innovations related to digitalisation. Major developments from the past decades, such as the bank card, the ATM and the electronic systems used for processing settlements, are good examples for the openness of the banking system towards innovation (for more details, see: Box 8-3). As a result, the largest buyer of IT services has long been the financial sector, and until the end of the 20th century, the banking system spearheaded the use of technological innovations (Arner et al., 2016). In the 21st century, smart phones became widespread and mobile Internet coverage expanded considerably, paving the way for the spread of applications, social networks and online services (Arner et al., 2016). The widespread use of online technologies is gradually becoming part of general thinking, and the consumer society will soon see the satisfaction of needs through digital channels in all areas as vital, and financial products and services are no exception. This need will continue to increase as digital natives grow up (EY, 2016). Recent technological innovations have been incorporated into the operation and product range of several industries, but the banking system has not integrated them into its operation as deeply as in earlier times, thereby losing its trailblazer role in the 21st century. This is partly attributable to the fact that bank executives often do not realise the potential of today’s innovations, and interpret digital transformation in a narrow sense. Several players justify their sluggishness by citing security risks (McKinsey, 2014).

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Banks in history: innovations and crises

One central element in harnessing the opportunities inherent in the digital revolution was that the NPL ratio and banks’ losses started to rise during the crisis as a result of unfavourable labour market conditions and falling property prices. This not only undermined the capital and income position of banks, but also tied down human resources in crisis management. On the liabilities side, the freezing of interbank markets substantially raised short-term funding costs. As a result of the crisis, consumer confidence in the banking system also weakened (Stevenson– Wolfers, 2011), which hindered the restoration of lending and banks’ profit generation. There is also room for improvement with respect to financial infrastructures, as these are unable to meet today’s challenges. From the supply side, several market failures and payment features are stifling competition between market participants. Due to the capitalintensive nature of the initial infrastructure investments, new players face high barriers to entry. However, this is difficult to recoup, since the payment market is networked, and therefore it is difficult to spread sophisticated services and thus gain new customers. This is because – due to the networked character of the system –innovation by a single service provider is not enough to raise the actual level of services: complex developments across the whole sector are needed for that. This means that it is very difficult for a new player or service to reach the critical mass where the capital invested in innovation is recouped and the business would be able to acquire new customers. As a result, the players on the payment market were not interested in radical, comprehensive developments. Thus, financial infrastructures did not keep up with today’s requirements. In many countries, continuous access or rapid (real-time) messaging is not possible either on banks’ or on the central infrastructure’s side, even though this has become a basic customer requirement in other walks of life. High operating costs are a global problem. Although the world’s largest banks were able to reduce their operating costs marginally after

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8. The effect of digitalisation on the banking sector

the crisis, in developing countries operating costs were rising (EY, 2017), even though their decline would facilitate the restoration of profitability. Measures aimed at cost effectiveness, such as the rationalisation of labour costs, the simplification of processes and the reduction in the number of branches, have not had the desired effect. Credit institutions’ early adjustment to innovations may be profitable, as the early use and adoption of innovations and ideas may provide a long-term competitive edge. In developed countries, consumers are reluctant to abandon the bank they are familiar with (McKinsey, 2016), which may facilitate banks’ cooperation with innovative companies. Shortening and increasing the transparency of banking processes will also provide an opportunity to acquire new customers, and a large existing customer base may prove to be a source of useful information for charting the paths of future development (FSB, 2017). If banks are able to transform, they can profit greatly from innovative solutions. The utilisation of the developments in the financial sector is also driven by public demand. For example, electronic payment services are increasingly like utilities, i.e. vital to everyday life. International studies and statistics confirm that in most European countries, the penetration of payment cards and accounts is relatively high, i.e. these services satisfy basic needs that are crucial in everyday life for large swathes of society. This is coupled with the fact that switching between payment service providers, for example due to more favourable fee conditions, typically requires plenty of administration, as account holders need to notify their economic partners and go to a branch in person, and sometimes even additional costs may be incurred. On account of the utilities-like nature and the difficulties associated with switching between service providers, consumers increasingly demand access to these services in a flexible framework similar to other sectors.

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8.2.3 Innovation trends in financial services

The latest milestone of the innovation process in the financial sector is the emergence of FinTech solutions. There is no generally accepted definition of FinTech (financial technology) in the economic literature; overall it is understood to refer to the use of innovative technology in the provision of financial services (Nicoletti, 2017). In the interpretation of the Financial Stability Board (FSB), FinTech is technology-enabled financial innovation that can produce new business models, applications or products, which can have a profound impact on financial markets and institutions as well as financial services themselves (FSB, 2017). FinTech refers to the technology-enabled development of the whole financial sector, including innovation pertaining to the activities of the front, middle and back office. FinTech is independent of the nature or size of the service provider, and therefore it can emerge in both retail and wholesale markets. Although due to the uncertain meaning of FinTech, there are significant variations in the available global investment data, the underlying trends are the same: up to 2015, venture capital investment in the FinTech sector grew globally, but this trend seems to have slowed down since 2016 according to some sources (KPMG, 2017), or since 2017 according to others (FinTech Global, 2017). The declining global investment sentiment may recover in the future, for example because of the expected spread of artificial intelligence (Chart 8-5). However, there are substantial differences across the various economic regions, which can be attributed to either consumers’ attitude or the historical development of the financial system. In the rapidly developing Asian countries, where the financial intermediary system is less deep, FinTech services may become more widespread. In North America, the development of the FinTech market is driven by an outstanding investment sentiment. By contrast in Europe, FinTech firms make developments either in

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8. The effect of digitalisation on the banking sector

cooperation with banks or using smaller market niches, but FinTech activities may considerably increase in the EU due to the introduction of PSD2 (the payment services directive) in 2018. Chart 8-5: Expectations of FinTech innovation efforts in the next 3–5 years (2017) 0

Per cent 90 100

Global Africa Oceania Latin America North America Asia Europe

Growth is expected Will not change Decrease is expected

90 100 Per cent

Note: Proportion of respondents. Source: PwC Global Survey.

Box 8-1 The hype cycle in technological innovations

Typically, new technologies have a significant long-term potential in the individual sectors of the economy, but various patterns can be identified in their evolution and widespread adoption. The ‘hype’1 cycle developed by Gartner, a consulting firm, provides a detailed overview about the development of new technology and its use over time (Chart 8-6).

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Banks in history: innovations and crises

Chart 8-6: The hype cycle depending on time and expectations

Expectations

Inflated expectations

nment ghte i l n e Increasing e of productivity Slop

Disillusionment Innovation Source: Gartner.com

Time

Five phases of the hype cycle can be identified, the first of which is the innovation trigger. Here a rudimentary product or service, without proven viability on the market, which is nevertheless expected to lead to a technological breakthrough, generates increasing interest among market participants and indirect stakeholders. In the early stages of development, further innovative solutions make it to the market based on the new technology. Due to the increased interest and as the potentially successful business models become increasingly popular, inflated expectations are formed, which may lead to an upsurge in market activity. On account of the steadily rising expectations, several companies seek to enter the emerging market as soon as possible, which may lead to many failures through the spread of inadequately planned business models. The failed product or service launches may temporarily undermine confidence, and disillusionment may mark a turning point in market activity. However, the fall may facilitate the development of an equilibrium path sustainable over the longer term. During the ‘enlightenment’ phase, in order to prevent another potential downturn, the market focuses on understanding the technology and thus also on developing real value-creating processes derived from the innovative technology.

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8. The effect of digitalisation on the banking sector

The cautious behaviour following the disillusionment gradually diminishes in the enlightenment phase as the technology and its potential impact are understood. As a result of the now not hype-driven, continuous and conscious development, the technology’s widespread, safe adoption leads to an improvement in long-term productivity.

Innovations have a significant effect on the financial infrastructure, as new, innovative players seek to address shortcomings in payment services. Due to their business model, smaller size and more flexible organisational structure, these actors respond more easily to the challenges posed by changing conditions. These firms typically target a special field with their innovations and provide more sophisticated payment services by utilising its features and existing infrastructural characteristics. One need only think of the options that are often better alternatives to costly, time-consuming cross-border bank transfers. Such services include Transferwise or the bank card-based mobile wallet systems created by BigTech (Milkau–Bott, 2015). Nevertheless, these developments only affect the service level and do not lead to substantial infrastructure developments in the interbank arena. Therefore – although they provide a solution in certain subfields – overall they increase the segmentation of the payment system and complicate the chain of payments with additional elements. FinTech companies mainly target payment services, this segment is where new market participants come up with the most developments (BIS, 2017; EBA, 2017). Specifically, new FinTech firms appear chiefly in connection with retail payments, principally on account of the increasing smartphone penetration and the increasing digital literacy of the younger generations who provide a constantly growing customer base for new service providers. FinTech firms believe that there are three key features related to payments and other financial services that could help them acquire customers: ease of use, 24/7 accessibility and rapid services (PwC, 2017).

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Banks in history: innovations and crises

In addition to so-called sustaining innovation based mostly on an existing infrastructure the efficiency of which is improved, more radical developments can also be observed around the world. Disruptive innovation is able to fundamentally transform the existing business models on a market, and therefore, innovations of this kind can induce quite substantial realignments (Bower–Christensen, 1995) (Chart 8-7). Such developments can often lead to exponential performance improvements and reduced costs. By nature, they are riskier and thus also involve a more uncertain outcome. Examples include cloud-based solutions, peer-to-peer lending and robo-advisory. Traditional financial intermediaries are also threatened on many fronts by global technology giants, i.e. BigTech companies (e.g. Apple, Google, Facebook), which are interested in financial services. This is because these companies have a huge advantage in the application of digital technology and can exert an enormous influence over the whole sector through their business models that generate new financial services developed for IT devices. Steadily improving digital penetration, increasingly buoyant investment sentiment regarding innovative services and the multitude of new products and services may also influence the significant increase in cyber risks. New financial services that generally do not concern traditional institutions, such as peer-to-peer lending, may also become available to consumers who have no experience in banking or managing their finances, but are digitally mature. Furthermore, automated communication between machines may also drastically expand as the Internet- and data-based technologies become increasingly widespread. Consequently, special attention has to be paid to keeping cyber attacks and system failures to a minimum as innovations spread.

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8. The effect of digitalisation on the banking sector

Chart 8-7: The role of FinTech innovations in the value chain of financial services API

Risk management based on Big Data

Blockchain

Artificial Intelligence

Cyber defense

Operations, infrastructure

Sustaining

Searching engines with comparative functions

Account information services Social Scoring Personal Finance Management

Mobile payment Mobile POS

Products Marketing, sale

Disruptive

Lending Account management Investment advice

Peer-to-peer lending Robo-advisory Crowdfunding

Transactions

Electronic money

Source: Authors’ own compilation.

8.2.4 The most widespread FinTech innovations and the affected financial services

Electronic money-based systems: Perhaps the best-known example of these firms is PayPal. They basically develop their own infrastructure to address the disadvantages of traditional systems, such as noncontinuous accessibility or non-immediate crediting on the beneficiary’s side. This makes for flexibility in product and service development, i.e. eliminates the difficulties arising from the networked nature of the payment market by the lack of need to take into account other players’ developments in the innovator’s own system. However, these solutions

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Banks in history: innovations and crises

result in additional closed, parallel systems that are often incompatible from the consumers’ perspective, consequently, the segmented structure may lead to inefficient solutions for the economy as a whole. Blockchain innovations: The ‘blockchain’ is a public ledger in which all value changes can be monitored, since transactions are shown chronologically. The blockchain is a public distributed ledger technology (DLT). The history of transactions is public, and it is stored by computers independent from each other, without a central server. This makes the ledger more transparent and controllable. A ledger distributed among financial actors could simplify and make more efficient syndicated lending, securities settlement systems and even cross-border payments. For example, one field where blockchain innovations are already used is bitcoin (an electronic money) and ‘smart contracts’, whereby the contracting parties can enter into digital, automatically performed contracts without revealing their identity or involving a third party. Box 8-2 Traditional payment systems challenged? — Bitcoin and other altcoins

Bitcoin appeared and became widespread after the 2008 crisis, partly as a result of the fact that confidence in traditional financial players had been shaken (Chart 8-8). It was able to use existing technological solutions to create a payment solution without a central party and independent from state supervision and the traditional banking system. Bitcoin’s functioning is ensured by the distributed ledger technology, whereas traditional currencies are backed by a country and its monetary authority. The system has no designated central party that validates the transactions, instead the majority of the community has to confirm that the sender actually has the amount sought to be transferred or spent in bitcoins.

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8. The effect of digitalisation on the banking sector

Chart 8-8: Evolution of the number and average price of bitcoins 18

Million pcs

Thousand USD

9 8

01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10. 01. 04. 07. 10.

2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 2017

Number of bitcoins Average price (right-hand scale) Source: blockchain.info

With all payments, the transaction is authenticated by the consensus of the players participating in the network, i.e. this mechanism ensures that the same amount cannot be spent multiple times. Bitcoin transactions are validated by 50 per cent +1 of the participants’ computing capacity. This is performed by the so-called miners who compete with each other in validating the transactions, during which they review the history of transfers (the earlier blocks from the blockchain). The essence of the competition is that the miners need to ‘prove’ (in the so-called proof-of-work protocol) that they make an effort to validate the transaction, which aims to prevent fraudulent transactions. Miners validate the transaction through certain mathematical calculations, receiving diminishing rewards for this time- and energy-intensive process. This prevents unlimited money being generated in the network, instead, supply increases gradually.

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Banks in history: innovations and crises

The advantages often cited in connection with bitcoin include speed and cheapness. It must be noted that although in certain payment situations (e.g. with cross-border payments) using virtual currencies may be truly more favourable based on these aspects (they are faster and cheaper to use), one must not forget that in most cases modern payment providers offer more sophisticated services. While the time required for transfers and card payments typically tends towards a couple of seconds, this may take up to an hour with virtual currencies due to the consensus system. Moreover, the energy use of mining will be increasingly substantial on account of the growing computational needs,376 and of course the growing costs need to be borne by consumers, thus traditional electronic payment methods have better prices. When it comes to transaction turnover, it can also be argued that a network of virtual currencies similar to bitcoin would be unsuited for handling the current retail electronic payments (Sompolonsky–Zohar, 2015). Due to the high costs of mining, companies specialising in this seek to find a location where operating costs can be kept to a minimum. Cheap labour (responsible for the maintenance of the computers) and cheap electricity helped the spread of such firms in China, and some of them have become so large that they buy energy directly from the power plants. The concentration of miners in China and their cost advantage mean that a large portion of the newly created bitcoins are clustered there, which may be important from the perspective of accessibility. Since bitcoins can be acquired through mining or secondary market purchases (at so-called bitcoin exchanges) or by accepting payments in bitcoin, the overrepresentation of Chinese miners also means that if domestic players wish to own bitcoins, they have to buy it from abroad at a bitcoin exchange. Transfers to a foreign account, the crediting and the fees charged for the actual bitcoin purchase may increase the costs of acquiring bitcoins, thereby slightly disincentivising its use.

376

ccording to O’Dwyer, K. J.–Malone, D. (2014), conducting all today’s payments A in bitcoin would require the energy need of a smaller country.

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8. The effect of digitalisation on the banking sector

Payment solutions: Financial innovations enable the separate management of payment services that used to be tied to the banking system, and these services can be significantly cheaper or faster than solutions offered by banks. They include mobile payment solutions and cross-border transfer systems. Peer-to-peer lending: Peer-to-peer (P2P) platforms may be able to fundamentally disrupt current banking business models. These platforms connect savers and credit applicants without the involvement of banks for a relatively low fee, thereby reducing the spread between lending rates and deposit interest rates. Their most important advantage is that they may mitigate the costs of financial intermediation (e.g. there is no need to build a branch network). Nevertheless, the lack of regulation on the P2P credit market as well as the potential proliferation of abuses may entail substantial risks. Crowdfunding: Crowdfunding is a solution in which several individuals finance start-ups with relatively low capital contributions. It is based on large social networks (e.g. social media), which provide ease of access. Crowdfunding may potentially improve entrepreneurship by expanding the group of investors. The most widespread forms of crowdfunding include the donation or gift-based model and the equity model. Personal finance management: This enables the management of account data from various banks on one platform. The FinTech service provider collects information directly from the account-servicing institutions. Participating banks provide this information to FinTech service providers through an application programming interface (API). Robo-advisory: Robo-advisers are digital platforms providing automated, algorithm-driven financial planning services, with minimal human supervision. The process starts with the compilation

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Banks in history: innovations and crises

of the information available on customers (financial position and future goals) and ends with the provision of advice and/or automatic investments based on such data. The appearance of modern roboadvisers has already substantially influenced investment markets in some countries, since they provide services directly to the consumers, without intermediaries. RegTech: ‘Regulatory Technology’ (RegTech) firms use their technology and software to help other companies in complying with specific regulatory requirements, making legal compliance for the latter more efficient and cheaper. InsurTech: It refers to the use of technological innovations in insurance, with the aim of increasing savings and efficiency. InsurTech is mainly typical in solutions, such as completely customised service packages and dynamic pricing, that are facilitated by the use of data from devices connected to the Internet. These companies are able to divide risk groups in a more detailed and accurate manner, making their products more competitive. Box 8-3 Comparison — FinTech innovations in the past and today

The FinTech phenomenon is not new: its roots reach back to the second half of the 1800s (examples include the invention of the telegraph and the laying of the transatlantic cables). Therefore, the developments in the second half of the 1900s can be referred to as FinTech 2.0.377 The development of IT and digitalisation were already key factors at the end of the millennium in the operation of the financial system and the emergence of its business model. This period of innovation started with the introduction of ATMs, which facilitated the spread of bank cards invented after the Second World 377

Arner et al. (2016).

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8. The effect of digitalisation on the banking sector

War. This was the first milestone in the history of self-service banking. The use of digital solutions in the banking sector became widely adopted in the 1960s and 1970s. Banks already used an electronic system that can be regarded as the forerunner to today’s online and mobile payments for conducting settlements. At the same time, banking processes were digitalised, which contributed to reducing costs and operational risks. By 1998, financial services had become the first digitalised industry. The digitalisation of interbank clearing and banking processes enabled the internationalisation of banking systems, and banks’ business model changed considerably (Arner et al., 2016). After the global financial crisis, technological progress gathered pace, ushering in a new era in the financial sector that brought about a paradigm shift. Banks started to adapt to the rapid technological progress only after they recovered from the crisis. Thus, non-bank players appeared on the financial market, which now poses a challenge to the banking system. FinTech 3.0, which started in 2008, exhibits much more innovations in a shorter time than earlier periods. The innovations cover almost the whole spectrum of financial services, with the biggest novelties being peer-topeer services, the new payment solutions, artificial intelligence and big data procedures. Breaking away from the earlier, traditional model, these new technologies allow the physical link between consumers and banks to be completely eliminated. Similar to earlier times, data security is once again a serious issue in FinTech 3.0, however, there is currently much more focus on the utilisation and usability of the dataset available to banks in connection with the development of new financial services. Another feature of FinTech 3.0 is that the innovations involve financial stability risks, and regulatory authorities need to develop appropriate strategies to manage them (Table 8-1).

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Banks in history: innovations and crises

Table 8-1: Characteristics of FinTech eras FinTech 2.0

FinTech 3.0

Time frame

1967–2008

Main innovators

traditional financial service start-ups, new market providers players

Main types of innovations

–B ank card, ATM – Electronic financial systems, financial infrastructure (SWIFT) – Electronic platforms (e.g. Bloomberg terminal)

–E lectronic payment systems (e-money) – Alternative funding channels (crowdfunding, P2P lending)

TOP FinTechs

– – – – –

Regulatory intervention is needed

ells Fargo &Co (US) W ICBC (CN) JP Morgan(US) CCB (CN) Bank of America (US)

2008–today

uFax (CN) L Square (US) Markit (US) Stripe (US) Lending Club (US)

Yes, the paradigm shift requires increased regulatory attention

Source: Authors’ own compilation based on Arner et al. (2016).

8.3 Potential impact of FinTech innovations on the banking sector 8.3.1 General impact of FinTech innovations on the banking sector

FinTech innovators typically influence financial markets not only through their new products and services, but also by establishing new business models and operating structures. This entails opportunities for incumbent market participants if they utilise the solutions appropriately. The new operating mechanisms may have several advantages for different banking systems, with automation as a prime example. First, due to optimisation, internal banking processes may become faster and more transparent, the spread of new business processes enables risks to be estimated and priced more accurately, and information asymmetry may decline. Second, rapid adaptation may strengthen the market — 640 —

8. The effect of digitalisation on the banking sector

position of institutions which focus on innovation. As a result of the more transparent operation, institutions’ acceptance improves among customers and investors alike. In order for the positive effects to take hold as soon as possible, the full commitment of traditional market participants is necessary, and therefore the innovation focus should be incorporated into institutions’ strategy, and innovative ideas need to be used and adopted as early as possible (Dapp, 2014). Banking system players usually have decades of operational experience and are thus competent in risk assessment, risk management and the necessary infrastructure requirements, among other things. Such knowledge is not necessarily available to a newly established FinTech firm, and therefore traditional market participants may enjoy a competitive edge over them in this area. In addition, banks are in regular contact with regulatory and supervisory authorities, they have a clearer picture about which of their development proposals can be implemented in the current regulatory environment, and about the legal provisions related to their operation and developments. Therefore, banks’ head-start may provide an appropriate basis for the development and use of innovations (BIS–FSB, 2017). Although it has considerably improved in recent years, the banking system’s cost level remains high: in Europe the average cost-to-income ratio is around 60 per cent, and the proportion of operating costs to assets is roughly 1.5 per cent. The high level of operating costs is also due to the institutions’ extensive network of branches. Banks offset the high costs by increasing revenues, which leads to more expensive financial services (Chart 8-9). By contrast, innovators’ operating costs are typically low, few of them have actual customer centres, their services are mostly available online, and thus they can pursue a more aggressive pricing policy and offer higher yields to investors. For consumers, the more favourable conditions compared to banking products enhance market competition, which further depresses prices. As a result, incumbent institutions experience revenue- and cost-side pressures at the same time, necessitating rationalisation on both sides in response. — 641 —

Banks in history: innovations and crises

The new technologies that have emerged with the appearance of the FinTech industry may prove suitable for transforming or overhauling the cost structure of banking operations, and thus a sustainable, lower cost level can be achieved, which may also improve the financial system’s overall efficiency (EC, 2017).

Net interest income / total assets (%)

Chart 8-9: Net interest income and operating expenses as a proportion of total assets in EU Member States 3.5

3.5 BG

3.0 GR

2.5

SK CY

2.0

1.5

FI LU

0.5 0.0

0.5

CZ LT

1.0

0.0

3.0

RO PL

1.0

HU*

2.0 1.5

IE IT

1.0

0.5 1.5

2.0

2.5

3.0

3.5

0.0

Operating expenses / total assets (%) Note: The data source contains consolidated data in line with IFRS. Annualised data from 2017 Q3. HU* refers to data without foreign affiliates, and the bank levy and the transaction tax, which are included among operating costs. Source: ECB.

Owing to their operational experience, banking system players have a large, comprehensive dataset on consumer and investor behaviour. They can assess current market needs by performing a detailed analysis of this data, and taking the data into account may also determine future avenues of development. The institutions have strong growth potential with respect to the utilisation of data, as due to the widespread

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8. The effect of digitalisation on the banking sector

availability of big data, banks can now also efficiently harness customer data from outside the bank. If they are able to establish a competitive data ecosystem, it can be of great assistance to them in both sales and risk management. Box 8-4 ‘Data is the gold of the future’ — Old players with new activities

The digitalised society generates large amounts of broadly usable data. The use of smartphones and other devices connected to the Internet generates 2.5 quintillion bytes of data globally each day. The amount of available data is expected surge even more, as 90 per cent of the currently available data was created in the past two years alone (WEF, 2017a). The spread of online social networks (e.g. Facebook) and commerce portals (e.g. Amazon) greatly contributes to the generation of data. In addition, large amounts of data are generated during communication between machines, card transactions and telecommunications. By analysing this extremely huge dataset (also known as big data) alone, companies can gain important insights into consumer habits; however, advancements in artificial intelligence make data even more valuable. The availability of high-quality data of sufficient volume is crucial for machine learning and its operation in the future. The widespread use of artificial intelligence will enable the automation of several processes. The biggest winners of the data revolution may be those who are able to efficiently utilise this continuously expanding dataset, which requires special expertise and a sophisticated infrastructure. Utilisation of data may also be beneficial for consumers, as it contributes to the availability of modern, cheap and tailored services. The growing amount of data and technological progress hold opportunities for the banking system as well. New data analysis methods coupled with artificial intelligence enable the development of systems that enhance themselves during operation, and whose performance constantly

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Banks in history: innovations and crises

improves. The banking sector can use this at various levels of the value chain. Deeper insights into consumer habits support product development and marketing, enabling the creation of tailored services. Highly accurate information on client risk allows custom pricing for credit products. And the automation of investment advice with the appearance of roboadvisers opens up this service to a broader group of consumers. The use of artificial intelligence may reduce banks’ operating costs, which also makes it favourable from the perspective of banks’ profitability.

However, the uncontrolled spread of new solutions may threaten the market position of incumbent market participants. Thanks to technology-enabled innovation, not only newly established companies, but also successful firms from other economic sectors may expand their product range to include financial services. As the lines between sectors become blurred, new business models and new types of products and services may emerge, while banks’ role and market share may decline. Especially technology companies’ interest in this field may threaten the banking system, as they may be popular among users due to their advanced IT systems and infrastructure (WEF, 2017b). Several FinTech innovations may base their activities on a new, unprecedented technology or business model, and therefore no activities exist that could be used as reference points when assessing their activities, hence the sustainability of innovators’ performance is difficult to measure. Whereas traditional market participants may often be able to take a systemic approach, plan accordingly and focus on the conditions of long-term operation, new players mainly wish to acquire a dominant market share in the short run. Therefore, the rapid growth and success of innovative firms may be misleading to incumbents, generating false incentives, while in the longer term the initial growth rate is not expected to be sustainable. Thus, in addition to adopting innovations, careful planning is still necessary (BIS–FSB, 2017). Banks’ transformation mechanism may be constrained by several factors. First, developing the strategy and future directions is expected — 644 —

8. The effect of digitalisation on the banking sector

to take time, as the transformation of complex institutions may be hampered by the interconnectedness of the different areas and the typically multi-level decision-making processes. Second, there may still be a need for offline administration in certain consumer groups, and therefore its incremental development may also be required in parallel with the establishment of digital channels. Due to the double focus, efficient resource allocation aimed at cutting costs cannot necessarily be implemented, as there is a risk that no substantial improvement can be achieved in reducing costs. Owing to the decline in market prices due to rising competition, traditional banking actors may experience considerable revenue losses in the short term. Due to slow cost-side adjustment, they may pursue a riskier business model to maintain profitability and offset the lost revenue. They may increase the share of customers with a higher risk rating, adopt less safe technologies, or spend less time than necessary on understanding and testing solutions in advance. Owing to the greater risk appetite, operational and systemic risks may both substantially increase (EC, 2017). If the traditional banking actors fall behind in the necessary reforms, they may lose their affluent customers who are open towards innovation. In parallel with this, the significant amount of lost revenues and funds due to a considerable reduction in customer numbers may increase the costs for banks’ remaining customers, which may further marginalise banks with respect to consumer preferences. However, there may also be solutions in technological development that potentially exclude many consumers from a large portion of banking products. Risk perception and assessment mechanisms may become distorted by large-scale data analysis and the optimisation of scoring models, and certain consumers who are deemed riskier may find it impossible to access specific products due to the unreasonably high prices determined during risk profile-based decisions (EC, 2017).

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Banks in history: innovations and crises

8.3.2 Impact of FinTech on the payment market

In the case of payments, two factors will bring about change in the near future that may also significantly affect the banking sector. First, the introduction of instant payments in several countries, which enables electronic payments in almost all situations. Second, the entry into force of the revised EU directive on payment services (PSD2),378 which regulates market entry for new non-bank (third party) payment service providers. This means more competition for current market participants, which may weaken their ties to customers, but the FinTechtype transformation and services are also available to traditional banking actors. PSD2: The revised European payment services directive (PSD2) which entered into force in 2018 aims to facilitate more efficient payments, enhance the security of online payments, protect consumers and boost competition among market participants. One central element of the last item is the regulation of the operation of third-party providers, during which account-servicing banks are also required to open up their systems for licensed, new FinTech service providers. However, PSD2 introduces new features in several other areas as well, for example strong customer authentication in certain situations, which requires the existence of two out of the three requirements of knowledge (e.g. PIN code), inherence (e.g. fingerprint) and possession (e.g. aÂ mobile phone), making electronic payments more secure. Furthermore, amendments favouring customers also take effect, such as shorter complaint-handling times and the burden of proof falling on service providers in disputed cases.

378

irective (EU) 2015/2366 of the European Parliament and the Council on payment D services in the internal market. http://eur-lex.europa.eu/legal-content/EN/TXT/ PDF/?uri=CELEX:32015L2366&from=EN

â&#x20AC;&#x201D; 646 â&#x20AC;&#x201D;

8. The effect of digitalisation on the banking sector

The introduction of instant payment services in more and more countries stems from the fact that financial infrastructures are unable to meet today’s consumer expectations and technological level. Having recognised this and the disadvantages arising from this as compared to the services of FinTech firms, commercial banks in several countries initiated developments themselves in order to establish the instant payment infrastructure. Central banks also took action in this issue, as instant payments enable the use of electronic payment methods instead of cash in many more situations than before. Many measures have been taken in this field at the European level as well, for example a rulebook aimed at the harmonised provision of services379 has been drawn up, and the European Central Bank is also looking into necessary infrastructure developments.380 In ‘almost’ all countries, instant payments are characterised by 24/7/365 availability and near-instant crediting on the beneficiary’s account (in a matter of seconds). In many cases, the introduction of instant payments goes hand in hand with the establishment of a central database containing secondary account identifiers (e.g. mobile phone numbers), which makes it easier for users to initiate transfers and eliminates the shortcomings of earlier financial infrastructures. In line with the European operational model, the Hungarian system is layered. It is based on central infrastructures and allows the market development of interoperable ancillary services through the central secondary account identifier database and the open standards used in payments; therefore, it also greatly fosters innovation. In addition to infrastructure developments, legal amendments may also result in the realignment of the payment market. While the payment accounts directive (PAD) introduced earlier made switching between service providers easier, the new market participants appearing due https://www.europeanpaymentscouncil.eu/document-library/rulebooks/2017sepa-instant-credit-transfer-rulebook 380 https://www.ecb.europa.eu/paym/intro/news/articles_2017/html/201706_ article_tips.en.html 379

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Banks in history: innovations and crises

to PSD2 may further boost competition, which may translate into cheaper services offering a better customer experience to consumers. The PSD2 regulates the emergence of two types of service providers: payment initiation service providers can be used by customers to submit transfer orders to their account-servicing payment service providers, while account information service providers can access information related to payment accounts (balance, transaction history), which provides customers with a one-stop-shop solution for managing their finances, even when they have accounts with several banks. Moreover, the service providers may also help in finding the best deals (e.g. loans, investments). Pursuant to the directive, the account-servicing institutions need to ensure that these service providers access the payment accounts, which means that in the future customers may not necessarily be in contact with their account-servicing banks, and tailored offers may even make them switch sooner between payment service providers (Cortet et al., 2016). Due to the legislative amendments, barriers to entry are considerably lowered on the payment services market, and FinTech firms with even a small amount of capital invested may appear at the service level. On the other hand, banks may also decide to become payment initiation service providers or account information service providers, i.e. traditional payment service providers may start transforming into FinTechs. The shifting the focus from infrastructure maintenance to service provision has been observed in many economic sectors, one only needs to think of the classic examples of Uber and Airbnb, which became dominant in passenger transportation and bookings without establishing their own infrastructure. Instant payment systems represent an infrastructure change and may expand electronic payment methods to far more situations than earlier, which may generate additional profits for payment service providers despite the stronger competition, as turnover will increase.

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8. The effect of digitalisation on the banking sector

In other words, although many more service providers are expected to compete for customers after PSD2 comes into force, in many countries – including Hungary – the electronisation of the now dominant cash usage represents an opportunity for additional profits for market participants as compared to earlier times. Another option for FinTech firms for entering the market is to be technical service providers, in a role which is less perceptible to customers. These services would be mainly provided to traditional banking actors, for whom it is often worth outsourcing certain tasks and processes. For example, the RegTech firms mentioned earlier emerged as a type of FinTechs, helping banks with compliance by providing automated reporting services (Deloitte, 2016).

8.3.3 Impact of FinTech on regulation

The emergence of FinTech innovations is transforming the financial intermediation market, affecting financial stability and thus also impacting regulation. These effects are partly positive: the emergence of new market participants diversifies the market, which bolsters financial stability. Cheaper, more accessible services are reaching more customers, helping to improve financial integration (Table 8-2). The appearance of new products, services and business models may result in a decentralised, diversified market, and alternative investment opportunities may arise with low correlation between them and other asset classes. Market concentration is projected to diminish, and the number of systemically important institutions may fall. The different technologies and operating mechanisms reduce the interconnectedness between market participants, and the financial system becomes more resilient to exogenous market shocks (FSB, 2017).

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Banks in history: innovations and crises

One possible avenue for FinTech innovations is the development and spread of the above-mentioned RegTech solutions, which can make compliance and the achievement of regulatory objectives for financial institutions more efficient and cheaper. Among other things, RegTech solutions can include reporting requirements, operational risk and credit risk compliance, consumer and data protection as well as the system against money laundering and terrorism financing. The innovations offer many opportunities to improve the efficiency of regulation, which may enhance financial stability (BIS, 2017). Thanks to technological innovation, financial products and services become available for a larger group of consumers and investors. On account of digitalisation, the players for whom the option of establishing banking ties is limited can use the products and services through various new channels. This phenomenon is especially important in the regions where the financial system is still underdeveloped. Due to deeper financial integration, the capital necessary for investments becomes more readily available to companies, whereby financial intermediation can support economic development more (BIS–FSB, 2017). Table 8-2: Potential positive effects of technological innovations on financial intermediation Area

Potential benefits

Effect on financial intermediation

Financial stability

reation of new products, services and business —C Diversification, models decentralisation — Financial system may become more resilient to exogenous market shocks

Institutional operation

Market efficiency

— S tronger competition reduces prices — Development of a more sustainable, lower cost level — Information asymmetry is expected to decline

Financial integration

—F inancial products become available to a broader customer base — Decreasing search costs, time for obtaining funds becomes shorter — Local adaptation of globally used products and services

Users

Source: Authors’ own compilation based on MNB (2017) and BIS–FSB (2017).

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8. The effect of digitalisation on the banking sector

However, FinTech services may also have a negative impact on the financial intermediary system (Table 8-3). This is because in several cases they are unregulated when they appear, and therefore regulatory authorities have no clear picture about their functioning, which entails risks. In the context of favourable effects, boosting market competition may encourage lending institutions and service providers to engage in procyclical operations, which accentuates real economy fluctuations. The increasing interconnectedness of market participants may result in elevated cyber risks. The innovations developing as a result of technological progress usually appear in the financial system in an unregulated form, and therefore regulatory authorities have no clear picture about and influence over them. The operation of new players is typically sensitive to liquidity shocks, certain activities may lead to high gearing, and the maturity mismatch between assets and liabilities may also be substantial. Due to their unregulated activities, innovators have only limited access to securities such as the central bank’s role as the lender of last resort, which is available to incumbents, to manage their temporary operational difficulties. Furthermore, the speed of the changes in the sector makes monitoring risks more difficult, and the quantification of expected market losses becomes uncertain. Overall, the effectiveness of macroprudential and microprudential regulation may decline, which may lead to a deterioration in the financial system’s resilience to shocks. This is another reason why the regulatory framework needs to be further enhanced (FSB, 2017).

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Banks in history: innovations and crises

Table 8-3: Potential negative effects of technological innovations on financial intermediation Area

Financial stability

Potential risk Regulatory arbitrage

— S pread of unregulated technologies in the financial system — Reduced efficiency of macroprudential regulation and the central bank’s function as the lender of last resort

Procyclicality

— S imilar patterns in market players’ decision-making may exacerbate fluctuations in economic growth and market prices — Risk of contagion effects via transmission channels

Build-up of systemic risks

—D ifficult to substitute a dominant, innovative player on the market — Instead of institutions, activities may become systemically important

Profitability, sustainability of operations

—T he relative scope for the performance measurement of new market participants is limited, their operation is sensitive to liquidity shocks — High leverage and maturity mismatches

Operational risks

— S tronger competition may boost the risk appetite of certain market participants — Data quality is crucial during operation — Development of a complex IT infrastructure and outsourcing limit the transparency of operations

Institutional operation

Users

Effect on financial intermediation

Customer protection, data management

— Risk of deception or harm to customers

Source: Authors’ own compilation based on MNB (2017) and BIS–FSB (2017).

The early adopters of novel solutions in the financial system may secure a significant competitive advantage. Compared to the other actors, innovators using new technologies and taking early action may acquire a large market share in a short time, which may increase short-term concentration risks. If an actor that became dominant and systemically important in a narrow segment sustains a shock, it is difficult to substitute it, as its business model is expected to be unique and similar competitors are potentially underdeveloped. The functioning of the financial system, especially bank lending is procyclical, since in an economic upturn banks are prone to relax their — 652 —

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lending conditions and harbour more optimistic expectations, whereas if there is a downturn in the economy, they significantly curb their lending activities in an effort to stop the deterioration of profitability and the capital position (Horváth et al., 2002). Since innovations are able to stimulate market competition, lending conditions may be significantly eased when the economy is in an upswing, while the interactions between investors and borrowers may exhibit larger fluctuations as compared to traditional forms of financing. The procyclical functioning of the financial sector may become stronger, and in a downturn, real economy losses may also increase substantially, due to the excessive competition-enhancing effect of innovations (FSB, 2017). Furthermore, the rapid growth of the industry and the increasingly widespread nature of innovations may prompt the financial system to become more sensitive to news or changes in the industry, creating an especially volatile market. As a result of technological progress and deepening financial integration, the institutions acting as traditional intermediaries may be left out of several transactions; however, the contagion channels between economic sectors may remain dominant. In the new business models, a direct interaction develops between supply and demand, which increases the interconnectedness of market actors. Due to direct interests, the decline of one player may be significant, which may also be exacerbated by the heightening cyber risks caused by the spread of IT systems. Since the main purpose of innovation efforts is typically the establishment of automated operation based on artificial intelligence, the human supervision of processes is also reduced, which could mean the realisation of unexpected risks. In several markets, the high level of interconnectedness between incumbent institutions may persist, and it could be supplemented by the interconnection of the information systems. The increasing interconnectedness, the standardisation of information systems and interfaces, as well as the incorporation of real economy actors into intermediation could mean several vulnerabilities for the entire financial system, and the risks could spill over to other economic sectors through the transmission channels (FSB, 2017). — 653 —

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8.4 Regulatory dilemmas and responses 8.4.1 Possible regulatory approach to FinTech innovations

The efficiency of macroprudential regulation may be significantly influenced by the fact that FinTech innovations can affect the whole financial system. The products, services and business models appearing due to technological progress may transform the operation of several companies across institutions and sectors, and many new businesses may be established using these. The effectiveness of the macroprudential instruments currently in use may be mostly mitigated by the market entry of new companies. These are regulated only at the micro level after obtaining their operating licence: therefore, the current regulatory framework needs to be reviewed at the macro level and extended to market players other than banks. The review must pay special attention to regulation applying to all players in proportion to their contribution to systemic risk, while establishing a level playing field (He et al., 2017). Creation of the regulatory framework may be difficult due to the potential lack of expertise necessary to understand the new technologies. The technological solutions that have appeared in FinTech are already characterised by a high degree of heterogeneity, and new ideas emerging in the future may result in an even more complex market. The emerging technologies are mostly unknown to regulatory authorities that do not have much experience in this field, but a thorough understanding of the technological background is vital for establishing the appropriate regulatory environment. Digitalisation may generate a need for overhauling the IT systems of regulatory and supervisory authorities, and enhancing the IT skills of workers, and the emergence of new business models may also bring about changes in the operation of regulatory authorities (BIS, 2017).

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Developing a regulatory framework for stimulating FinTech innovations may be beneficial from a national economy aspect and also from the perspective of financial system’s competitiveness. Development of the appropriate regulatory responses may have the positive effects of improving cost effectiveness in the financial sector through FinTech innovations, greater stability and the potential increase in the consumer surplus. Overall, the way a given regulatory system addresses the advent of FinTech innovations, and the extent to which it can appropriately encourage their dissemination while efficiently addressing risks may have a meaningful effect on the long-term performance and competitiveness of the economy (MNB, 2017). Regulatory authorities need to strike a balance between the ‘laissez faire’ and the completely prohibitive regulatory approach to foster technological progress without jeopardising financial stability (Chart 8-10). Chart 8-10: Regulatory dilemma linked to FinTech solutions

‘Laissez-faire’

Excessive restrictions

Supervisory dilemma Unfair advantage Competitive advantage of FinTech over strictly regulated financial institutions

Aim: Finding the balance between the supervisory approaches —

Consumer protection Threat to depositors and investors

Promoting FinTech innovations while maintaining financial stability

Source: MNB.

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Losing control Spreading of cross-border activities, regulatory arbitrage Obstacles to innovation Maintaining the inefficient business models of ‘traditional’ financial institutions and hampering development

Banks in history: innovations and crises

The ‘laissez-faire’ regulation of FinTech innovations

A lenient regulatory approach would probably rapidly improve awareness of the new products and services under the current market conditions. For example, the costs borne by consumers would decrease, which would vastly improve digital customer satisfaction. However, this would involve several risks. First, as compared to the strict regulatory requirements imposed on banking players, FinTech solutions would enjoy an unfair advantage, and the lack of detailed rules also poses risks to stakeholders. If a rudimentary solution reaches the market too soon, it may cause unexpected losses to both consumers and funders. The excessively lenient regulatory approach may push financial intermediation into a segment where regulatory authorities have only limited powers, and therefore the effective risk management mechanism of smaller and less experienced market participants cannot develop (Zetzsche et al., 2017). Complete prohibition of FinTech innovations

The complete ban of FinTech solutions may curb the willingness to innovate, and the classic functioning of the traditional actors in the banking system would become ossified. In an excessively stringent regulatory environment, both innovations and customers may abandon the domestic market. The exploitation of cross-border opportunities would probably further increase the costs for consumers in the traditional banking system, since the fact that customers preferring the more innovative options abroad turn away from the domestic actors would be offset by higher prices (WEF, 2016). New entrants and the lack of competition have posed a major problem to the domestic financial sector in the past decades, since financial services continue to be expensive in Hungary, and the innovations so far have not delivered significant benefits to consumers (Nagy–Vonnák, 2014).

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8. The effect of digitalisation on the banking sector

8.4.2 Regulatory responses

The currently effective international legislative framework does not provide appropriate support to FinTech innovations (EBA, 2017). One of the reasons for this is that a dominant share of the legislation was drawn up right after the crisis and has not been updated since then. The other reason is the nature of the regulation: legislators have basically always wanted to introduce separate legislation for keeping the low number of major technological innovations and the institutions using them in a regulated framework, and therefore the existing legislation has been only slightly amended (BIS, 2017). The regulatory framework also has to be reviewed at the national level, as there may be huge differences in the country-specific regulations depending on the various national features and previous development patterns. As a result, a large part of the national legislation probably does not reflect the advantages offered by technological progress and imposes undue limits hampering innovation. Therefore, the legislation and sectoral laws should be reviewed and modernised, if necessary, at the national level. When amending laws, their long-term sustainability should also be taken into account. The creation of new regulatory processes should be considered for regulating and supporting FinTech innovations. In international practice, the application of the Innovation Hub and the Regulatory Sandbox is an increasingly popular solution for this. The aim of an Innovation Hub is to provide guidance to banks, other market participants and FinTech firms in legal and operational issues related to innovations. The Regulatory Sandbox is a controlled environment for testing innovative solutions where these actors can obtain temporary exemptions from certain prudential requirements. Such solutions may even appropriately resolve the regulatory dilemma described above, as a solution halfway between the laissez-faire and the prohibitive regulatory approach.

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Banks in history: innovations and crises

8.4.2.1 Innovation Hub

An Innovation Hub is the primary platform for information exchange, where the regulatory authority’s experts answer the questions from the representatives of FinTech innovations, help to interpret the legal framework, and assess the needs for amending the legislation and pass on their experiences to decision-makers (Chart 8-11). Communication between the actors is typically open, and mostly informal (BIS, 2017). An Innovation Hub is a platform provided by the regulatory authority where the developers of the FinTech innovations receive guidance from the regulator and from each other. Its main functions are to support new ideas and provide guidance and advice. An Innovation Hub is available to unregulated and currently regulated activities as well, and both the innovations of newly established companies and the new technological solutions of existing, incumbent institutions (e.g. banks, insurers) may appear there. Chart 8-11: Schematic flowchart of the operation of an Innovation Hub

FinTech firm / Financial institution with a question

Innovation Hub

Regulatory / Supervisory authority

Professional assistance ▪ Interpretation of legislative frameworks ▪ Guidance ▪ Assistance in licensing process

Dedicated expert team

Monitoring of Innovation Hub’s participants

Need for legislative changes

Source: Authors’ own compilation based on international examples.

The scope of activities of Innovation Hubs can cover a broad spectrum. Basically, Innovation Hubs are created to answer the relevant, FinTechspecific, banking-related questions, but several additions have been — 658 —

8. The effect of digitalisation on the banking sector

observed in response to market needs. An Innovation Hub is usually extended to the InsurTech and RegTech sectors as well.381 As market competition affects this segment, questions related to competition rules could also be submitted. In addition to advice and guidance, several Hubs offer an opportunity for continuous contact, during which they also assist in acquiring operating licences. The Hubs monitor and support newly established enterprises for a specific period of time, typically for 12 months following the date of obtaining the license. 8.4.2.2 Regulatory Sandbox

In a Regulatory Sandbox, the key parameters for testing FinTech solutions in a constrained environment are determined by the applicant and the regulatory and supervisory authorities, including the aim and duration of testing, and the reference values of the key performance indicators in a successful and an unsuccessful test. During testing, detailed reports should be prepared for the regulatory authority about the status of the project, any operational problems and the measures taken to eliminate them. The assessment of the test’s success also requires that detailed evaluations be submitted. After successful testing, the actual market entry may follow, and in such a case all regulatory requirements become compulsory (Chart 8-12). The time that can be spent in the Regulatory Sandbox varies across countries, but it is typically between six months and one year. A Regulatory Sandbox is a regulatory framework used for testing innovative technologies according to a predetermined schedule. The test environment is typically available to FinTech firms as well as incumbents. It is mainly used by FinTech companies because most of them have no sound impact assessments in relation to the safe introduction of products.

381

I nsurTech refers to the new, innovative technologies that appear in the insurance sector.

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Banks in history: innovations and crises

Chart 8-12: Schematic flowchart of the operation of a Regulatory Sandbox Specific group of consumers

FinTech company / bank / insurance company

Admission of candidates

Setting testing conditions for the given innovation with the supervisory authority

Market entry Testing

Evaluation

Unsuccessful testing

Regulatory Sandbox Supervisory monitoring and proposal for change in legislations if needed Source: MNB (2017) based on international examples.

Regulatory Sandboxes provide a solution for managing the potential risks entailed by innovations without unduly frustrating innovation. Legislators are often unable to keep up with the rapid spread of innovative solutions, and therefore sometimes the legal background of certain newly developed services is not appropriately established. A Sandbox helps innovators test their financial product or business model for a predetermined period, in an environment controlled by the regulatory authority, with real consumers and exempt from specific regulatory requirements. The test run helping FinTech firms and financial institutions also provides valuable information to the regulatory authority, as during the pilot phase the viability of the innovation and the business model can be observed in detail, and decision-makers can use their familiarity with the technology to develop customised and appropriate regulations for the new service.382 In order to keep risks low, only the FinTech firms and financial institutions 382

or more on the concept and advantages of Regulatory Sandboxes, see He et al. F (2017), EFR (2016) and Arner et al. (2017).

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meeting the criteria set by the supervisory authority can be admitted to a Regulatory Sandbox. The authorities expect a clear design documentation from potential testers, with straightforward objectives, a schedule and a feasibility study. The regulatory authority may introduce temporary relief from certain regulatory requirements for the new entrants to the Regulatory Sandbox. In the case of institutions with an operating licence, three directions can be identified with respect to the types of temporary relief. In the framework of most supervisory authorities, FinTech service providers or incumbent institutions can be exempt from certain legal requirements, taking into account financial stability aspects.383 The supervisory authority may also provide letters of intent on the restriction of supervisory measures (no enforcement action letters, NAL) that remain in effect as long as the testing requirements are met, and the supervisory authority may also provide special guidance to facilitate compliance with the legal environment.384 Finally, for the companies without authorisation, a limited, temporary operating licence may be provided. In such cases, the request for an operating licence may be assessed more swiftly, and compliance with the regulatory requirements is in direct proportion to the nature of the service to be tested (ASIC, 2017). Supervisory authorities pay special attention to protecting the interests of the consumers that take part in the test. Existing Regulatory Sandboxes contain various safeguards for mitigating risks and consumer losses due to testing. Typically, only voluntary consumers who fully understand the risks can access the Regulatory Sandbox. In several countries, the number of consumers, the value or frequency of the transactions and consumers’ profile are regulated.

or the list of requirements that can be subject to relief, see for example: MAS F (2016). 384 For more details, see the FCA (2015) paper. 383

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Banks in history: innovations and crises

In addition, coverage of consumers’ losses may be required, as well as a mechanism for individual legal redress. Regulatory Sandboxes are becoming widely used all over the world. The first Regulatory Sandbox was established in the United Kingdom. In addition to the British example, the Netherlands and Switzerland also operate such a regulatory framework in Europe. Lithuania launched an official consultation on introducing such a solution in the summer of 2017. In the past two years, almost a dozen countries, including Russia, the United States and India, have indicated that they were considering the introduction of a Regulatory Sandbox (Chart 8-13). Chart 8-13: International examples of Regulatory Sandboxes and the date of introduction United Kingdom, 2015 Canada, 2017

Netherlands, 2017 Switzerland, 2017

Hong Kong, 2016 Brunei, 2017 Singapore, 2016 Thailand, 2017 Bahrein, 2017

Malaysia, 2016 Abu Dhabi, 2017 Dubai, 2017 Australia, 2017

Note: The chart shows information available at the end of 2017. Source: Authors’ own compilation.

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8. The effect of digitalisation on the banking sector

8.5 Outlook for the future 8.5.1 Potential main directions of development for FinTech innovators

It is difficult to predict how the FinTech phenomenon will pan out. There has always been considerable uncertainty around the utilisation and long-term persistence of developments and new technologies. For example, Thomas Watson, the head of IBM, was sceptical about the future of computers in 1943: ‘I think there is a world market for maybe five computers’ (Lautenschläger, 2017). In a similar vein, in the early days, not many people suspected that the Internet would fundamentally change people’s day-to-day lives. The question how the FinTech evolution will pan out also arises. Will the increasing prominence of FinTech innovators put an end to traditional banking systems? Or will banks be able to cooperate with the companies developing the new technologies? Projections are difficult because technologies are expected to continue to change, and currently unknown products and services are forecast to be adopted in the coming years. FinTech development may occur in several scenarios (Chart 8-14) (Lautenschläger, 2017). One possibility is that the incumbent market participants initiate the innovation, for example in the form of a partnership agreement, acquisition or internal innovation, either at the local or the global level. As a result, innovative firms become part of the traditional financial intermediary system. Innovators may also decide to specialise and affect a single element of the value chain, serving a specific customer base. In the third scenario, the FinTech firms cover the whole value chain and crowd out traditional financial actors. This latter possibility represents the greatest challenge for not only the incumbent players, but also for regulatory and supervisory authorities. According to a PwC survey from 2017, incumbents increasingly feel threatened: in 2016, 83 per cent of respondents globally believed that

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Banks in history: innovations and crises

their business activities were threatened by FinTech companies, while the same figure was 88 per cent in 2017. Nevertheless, 82 per cent plan to enter into a partnership agreement with FinTech firms in the next 3–5 years (PwC, 2017). Chart 8-14: Possible development paths for FinTech companies Local level

Local banks

Partnership Acquisition

Global level

International banks

Innovations of market participants

Own innovation

One part of the value chain is affected

FinTech

Specialization

Coverage of the whole value chain

The total value chain is affected

BigTech

Source: Authors’ own compilation based on Lautenschläger (2017).

8.5.2 Expected development paths in various regions

The development options of FinTech are strongly influenced by the sophistication of a specific region’s financial infrastructure. In areas where access to banking services is characterised by fundamental shortcomings, innovative technologies are more likely to develop and spread on new platforms, rather than within the framework of the traditional banking system. The financial embeddedness of the public varies widely across regions. In low-income countries, the

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share of account holders among those aged over 15 is only slightly more than 20–30 per cent. By contrast, their share is over 90 per cent in high-income countries. With respect to the mobile service provider infrastructure, which represents one of the main channels of the spread of innovative products, several regions lag behind much less in relative terms (Chart 8-15) (World Bank, 2017). Targeting potential consumers living in less affluent areas is a promising opportunity for the service providers that offer relatively cheaper FinTech solutions. Chart 8-15: Development level of financial and mobile service infrastructure by regions 120

Per cent

Pieces

120

OECD countries

East-Asia

LatinAmerica

South-Asia

100

Sub-Saharan Africa

100

Has bank account Has mobile subscription (of 100 people, right-hand scale) Note: Based on a 2014 survey among those aged over 15, proportion of respondents. Source: World Bank.

In Africa, FinTech solutions have been operating as greenfield investments since the early 21st century. The establishment of a traditional banking system in the region was hampered by several factors. Infrastructure is typically poor, roads are scarce, and the

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electricity supply is haphazard. It takes a very difficult bureaucratic procedure to open a bank account, and there is a prejudice that banking is the privilege of the wealthy. With the exception of South Africa, the level of financial integration is low, and banking services are generally underdeveloped and less accessible. Roughly 80 per cent of Africa’s 1 billion inhabitants do not have access to traditional banking services (Arner et al., 2016). However, the spread of FinTech solutions outside the banking system was strongly supported by the fact the mobile penetration in African countries lags behind developed countries much less than the sophistication of the financial infrastructure and intermediation (Chart 8-15). Accordingly, FinTech developments are mainly linked to telecommunication companies, e-money is widely used for savings, transfers and paying bills through a mobile phone. The perhaps best-known e-money with the greatest penetration is M-Pesa, linked to Vodafone’s Kenyan operations. The service was started ten years ago, and it is now available to 30 million consumers in ten countries (Vodafone, 2017). This clear separation suggests that FinTech service providers will become the traditional banking system’s competitors or even substitutes in the region (IFC, 2017). Asian countries currently dominate the rapid rise of the FinTech industry, as several FinTech firms are already dominant players in financial intermediation (EY, 2015). Currently, China and India are the two main hubs of growth, while South East Asia’s role is also central in digitalisation (Intel, 2017). Activity in the other regions of the continent is muted, the current top countries are expected to retain their leading role, which may deepen the existing regional differences. The rapid digitalisation of innovative countries is partly due to the fact that regulatory authorities have been supporting the market entry of innovative solutions since the emergence of the FinTech industry, as they aim to make incumbent institutions optimise their performance by strengthening competition. On the other hand, a major portion of the Asian population is digitally mature, and there is a strong need for the

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8. The effect of digitalisation on the banking sector

use of technology-based innovation (McKinsey, 2015); moreover, similar to Africa, the banking infrastructure is less developed in other parts of the continent, and therefore no special incentives had to be introduced by regulators. Additionally, the spread of innovations in Asia is aided by the fact that users willingly share their data with various service providers, and no strict, constraining regulation is in place regarding data usage. However, from the perspective of future development, it may be important that due to the build-up of risks and the spread of shadow banking, regulatory authorities may introduce constraints, thereby arresting the industry’s growth (IFC, 2017). By contrast, barriers to entry to financial intermediation in Western countries are still high, and the cost level of the banking system is excessive. Therefore, many Western European regulatory authorities are developing an incentive scheme whereby they can support market competition (Clifford Chance, 2017). The traditional, ossified operation of incumbents is expected to transform slowly, but FinTech firms can achieve spectacular results in certain segments. At the same time, certain FinTech companies pose a serious threat to banks, even though incumbents do not need to expect to be fully crowded out from the market, as the risk-averse user base who are warier of new institutions may remain large. This is supported by the Capgemini survey that found that despite the widespread Internet penetration and the popularity of social networks in Western European countries, the use of new, innovative solutions is still limited (Capgemini, 2017) (Chart 8-16).

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Banks in history: innovations and crises

Chart 8-16: Share of those using at least one non-traditional financial service 100 90 80 70 60 50 40 30 20 10 0

Netherlands

Belgium

France

Canada

Japan

Australia

United States

United Kingdom

Singapore

Hong Kong

Per cent

United Arab Emirates

India

Per cent

China

100 90 80 70 60 50 40 30 20 10 0

Internet penetration Number of Facebook profiles compared to the population Share of those using at least one non-traditional financial service Note: Proportion of respondents. Source: Capgemini, World FinTech Report 2017, Internet World Stats, 30 June 2017.

In countries with a smaller market but an advanced financial infrastructure, such as the Central and Eastern European region, FinTech firms and banks are expected to cooperate closely. In countries with a smaller market but an adequate coverage as regards bank branches, administration in banks may remain dominant for consumers. For many FinTech solutions, the markets of these countries may prove to be small. The use of technological innovations may also be hampered by consumers’ muted risk appetite; therefore, the interaction with customers is expected to be conducted through banks, or the initially independent companies will start cooperating with banks in order to optimise their operation. Therefore, most innovations will be realised as the banking system’s developments (Accenture, 2015).

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8. The effect of digitalisation on the banking sector

Overall, the widespread use of FinTech innovations may fundamentally transform the operation of the financial intermediary system. The direction of development is difficult to predict, the main question is whether FinTech firms enter the market in cooperation with incumbents, or the latter should expect to be crowded out partly or even completely. Taking into account current trends, it seems that the development of the market structure will vary from region to region. In less developed areas, such as the African countries, newly emerging FinTech players could stay viable and independent from the incumbents. In Asia, the regional differences and the developing regulation may substantially influence the direction of technological progress. In advanced Western countries, certain competitive FinTech companies may pose a real threat to ‘traditional’ financial market participants, but the former will be able to completely crowd out the latter from the market only in a few segments. And in the countries with smaller markets but sophisticated financial infrastructures, the most likely path for development is the cooperation between new players and incumbents.

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Key terms bank efficiency digitalisation financial regulation financial stability FinTech

global financial crisis globalisation incumbent institutions Innovation Hub Regulatory Sandbox

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Cortet, M. – Rijks, T. – Nijland, S. (2016): PSD2: The digital transformation accelerator for banks. Journal of Payments Strategy & Systems, Vol. 10. No. 1. https://www.innopay.com/assets/ Publications/JPSS-Spring-PSD2-digital-transformation-for-banks-Innopay.pdf Dapp, T. (2014): Fintech – The digital (r)evolution in the financial sector. https://www.deutschebank. nl/nl/docs/Fintech-The_digital_revolution_in_the_financial_sector.pdf Deloitte (2016): RegTech is the new FinTech. How agile regulatory technology is helping firms better understand and manage their risks. https://www2.deloitte.com/content/dam/Deloitte/ie/ Documents/FinancialServices/IE_2016_FS_RegTech_is_the_new_FinTech.pdf Dossi, P. (2008): Hype! Művészet és pénz (Art and Money). Corvina Kiadó Kft., Budapest. Ernst & Young (EY) (2015): Banking in Asia-Pacific. http://www.ey.com/Publication/ vwLUAssets/EY-banking-in-asia-pacific/$FILE/EY-banking-in-asia-pacific.pdf Ernst & Young (EY) (2016): Transforming talent, The banker of the future. Global banking outlook. http://www.ey.com/gl/en/industries/financial-services/banking---capital-markets/eytransforming-talent-the-banker-of-the-future Ernst & Young (EY) (2017): Global Banking Outlook. http://www.ey.com/gl/en/industries/ financial-services/banking---capital-markets/ey-global-banking-outlook-2017 European Banking Authority (EBA) (2017): EBA Discussion Paper on the EBA’s approach to financial technology (FinTech). https://www.eba.europa.eu/documents/10180/1919160/EBA+Discussi on+Paper+on+Fintech+%28EBA-DP-2017-02%29.pdf European Commission (EC) (2017): FinTech: A more competitive and innovative European financial sector. European Commission Consultation Document. https://ec.europa.eu/info/sites/info/ files/2017-fintech-consultation-document_en_0.pdf European Financial Services Round Table (EFR) (2016): European Financial Services Paper, September 2016. http://www.efr.be/documents/news/99.2.%20EFR%20paper%20on%20 Regulatory%20Sandboxes%2029.09.2016.pdf Financial Conduct Authority (FCA) (2015): Regulatory sandbox, November 2015. https://www. fca.org.uk/publication/research/regulatory-sandbox.pdf Financial Stability Board (FSB) (2017): Financial Stability Implications from FinTech. http://www. fsb.org/wp-content/uploads/R270617.pdf

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Banks in history: innovations and crises FinTech Global (2017). http://fintech.global/fintech-investment-in-q2-2017-grew-over-50compared-to-the-years-opening-quarter-despite-a-fall-in-deal-activity/ He, D. – Leckow, R. B. – Haksar, V. – Griffoli, T. M. – Jenkinson, N. – Kashima, M. – Khiaonarong, T. – Rochon, C. – Tourpe, H. (2017): Fintech and Financial Services: Initial Considerations. IMF Discussion Note, SDN/17/05. Horváth, E. – Mérő, K. – Zsámboki, B. (2002): Tanulmányok a bankszektor tevékenységének prociklikusságáról (Studies on the procyclical behaviour of banks). MNB Occasional Papers. https:// www.mnb.hu/letoltes/op2002-10.pdf Intel (2017): Future of FinTech in Asia, Intel and Kapronasia. https://www.intel.sg/content/ dam/www/public/apac/xa/en/asset/pdf/20170217-kapronasia-intel-future-of-fintechin-asiafinal.pdf International Finance Corporation (IFC) (2017): How Fintech is Reaching the Poor in Africa and Asia: A Start-Up Perspective. World Bank Group. International Monetary Fund (IMF) (2017): Global Financial Stability Report 2017. KPMG (2017): The pulse of FinTech, 2017 Q2. https://home.kpmg.com/xx/en/home/ insights/2017/07/the-pulse-of-fintech-q2-2017.html Lautenschläger, S. (2017): Digital na(t)ive? Fintechs and the future of banking. ECB Statement. https://www.ecb.europa.eu/press/key/date/2017/html/sp170327_1.en.html Magyar Nemzeti Bank (MNB) (2017): Innováció és stabilitás, FinTech körkép Magyarországon (Innovation and Stability: Overview of FinTech in Hungary). Consultation document. https://www. mnb.hu/letoltes/consultation-document.pdf McKinsey&Company (2014): The rise of the digital bank. https://www.mckinsey.com/businessfunctions/digital-mckinsey/our-insights/the-rise-of-the-digital-bank McKinsey&Company (2015): Digital Banking in Asia: What do consumers really want? https:// www.mckinsey.com/global-themes/asia-pacific/digital-banking-in-asia-what-do-consumersreally-want McKinsey&Company (2016). FinTechnicolor: The New Picture in Finance. http://www.theblockchain.com/docs/FinTechnicolor-The-New-Picture-in-Finance%20-%20Mckinsey.pdf Milkau, U. – Bott, J. (2015): Digitalisation in payments: From interoperability to centralised models? Journal of Payments Strategy & Systems Volume 9 Number 3 pp. 321–340. Monetary Authority of Singapore (MAS) (2016): Fintech regulatory sandbox guidelines. November 2016. http://www.mas.gov.sg/~/media/Smart%20Financial%20Centre/Sandbox/FinTech%20 Regulatory%20Sandbox%20Guidelines.pdf Nagy, M. – Vonnák, B. (2014): Egy jól működő magyar bankrendszer 10 ismérve (10 features of a wellfunctioning Hungarian banking sector). https://www.mnb.hu/letoltes/egy-jol-mukodo-magyarbankrendszer-10-ismerve.pdf

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8. The effect of digitalisation on the banking sector Nicoletti, B. (2017): The future of FinTech, Integrating Finance and Technology in Financial Services. Palgrave Macmillan O’Dwyer, K. J. – Malone, D. (2014): Bitcoin Mining and its Energy Footprint. Hamilton Institute, National University of Ireland Maynooth. PwC (2017): Global FinTech Report. https://www.pwc.com/jg/en/publications/pwc-globalfintech-report-17.3.17-final.pdf Sogeti VINT (2014): Research Report - The Fourth Industrial Revolution Things to Tighten the Link Between IT and OT. Sompolonsky, Y. – Zohar, A. (2015): Secure high-rate transaction processing in Bitcoin. In: Böhme R., Okamoto T. (eds) Financial Cryptography and Data Security, FC 2015, Lecture Notes in Computer Science, vol. 8975. Springer, Berlin, Heidelberg. Stevenson, B. – Wolfers, J. (2011): Trust in Public Institutions over the Business Cycle. The American Economic Review, Vol. 101. No. 3. Vodafone (2017): M-Pesa, technical development and subsequent impact of the world’s leading mobile money service. http://www.vodafone.com/content/index/what/technology-blog/m-pesacreated.html World Bank (2017): Global Financial Inclusion. Global Findex Databank World Economic Forum (WEF) (2016): The Complex Regulatory Landscape for FinTech. http:// www3.weforum.org/docs/WEF_The_Complex_Regulatory_Landscape_for_FinTech_290816.pdf World Economic Forum (WEF) (2017a): The value of Data. https://www.weforum.org/ agenda/2017/09/the-value-of-data/ World Economic Forum (WEF) (2017b): Beyond FinTech: A Pragmatic Assessment of Disruptive Potential in Financial Services. https://www.weforum.org/reports/beyond-fintech-apragmaticassessment-of-disruptive-potential-in-financial-services Zetzsche, D. A. – Buckley, R. P. – Arner, D. W. – Barberis, J. N. (2017): Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation. European Banking Institute (EBI) Research Paper Series, Vol. 2017. No.11.

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Digitalisation and the monetary system Szilárd Benk–László Kajdi–András Kollarik–Zoltán Mamira– Miklós Szebeny–Gergő Török–Lóránt Varga

The relationship between digitalisation and the monetary system can be examined in three main perspectives from a central banking aspect: payments, monetary policy and financial stability. This chapter gives an overview of the issues related to digitalisation and pertaining to the various business areas of the Magyar Nemzeti Bank, presented by staff members from the individual business areas. Two topics are highlighted during the examination: the emergence of virtual currencies and the concept of central bank digital currencies (CBDCs). Virtual currencies refer to the non-central bank-issued currencies that appear in electronic form and provide anonymity to their holders. The virtual currency with the largest market capitalisation is currently bitcoin. Virtual currencies are not yet used widely in payments, and in their present form they are not expected to be used in the future either. Virtual currencies fulfil the functions of money only to a very limited extent, as their acceptance is not guaranteed, and they are not backed by any institutional system or collateral. Moreover, their supply is usually inflexible, which contributes to the fluctuations in their value. Nevertheless, the distributed ledger technology used by most of them could be adopted by the banking system in various areas, for example in cross-border transfers. Given that virtual currencies today do not fulfil the functions of money, they have no influence over monetary policy. Yet, where monetary policy’s commitment to maintain price stability is not credible, the emergence of virtual currencies may force the central bank to discipline such. Virtual currencies threaten financial stability, primarily through potential price bubbles and cyberattacks.

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CBDC is electronic money issued by the central bank. It differs from commercial banks’ central bank reserves in that it is widely available to economic actors. Until now, only the Central Bank of Ecuador had introduced CBDC, and it has already abandoned it. The next central bank closest to implementing this system is the Swedish, which plans to make a decision on the introduction by the end of 2018. The CBDC may be realised in various schemes, which can have different effects on the economy. On the one hand, from the perspective of payments, perhaps the main advantage of this scheme is that replacing cash with CBDC would be cheaper and more efficient for society. On the other hand, the decline in financial innovation and potential cyberattacks would mean a payment risk. Although using CBDC could improve the monetary policy transmission, economic growth could be curbed if the new money crowds out commercial banks’ funds. CBDC poses a threat to financial stability mainly through the deterioration of the banking system’s liquidity, capital and income position. Perhaps the chief financial stability risk posed by a widely available central bank digital currency is that, in a financial crisis, it can facilitate escape to high-quality assets as it allows ‘digital runs’. ‘Digital runs’ can weaken institutions and markets at an unprecedented pace, which poses new challenges to institutions and authorities alike. Nonetheless, these risks can be mitigated through the appropriate parameterisation of the system. The key to the introduction of the CBDC is whether the long-term net advantages of its use outweigh the costs and risks of the transition from the old system to the new.

9.1 Digitalisation and payments 9.1.1 New currency categories related to digitalisation

The evolution of the different manifestations of money can be regarded as a series of innovations. Five major functions can be attributed to money that help it facilitate the functioning of the economy: medium of exchange, unit of account, means of payment, store of value and world currency. During the history of money, the

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different forms of money, such as commodity money, gold and fiat money, fulfilled these functions to varying extents. Therefore, the history of money has been marked by a series of innovations that contributed to the emergence of new forms of money more and more suitable for conducting economic transactions by solving the efficiency issues of earlier types. These innovations can be divided into two main groups. First, there are institutional innovations that concern the essence of money, and these include changes such as the monopolisation of minting or the appearance of fiat money without intrinsic value that helped the state influence the economy much more directly. The other group of innovations is technological, for example due to digitalisation, records of account balances that used to be kept in physical form in books can now be managed electronically. The types of money that emerged in different eras and economic situations through various innovations should be distinguished along four basic criteria (Table 9-1). One important aspect is whether the given money is issued by the central bank or another organisation, as money that represents claims on the central bank is less risky and its acceptance is guaranteed by law. Of course, nowadays in the digital age, usability is also heavily influenced by whether money is stored electronically or in physical form. Another crucial feature is anonymity, which is usually regarded as an advantage (or disadvantage) of cash over electronic forms of money, and it is also a major feature of many virtual currencies. The fourth characteristic is availability, i.e. whether a given type is widely available (to consumers and companies) or it is accessible by only a small group of users (e.g. commercial banks).

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Table 9-1: Classification of the different types of money Anonymous

Central bank issued

Non-central bank issued

Non-anonymous

General availability

Limited availability

Electronic

CBDC

Commercial banks’ central bank accounts

Physical

Cash

Virtual currencies (e.g. bitcoin)

Commercial bank deposit money, e-money

Closed-network virtual currencies created by market participants

Electronic Physical

Source: Authors’ own compilation.

Two recently emerged types of money, virtual currencies and CBDC, should be distinguished (Table 9-2). Virtual currencies similar to, for example, bitcoin385 generally function without a centralised institutional system, using a so-called distributed infrastructure, in networks where the individual nodes can be regarded as equal. By contrast, in the case of CBDCs, the network is centralised, and a central player (the central bank) sets the rules of operation. This is where the other major difference comes in, namely, that while virtual currencies function in open, publicly available networks, CBDC operates in a closed network where the group of participants can be restricted. Another difference between the two types of money is that while in the case of the CBDC, acceptance can be regulated by law as the currency is issued by the central bank (although technological and infrastructural issues might arise), this is not the case with virtual currencies. Virtual currencies are not claims on any natural or legal person, and holders of such currencies can only hope that someone will accept the money they have as a means of payment.

385

Bitcoin is presented in Chapter 8.

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Table 9-2: Comparison of virtual currencies and CBDC Virtual currency Structure of the system

Decentralised

Centralised, hierarchical

Open, equal agents

Closed, one central agent with special functions

Not guaranteed, not a claim

Claim on central bank, acceptance guaranteed by law

Based on probability

Determined by law

Type of network Acceptance

CBDC

Settlement finality Source: Authors’ own compilation.

There are also huge differences between the currencies regarding settlement finality. While in its current forms, the central bank money’s settlement finality is determined by law, and probably a potential CBDC issue would also have this feature, due to the way virtual currencies such as bitcoin function, settlement finality in their case can only be interpreted in terms of probability. In the blockchain technology used by bitcoin, the individual transactions are organised into blocks, and blocks into chains. Therefore, the blockchain contains the transaction history, which could only be changed if any player in the network took control over more than half of the network’s computing capacity. Precisely because of the system’s distributed nature, the likelihood of this is very low for now, although in theory a player may be able to do this, so all that can be said about the finality of a transaction’s settlement is that it is highly unlikely that anyone would change the transaction history, thereby eradicating a payment conducted earlier. Nevertheless, even this minor probability may raise legal issues with respect to the contractual relationships between real economy actors and the virtual currency-based functioning of the economy (ECB, 2017a, Mills et al., 2016). For example, when bitcoin considers a transaction final after processing six blocks, it merely applies the rule that the probability of the network later eradicating the transaction is negligible. Based on the above, CBDC can be defined as follows: an electronic currency issued by the central bank that is widely available (i.e. to — 678 —

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consumers, too) on a permanent basis, i.e. round the clock, 365 days a year, and whose certain manifestations can guarantee a degree of anonymity similar to cash (Bech–Garratt, 2017). Thus, because the central bank issues it, this type of money is a claim on the central bank.

9.1.2 Payment challenges of digitalisation for central banks

According to the evolution of money presented above, two new types of money can be identified that may pose different challenges to central banks than traditional electronic payments: virtual currencies and CBDC. It is worth examining both innovations with respect to how much they can change today’s payments, i.e. how much they are expected to spread, and whether these currencies may be the next milestones in the history of money. 9.1.2.1 The challenge posed by virtual currencies

The truly promising part of the innovation represented by virtual currencies is its technological side. In the case of these currencies, the technological innovation was that, by utilising technological solutions developed earlier, an electronic payments network without a central player was created that excludes state authorities, regulators and supervisory bodies from its functioning. From the perspective of institutional innovation, it should be assessed to what extent these currencies fulfil the functions of money mentioned above, and whether they can function as money on a broad scale at all. Currently, the bestknown virtual currency with the greatest market capitalisation and turnover is bitcoin, therefore this chapter takes a look at its features. One of the central problems with virtual currencies such as bitcoin is that the pace of currency issues is predetermined, i.e. it does not adapt to the current currency need of the economy (Chart 9-1). Since their supply cannot be adjusted to the variable demand for money, the currency loses its very important feature that was already achieved earlier in the history of money by transcending gold and currencies — 679 —

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functioning with full gold backing. Due to their inflexible money supply, in their current form, virtual currencies can mostly be regarded as digital commodity money, therefore they could hardly function as general means of payment in today’s modern economies. Chart 9-1: Number of bitcoins since the currency’s creation 21

Million units

21 18

3 January 2018: 16,780,550 units

15 12

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033

Stock of Bitcoins Note: The forecast shows the maximum money supply. Source: Blockchain.net

Medium of exchange function

In a highly constrained manner, bitcoin currently performs merely its medium of exchange function, as it is increasingly accepted as a medium of exchange, however, its share within total turnover is still negligible. The technological features underlying its functioning suggest that no major change will happen in this regard. Currently, the system can handle 7 to 10 transactions per second, which is dwarfed in comparison to the number of transactions even in a smaller country. The low number of transactions conducted is due to the rules established when the bitcoin system was created, because a size limit of one megabyte was stipulated for new blocks, therefore only a limited — 680 —

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amount of transactions fit in each block (the size of the information describing a transaction in encrypted form is around a couple of kilobytes). This results in excess demand, where the transaction costs of transfers and the time necessary for settlement increase, which runs counter to the advantages promised by bitcoin. Nothing guarantees the acceptance of virtual currencies, and the network where they are accepted is not very broad either due to their unfavourable characteristics.386 Unit of account function

The unit of account function has not yet been fulfilled, which is attested by the fact that products are still priced in USD (or another currency), which is then converted into bitcoin. Failure to fulfil this function is partly due to high exchange rate volatility, since frequent repricing pressure arising from this would entail high menu costs. Moreover, risk-aversion aspects also play a role, since money is expected to have stable purchasing power, which bitcoin cannot fulfil, not even in the short term. Another practical explanation is the distortion of consumer price perceptions, because due to the high exchange rate, the prices of small-value items expressed in bitcoins are very low, which makes it hard for consumers to compare prices (Yermack, 2013).387 388 Store of value function

Bitcoin cannot fulfil money’s store of value function either, since the volatility of its price is greater than any other currency or of gold (Chart 9-2). This makes it almost impossible to manage the risks arising ranted, a part of tax payments in the Swiss town of Chiasso can be made in bitcoin G since 2018. According to chartalism, this may pave the way for the currency being more widely accepted in the canton (Knapp, 1905). https://www.coindesk.com/ swiss-town-to-accept-tax-payments-in-bitcoin/ 387 Bitcoin is a money changer: 1 bitcoin is worth 100 million satoshi, although currently this is not generally known. 388 A similar, but contrary, problem is when prices are too high in the economy, and too large denominations are in circulation. One recent example is Romania where in early 2005, four zeros were simply cut off from the end of all coins, banknotes and the price tags of all products. 386

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from exchange rate volatility. However, the limited supply may make bitcoin an attractive investment due to long-term appreciation, although this is more characteristic of a listed stock than money. The store of value function is also influenced negatively by the lack of an institutional system, since the natural and legal persons who keep their savings in a virtual currency need to undertake much more than average risk, which raises consumer protection issues. That is why cybersecurity risks also must be mentioned. There have been cases when hackers managed to steal bitcoins from digital wallets, and the payment systems of bitcoin exchanges have also been attacked. These undermine the confidence in bitcoin as a store of value. The fulfilment of this function is further hampered by the lack of lending opportunities. Although the forms of online peer-to-peer lending are increasingly popular all over the world, using these with bitcoin entails technological risks and thus also moral hazards. This is because a transaction from Person A to Person B can only be initiated by Person A, since there is no authority that would be able to enforce this (Bank of Finland, 2017). Therefore, if A extends a loan to B, the former has to transfer the amount from their own digital wallet to B’s. However, without the enforceability of repayment, B has disincentives to repay their debt.389

389

I t must be noted that by using ‘smart contracts’, even virtual currencies may become loanable (Szabo, 1996). This is not possible with bitcoin, but there are other virtual currencies that offer such services.

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Chart 9-2: Standard deviation of daily yields of asset classes in 2017 5

Per cent

5 4

USA Germany Japan UK EM Hungarian USA Germany Japan UK EM Hungarian USD EURUSD JPYUSD GBPUSD EM index EURHUF Gold WTI Brent Maize Copper Aluminium Bitcoin

Long government bond

Stock markets

Commodities

Source: Bloomberg.

World currency function

Usually the money fulfilling the world currency function can perform the three above-mentioned functions in domestic and international payments, too. Bitcoin fulfils the functions of money only to a very limited extent, however, without a central issuer it was designed to become a world currency. One of the greatest advantages of bitcoin compared to traditional currencies is that the nationality or location of the parties does not matter in transactions. Furthermore, the distributed ledger technology (DLT)390 allows transactions to be easily controlled. Therefore, international transfers do not necessarily entail higher costs or longer settlement times than cross-border payments conducted in

390

For more on the DLT, see Chapter 8.

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the current, traditional infrastructure.391 This beneficial role is also highlighted in the Financial Stability Board’s FinTech report (FSB, 2017). This may facilitate the spread of retail international services. However, the development of instant payment systems will enable ever faster domestic and international payments, therefore bitcoin’s allure may fade if these projects come to fruition. Due to the characteristics listed and the limited extent to which virtual currencies fulfil the functions of money, they are not expected to become widely used as general means of payment in their current form and replace the electronic payment methods used today. 9.1.2.2 The possible reasons for and risks surrounding the introduction of CBDC

The introduction of CBDC may influence the current operation of the economy, specifically the financial sector, and it affects several central banking areas, such as monetary policy and macroprudential policy, however, first the issue will exclusively be examined from a payment perspective. As has already been shown, the history of money can be regarded as a series of innovations, and a review of the types of money from this perspective attests that while central bank money that is accessible only to a limited group (mostly commercial banks) has already been digitalised, the central bank money available widely, to natural persons, too, only exists in physical form, as cash. Earlier, the digitalisation of cash was hindered by technological barriers, in other words the technology and computing capacity was simply not available that would have allowed accounts and payments of

391

ven though several FinTech service providers already offer cost effective solutions, E in the near future, instant settlement and low costs will become available even for cross-border bank transfers.

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huge groups with millions of users to be managed.392 However, in the 21st century the exponential development of information and communication technologies has enabled the introduction of CBDC from a technological perspective, therefore the theoretical and economic aspects have become more prominent. This subchapter examines the advantages and risks of the introduction of CBDC from a payments perspective. Both advantages and risks are distinguished based on whether CBDC would replace cash or commercial bank deposit money. The advantages of CBDC replacing cash

The introduction of CBDC would be justified, for example, by the lower social costs. As shown in several studies, including one by the MNB (Dr. Turján et al., 2011), electronic payments entail much lower costs for society than cash. Since the share of cash transactions is over 75 per cent in Hungary (Ilyés–Varga, 2015), the electronisation of payments would lead to substantial savings as a percentage of GDP, and CBDC would contribute to this by supplementing other electronic forms of payment based on commercial bank money. CBDC could also have a positive effect on financial awareness. Many people do not use electronic forms of payment simply due to a lack of confidence in market participants. CBDC could provide a solution to this, as it would be backed by the central bank and provide basic electronic payment services, perhaps even by excluding market participants. In other words, this new type of central bank money could also significantly contribute to increasing financial awareness and financial inclusion. One prerequisite for this is that the new currency be introduced in a simple and easy-to-use form so that even 392

Although Bech–Garratt (2017) argue that technologically it has been possible for a long time to enable public access to central bank accounts (this is or has already been achieved in one-tier banking systems), they believe that in order to replace cash, the central bank needs to provide payment services (e.g. instant settlement) that have only recently become available. It has to be noted that the concept of deposited currency accounts (DCA) suggested by Tobin (1987) is equivalent to the account-based dematerialised central bank money scheme.

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those with scarcely any knowledge about the digital world can use it confidently. The advantages of CBDC replacing commercial bank money

The world is currently heading towards ever greater digitalisation, which can also be felt in payments through the continuous rise in electronic payments. In an (almost) cashless society, this raises two concerns. First, to a large portion of consumers, almost nothing other than commercial bank money will remain available, without cash as a quasi-risk-free alternative. In other words, in the case of larger financial shocks and resulting potential bank failures, households and companies would be more vulnerable, which can only be partly offset by the guarantee of state deposit insurance. Second, another argument for the introduction of CBDC is that a cashless society is also more vulnerable to cyberattacks. As electronic payments become the only means of payment, the infrastructure related to cash, such as banknote and coin production, and cash transport would probably be dismantled due to economic considerations, therefore in a financial crisis or when commercial bank deposit money would even temporarily become unavailable, there would be no alternative means of payment that could run the economy. However, if CBDC functioned in a segregated infrastructure, payments would keep functioning even if most commercial bank systems became unavailable due to a larger cyberattack. The general risks of CBDC

In addition to the potential payment advantages listed above, several challenges may arise in connection with the introduction of CBDC. Central banks’ tasks would be fundamentally transformed, and irrespective of how the new currency is introduced (account-based, value-based or DLT-based method, see below) it would entail substantial costs. Operation would also require completely new tasks (e.g. a widely available customer service) from the central bank, and it would also entail further costs. The central bank would have to comply

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with the statutory anti-money laundering and customer identification requirements, and it is not prepared for that with such a high number of customers. Moreover, when choosing the method of introduction, further deep analysis is required with respect to whether and to what extent anonymity needs to be ensured. In the case of cash, anonymity has obvious technological reasons, which, however, have been eliminated by the developments in digitalisation, therefore the level of anonymity that would be optimal for society should be considered. It also has to be borne in mind that the introduction of CBDC also raises several legal issues. It has to be examined, among other things, whether central banks’ legal mandate authorises them to issue widely available CBDC, or how the new currency relates to the issuance of already regulated electronic currencies. The risks of CBDC replacing cash

The disappearance of physical cash may even entail the ‘financial exclusion’ of certain social groups. Although for society as a whole, electronic payments are obviously cheaper than physical cash, handling digital assets may mean considerable difficulties to certain social groups. Therefore, the introduction of CBDC and the phasing-out or disappearance of physical cash could entail, even contrary to public policy wishes, the ‘financial exclusion’ of these social groups. The development of the infrastructure necessary for a widely available CBDC must be implemented and the related costs divided, i.e. it should be considered whether the central bank has to provide merchants with the devices necessary for accepting payments from consumers or whether these costs should be borne by economic actors. The risks of CBDC replacing commercial bank money

Another change from a cybersecurity perspective would be if most existing commercial bank accounts were terminated by consumers and central bank account-keeping was used instead. This is because the current system practically distributed between the account-

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servicing payment service providers would be replaced by a central infrastructure, which could entail critical risks from the perspective of system security. While, for now, the hacking of an account-servicing payment service provider’s system enables access to or abuse of the data of a limited number of customers, in the case of central bank accountkeeping, the data of the overwhelming majority of customers would cluster in a single system, therefore a cyberattack would inflict much greater damage. In addition, an inadequately introduced CBDC could also stifle innovation, because the payment services to be provided by the central bank along with the new currency have to be precisely determined (IMF, 2017). If a wide range of payment services can be provided centrally, some market participants may abandon the payment market. Cessation of competition and monopolisation of developments may lead to a setback in innovation in the long run, and consumers may have to face ever lower standards in payment services relative to the technology available in the given age. Therefore, for example, according to the notice issued by the Chinese central bank, one possible solution could be that as CBDC is introduced, the payment services would be provided by market participants (Knight, 2017). Full-reserve banking is a similar system, and it will be presented in Box 9-2. 9.1.2.3 Possible ways of introducing CBDC

From a technological perspective, CBDC can be introduced in three principal ways. The main premise of the register- or account-based approach is that today’s high-quality IT and computing capacities allow central banks to keep accounts for not only a limited group (such as commercial banks) but also for a wide range of consumers, even millions of people. With this method, central banks would manage millions of accounts, and similar to opening an account today with commercial banks, account holders would be identified, i.e. this system does not provide anonymity. But let us not forget that opening and managing a huge number of accounts requires an infrastructure from

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9. The effect of digitalisation on the banking sector

the central banks (e.g. branches, customer service) that they currently do not have and that would entail considerable costs to develop (or rent). The next is the value-based approach, which can even be combined with the former, account-based method. The essence of this is that central bank money would be recorded on devices or (mobile) applications, similar to today’s prepaid cards. Central bank money would be kept by holders on a device in physical form, and payments would be conducted offline, simply between the devices, without using a central network and its authorisation. This solution could be mainly useful for retail payments, and it would address users’ calls for anonymity with electronic payments similar to using cash. This approach would present an alternative mainly to those who also wish to enjoy the benefits of central bank money (e.g. risk-free) in electronic form, without opening an account with the central bank. The third option would apply the distributed ledger technology, which is used by, among others, virtual currencies. Here it has to be noted that although several studies have been launched, some even by central banks (e.g. BCB, 2017, HKMA, 2017), it is not currently clear how and to what extent this new technology could be used, and how the arising issues could be solved. In addition, the analyses focusing on the introduction of CBDC (such as Barrdear–Kumhof, 2016 or Riksbank, 2017) need to be distinguished from the central bank projects and studies that aim to shift the existing payments infrastructure (e.g. RTGS393 or securities settlement) to a DLT basis (ECB, 2017b; ECB, 2017c; Chapman et al., 2017; Deloitte–MAS, 2017). It is still unclear whether the system can handle the huge volume of transactions conducted in retail payment systems; one only needs to think of the corresponding limits of bitcoin, which uses similar technology. Another issue that may arise is privacy, i.e. how to ensure that the individual players cannot 393

Real-time Gross Settlement Systems, payment systems for settling mainly wholesale and extremely urgent financial transactions, such as VIBER in Hungary.

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Banks in history: innovations and crises

identify the payment transactions of others, since that may violate bank secrecy. Privacy may also be important from the perspective of how anonymity similar to that of cash payments can be ensured with this technology, or whether it is possible at all. In addition, although one of the main advantages of this technology is usually regarded to be its cyber-resilience due to its distributed nature, it is doubtful whether it is worth basing the operation and stability of a whole country’s economy on a rudimentary technology.

9.2 Digitalisation and monetary policy 9.2.1 Virtual currencies

Since the issuance of virtual currencies is not regulated by laws or other provisions, new virtual currencies emerge every day due to their popularity, which is expected to remain so in the near future.394 The characteristics and underlying services of newly created currencies can be determined by the creators, which results in many competing assets with more or less divergent features.

394

According to centralbanking.com, there are over 1,300 virtual currencies in circulation. To put this into perspective, the 193 UN members have 180 official currencies altogether. https://www.centralbanking.com/central-banks/currency/ digital-currencies/3325466/how-crypto-is-my-currency

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9. The effect of digitalisation on the banking sector

Box 9-1 Types of virtual currencies

Besides bitcoin, several virtual currencies can be distinguished, which can be attributed to the increasing number of online groups (social networks, online games) that are being established as Internet access becomes widely available, and users have already considered using proprietary money. On the other hand, confidence in the banking system was undermined by the 2008 crisis, which contributed to the development of currencies independent from the current financial system. Based on the ECB’s (2012) classification, three main categories of virtual currencies can be distinguished. – Closed virtual currency schemes: they have almost no link to the real economy, usually they can be acquired and typically spent only in online games (although there are online ‘black markets’ for exchanging them). Example: WoW Gold, money from the popular game, World of Warcraft. – Virtual currency schemes with unidirectional flow: they can be exchanged at specific exchange rates from official currencies, but they cannot be exchanged back. Facebook Credits were an example of this. – Virtual currency schemes with bidirectional flow: they can be freely exchanged against official currencies issued by central banks. The best-known representative of the third category is bitcoin; however, hundreds of other virtual currency schemes have appeared over time, which are collectively referred to as ‘altcoin’. Since bitcoin is open-source, most competitors have been developed based on this, and their operation is very similar, merely small improvements were made to increase efficiency. Virtual currencies can differ in various respects (ECB, 2015): –T ransaction validation: the first decentralised virtual currencies (e.g. Bitcoin, Litecoin) function based on the so-called proof-of-work (PoW) concept, which depends entirely on computational power, however, later

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Banks in history: innovations and crises

proof-of-stake (PoS) methods also emerged (e.g. Nxtcoin), which also takes into account the virtual currencies owned by the players and makes validation more efficient. Certain types of currencies (e.g. BlackCoin) combine the two methods, i.e. using the PoW approach up to a certain amount of money in circulation, then switch to PoS functioning after reaching the limit. – Data processing algorithm: this largely determines the data processing speed, for example. Two main groups can be distinguished, the currencies using the SHA-256 algorithm (e.g. Bitcoin) and those utilising the Scrypt algorithm (e.g. Litecoin), which can be regarded as the extension of the former. – Total issuance volume: typically, there is a fixed upper limit (e.g. Bitcoin, Litecoin), but there are schemes with flexible money supply (e.g. Peercoin targets 1 per cent inflation). – Functionality: several virtual currency schemes seek to expand their services, for example Nxtcoin offers several additional functions, including a P2P marketplace. Some major virtual currencies besides bitcoin (Hileman–Rauchs, 2017): – Ethereum: the decentralised platform with the second largest market capitalisation behind bitcoin that enables smart contracts was officially launched in 2015, and it uses its own currency called ‘ether’ for the applications in the system. – Dash: its main feature is that it offers more anonymity than bitcoin, and miners share rewards equally, while 10 per cent of the fees go to the central ‘treasury’ to finance later developments.

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9. The effect of digitalisation on the banking sector

– Ripple: it offers instant and cheap cross-border transactions to banks. Instead of blockchain, it uses a so-called consensus ledger, which does not require mining, therefore its operation is more efficient. – Litecoin: the scheme launched in 2011 operates by and large similar to bitcoin, however, it differs in certain respects (e.g. the algorithm used) from its forerunner, which makes processing transactions faster. Chart 9-3: Percentage change in the exchange rates of virtual currencies in 2017 1,800

Per cent

36,000

1,600

32,000

1,400

28,000

1,200

24,000

1,000

20,000

800

16,000

600

12,000

400

8,000

200

4,000

0 Dec. 2017

Nov. 2017

Oct. 2017

Sep. 2017

Aug. 2017

Jul. 2017

Jun. 2017

May 2017

Apr. 2017

Mar. 2017

Feb. 2017

Jan. 2017

−200

0 −4,000

Bitcoin Litecoin Ethereum (right-hand scale) Ripple (right-hand scale) Source: Bloomberg.

Rather than the advantages it offers, bitcoin garnered considerable attention due to its steeply rising price and its extreme volatility (Chart 9-3). Although the number of places where it is accepted continuously increases (mostly online stores, but there are also bitcoin ATMs where the official currency can be withdrawn from bitcoin wallets — 693 —

Banks in history: innovations and crises

or the official currency can be used to top up the wallet with bitcoin), its transaction turnover is low, it has become widespread mostly as a speculative asset. This role is projected to strengthen as institutional investors are increasingly entering the bitcoin market with an intention to buy. It must be noted, though, that more and more countries are deciding to ban bitcoin trading (e.g. China, Russia). Chart 9-4 compares the advantages promised by bitcoin to users and the actual situation. Several economic issues arise in connection with bitcoin, however, the most central question is whether the high volatility of its price will moderate, and how long the rate will continue to increase. As many people are still suspicious about bitcoin, it is often compared to the dot-com bubble or the Tulip mania of 1636 to 1637. The limited supply and the growing number of investors point towards a price increase; however, the expanding number of altcoins also means growth in the substitutes for bitcoin. This may make the virtual currency market more flexible, as it may become able to respond to the changes in demand, thereby mitigating price fluctuations. Chart 9-4: Bitcoin’s offered advantages to users and its disadvantages Bitcoin promises

Real Bitcoin situation

Anonymous

Customer can be identified at exchange to traditional money

Fast

Traditional infrastructures heading towards instant processing

Cheap

Many hidden costs, more and more expensive system operation

Safe

Lack of consumer protection, volatile exchange rate

Source: Authors’ own compilation.

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9. The effect of digitalisation on the banking sector

One can detect further monetary history parallels with the supply of bitcoin. Such an example is the use of gold as commodity money or later the use of the gold standard. When gold was considered money, raising its volume was limited due to the capacities of the mines, then later it became unable to keep up with the growing demand arising from economic growth. As has been pointed out by Hampl (2017), the vice-governor of the Czech National Bank, economic efforts have to be made in order to increase supply. In the case of physical gold, mining used to require physical effort; however, today ‘mining’ digital currencies calls for digital effort by computers. 9.2.1.1 The impact of virtual currencies on today’s monetary policy

Nowadays, bitcoin has no effect over monetary policy, as it cannot widely fulfil the role of money, and its overall financial weight is small. The former is attributable to the fact that bitcoin is unable to fulfil the functions of money, therefore monetary policy transmission channels are not damaged. As bitcoin integrates into economic life within a country, it starts competing with the legal tender. This is not unprecedented, the legal tender is often challenged by other types of (commodity) money, one only needs to think of gold, silver, foreign currencies or regional currencies. However, when examining the functions of money, it was concluded that virtual currencies are not expected to become widely used as general means of payment in their current form (Subchapter 9.1.2.1). Without fulfilling the functions of money and widespread use, the impact of bitcoin and altcoin on monetary policy is negligible, but some possibilities should nevertheless be highlighted. Holding bitcoin as an investment instrument may reduce the volume of domestic actors’ cash and bank deposits. This is due to the reasons mentioned in Chapter 8, domestic actors are likely forced to purchase bitcoin for hard currency from foreign players. This may reduce banks’ balance sheets and increase commercial banks’ external borrowing, which may even decrease foreign exchange reserves. Buying bitcoin from abroad can be interpreted as capital outflow, however, due to its limited extent, its — 695 —

Banks in history: innovations and crises

effect on the exchange rate is insignificant, therefore it does not increase inflationary pressure generated by import prices and does not influence net exports. Consequently, it does not have an unfavourable impact over monetary policy’s exchange rate channel. The currency is not expected to damage the interest rate channel or the asset price channel, as purchasing bitcoin is costly and time-consuming (since it usually requires foreign currency and international transfers). Therefore, it is unlikely that the changes in the domestic interest rate environment would urge players to invest a portion of their investment portfolio in bitcoin. And even if they did so, transmission would not be damaged. This is because in the case of an interest rate increase, the bitcoin portfolio would depreciate in domestic currency ceteris paribus, therefore both the balance sheet channel and the asset price channel would function. Due to the above, bitcoin’s impact on the monetary policy of developed countries is negligible. It could exert much more of an effect in developing countries where monetary policy’s commitment to maintain price stability is not credible, inflation expectations are not anchored, or inflation is persistently high. However, certain conditions (internet access, electronic banking options, an adequate level of foreign exchange reserves, etc.) need to be met so that a large number of actors switch to using bitcoin. In such a case, bitcoin may help central banks’ commitment to maintain price stability (Fernández-Villaverde, 2017). A similar phenomenon can be observed in Kenya, where the M-Pesa payment system, launched by a telecommunications corporation, is trusted more than the Kenyan banking system (Raskin–Yermack, 2016). Furthermore, bitcoin may also be used to circumvent capital controls, as is usually mentioned in connection with Zimbabwe. This is because using the virtual currency would reduce the role of the central bank, which can be prevented by conducting efficient and successful monetary policy. The central bank’s credible communication on this can strengthen the role of the expectations channel and make its overall monetary policy more efficient. — 696 —

9. The effect of digitalisation on the banking sector

9.2.1.2 The impact of the widespread use of virtual currencies on monetary policy

Due to its failure to fulfil the functions of money, bitcoin is not expected to be widely used for payments or other purposes, hence, it will not have a substantial impact on monetary policy. Nevertheless, the potential effect of its widespread use should be examined. Let us assume that economic actors conduct their purchases with bitcoin rather than cash and bankcards. If this happened, it would reduce the efficiency of monetary policy and completely transform its functioning. This is hardly surprising, given that the intention behind the creation of bitcoin was to establish a currency independent from countries, monetary authorities and banks. The first major factor is whether economic actors realise income in the domestic currency or bitcoin. In the latter case, the transition to that would require actors to accumulate large bitcoin holdings (for the effect of this process on the balance sheet of commercial banks, see Chart 9-5), which they often have to acquire from foreign players. This leads to the depreciation of the home currency, and the central bank’s foreign exchange reserves and balance sheet may also decline. After the transition, bitcoin would function as money in commerce, which would be similar to dollarization. If economic actors realise their income in the domestic currency (for example due to legal provisions), consumers would face a sort of money-holding problem (Baumol, 1952; Tobin, 1956). This would affect the exchange rate of the domestic currency. The root of the problem is that people need bitcoin for their purchases, which is costly to acquire, and since holding it does not bear interest,395 they have to take into account the foregone interest income due to purchasing bitcoin. If they convert their income to bitcoin in several steps, the exchange rate of the domestic currency may become volatile within the month. The cyclical 395

ranted, its exchange rate may move, therefore this is not strictly the Baumol– G Tobin model.

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Banks in history: innovations and crises

development of the exchange rate would also be heavily influenced by the corporate sector. If it realised its revenues in bitcoin while paying wages in the domestic currency, it would typically sell a huge amount of bitcoin early in the month, which would lead to an appreciation of the domestic exchange rate. A similar exchange rate cycle may be observed with large amounts transferred to the state related to tax payments. On account of exchange rate volatility,396 the role of the exchange rate channel would weaken, which would be exacerbated by the fact that it would mean further costs to companies due to the unpredictability of import prices, resulting in higher cost-side inflationary pressure. The effect of monetary policy through the credit channel (bank lending and balance sheet channel) could be damaged if holding bitcoin as an investment instrument becomes widespread. The disadvantage of bitcoin relative to other, traditional investment instruments (government securities, stocks, bonds etc.) is that it is not eligible or, due to its high volatility, only to a limited extent, for being accepted as collateral when borrowing. Therefore, in parallel with the amount of available collateral, loanable amounts may also diminish. On the other hand, bitcoin may also damage banks’ lending capacity, which may increase banks’ lending costs. It would possibly have a more muted impact on households’ saving behaviour, as in economics, households are generally assumed to be risk-averse, therefore they would not hold their longer-term savings in bitcoin (due to its high volatility and the lack of interest payments). Therefore, the role of the domestic banking system would be preserved, however, deposits would considerably decline due to bitcoin use, and, on account of the effect of purchasing bitcoin from abroad, acquiring funds denominated in foreign currency would become necessary, which may result in the reduction of banks’ lending capacity and the demand for bank loans. 396

he central bank is assumed not to stabilise bitcoin’s price (for example through T foreign exchange market transactions).

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9. The effect of digitalisation on the banking sector

The central bank would still be able to influence economic actors’ savings and investment decisions through the interest rate channel. Changing the interest rates would directly affect people’s demand for bitcoin, thereby, also directly influencing the amount of bank deposits. This is because the opportunity cost of holding their wealth in bitcoin is the foregone interest that would have been realised if their assets had been held in bank deposits (or in another interest-bearing instrument) (the effect of a central bank interest rate increase on commercial banks’ balance sheet is shown in Chart 9-5). Moreover, it can be assumed that corporations would still use bank lending for their investments.397 This is all the more likely because there is no actor other than banks that would be able to perform the maturity, risk and volume transformation. Chart 9-5: Stylised balance sheet of commercial banks during the build-up of the Bitcoin stock (A) and in the case of a central bank interest rate hike (B) (A)

Assets Loans (HUF) FX ($)

(B)

Liabilities +/−

Assets Loans (HUF) FX ($)

Deposits (HUF) FX funds ($)

− +

Liabilities +/−

Deposits (HUF) FX funds ($)

+ −

Note: An open economy is considered which does not issue hard currency (here: USD). HUF stands for domestic currency, furthermore it is assumed that bitcoin can be purchased from foreign actors. When the customer wants to buy bitcoin, the bank acquires foreign currency funding from abroad to be able to transfer foreign currency, and the customer’s HUF account is reduced by this amount. In the case of an interest rate hike, customers buy HUF in exchange for bitcoin, therefore the process is the reverse. The bank reduces its foreign funding by the foreign currency obtained from the customer, and credits the customer’s HUF account by the corresponding amount. Source: Authors’ own compilation.

397

t least where this is currently the case (instead of capital market financing). But A even with capital market financing, investment service providers would probably survive, and the central bank would influence the interest rate conditions.

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Banks in history: innovations and crises

9.2.2 Central bank digital currency 9.2.2.1 Monetary policy objectives and instruments

Central bank digital (or dematerialised) currency refers to fiat money issued by the central bank that appears in electronic (rather than physical) form, and all (domestic) economic actors can access it. The technological implementation may vary, therefore there is accountbased, value-based and distributed ledger (DLT) CBDC. However, from a monetary policy perspective, this technological distinction is almost irrelevant. The same conclusion is reached when using the accountbased system and the DLT; yet CBDC would bear no interest in a valuebased scheme.398 If the central bank issues CBDC, its instruments potentially become more complex. Besides the two former types of central bank money, i.e. cash and commercial bank reserves, a new, third type appears, with potentially different conditions than the previous two. Therefore, the monetary base would consist of three types of money. In this case, the central bank would need to decide on the following: – t he exchange rate between CBDC and cash; –w hether CBDC should bear interest, and if yes, how; –w hether it should determine its quantity or price (interest rate); –w hether there should be limits for individual money holders; – whether commercial bank deposit money should be directly convertible to CBDC. 398

It is assumed that CBDC based on the distributed ledger technology would also be loanable (for example, it would not be completely anonymous, or it would be combined with ‘smart contracts’, Szabo, 1996). If CBDC is completely anonymous (e.g. value-based scheme), the money does not bear interest.

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9. The effect of digitalisation on the banking sector

The above questions also show that the introduction of CBDC would complicate the functioning of monetary policy. Just as in today’s monetary system, the central bank can use various operational and intermediate targets in the CBDC scheme, too. As an operational objective,399 it can maintain the identical level of the money market interest rate and the central bank base rate. But another operational target may be to keep the monetary base or certain parts of it at the level desired by the central bank. In an inflation targeting regime, the central bank wishes to reach its ultimate objective, price stability, without an intermediate objective.400 In other monetary regimes, intermediate objectives are possible. Examples include the monetary aggregate or the exchange rate. If an inflationtargeting central bank uses CBDC, it can keep operating without an intermediate target. However, CBDC does not prevent central banks from setting an intermediate objective. The central bank may face an impossible trinity if it wishes to peg the exchange rate of the CBDC to cash, determine its interest rate and also decide on its amount at the same time. If the central bank uses a fixed exchange rate between the various types of central bank money (for example an exchange rate of 1), it cannot determine the interest rate and amount of CBDC at the same time, just as today the price and amount of cash and central bank reserves cannot be determined at the same time. Because if the central bank does so and offers less CBDC than the demand for it at a specific interest rate, market participants will expect

The operational objective of the central bank is that the price or quantity of an instrument directly influenced by it be in line with its expectations. One typical operational objective is to have the same money market interest rate and central bank base rate. 400 In other words, in an inflation targeting framework, the intermediate target is to keep inflation projections in line with the inflation target. 399

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Banks in history: innovations and crises

cash to appreciate against the CBDC.401 However, this is impossible due to the fixed exchange rate, therefore cash immediately depreciates on the secondary market, which is inconsistent with the central bank’s intention. Therefore, no matter whether the central bank determines the interest rate or the amount of CBDC, the other variable will emerge endogenously in the context of a fixed exchange rate. As an interesting point, it should be noted that in the extreme case of having only CBDC in an economy, another impossible trinity arises.402 If CBDC crowded out today’s money (cash, commercial bank deposits), then, in a closed economy, the assets side of a simplified central bank balance sheet would contain government securities,403 while the liabilities side would show the CBDC, i.e. the total money supply.404 Therefore, three major monetary questions can be asked: (1) How many government securities should the central bank purchase? (money supply); (2) What price should it pay for them? (base rate); (3) What interest should it pay for the money created? It can be seen that in the context of a given IS curve, aggregate supply, money demand and inflation expectations, the central bank has to answer precisely two out of the three questions, as the third is answered by the economy (Chart 9-6).

ncovered interest parity is assumed between cash and CBDC. U This is Case 3 in Box 9-2, i.e. the case of a sovereign money system. 403 Or securities loans, reverse repurchase agreements provided to banks. If the central bank purchases government securities, the issue of monetary financing may arise. Currently, Article 123 of the Treaty on the Functioning of the European Union prohibits monetary financing in the EU. 404 Here it is assumed that commercial bank reserves and CBDC would be available to money holders under the same conditions. Only the groups of money holders would differ in the case of the two types of money (commercial banks or other actors). 401 402

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9. The effect of digitalisation on the banking sector

Chart 9-6: The money market in the case when there is only CBDC in the economy i−d

i*−d* Ld(P;Y;i−d)

Note: This case is examined as this is the simplest to present. Legend: i is the (nominal) central bank base rate (government bond yield), d is the (nominal) CBDC yield, M is the money stock, P is the price level, Y is the real GDP, Ld denotes money demand and asterisks are equilibrium values. Both P and Y raise money demand. But as i - d (the opportunity cost of holding money) increases, economic agents wish to hold less and less money. If liquidity always has a value at the margin, then i - d is positive everywhere. However, d can have any sign, thus i can also be negative. The central bank has to decide on exactly two out of the three (M, i, d). Source: Authors’ own compilation.

Box 9-2 Various cases of CBDC implementation

The concept of CBDC has appeared in the communication of several central banks. However, it has typically also been found that, when certain conditions are met, the introduction of CBDC does not mean a mere formal change, as it may also affect money creation, lending and the structure of the financial system (for example Hampl, 2017; Mersch, 2017; Thiele, 2017).

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Banks in history: innovations and crises

In the current financial system, money creation primarily happens in the banking system. When banks lend, they create deposit money in parallel with that (Riesz, 1980; Szalai, 1994; McLeay–Radia–Thomas, 2014; Werner, 2014a, 2014b, 2015; Jakab–Kumhof, 2015; Ábel–Lehmann–Tapaszti, 2016; Bundesbank, 2017). The banking system is largely able to create money almost ‘from nothing’, because the resulting money is an accepted means of payment in the economy (Kumhof–Jakab, 2016) without being converted to fiat money created by the central bank. However, this is principally attributable to form: it is more convenient to store money in digital form than in cash. However, currently the digital money available to households and companies is issued only by the banking system, while central bank money issuance available to the non-bank private sector is limited to cash (Skingsley, 2016). With the introduction of CBDC, the money issued by the central bank may once again compete with the types of money issued by commercial banks because all other things being equal, holding CBDC may be more favourable than holding deposits. Central bank money is a risk-free, ultimate means of payment, while commercial bank money is a claim on central bank money, the debt of the bank (Riesz, 1980), and its safety depends mainly on the bank’s capital adequacy and liquidity position as well as on deposit insurance. Depending on the popularity of CBDC and the size of the central bank’s standing facility to commercial banks,405 the financial system may change to different extents. The horizontal axis of Chart 9-7 shows the popularity of CBDC. The left end of the axis displays a situation where CBDC is not popular at all, even though it has been introduced, therefore no demand deposits flow into central bank money. By contrast, the right end of the axis represents a scenario where 100 per cent of demand deposits flow 405

he central bank standing facility usually means the central bank’s credit instrument T to which commercial banks have unlimited recourse every day at a given interest rate (or it may be limited by the assets eligible as collateral between commercial banks and the central bank). This chapter uses the concept in a broader sense, including the scenario where the central bank is willing to purchase an unlimited amount of commercial bank assets at a given price.

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9. The effect of digitalisation on the banking sector

into CBDC. The vertical axis shows the size of the central bank standing facility in reverse. At the lower extreme, there is an unlimited standing facility, i.e. the central bank is willing to exchange all the banking system’s assets to central bank money without a haircut or accept them as collateral. By contrast, the upper end reflects a situation where there is no standing facility at all.

Central bank refinancing conditions

There is no central bank refinancing

Chart 9-7: The financial system as a function of the popularity of the CBDC and of the central bank standing facility Sovereign money system Full reserve banking (without refinancing)

No change

Full reserve banking (with refinancing) CBDC more popular than commercial banks’ deposit money CBDC quality CBDC interest rate Deposit insurance Default regulation Marketing

Note: Under full-reserve banking, the central bank imposes a 100 per cent required reserve ratio on (demand) deposits of commercial banks. As in this case deposits are backed by commercial bank reserves, this can be regarded as an indirect realisation of the CBDC concept. Full-reserve banking is also called narrow banking (Kay, 2009). In a sovereign money system, the only money creator is the central bank, while commercial banks just redistribute money by lending, moreover, central bank money is backed by government debt (Huber–Robertson, 2000; Jackson–Dyson, 2012). Source: Authors’ own compilation.

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Banks in history: innovations and crises

The chart shows that these two dimensions can generate an infinite number of different situations. Although they cannot be precisely delineated, at least three areas should be distinguished on the plane that represent changes of three different magnitudes. 1. If CBDC is not very popular, its introduction does not trigger change, since the banking system’s ability to create money while lending remains the same, and the created deposit money does not leave the banking system, as it is more popular than CBDC. 2. If CBDC is more popular than demand deposits but the central bank standing facility is large, commercial banks create money when lending, but deposits wish to flow into central bank money. The bank can execute the transfer by exchanging the credit instrument to central bank money with the central bank, therefore ultimately, either directly or indirectly, both the loan and the deposit money are recorded at the central bank. This type can lead to a somewhat controversial financial system where lending is still initiated by banks, but its risk is passed on, at least partly, to the central bank. This is because in such a scenario, the credit instrument provided by commercial banks is the collateral for the central bank standing facility. 3. If CBDC is much more popular than bank deposits, then money from bank deposits largely or entirely flow into CBDC, and there is no central bank standing facility in parallel with this, i.e. commercial banks cannot exchange their instruments to central bank money with the central bank, the change can bring about a framework similar to the sovereign money system presented above. 4. Finally, a fourth case is mentioned that is not shown on the chart. The above-mentioned three cases all assume convertibility between commercial bank deposits and CBDC. By contrast, Barrdear–Kumhof (2016) examine a system where CBDC cannot be directly acquired by transferring commercial bank deposits. In their model, those who wish to purchase

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9. The effect of digitalisation on the banking sector

CBDC need to sell government securities to the central bank. This406 ensures the survival of today’s banking system: banks would continue to create the marginal unit of money. On what then, does the extent of change caused by the introduction of CBDC depend? The answer is that the rules of convertibility of different types of money, and the factors influencing the central bank standing facility and the popularity of CBDC are mostly determined by the central bank. Therefore, by setting out the related conditions, the central bank can substantially influence the extent of change ultimately induced by the introduction of CBDC. In addition to the conditions of the central bank standing facility, the formal quality of CBDC (e.g. anonymity, online platform), its interest rate, any change to the deposit insurance conditions, the default regulations and the promotion of the new instrument may all be crucial conditions when developing the system. 9.2.2.2 Macroeconomic effects

From a macroeconomic perspective, perhaps the most sensitive issue related to the introduction of CBDC is its impact on lending, investments and, ultimately, economic growth and business cycles. These effects depend heavily on precisely how the system is implemented (see Box 9-2). One extreme is the case examined by Barrdear–Kumhof (2016). In such a system, the marginal unit of money would continue to be created by commercial banks. In the authors’ model, CBDC bears interest that does not exceed the interest on central bank reserves, i.e. the base rate. According to calculations by Barrdear–Kumhof based on pre-crisis US data, the introduction of CBDC would increase real output by around 3 per cent in a steady state. This would be attributable partly to the lower base rate (real interest rate), which would emerge due to credit 406

urthermore, the Barrdear–Kumhof model would keep deposit insurance, which F also points towards the preservation of the financial system.

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Banks in history: innovations and crises

risk decreasing on account of dropping government debt. In addition, the distortionary fiscal tax rates would also be reduced, as the interest expenses of the consolidated general government would decline. Third, ‘liquidity taxes’ (monetary distortion) would also be lower because of the greater total money supply. However, output would be curbed by the slightly higher bank deposit rates. The authors also note that CBDC can be a secondary countercyclical instrument in the hands of the central bank. If the central bank decides on the interest of CBDC, it can constrain the money supply even with the base rate unchanged by cutting this rate in an upswing, which may stifle economic growth. In a similar fashion, if the central bank decides on the amount rather than the interest rate, it can also constrain the CBDC supply in a boom. Furthermore, if CBDC was not issued anonymously, the central bank would have more data on economic transactions than today, which may simplify the pursuance of the macroeconomic stabilisation policy. However, Barrdear and Kumhof also warn of the risks of a CBDC introduction. Besides the financial stability risk, (see Subchapter 9.3.1.2), transition risk is also identified. Even if, in the long run, the system would have genuinely favourable consequences, it is unclear how to get there. For example, during the transition, new financial instruments need to be tested, a carefully tested and reliable infrastructure has to be developed and the human operators of the system need to be trained appropriately. The main question is whether the risk of mismanaging these issues outweighs the expected long-term benefits of the system. In addition, the risk of the increasing interdependence of monetary and fiscal policy is also considered. The other extreme is when CBDC crowds out commercial bank money, due to prohibition or other measures (e.g. the elimination of deposit insurance, or if the central bank does not have a credit facility for commercial banks). In such a scenario, commercial banks would not

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9. The effect of digitalisation on the banking sector

be able to create money, they would only redistribute money through lending. Under this scheme, commercial bank lending would require prior fundraising, which could considerably reduce the lending capacity of the banking system (see, for example, Vickers, 2012). Banks would intermediate only existing money, which they have to access, possibly even under limited supply conditions. Therefore, the banking system would be able to increase its leverage less or only more expensively. The deteriorating lending capacity may entail a reduction in banks’ credit supply, which may ultimately lead to a fall in investments and economic growth. According to other authors, however, investments would not necessarily decline (Lerven–Hodgson–Dyson, 2015). Firstly, investments are not financed exclusively from bank loans (especially where capital market financing is widespread, e.g. in the US). Second, lending does not always finance investments, therefore a drop in the former may have a smaller impact on the latter. Furthermore, the central bank can adjust to the new situation by a looser monetary policy. It may provide refinancing to commercial banks if necessary, not in the form of a standing facility, but within the framework of a lending incentive scheme. If banks can only extend loans that redistribute money, the procyclicality of the banking system’s functioning would be lower than today (Jakab– Kumhof, 2015). The money-creating banking system is characterised by procyclicality in several cases, while a money-redistributing banking system is not. For example, if the riskiness of borrowers diminishes, banks’ profitability jumps. As a response, they increase their credit supply, which stimulates aggregate demand. If banks can create money, lending soars, but if they cannot, lending expands only gradually. Overall, in the money-creating scenario the expansion of equity (the improvement of profitability) is dominated by credit expansion, i.e. leverage in the banking system grows. Whereas in the redistribution scenario the reverse is the case, the improvement of profitability — 709 —

Banks in history: innovations and crises

dominates, whereby leverage declines. In addition, Benes–Kumhof (2012) also find that in a special full-reserve system, which is referred to as the ‘Chicago Plan’, business cycle fluctuations could be controlled much more. Chicago Plan: The financial reform package proposed by a group of American economists after the Great Depression is called the Chicago Plan. The greatest proponent of the plan was Henry Simons, a professor from the University of Chicago, hence the name. Another well-known supporter was Irving Fisher from Yale University. The proposal envisaged the separation of banks’ monetary and lending activities. It recommended a 100 per cent reserve requirement for deposits and sought to ensure that banks only play a redistributive role. The perhaps best-known modern version of the proposal is the Chicago Plan Revisited, prepared by Jaroslav Benes and Michael Kumhof, two IMF economists, in 2012 (Benes–Kumhof, 2012). 9.2.2.3 Monetary transmission

Among monetary policy transmission channels, the most affected by the introduction of CBDC would be the interest rate and risk-taking channels. In line with Balogh–Horváth–Kollarik (2017), the (broad) interest rate channel is understood to include not only the traditional interest rate channel but also the credit channel. Since, at least in the versions where there is convertibility between commercial bank money and CBDC, the banking system’s money-creating and lending capacity may change, the transmission of the central bank’s interest rates through the banking system may also vary. And this concerns mainly the abovementioned two channels. Keeping everything else constant, using CBDC leads to tighter monetary conditions. Currently, commercial banks finance their assets not only from funds with market interest rates but also demand deposits. Before the crisis, the interest rate on demand deposits was typically below the

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9. The effect of digitalisation on the banking sector

central bank base rate (Meaning et al., 2017). However, the introduction of the CBDC could result in rising funding costs for banks in two ways. – First, as CBDC has better liquidity characteristics than cash, it should have a higher equilibrium price than cash. In this case, the price of CBDC is its opportunity cost, i.e. the difference between the interest rate on demand deposits and the CBDC interest rate. Therefore, if the central bank continues to pay zero interest on the money issued by it, the interest rate of demand deposits would raise. Second, in the version where the central bank would provide – refinancing to the banking system to replace the outflow of deposits (Case 2 in Box 9-2), the demand deposits bearing interest below the base rate would be replaced by central bank loans bearing interest at (or above) the policy rate. And the higher funding costs would lead to higher lending rates ceteris paribus. Nonetheless, it must be noted that these potentially tighter monetary conditions may be consistent with the central bank’s objectives. This is because banks’ average funding costs would be closer to the central bank base rate than in today’s system. The transmission of the CBDC interest rate to the demand deposit rate may be faster than in a hypothetical economy where the central bank pays interest on cash.407 Since it is technologically easier to move digitally stored money around than cash, CBDC can be more of an alternative to demand deposits. And the greater competition can make commercial banks adjust the interest rate on the demand deposits collected or created by them faster when the central bank modifies its own interest rates.

407

For the practical implementation of paying interest on cash, see Buiter (2005, 2009).

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Banks in history: innovations and crises

9.2.2.4 Unconventional instruments

If CBDC was the only type of central bank funds available to everyone (i.e. cash disappears), the zero lower bound of the nominal interest rate could be eliminated. Currently, the zero yield on cash means the lower limit to bank deposit rates.408 If cash disappeared, the alternative form of investment would be CBDC, and the central bank can pay negative interest on that, especially in the case of extreme shocks, to ensure price stability (Dyson–Hodgson, 2016; Goodfriend, 2016; Bech–Garratt, 2017). However, the use of negative interest rates raises several issues. – First, in theory, negative interest rates are already possible in today’s monetary system (Buiter, 2005, 2009). – Second, the use of negative interest rates is unclear (Camera, 2017). This is because, at least up to a certain point, they can be replaced by other unconventional instruments, such as quantitative easing (or by increasing the CBDC supply). Moreover, they can have unintended consequences. For example, they may not stimulate consumption (the income effect could exceed the substitution effect). – Third, the feasibility of negative interest rates can be uncertain even when CBDC is used. If the central bank paid deeply negative interest on the money created by it, economic actors may start using money substitutes that retain their value better (Keynes, 1936, 382). – Finally, it should be noted that the negative interest paid by money holders would mean profits to the central bank. It is unclear how economic actors would respond to this implicit tax; it is probable that a separate law would have to be introduced on its use (Gesell, 1916).

408

The effective lower bound (ELB) is slightly below zero, as holding cash entails costs.

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9. The effect of digitalisation on the banking sector

Another aspect of issuing CBDC is that it may make quantitative easing more effective (Barrdear–Kumhof, 2016). In today’s monetary system, quantitative easing can ease monetary conditions through two channels: it can depress long-term government securities yields and expand the money supply in the real economy. However, the latter requires purchasing government securities from actors outside the banking system. Then the balance sheet of the banking system increases, due to created central bank money on the assets side and new commercial bank deposits on the liabilities side. Nevertheless, if the behaviour of commercial banks is inconsistent with the central bank’s objective, for example they sell assets or collect long-term funds, commercial bank money is eliminated. By contrast in a CBDC system, the central bank can expand the money supply directly, by circumventing commercial banks. The new system would make it technically easier for the central bank to use helicopter money. Helicopter money: the concept got its name from Friedman’s (1969) thought experiment where real economy actors (households) receive transfers from the central bank, either directly or indirectly, through the budget. This is not only about the expansion of money supply (and the corresponding drop in interest rates) in the form of, say, open-market operations, but also income received by households.

If a major portion of economic actors have CBDC, it is technically easier for the central bank to give them money to influence their consumption decisions. However, there are several arguments against using helicopter money. First, if the losses of the central bank are covered by the budget, even if the central bank provides money to economic actors directly, the general government also takes part in the process. Thus, the problem of monetary financing (see Footnote 403) arises with both the direct and indirect method. Second, as helicopter money is a sort of transfer to households, this is a quasi-fiscal activity, which should not necessarily be performed by the central bank. — 713 —

Banks in history: innovations and crises

9.2.2.5 Seigniorage

The effect of CBDC on the profits accrued by public money issuance, i.e. seigniorage is unclear. Usually, two seigniorage concepts are distinguished (Kun, 2010): –m onetary (cash flow) seigniorage = the increase in the monetary base minus the cost of creating the monetary base; – f iscal (opportunity cost) seigniorage = earnings on the funds emerging through money creation minus the costs related to money creation.409 It can be seen that the cost of money creation appears in both definitions. If CBDC was not very popular, this cost would probably increase with the introduction of the new currency. This is because the infrastructure needs to be built, i.e. growing returns to scale would arise, while output had no economies of scale. Yet with greater output, the system may be cheaper to operate than today’s cash logistics. The development of monetary seigniorage is mainly influenced by whether CBDC would crowd out only cash, or commercial bank deposit money as well. If only the former (even partly), the monetary base would not change, hence neither would monetary seigniorage. But if commercial bank deposits also flowed to the central bank, the monetary base would expand (and the money multiplier would diminish in parallel with that), which would entail a rise in monetary seigniorage. The development of fiscal seigniorage is influenced directly not only by stock levels but also interest rates. Therefore, the different schemes lead to different results. For example, if narrow banking 409

wo accounting approaches to (central) bank money underlie different seigniorage T concepts. While in the case of monetary seigniorage the issuer considers money equity, fiscal seigniorage is consistent with an interpretation where money is borrowed funds for the issuer. The currently accepted accounting rules usually apply the latter approach. However, there are also counterexamples, as coins issued in the United States should be regarded as the equity of the Treasury (FASAB, 2012).

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9. The effect of digitalisation on the banking sector

emerged and cash was eliminated as well (i.e. if only CBDC remained in the economy), the central bank would face a trade-off between the interest margin and the balance sheet total. If it is assumed that the demand for money is affected negatively by the central bank’s interest margin,410 a higher interest margin produces greater average earnings for the central bank, but it will be realised on a smaller stock. Granted, the money demand function cannot always be specified appropriately, therefore the central bank cannot necessarily easily optimise, provided that it maximises seigniorage. Box 9-3 Where are the profits of money issuance realised?

The traditional theories on the evolution of money argue that money is an innovation that reduces transaction costs, and the emergence of money was the result of spontaneous decisions by market participants. According to these theories, market participants initially bartered for their goods and services to be sold or purchased. However, bartering is inefficient, since it only happens if in a given moment one party wishes to sell precisely the goods that the other needs, and vice versa. The transaction is easier if there is a medium of exchange accepted by everyone. Initially, several types of commodity money could appear, out of which precious metals stood out due to their favourable characteristics (metallist economic theory). The next stage in the evolution of money was when various paper and account note substitutes appeared for precious metals, with the latter initially appearing in book form, then digitally and finally also online. In the interpretation presented above, the emergence and evolution of money is the result of spontaneous actions of market participants, and the main driver is the reduction of transaction costs.

410

he money demand function has a negative slant, since from the perspective of T economic actors, the central bank interest margin equals the opportunity cost of holding money (i - d on Chart 9-6).

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Banks in history: innovations and crises

This interpretation of the evolution of money seems logical, however, archaeologists and economists focusing on the theory and history of money, such as Graeber (2011), have pointed out that apart from a few exceptions, this process could be observed nowhere. The emergence of money can be linked much more to state power (chartalist theory of money), the intention of the state to reduce transaction costs, taxation and incurring seigniorage income. The state simply introduced a given money and made paying taxes or the settlement of other transactions with that money compulsory, thereby generating demand. In this approach, the main role in the emergence and evolution of money was played by the state rather than the market. Certain theories regard money creation as debt assumption by the issuer. In this approach, money appears on the liabilities side of the issuer’s balance sheet, i.e. money can be seen as the issuer’s debt. Money is recorded as an asset for households and companies who demand purchasing power from the issuer of the money and undertake to pay taxes with this money (Knapp, 1905). However, it should be noted that in practice this claim has no maturity. The economy has transaction money demand on the one hand, and asset demand on the other hand. This means that after a given money is declared to be the official currency in a country, economic agents continuously need some money to conduct transactions, and assuming that there is confidence that the currency will preserve its value, certain actors accumulate it to ensure future purchasing power. Therefore, economic actors generate demand for some money from the side of transactions and investments as well. This quantity should not necessarily be regarded as a maturing debt for the issuer, since it is typically not actually redeemed but remains a claim without maturity. Therefore, the economic substance is better represented if at least a part of money issuance is regarded as profits from issuance rather than debt (monetary seigniorage, see Subchapter 9.2.2.5). The issuer

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9. The effect of digitalisation on the banking sector

issues money, paying for goods and services with it. However, money remains money, i.e. it is not redeemed for products or services at the issuer. Even though precious metal systems also had periods when monarchs transferred their monopoly on money creation to private actors, before the establishment of modern central banks, money issuance was traditionally the prerogative of monarchs or the state. Modern central banks enabled greater monetary growth by issuing paper money, which may have also contributed to faster economic growth. However, a major portion of the proceeds from money creation was transferred to private actors, the owners of the central bank. Most modern central banks, or their forerunners, were established as limited companies during the 17th–19th centuries. Although the establishment of modern central banks is attributed to the financing requirement of the state, it should be noted that most privately owned central banks did not provide savings to the state, but generated purchasing power through banknotes created ‘from nothing’ and accepted in the economy. Kregel points out that the owners of several central banks paid the equity necessary for the institution’s creation subsequently from loans extended by the central bank itself (Kregel, 1998). The author also argues that the balance sheets of many modern central banks comprised mostly of interestbearing government bonds (and only a smaller share of precious metals) on the assets side, and banknotes on the liabilities side. In practice, this means that the central bank financed government bond purchases from issuing banknotes created ‘from nothing’. The controversy here was that the state could have equally issued its own cash (government notes) to finance government debt. By allowing a private institution to issue money, it transferred the interest on government debt to the private sector. Every year, the privately owned central bank earned the difference between the interest rates on its assets side and liabilities side,

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Banks in history: innovations and crises

i.e. the interest on government debt if it did not pay interest on banknotes (fiscal seigniorage, see Subchapter 9.2.2.5).411 When the tax burden is high, the government budget may run a deficit even with a positive primary balance, and the state fails to earn the proceeds from money creation and even loses on it, which needs to be covered by additional taxes, expenditure cuts and selling assets. In the 1930s and after the Second World War, most privately owned central banks were nationalised. Today, to the best of our knowledge, only eight countries still have private ownership in the central bank: Belgium, Greece, Italy, Japan, Republic of South Africa, Switzerland, Turkey and the US.412 However, from the 19th century, deposit money increasingly replaced cash as the dominant means of payment (Laina, 2015). Therefore, despite most central banks becoming government-owned and the monopolisation of cash issuance in most countries by the central bank, the proceeds from money creation is increasingly linked to the creation of deposit money. In most countries, the central bank is prohibited by law from keeping accounts for households and companies, i.e. to create deposit money in this way. Account-keeping, i.e. the issuance of money existing in digital form was taken over by commercial banks. Therefore, in most countries, commercial banks rather than the central bank became the main moneycreating institutions. Depending on how it is implemented, the introduction of CBDC can make the now state-owned central banks money-creating institutions once again, which may even herald a new chapter in the history of money. Although banknotes could in theory be exchanged for precious metals, and this liquidity risk meant higher implicit funding costs for the bank, in practice, redemption was suspended during mass redemption requests. 412 h ttps://www.resbank.co.za/AboutUs/History/Background/Pages/ OwnershipOfTheSouthAfricanBank.aspx 411

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9. The effect of digitalisation on the banking sector

9.3 Digitalisation and financial stability 9.3.1 General financial stability issues 9.3.1.1 Virtual currencies and the financial system

The spread of virtual currencies exerts several effects on the financial system, which may facilitate access to financial services and lead to a drop in transaction costs on the one hand, but may also entail considerable risks to financial stability on the other hand. All in all, the potential effects and contagion mechanisms with respect to financial stability depend on how widespread virtual currencies have become. The spread of virtual currencies is heavily influenced by the role and goals they have in the economy. In most cases, virtual currencies are present in the economy as a means for wealth accumulation (investment), they are used infrequently as a medium of exchange and never as units of account, although several large banks plan to conduct settlements and clearing among each other in virtual currencies in the near future. However, such projects assume closed systems, i.e. in contrast to virtual currencies such as bitcoin, not everyone could join. Due to their limited role and the resulting low penetration, virtual currencies do not currently pose a material risk to financial stability. However, their rapid spread requires close regulatory attention, since financial stability risks may arise over time as virtual currencies become more widespread. Below, the potential benefits of the spread of virtual currencies will be reviewed, then its risks to financial stability will be briefly presented. Benefits to the financial system

The spread of virtual currencies may help bolster the financial system through improving access to financial services.

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Banks in history: innovations and crises

It supports easier access to financial services especially in areas where traditional banking services have not been fully developed or where confidence in these has remained low. However, several emerging economies are characterised by widespread use of mobile phones, which may be a crucial field in the spread of virtual currencies, as it enables mobile phone transactions. Financial stability risks

Virtual currencies do not pose a financial stability risk yet, but a further increase in their market capitalisation may lead to a price bubble that could be risky. Virtual currencies are present in the economy mainly as investment instruments, therefore the financial stability risk is mostly posed by the emergence of a price bubble. A price bubble occurs when the price persistently and considerably exceeds the present value of monetary and other benefits provided by the given product. This means that the price bubble is a significantly positive mispricing, which may substantially distort production and consumption conditions as well as financial intermediation. Judging from, at present, short-term historical data, the price fluctuations of virtual currencies are much greater than with traditional currencies. The price fluctuations arise because on the demand side, technology and regulation considerably modify the expectations about virtual currencies and thereby, also the present value of the future returns on holding virtual currencies. Besides the volatile demand, supply is usually inflexible, which generates the large price fluctuations. According to December 2017 data, the combined market capitalisation of all virtual currencies is USD 634 billion (Chart 9-8),413 which does not pose a stability risk yet due to its size, not even if prices plummet, and the effects of a potential decrease in prices would only impact virtual 413

https://coinmarketcap.com/all/views/all/

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9. The effect of digitalisation on the banking sector

currency holders. Of course, there are cases when the drop-in prices may spill over to other economic agents, too (leveraged positions, debt financing). Chart 9-8: Comparison of market capitalisation of virtual currencies with that of other assets Derivatives 59.09%

0.56%

Gold: 0.52%

Stocks 4.95%

Virtual currencies 0.04%

M3: 6.13% Real estate 14.70%

Debt securities 14.57% Capitalisation

Virtual currencies Apple Inc.

USD bn

634

0.043%

807

0.055%

Fed balance sheet

4 500

0.305%

Banknotes

7 600

0.515%

Note: December 2017 data. The comparison is not comprehensive, it includes only the most important asset classes. Source: money.visualcapitalist.com

Currently, virtual currencies do not function as money in society. Nevertheless, if the widespread use of virtual currencies urged the traditional financial system to use them or they could become genuine competitors to traditional currencies upon becoming widespread, that would entail financial stability risks.

â&#x20AC;&#x201D; 721 â&#x20AC;&#x201D;

Banks in history: innovations and crises

If virtual currencies competed with traditional means of payment issued by banks, the banking system would be forced to compete, which could improve account-keeping services (e.g. increase the interest on demand deposits). This may undermine the banking system’s profitability and thus also its solvency. But banks may also issue their own virtual currencies to compete. If virtual currencies became widely used, and they crowded out bank money, that could entail a drop in the demand for bank money and bank loans. This could reduce the banking system’s balance sheet, which may decrease the profitability of the banking system ceteris paribus.414 Yet if banks’ liquid asset holdings do not change considerably, the contraction in the balance sheet total could improve liquidity. The manner in which economic actors acquire virtual currencies is important (mostly in countries not issuing hard currency, such as USD or EUR). If they do so on the foreign exchange market, then presumably they first convert the domestic currency into a hard currency, which is used to purchase the virtual currency. However, the hard currency purchase would probably occur through the banking system, which opens banks’ foreign currency position. This raises the issues of foreign currency liquidity, foreign currency funds and covering the foreign currency position. The widespread use of virtual currencies in the financial system entails enormous liquidity risks. If deposit-taking (money creation) and lending in virtual currencies became widespread, in the case of a bank run, central banks would be unable to provide liquidity as lenders of last resort to halt the process. This is because central banks cannot create virtual currencies (only a claim on them). If the deposits denominated in virtual currencies were withdrawn from banks in large numbers, the 414

lternatively, the banking system’s balance sheet may not shrink, and banks could A acquire foreign funds instead of domestic deposits (Chart 9-5). However, in this case profitability may decline anyway, due to rising funding costs.

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9. The effect of digitalisation on the banking sector

financial system could most likely be stabilised only by suspending the redemption of deposits and the devaluation of bank money based on virtual currencies (similar to banking systems based on precious metal coins). The evolution of virtual currencies needs to be monitored, and necessary steps may have to be taken in financial regulation. 9.3.1.2 CBDC and the financial system Financial stability

The introduction of CBDC may cause a substantial transformation in the structure and functioning of the financial system if the overwhelming majority of demand deposits are converted into CBDC. This also represents one of the greatest financial stability risks related to the introduction of CBDC, which is pointed out by Barrdear–Kumhof (2016) in their detailed study on the issue of CBDC. The large-scale transfer of households’ and companies’ bank deposits to central bank money would cause liquidity and solvency issues in the banking system. Granted, under certain conditions, central banks can prevent mass deposit withdrawals through, to use the example cited by Barrdear and Kumhof, quantitative limits on central bank money or subjecting the issuance to conditions. Quantitative limitations and interest rate conditions, coupled with high supply and demand conditions, means CBDC can only be held with less favourable interest rates than bank deposits. Such a framework may be adequate for preventing mass deposit withdrawals, but setting the quantitative limit appropriately is key. Another method for avoiding the risks related to mass deposit withdrawals may be for central banks to issue CBDC only against specific instruments (e.g. government securities). This would prevent the high demand for CBDC from reducing the assets side of the banking system in aggregate, since the volume of government securities on the market would decline instead. One extreme case of the introduction of CBDC is when the central bank introduces the currency available to households and companies in unlimited supply and under favourable conditions (interest, fees). — 723 —

Banks in history: innovations and crises

This may ultimately lead to a financial system where the central bank creates money, and lending banks can only lend out the existing savings (deposits). In the current financial system, banks create deposit money when lending. If, however, the CBDC was a more popular form of holding money than bank deposits, commercial banks would be unable to lend without acquiring funds in advance, provided that the central bank had no unlimited standing facility for them, since the deposits created by them would be at least partly converted into the digital currency. If the CBDC was highly popular, payment services would mostly be transferred to the central bank, which would mean huge revenue losses for the banking system. Payment services are currently among the highest-margin banking activities, at least in Hungary. In the first half of 2017, half of the net fee and commission income of the Hungarian credit institution sector came from net fee and commission income from payment services. The introduction of CBDC may be desirable even when taking into account financial stability risks. According to Barrdear and Kumhof, the positive effects include the potential drop in the number of ‘too big to fail’ banks, since the financial services provided by the central bank would be a genuine alternative to account-keeping by credit institutions. Furthermore, central banks could probably provide the infrastructure necessary for account-keeping and transfers to all households and companies at a lower price than today, potentially for free by making account-keeping a quasi-public good. Therefore, even the failure of a large bank would not necessarily disturb the payments system. One-tier or two-tier banking system

It is interesting to examine the question of whether a one-tier or a twotier banking system would emerge if CBDC became more popular for holding money than bank deposits. Taking into account the current results from international central banking research, the issue was

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9. The effect of digitalisation on the banking sector

recently analysed by Szabó and Horváth (2017), and their main findings are summarised here. In the extreme case of the CBDC’s introduction, the central bank creates money and commercial banks lend from existing savings. While the central bank enjoys a monopoly in money creation, commercial banks compete for savings and undertake lending risk. One-tier banking systems are usually associated with socialist countries and strong central planning. However, the definition of one-tier and two-tier banking systems is not uniform, there are at least five different versions (Table 9-3). It is interesting to see which category the CBDC scheme falls into based on the definitions presented. Table 9-3: Classification of the financial system with CBDC with respect to banking system tiers Definition of being one-tiered

Note

The central bank plays both the In the baseline CBDC system, the central bank does not central and commercial bank roles. grant loans to agents outside the banking system. There is a direct link between the The current system also includes a link between the central bank and households and central bank and households through cash. There is no companies. material difference between cash and deposit money. There are no actual market mecha- In the CBDC system, financial intermediation occurs on a market basis. nisms with respect to lending. According to a certain definition, banks are the money creators. Thus, if there is only one money-creating bank in the economy, the banking system is one-tiered.

From this point of view, the CBDC system can be regarded as one-tiered but the definition can be seen as arbitrary because in everyday life the term ‘bank’ also refers to the institutions intermediating savings and loans.

Households and firms have accounts From this point of view, the CBDC system can be regarat the central bank. ded as one-tiered, but lending still occurs at the second tier. Note: Blue denotes the definitions where the CBDC system would be two-tiered, brown denotes the definition where it is unclear, and red denotes the definition where it would be one-tiered. Source: Szabó–Horváth (2017).

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Banks in history: innovations and crises

If ‘tiers’ in the tiers of the banking system denote the various levels (central bank, commercial bank) where private (non-bank) players can form ties with the banking system, then the CBDC scheme is the same as the current one. In both cases, the central bank has a liability towards households and companies (in the form of cash and CBDC), while the banking system holds receivables and payables against households and companies. It must be noted that in the version where the CBDC is an attractive alternative to commercial bank money and there is an unlimited central bank standing facility (Case 2 in Box 9-2), the central bank may have greater influence over commercial bank lending than today. This can be interpreted as a shift towards the one-tier banking system.

9.3.2 Microprudential regulation and supervision

Despite the opportunities offered by technology, virtual currencies cannot be regarded as official means of payment, since pursuant to current laws, they do not meet the requirements of money, money substitutes, electronic money or cash substitute payment instruments. They do not meet the requirements in the prevailing laws partly because virtual currencies are generated using an IT solution, therefore they appear only electronically rather than in physical form. Issuance is not performed by countries’ central banks, and the issuance of various virtual currencies is not related to specific institutions, as the community of users created by the issuance cannot be regarded as an institution. However, in view of rapid developments in IT in recent years, virtual currencies may become official means of payment in the future. However, this requires further technological solutions to ensure the long-term sustainability of the system’s safe operation. It needs to be borne in mind that as computational capacity steadily increases, the currently accepted cryptographic solutions, providing the basis for the system’s safe functioning, may become easy to hack in the future. In addition to addressing technological risks, an internationally accepted — 726 —

9. The effect of digitalisation on the banking sector

regulated framework needs to be established, and the shortcomings related to the functions of money (mainly price fluctuations arising from inflexible supply) must be tackled for the system to become truly accepted. The current situation is exacerbated by the fact that the term ‘cryptocurrency’415 is very popular now, therefore the investment risks related to fraud and customer grievances are high. The OneCoin initiative disguised as a cryptocurrency may be mentioned as an example. This solution fails to provide the open-source functioning of virtual currencies, as accurate, community-based blockchain operation is not ensured. In order to avoid the risks related to virtual currencies, i.e. the potential losses suffered by customers, the authorities supervising financial institutions regularly warn the public about the risks of these solutions.416

9.4 Main conclusions This chapter gave an overview about the relationship between digitalisation and the monetary system. Two special types of money were examined, virtual currencies similar to bitcoin and the central bank digital currency. It was concluded that in their current form, virtual currencies do not pose a major challenge to most central banks. Using the distributed ledger technology usually characteristic of virtual currencies is possible in many areas of the banking system. Another advantage may be that they can encourage central banks that are not credible enough to achieve

ryptocurrency is an alternative term for virtual currency that comes from using C cryptography. 416 For example, the European Banking Authority issued a warning on this topic in 2013. https://www.eba.europa.eu/documents/10180/598344/EBA+Warning+ on+Virtual+Currencies.pdf 415

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Banks in history: innovations and crises

price stability. However, they pose a threat to financial stability through potential price bubbles and cyberattacks. The CBDC can be realised in various schemes, which have different effects on the economy. The main question is whether CBDC would rather replace cash or commercial bank money. Four implementation methods in total were highlighted in Box 9-2. The main advantages and risks of the cases are summarised in Table 9-4. Table 9-4: Advantages and risks of the CBDC system according to different central bank points of view and realisation methods

Type

Advantage Payments Risk Advantage Monetary policy Risk

Advantage

1 Substitutes cash

4 Conversion between commercial bank money and CBDC is prohibited (Barrdear– Kumhof)

Social costs can be reduced

Alternative in case of negative shocks to commercial banks

Financial exclusion

Less innovation

More effective unconventional instruments

Better monetary transmission

Unconventional tools are questionable

Tighter monetary conditions

May reduce economic growth

Higher interdependence of monetary and fiscal policies

‘Too big to fail’ problem can be reduced

Commercial Commercial banks’ banks’ liquidity profitability can can deteriorate deteriorate

Financial stability Risk

2 Substitutes commercial bank money + there is standing facility

3 Substitutes commercial bank money + no standing facility (sovereign money system)

Source: Authors’ own compilation.

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Smaller cyclical Higher real GDP fluctuations in the long run

9. The effect of digitalisation on the banking sector

Whichever case is considered, besides the above, the risk of transition from the old system to the new also arises. Therefore, if overall, in the long run the CBDC system seems to be more favourable than the current system, it must be assessed whether this benefit exceeds the costs and risks of the transition. If the answer is yes, then, at least in the cases where CBDC replaces commercial bank money, the introduction of CBDC may open a new chapter in the history of money.

Key terms Bitcoin central bank digital currency (CBDC) Chicago Plan cryptocurrency distributed ledger technology electronic payment methods

financial system full-reserve banking narrow banking seigniorage sovereign money system virtual currency

References Ábel, I. – Lehmann, K. – Tapaszti, A. (2016): A pénz és a bankok ellentmondásos kezelése a makroökonómiában (The controversial treatment of money and banks in macroeconomics). Financial and Economic Review, Vol. 15 (2), June 2016, pp. 33–58. Balogh, A. – Horváth, Zs. – Kollarik, A. (2017): A hagyományos monetáris politikai transzmisszió (Traditional monetary policy transmission). MNB Handbooks, No. 17, September 2017. Banco Central do Brazil (BCB) (2017): Distributed ledger technical research in Central Bank of Brazil. Barrdear, J. – Kumhof, M. (2016): The macroeconomics of central bank issued digital currencies. Bank of England, Staff Working Paper No. 605. Baumol, W. J. (1952): The Transactions Demand for Cash: An Inventory Theoretic Approach. Quarterly Journal of Economics. 66 (4): 545–556. Bech, M. – Garratt, R. (2017): Central bank cryptocurrencies. BIS Quarterly Review, September 2017. Benes, J. – Kumhof, M. (2012): The Chicago Plan Revisited. IMF Working Paper 12/202. Bank of Finland (2017): Monopoly without a monopolist: An economic analysis of the bitcoin payment system.

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Banks in history: innovations and crises Buiter, W. H. (2005): Overcoming the Zero Bound: Gesell vs. Eisler. In: International Economics and Economic Policy, Vol. 2, No. 2–3, pp. 189–200. Springer-Verlag GmbH. Buiter, W. H. (2009): Negative Nominal Interest Rates: Three Ways to Overcome the Zero Lower Bound. NBER Working Paper No. 15118. Camera, G. (2017): A perspective on electronic alternatives to traditional currencies. Sveriges Riksbank Economic Review 2017:1, pp. 126–148. Chapman, J. – Garratt, R. – Hendry, S. – McCormack, A. – McMahon, W. (2017): Project Jasper: Are Distributed Wholesale Payment Systems Feasible Yet? Bank of Canada, Financial System Review, June 2017. Deloitte – Monetary Authority of Singapore (MAS) (2017): The future is here. Project Ubin: SGD on Distributed Ledger. Deutsche Bundesbank (Bundesbank) (2017): The role of banks, non-banks and the central bank in the money creation process. Deutsche Bundesbank Monthly Report, April 2017, pp. 13–33. Dr. Turján, A. – Divéki, É. – Keszy-Harmath, Z. – Kóczán, G. – Takács, K. (2011): Semmi sincs ingyen: A főbb magyar fizetési módok társadalmi költségének felmérése (Nothing is free: A survey of the social cost of the main payment instruments in Hungary). MNB Occasional Papers, No. 93. Dyson, B. – Hodgson, G. (2016): Digital cash: why central banks should start issuing electronic money, Positive Money. European Central Bank (ECB) (2012): Virtual currency schemes. European Central Bank (ECB) (2015): Virtual currency schemes – a further analysis. European Central Bank (ECB) (2017a): Impact of digital innovation on the processing of electronic payments and contracting: an overview of legal risks. Legal Working Paper Series, No 16 / October 2017. European Central Bank (ECB) (2017b): Payment systems: liquidity saving mechanisms in a distributed ledger environment. STELLA - a joint research project of the European Central Bank and the Bank of Japan. European Central Bank (ECB) (2017c): The potential impact of DLTs on securities post-trading harmonisation and on the wider EU financial market integration. Advisory Group on Market Infrastructures for Securities and Collateral. Federal Accounting Standards Advisory Board (FASAB) (2012): Federal Accounting Standards Advisory Board Handbook, Statements of Federal Financial Accounting Standards 7, pp. 106–107. Fernández-Villaverde, J. (2017): On the economics of currency competition. VOX, 3 August 2017. http://voxeu.org/article/competition-between-government-money-and-cryptocurrencies Accessed: 14/12/2017. Financial Stability Board (FSB) (2017): Financial Stability Implications from FinTech. FSB, June 2017.

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9. The effect of digitalisation on the banking sector Friedman, M. (1969): The Optimum Quantity of Money. In: Milton Friedman: The Optimum Quantity of Money and Other Essays. Transaction Publishers, New Brunswick, New Jersey, 2007, pp. 1–50. Gesell, S. (1916): A természetes gazdasági rend szabadföld és szabadpénz révén. (Die natürliche Wirtschaftsordnung durch Freiland und Freigeld.) Transl. by István Síklaky. Kétezeregy Kiadó, Piliscsaba, 2004. Goodfriend, M. (2016): The case for unencumbering interest rate policy at the zero bound. Paper presented at the Economic Policy Symposium at Jackson Hole. Graeber, D. (2011): Debt: The First 5,000 Years. Melville House. Hampl, M. (2017): Central banks, digital currencies and monetary policy in times of elastic money. Speech, https://www.bis.org/review/r170720b.htm Accessed: 13/11/2017. Hileman, G. – Rauchs, M. (2017): Global cryptocurrency benchmarking study. Cambridge Centre for Alternative Finance. Hong Kong Monetary Authority (HKMA) (2017): Whitepaper 2.0 on Distributed Ledger Technology. Huber, J. – Robertson, J. (2000): Creating New Money: A Monetary Reform for the Information Age. New Economics Foundation. Ilyés, T. – Varga, L. (2015): Mutasd, mivel fizetsz, megmondom, ki vagy – A pénzforgalmi szokásokat befolyásoló szociodemográfiai tényezők (Show me how you pay, and I will tell you who you are – Sociodemographic determinants of payment habits). Financial and Economic Review, Vol. 14 (2), June 2015, pp. 26–61. International Monetary Fund (IMF) (2017): Fintech and Financial Services: Initial Considerations. IMF Staff Discussion Note 17/05. Jackson, A. – Dyson, B. (2012): Modernising money: why our monetary system is broken and how it can be fixed. Positive Money. Jakab, Z. – Kumhof, M. (2015): Banks are not intermediaries of loanable funds – and why this matters. Bank of England Working Paper No. 529. Kay, J. (2009): Narrow Banking. The Reform of Banking Regulation. http://s297553056. websitehome.co.uk/wp-content/uploads/2009/09/JK-Narrow-Banking.pdf Accessed: 14/12/2017. Keynes, J. M. (1936): A foglalkoztatás, a kamat és a pénz általános elmélete. (The General Theory of Employment, Interest and Money.) Transl. by Péter Erdős. Közgazdasági és Jogi Könyvkiadó, Budapest, 1965. Knapp, G. F. (1905 [1905]): The State Theory of Money. Macmillan, London, 1924 a translation of the 4th German edn., 1923; 1st German edn. Knight, W. (2017): China’s Central Bank Has Begun Cautiously Testing a Digital Currency. MIT Technology Review.

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Banks in history: innovations and crises Kregel, J. (1998): The past and future of banks. Bancaria Editrice. Kumhof, M. – Jakab, Z. (2016): The Truth about Banks. Finance & Development. IMF. Kun, J. (2010): Seigniorage saját pénz nélkül (Seigniorage without own money). PhD thesis. Laina, P. (2015): Proposals for Full-Reserve Banking: A Historical Survey from David Ricardo to Martin Wolf. Economic Thought. Lerven, F. v. – Hodgson, G. – Dyson, B. (2015): Would there be enough credit in a sovereign money system? Positive Money report. McLeay, M. – Radia, A. – Thomas, R. (2014): Money Creation in the Modern Economy. Quarterly Bulletin. Bank of England. Meaning, J. – Barker, J. – Clayton, E. – Dyson, B. (2017): Broadening narrow money: monetary policy with a central bank digital currency. Manuscript. Mersch, Y. (2017): Digital Base Money: an assessment from the ECB’s perspective. Speech at the Farewell ceremony for Pentti Hakkarainen, Deputy Governor of Suomen Pankki – Finlands Bank, Helsinki, 16 January 2017. https://www.ecb.europa.eu/press/key/date/2017/html/sp170116. en.html Accessed: 14/12/2017. Mills, D. – Wang, K. – Malone, B. – Ravi, A. – Marquardt, J. – Clinton – Badev, A. – Brezinski, T. –Fahy, L. – Liao, K. – Kargenian, V. – Ellithorpe, M. – Ng, W. – Baird, M. (2016): Distributed ledger technology in payments, clearing, and settlement. Finance and Economics Discussion Series 2016-095. Washington: Board of Governors of the Federal Reserve System. Raskin, M. – Yermack, D. (2016): Digital currencies, decentralized ledgers, and the future of central banking. NBER Working paper No. 22238. Riesz, M. (1980): Pénzforgalom és hitel (Payments and credit) (Fourth edition). Tankönyvkiadó. Riksbank (2017): The Riksbank’s e-krona project. Report 1. Sveriges Riksbank. Skingsley, C. (2016): Should the Riksbank issue e-krona? Speech. FinTech Stockholm 2016, Berns. 16 November 2016, (Revised 30 November 2016). http://www.riksbank.se/Documents/Tal/ Skingsley/2016/tal_skingsley_161116_eng.pdf Accessed: 14/12/2017. Szabo, N. (1996): Smart Contracts: Building Blocks for Digital Markets. http://www.fon.hum.uva. nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best. vwh.net/smart_contracts_2.html Accessed: 13/11/2017. Szabó, G. – Horváth, G. (2017): Pénzteremtés és eladósodás szétválasztásának lehetőségei – a digitális jegybankpénz javaslat egy lehetséges értelmezése (The options for decoupling money creation from indebtedness – one possible interpretation of the central bank digital currency proposal). Manuscript. Szalai, Z. (1994): A fejlett országok pénzintézeti rendszereinek fejlődési irányzatai I-II. rész (The development paths of financial institution systems in developed countries, Part I–II). Bankszemle, Issue 1994/7-8, pp. 14–33., 10–32.

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9. The effect of digitalisation on the banking sector Thiele, C-L. (2017): From Bitcoin to digital central bank money – still a long way to go. Keynote at the OMFIF roundtable discussion. London, 20. 09. 2017. https://www.bundesbank.de/Redaktion/ EN/Reden/2017/2017_09_20_thiele.html Accessed: 14/12/2017. Tobin, J. (1956): The Interest Elasticity of the Transactions Demand for Cash. Review of Economics and Statistics. 38 (3): pp. 241–247. Tobin, J. (1987): The Case for Preserving Regulatory Distinctions. In: Restructuring the Financial System, Federal Reserve Bank of Kansas City, pp. 167–183. Vickers, J. (2011): Independent Commission on Banking Final Report Recommendations. Domarn Group, London. Werner, A. R. (2014a): Can banks individually create money out of nothing. The theories and the empirical evidence. International Review of Financial Analysis, 36, pp. 1–19. Werner, A. R. (2014b): How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking. International Review of Financial Analysis 36, pp. 71–77. Yermack, D. (2013): Is Bitcoin a real currency? An economic appraisal. NBER Working Paper Series No. 19747.

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10.

Banking regulation and supervision Dr Csaba Kandrács–Réka Fenyvesi–László Seregdi–Bence Varga– László Péter Szegfű

The emergence of banking supervision is principally due to the fact that banks are special players in the economy, and their operation can exert a substantial impact, either positive or negative, over financial stability. Banking supervision started developing in the 19th century, but it lacked a full-fledged institutional system and instruments for a long time, therefore it was unable to effectively prevent banking crises. The 1929–1933 Great Depression represented a milestone in the evolution of banking supervision, as before that the supervisory body had not normally been clearly stipulated in law, and supervision followed informal rules. However, the crisis highlighted the weaknesses of the supervisory system, and as a result the supervision of the financial sector was put on new footing in several advanced countries. This included the sound legal specification of supervisory processes and the role of the supervisory authority. Nevertheless, banking supervision failed to reach international dimensions up until the 1970s. The Basel Committee on Banking Supervision emerged as the forum that, thanks to its reputation in professional circles, was able to coordinate the development of banking regulation and banking supervision methods globally. Internationally accepted rules and practices that are applied uniformly by developed countries are important not only because they lay down the minimum requirements of safe banking operation, but also because this also creates a level playing field for the activities of the banking groups registered in different countries. The harmonised development of regulatory and supervisory methodology is especially important in the European Union where the single internal market

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and the freedom to provide financial services make the level playing field even more vital. The European Union not only adopts the Basel Committee’s standards and guidelines, but also incorporates them into its directives and regulations in a much more detailed form, applicable to all credit institutions and investment firms. To achieve the highest possible level of convergence in regulation and supervision in the European Union, a dedicated institutional system has been set up, including the European Banking Authority that contributes to harmonisation by preparing draft implementing standards related to banking regulation and supervisory methodology documents, as well as the European Central Bank that is responsible for operating the Single Supervisory Mechanism within the banking union, which affects not only the members of the banking union but also the EU as a whole. The legal framework of the European Union also allows for the conditions of banking operation to be regulated uniformly and in directly applicable regulations, and the tasks and responsibilities of home417 and host418 supervisory authorities to be determined in a much more detailed fashion than at the global level. Banking supervision always focuses on the risks taken by banks and the banking system as a whole. Accordingly, banking supervisors need to assess not only the risks posed by a bank or banking group at a specific point in time, but also the potential issues the bank’s business model, strategy, internal procedures, and risk management techniques may predict for the institution and for the financial system as a whole. The introduction of Basel II increased banks’ freedom in choosing the methods for calculating their capital requirement with respect to the risk types419 characteristic of their activities, however, this he home supervisor is the competent supervisory authority where the foreign T institution establishing a branch, or the parent institution of a subsidiary is registered, and in the case of cross-border services, the competent supervisory authority where the institution providing the services is registered. 418 The host supervisor is the competent supervisory authority supervising the subsidiary or branch in an international financial group where the subsidiary is registered, and in the case of cross-border services, the competent supervisory authority where the services are rendered. 419 The main risk types include credit, market and operational risk, although banks’ operation may be affected by several other risk types (e.g. concentration, legal or reputational risks), depending on their activities. 417

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freedom was complemented by a much more direct, flexible banking supervision procedure based on the given bank’s unique risks and features. Therefore, in the supervisory review process, the banking supervisor must take into account the given bank’s risks when determining the additional capital, liquidity and other requirements that the bank must meet besides the minimum requirements stipulated in the regulation. The 2008 global financial crisis accelerated the evolution of banking regulation and supervision, however, the details of the responses given to the crisis have not yet been finalised. Banking supervision continuously develops by keeping up with changes in the financial sector, and financial crises provide a huge boost in this respect. From the perspective of the future banking system, it will be crucial whether regulation and supervision can appropriately respond to current major developments (IT, cryptocurrencies, FinTech). The latest global financial crisis not only fostered the development of banking regulation and tailored banking supervision, but also played an important part in highlighting macroprudential supervision and resolution. While the former mainly concentrates on assessing and addressing systemic risks, the latter focuses on the rapid and efficient preparation of authorities’ decisions, and, if resolution is used, on managing losses without involving taxpayers’ money. Both areas are special, since banking supervision can be divided into many pivotal elements, and distinct fields have developed within it (microprudential, macroprudential, consumer protection, market surveillance and resolution), and no efficient banking supervision can be implemented without appropriate coordination between these fields. Overall, the historical analysis of banking supervision’s evolution shows that until now, developments were basically determined by new, marked risk factors or the banking crises themselves. Regulation and supervision should not lag behind market developments but be able to intervene in a manner that prevents problems. The institutional system for this has been set up at the global, EU and Hungarian levels, which is definitely promising for the future.

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10. Banking regulation and supervision

10.1 Features of banks’ operation and supervision today, from a European Union perspective Currently, the regulation and supervision of commercial banks is based on a set of highly complex and detailed legal provisions and methodological procedures. It is implemented in the form of requirements aimed at the prudent functioning of individual banks and the banking system as a whole, and it continues to develop in parallel with the changes of the financial world. As a result of the rise of globalisation and the ensuing regulatory and supervisory convergence, the banking regulation and supervision systems of countries with a mature financial system are based on a similar or sometimes even completely identical footing. The current rules, supervisory structures and methods are the result of a long development process whose milestones were always represented by the severe crises of individual banks or the whole banking system. The regulatory and supervisory responses to these crises gave rise to today’s system of banking supervision, and this process is presented below. First, in order to understand the basics of banking supervision, the reason why banks need to be regulated at all must be clarified. With respect to other actors in the economy (e.g. industrial or agricultural companies, service providers), the regulation of prudent operation is clearly much less crucial. However, with banks, regulation is mainly necessitated by the special nature of their operation, namely that their share of borrowed funds is much higher than in the case of other market participants. In other words, they finance only a small portion of their activities from their own funds. Consequently, their leverage is much higher than in case of other actors, and if a bank suffers a major loss, it is uncertain whether its own funds can cover it.

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Another special feature of banks’ operation is that due to long-term lending, banks may be prone to excessive risk-taking, because in that way they can record high profits in the short run, while losses on account of excessive risk-taking only emerge in the long run. In the case of banks, the high share of borrowed funds leads to a greater risk of internal fraud and abuses. Experience shows that with banks, the market’s self-regulation is inefficient due to the yields that can be achieved; therefore the state has to lay down the minimum requirements of operation and check whether they are adhered to. The state must also regulate and supervise banks as, due to the spillover effects of banking operation, the failure of even a small or medium-sized bank may threaten the stability of the financial system and the economy. And due to globalisation, some banks have grown to a size that their balance sheet total may be multiple times larger than the GDP of the country where they are registered, thus the state has insufficient funds to manage the crisis of such bloated banks. While banks have very detailed information about their customers, customers’ information about the bank are incomplete, and they do not even have the means to assess the risks of a bank’s operation. On account of this information asymmetry, the state has to create a supervisory body that can assess, in lieu of customers, how safe are the deposits placed in a bank. Supervisors principally control this through banks’ legal compliance, however, they also have to assess the current and expected risks surrounding banks’ activities and financial position. Banks are extremely complex institutions, therefore understanding their financial position and the establishment of the necessary measures requires special expertise and methodologies that can be provided only by an organisation that has the necessary powers (licensing, access to information, measures) and expertise. In the early days of banking supervision, virtually the only major goal was to keep bank deposits safe and maintain confidence in the banking

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10. Banking regulation and supervision

system. Accordingly, banking regulation primarily sought to limit the risks that may be assumed by banks and enforce prudent operation. Thus, the supervision of individual banks and banking groups fell within the purview of microprudential supervisory authorities, and for a long time this was the sole focus of supervisory activities. As banking products became increasingly complex in the 2000s, consumer protection and market surveillance duties moved to the forefront, which emerged for the protection of not only depositors but all bank customers, i.e. also debtors. Consumer protection focuses not on the prudent operation of banks, but on preventing banks from abusing the advantage, vis-à-vis customers, that they have thanks to funds, expertise, market share and legal competence. Macroprudential supervision and resolution received more attention in the wake of the 2008 global financial crisis. In essence, macroprudential supervision does not examine banks’ individual risks, but the potential systemic risks that may undermine financial stability. It is not always easy to decide whether a risk should be handled by macroprudential or microprudential supervision, therefore these supervisory bodies need to work in close cooperation. The most important instruments in macroprudential supervision are capital buffer requirements, but the macroprudential supervisors may also enact other laws or initiate amendments (e.g. examples in Hungary include debt brake rules or special minimum liquidity and funding requirements). Another lesson learnt from the latest financial crisis was that certain banks and banking groups have grown so large that bailing them out in a potential crisis may place a disproportionate burden on the countries where they are registered, what is more, this could only be financed using primarily taxpayers’ money. On the initiative of the Financial Stability Board (FSB), the European Union specified the responsibilities, tasks and instruments of the resolution authority in a separate directive

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(BRRD420). The main aim was to enable supervisors to decide quickly about a bank’s liquidation or resolution in a banking crisis, and not to rely solely on taxpayers’ money when absorbing the losses in a potential resolution. To this end, the resolution authority prepares a resolution plan for all major banks and determines a minimum requirement for own funds and eligible liabilities (MREL), which specifies the additional assets besides own funds that are eligible for absorbing losses. There are differences in the financial supervisory structure of EU Member States, predominantly due to the historical traditions of the countries. The key differences pertain to whether banking supervision was established within the central bank of the given country or independent from it, and whether the same body supervises banks and insurers, investment firms and pension funds. If the same organisation supervises all sectors, it is called integrated, i.e. uniform, supervision, which may be implemented within or outside the central bank. In Hungary, all four supervisory responsibilities (microprudential [Table 10-1], macroprudential, consumer protection, resolution) fall to, and all sectors are supervised by the MNB.

420

irective 2014/59/EU of the European Parliament and of the Council of 15 May D 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms, which was implemented in Hungary pursuant to Act XXXVII of 2014 on the Further Development of the System of Institutions Strengthening the Security of the Individual Players of the Financial Intermediary System.

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10. Banking regulation and supervision

Table 10-1: The main activities of microprudential supervision Consumer protection and market surveillance

Supervision

Licensing and enforcement

Supervision: — on-site (comprehensive, thematic and targeted) examinations — off-site examinations (regular and extraordinary reporting) — rating, assessment — SREP procedure

Licensing: establishment, activities, senior executives, acquisition, merger, division, the use of internal models for calculating the capital requirement

Consumer protection: examinations, information provision, advice, recommendations, consumer protection penalty

Enforcement: discretionary measures, obligatory measures, exceptional measures, penalties, appointment of a supervisory commissioner

Market surveillance procedures: identification of unlicensed activities, insider trading, market manipulation analysis and related measures

Regulation: cooperation in legislation, MNB decrees, other regulatory tools Source: MNB.

Currently in the European Union, and thus, also in Hungary, the prudential rules on credit institutions are stipulated in Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms (CRR), Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (CRD IV) and EU Commission regulations specifying further detailed rules. The CRD IV was implemented in Hungary principally through the Credit Institutions Act and the MNB Act, and it contains provisions on the establishment of credit institutions, their cross-border activities, supervision, corporate governance and the applicable capital

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buffers. The CRR mainly contains the rules on capital adequacy, large exposures, liquidity, disclosure and leverage.421 According to the definition of capital requirements, the overwhelming majority of banks’ activities are dominated by credit risks, which are followed by operational and market risks (Chart 10-1). The significance of the other risk types depends heavily on the individual features of banks’ operation. Chart 10-1: The main risks and regulatory areas of banking operation Risks subject to detailed regulation Pillar I risks — Credit risk and partner risk (including dilution risk and residual risk) — Market risk (foreign exchange, interest rate, exchange rate and commodities) — Operational risk (human resources, failure, IT, fraud, robbery) Risks regulated by legislative tools — Liquidity risk — Excessive leverage — Securitisation risk — Large exposures — Interest rate risk in the banking book Macroprudential risks — Systemic importance — Systemic risks — Excessive credit growth — Business cycles — Capital conservation Corporate governance risks — Transparent ownership structure (establishment, acquisition) — Prudent operation of management bodies — Risk management, internal controls, compliance 421

he EU Commission published its proposal amending the CRD and the CRR T on 23 November 2016. The main points included the finalisation of the rules on leverage and the NSFR, review of the risk weighting of market risk, counterparty risk and central counterparty (CCP) exposures, as well as the establishment of simpler rules for smaller institutions based on the principle of proportionality.

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10. Banking regulation and supervision — Internal and connected loans, connected clients — Remuneration incentives, appropriate banking employees — Crisis management, resolution Consumer protection Risks not subject to detailed regulation — Other concentrations (country, transfer, geographical, sectoral, deposit) — Indirect foreign exchange risk — Outsourcing — Accounting, supervisory reports, disclosure — Business continuity — Legal and regulatory risks — Risk of the appropriateness of the models used for capital requirements calculation — Step-in risk — Reputational risk — Shadow banks — Separation of banking and investment services — Business model, strategic risk — FinTech risks — Profitability — Market environment — Loss of market share — Conduct risk Source: MNB.

Box 10-1 Banking operational risks

The Barings Bank was established in 1762, and with the exception of its crisis at the end of the 1800s due to its Argentinian exposures, it functioned for 200 years without any major financial difficulties. Until the late 1980s, Barings was principally engaged in traditional banking activities, however, management decided to make a strategic shift and turn towards new, more modern business activities (RBAB, 1995). One of these new areas was securities trading, which was conducted through subsidiaries created specifically for this purpose. According to financial statements, the best results were recorded by the Singaporean securities trading subsidiary (Barings Futures Singapore, BFS), reported at GBP 102 million. However, in reality, there were no profits, and losses amounted to GBP 200 million

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in December 1994. Further examinations by the Bank of England revealed losses of GBP 927 million in total. The huge losses were caused by a single person, Nick Leeson, a trader at the Singaporean subsidiary originally authorised only to conduct arbitrage transactions. The bank assessed this activity as mostly low-risk, therefore it was not controlled very tightly. However, Nick Leeson overstepped his initial powers and opened positions in various stock market indices that led to massive losses due to the unfavourable turn of the market. The situation could arise because management, risk management, and both internal and external controls in the banking group were utterly weak. The greatest problem was that Nick Leeson controlled both the front office and back offices areas, so he was able to conceal the positions he had opened from the bank’s management and the oversight areas by using secret accounts. In practice, no one controlled Nick Leeson’s activities, and the bank’s management was also interested in giving him free rein, because the overwhelming majority of the profit of the whole group was generated by the Singaporean subsidiary. Nick Leeson started manipulating the books in January 1992, and his actions remained concealed until early 1995. Even when risk management shortcomings were pointed out by internal examinations, management dragged their feet when responding. The most important lesson from the case for banks and supervisors was that banks’ management and risk management must be able to understand and comprehend all the bank’s activities, and that banking processes need to include control points that can prevent a similar fraud. The Barings case was one of the reasons why regulators paid more attention to banks’ corporate governance processes and operational risks. Barings Bank was later acquired for one pound by ING, which sold some of its business units and merged the rest into the ING Group.

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10. Banking regulation and supervision

In the European Union, the single internal market necessitates collaboration between Member Statesâ&#x20AC;&#x2122; financial supervisors even more, and a common set of rules enables much deeper and more detailed cooperation than between two completely independent countries. Accordingly, today in the European Union banking groups are supervised by the home supervisory authority, which uses a joint decision-making process with the host supervisors to decide on the material questions concerning the group, such as the internal models applicable by the group members or the capital add-on imposed on the whole group or individual members (Table 10-2). In the case of the biggest banks in the euro area, the European Central Bank acts as the home supervisor. Table 10-2: The distribution of home and host supervisory roles in the EU Form of activities

Home supervisor

Host supervisor

Consolidated prudential supervision, covering activities in other countries

No direct influence, but may gain information about the overall performance of the group through supervisory colleges

Decision making as consolidating supervisor (use of internal models, supervisory capital addon and liquidity requirements)

Authorises the foundation of subsidiaries, but has only a limited supervisory function; member of the supervisory college

As a consolidating supervisor, responsible for the supervision of the branch

Main responsibility is consumer protection, it may take prudential measures only in exceptional cases; member of supervisory college only if the branch is significant

As a consolidating supervisor, Cross border responsible for the supervision of activity in another the direct provision of services EU Member State

Main responsibility is consumer protection, it may take prudential measures only in exceptional cases

Parent company

Subsidiary in another EU Member State

Branch in another EU Member State

Source: MNB.

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10.2 The evolution of banking regulation and supervision The development of banking regulation and supervision can be divided into two main phases. The first period lasted until the 1970s, and this was when regulation and supervision emerged in different countries more or less independent from each other, under national direction. It can best be illustrated by national examples in that the main drivers behind the rise of banking regulation and supervision in various countries in the early years, i.e. in the second half of the 19th century, were historical and market features. In the second half of the 20th century, the milestones of regulation and supervision were determined by economic and financial crises and the corresponding responses, then the Second World War was followed by centralisation and nationalisation in many countries, and thus also a change in supervisory duties. Although there was some cooperation among banking supervision bodies before the 1970s, it was fairly loose and ad hoc. In the second period, from the 1970s, national banking crises had increasingly profound international consequences due to the rise in globalisation, which forced national supervisory authorities to cooperate more closely and establish a jointly accepted set of minimum requirements. The Basel Committee on Banking Supervision, which used the agreements jointly adopted by the banking supervision bodies from the most advanced countries to publish standards and guidelines on regulation and supervision, became the primary global standard setter for the prudential regulation of banks. From then on, the development of banking supervision was increasingly dominated by international considerations, while the development of national authorities exhibited fewer and fewer national characteristics. This is particularly true in the European Union, where most of the prudential requirements are not within the national scope of competence, as the requirements are determined by regulations directly applicable in the Member States.

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10. Banking regulation and supervision

10.2.1 The early steps leading to the emergence of banking regulation and supervision in the second half of the 19th century

Banking supervision was unregulated for a long time. There are countless examples in the second half of the 19th century for the lack of designation in law of the body in charge of supervisory activities. Supervision rested on informal rules and agreements, and central banking and supervisory functions were concentrated within the same institution. The main drivers behind the rise of banking regulation and supervision in various countries were historical and market features, determining when and what steps were taken in the development of regulation and supervision. As a result of the special form of government in the United States, the supervisory tasks related to banks’422 operation moved to the forefront quite early on (Jakabb et al., 1941). The history of institutionalised banking supervision goes back over 150 years. The National Currency Act of 1863 established the Office of the Comptroller of the Currency (OCC) that performed both central banking and supervisory tasks, and one of its main aims was to create some kind of consistency with respect to the licensing of banks, since until then different rules applied to the establishment of banks in the different states. Besides the OCC, certain states also boasted so-called banking departments, which also performed supervisory duties, while elsewhere there were state auditors or secretaries. Regulations on banks’ operation also varied, for example some states required banks’ shareholders and executives to pay twice the face value of the shares owned by them in the case of insolvency, while other states did not stipulate this. Banking regulation was closely linked to the financing of the Civil War, as pursuant to the National Currency Act, banks not only had to comply with minimum capital requirements but also purchase government bonds and deposit them 422

I n the early 1860s, the United States was dominated by ‘state banks’, which temporarily lost their dominance (in 1860 there were 1,600 state banks, while in 1866 only 300 remained), and, in line with the consolidation efforts, ‘national banks’ were established.

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with the OCC, which could even conduct a supervisory examination at the banks. The latter was a major achievement, since formerly, Congress could only request the financial statements, it had no right to verify the accuracy of their content (Mitchener–Jaremski, 2012). However, the National Currency Act was highly imperfect and rudimentary, therefore it came into effect again in 1864 in an extended form, under the name of National Banking Act. This stipulated activities that banks could not engage in or only with restrictions, such as real estate leasing. Without prejudice to the independence of the OCC, the Act stated that the Comptroller was to report directly to Congress, and the options for removing the Comptroller from office were also constrained. The first Comptroller of the Currency, Hugh McCulloch, laid down a principle of prudent operation in a ‘circular’ addressed to the banks: ‘Never be tempted by the prospect of large returns to do anything but what may be properly done’ (OCC, 2011a:6). The examiners423 carrying out the on-site examinations were independent counterparties who were paid by the bank under review for the examination, therefore their independence and the effectiveness of the examinations were not ensured. Examiners were interested in conducting examinations at as many banks as possible, for example, in 1887 an examiner was responsible for examining 90 banks in seven states. Taking into account how the railway operated at that time, the possibility of conducting such a high number of examinations was very low, therefore examiners had to fast-track the examinations to avoid waiting for several days. There were many initiatives to overhaul the performance- and fee-based system, but the change only came in the 1910s when examiners started receiving a set fee.424

ank clerks, tellers, lawyers and others could all be examiners. O. Henry (William B Sydney Porter), the excellent American author known for his stories with a surprise ending, worked as a bank clerk and as an examiner at the OCC before his writing career. 424 The professional requirements for those working in the examination field (e.g. university education) were prescribed in the 1960s. 423

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The next milestone in the history of supervision was 1913, when the Federal Reserve System (Fed) was established with the Federal Reserve Act, separating the central banking and supervisory functions. From then on, the primary task of the OCC was to ensure banks’ safe and prudent operation. The De Nederlandsche Bank (DNB) in the Netherlands was established in 1814 to jumpstart the economy. Initially, it was not responsible for monetary and financial stability at all; it functioned as a commercial bank that was allowed to issue banknotes. However, economic actors did not really have confidence in these banknotes, and credit demand was also quite low. As the Dutch banking sector matured, the provision of banking services was gradually taken over by market participants, and the DNB’s supervisory role emerged in parallel with this. As the DNB preserved its ties to credit institutions, it had detailed information on their operation.425 Nevertheless, not even the Bank Act adopted in 1903 stipulated clearly that the DNB was responsible for banking supervision, even though informally it held that function. The supervisory task was derived from the ‘bank of banks’ role, and the DNB was responsible for it as the lender of the banks it financed. In mid-19th-century Belgium, addressing the structural weaknesses of the banking system was increasingly pressing, therefore the finance minister (Walthère Frère-Orban) decided to introduce several largescale reforms. Between 1850 and 1865, certain activities performed by universal banks were delegated to independent, special financial institutions, and in 1850 the National Bank of Belgium (NBB) was established (Erik–Ivo, 2008). 425

At the end of the 1880s, the DNB found in the case of the Zuid-Hollandsche Crediet-Vereeniging that the credit cooperative’s lending policy was inappropriate, threatening financial stability and causing heavy losses. Nicolaas Gerard Pierson, the director of the DNB motioned to remove the executives of the credit cooperative from office, and the new managers could only be appointed with his consent.

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Due to historical reasons, the emergence of the Hungarian and Austrian banking supervision was closely intertwined (Varga, 2016b). With respect to banks, the Austro–Hungarian Bank was able to exert some control through its refinancing policy from the second half of the 1870s (Kövér, 1993). In Hungary, the first banking supervision institution was the Magyarországi Pénzintézetek Országos Szövetsége (National Association of Hungarian Financial Institutions), established in 1903, although the idea of creating a supervisory body had been put forward much earlier, in 1842 (Kovács, 2013). Although the National Association of Hungarian Financial Institutions primarily represented the interests of the sector, its activities were important from a supervisory aspect as well, since a separate examiner’s committee was formed within the organisation, which could even conduct unannounced examinations. Its activities hinged on the so-called ‘four eyes principle’, also used in today’s supervision, which required at least two examiners to carry out the audits, and the examiners also had to respect bank secrecy, and violations entailed disciplinary proceedings. The statute of the National Association of Hungarian Financial Institutions required examiners not only to record findings in their examination report but also to make recommendations on eliminating the identified shortcomings. However, from a supervisory perspective, the operation of the National Association of Hungarian Financial Institutions was inefficient, since the scope of its activities was too broad, and larger banking groups did not join it, therefore they could not be examined (Botos, 1994; Hantos, 1916). The efficiency of the National Association of Hungarian Financial Institutions was further undermined by the Pénzintézetek Országos Egyesülete (National Association of Financial Institutions), which was established around that time and basically acted as the National Association of Hungarian Financial Institutions’ ‘rival’. The conflicts arising between the associations were detrimental to the course of business in both (Varga, 2016a). The first Hungarian integrated supervisory body, the Pénzintézeti Központ (Central Corporation of Banking Companies, CCBC), was established on 1 June 1916. Initially, it could only implement audits — 750 —

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at member institutions with a share capital of less than 20 million koronas that requested this on a voluntary basis, or that had obtained a loan from it. In addition to its supervisory role, the CCBC also had a resolution function, which meant that it provided temporary liquidity to distressed but viable financial institutions. The establishment of the resolution function was a major achievement, as in most countries similar institutions were created only after the Great Depression of 1929 to 1933. To widen the scope of the examined institutions, only members of the CCBC were allowed to accept deposits and handle public funds from 1 January 1921 (Tomka, 2000), which significantly strengthened the role and economic clout of the CCBC, and nudged non-member financial institutions towards joining (Varga, 2017). Another incentive for joining was that public institutions were only allowed to accept surety by a member of the CCBC.

10.2.2 The impact of the Great Depression on financial regulation and supervision

Economic and financial crises had a profound impact on financial regulation and supervision. Generally, crises point out the structural shortcomings and weaknesses of countries and financial systems, as well as the necessity of reforms, whereby financial regulation and supervision gains more importance. The Great Depression of 1929 to 1933 should be mentioned as an example, as the measures taken in the aftermath are crucial milestones in tightening and putting banking supervision and regulation on new ground in certain countries.426

426

I t should be noted that the same trends characterise the period after the 2008– 2009 economic crisis, the only difference is that the approximately 40 new laws adopted since the crisis to bolster financial stability and market confidence were born within the harmonised European regulatory framework.

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Box 10-2 The separation of investment and commercial banking in the US

The Glass–Steagall Act, named after its sponsors in Congress, Senator Carter Glass and Representative Henry B. Steagall, was signed by President Franklin Roosevelt in 1933, and was in force until 1999. It aimed to separate investment and commercial banking in order to combat stock market speculation and preserve the integrity of the banking system. The argument behind the Act was that there was a considerable conflict of interest between these two activities. First, banks had much more information on their customers than other market participants, which could be abused during their trading activities, and second, they were presumed to be prohibited from using depositors’ money for holding risky positions. The financial lobby started attacking the stipulations in the Act right after its adoption, mainly arguing that the overregulation of market participants stifled growth. Although the Act was in force for decades, the 1987 report by the Congressional Research Service pointed out that market participants sought to circumvent the firewalls erected between banks and brokerage firms (for example, banks developed several new forms of investment and financial instruments similar to securities). It is interesting to note that the efforts to separate investment and financial services returned after the financial crisis of 2008. Many pundits believe that allowing banks to provide trading and investment services was a major contributor to the emergence of the latest global financial crisis. Having drawn these conclusions, the European Commission published a draft regulation in 2014 to remove overly risky activities from banks. However, according to the work programme of the Commission for 2018, the legislative package is expected to be withdrawn, since no headway has been made since 2015 in this regard, but several other proposals were introduced to strengthen financial stability.

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The Great Depression started in 1929 in the United States with the crash of the New York Stock Exchange. Many factors contributed to the spillover of problems, for example the McFadden Act adopted in 1927 that allowed banks to raise the upper limit on loans provided for individuals and engage in mortgage lending and securities trading. However, at the time of the Great Depression, securities trading was detrimental to banks, as it further increased the number of insolvent institutions. In 1933, a bank holiday was declared, and the OCC played a major role in the efforts to restore the banking system. During the bank holiday, the OCC conducted an audit at several banks to establish whether to withdraw their licence or allow them to continue operating under strict supervision after their resolution (OCC, 2011a). The crisis considerably affected banks as well, over 1,000 banks failed in 1931 Q4 (OCC, 2011b). On account of the crisis and to curb speculation as much as possible, the Glass–Steagall Act was adopted in 1933, which was significant in that it separated investment and commercial banking functions. Commercial banks had to sell or scale down their securities investment and securities trading companies (Botos, 1996), several deposit products were regulated, the minimum capital requirement was increased, and deposit insurance was born. Although joining the latter was not compulsory at that time, banks were interested in doing so to boost public confidence and thus acquire customers. As a result, banks were subject to co-supervision: the Glass–Steagall Act created the Federal Deposit Insurance Corporation (FDIC), but the OCC, the Fed and the state authorities all engaged in supervision related to their activities. This co-supervision and regulation led to an agreement in 1937, which prescribed a more consistent treatment and assessment of loans and securities by supervisors, and introduced a common reporting form. Nevertheless, the supervisory framework did not become completely uniform due to different practices of the various organisations. Still, it was an extraordinary achievement (OCC, 2011a).

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Germany was also hit by a severe banking crisis during the Great Depression, which began with the failure of Creditanstalt, an Austrian bank. After that, several banks suffered catastrophic losses and were forced to close, investor confidence was shaken, and Germany spent 1.3 billion Reichsmarks to tackle the situation. The 1931 German banking crisis showed that a full-fledged state-run banking supervisor had to be established, and an emergency decree ensuring banking supervision through monitoring was issued in September 1931 to stabilise the financial system. As a result, a comprehensive legal framework was established in banking supervision, and the German Banking Act was enacted in December 1934 (Bafin, 2018; Bundesbank, 2018). While the United States and Germany were battered by an acute banking crisis in addition to the economic crisis, the United Kingdom was characterised by another type of financial upheaval, a currency crisis. The banks in the City were unharmed, no bank failures occurred in the 1930s, and the Bank of England (BoE) was able to effectively monitor the financial system and banking activities. Consequently, there was no major shift towards regulating banks more tightly in the United Kingdom. The financial market in the UK and the role of the BoE in financial supervision were characterised by ‘regulatory informality’ for a long time, during which decisions related to regulation were left to the market or associations of market participants (e.g. Managers and Brokers Regulatory Association). The system was able to operate until the 1970s, then the banking crises necessitated the Banking Act be enacted, which provided a legal basis for regulation and strengthened supervisory powers. Belgium suffered many severe financial shocks even in the years prior to the Great Depression, especially in the 1870s and 1880s, still it did not decide to introduce structural reforms, therefore the regulation and supervision of the financial system was placed on new institutional ground only after the global crisis. The consequences of the banking crises that shattered the country show that overall the bailout of

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institutions was heavily influenced by the finance minister’s decision. If the minister argued for intervention, usually a group of financial institutions was established to support the distressed bank. In addition, the minister took into account the activities of the bank when deciding whether to use the assistance of the NBB, although the experiences from the second half of the 19th century attest that all in all, the finance minister and the Société Générale were more important in helping distressed institutions than the NBB. When the crisis and several bank failures in the 1930s pointed out the weaknesses of the Belgian financial system and the necessity of reforms, intervention, the regulation of the financial sector’s activities and the establishment of new institutions were decided to ensure the efficient supervision of the financial sector and restore confidence. One notable example of the new decrees divided universal banks into two types (deposit bank/holding company), to reduce liquidity risks, protect savings and thus restore confidence. The Office Central de la petite Épargne (OCPE), which formed a part of the NBB, was tasked with monitoring savings banks. Furthermore, the independent Banking Commission that nevertheless cooperated with the NBB was established for the banking supervision function in 1935, and its powers included setting liquidity and solvency ratios, and appointing independent examiners monitoring the activities of individual banks. Institutions were supervised by these two organisations, and public credit institutions with special supervisory status were supervised by the government. In the Netherlands, 61 banks closed in the aftermath of the 1922– 1927 banking crisis. During this time, the DNB’s function as the lender of last resort started to take shape, and it also decided which banks were worthy of receiving liquidity assistance. However, this was not banking supervision in today’s sense, as that continued on an informal basis. The year 1932 marked the beginning of a series of gradual changes, whereby the DNB requested commercial banks provide quarterly reports for the first time to gain more detailed information about the credit market,

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and soon monthly reports were introduced. The commercial banks also agreed to let DNB examiners assess whether the reports were consistent with banks’ internal records, therefore an organisational unit specialising in audits was set up in the DNB in 1940. The banks also volunteered to notify the DNB about overdue loans exceeding five per cent of their capital. In Austria and Hungary, the 1929–1933 global crisis exerted a massive impact not only on financial institutions but also on financial supervision. The enormous impact on financial institutions was attributable to two main reasons in both Hungary and Austria (and in Central and Eastern Europe in general): the great dependence on foreign capital and the close integration of banks and industrial companies. The failure of Creditanstalt in Vienna: The largest Austrian bank, Creditanstalt, declared insolvency in May 1931, which had a substantial effect not only on Germany and Austria, but also on Hungary because the bank was a major player in financing the Hungarian banking system (Clavin, 2000). After the announcement, the Austrian government spent vast amounts on recapitalising the bank, and acquired full ownership in Creditanstalt (seizing 65 per cent of the company’s capital, too) and several other banks. On account of the integration of banks and industrial companies, boosting lending was a priority.

The crisis shifted supervisory priorities and the focus of audits, and the CCBC’s tasks related to liquidation and resolution also increased. It was around this time that liquidity considerations gained importance (Walder, 1939), similar to on-site examinations (Jakabb et al., 1941). Even after the crisis, many supervisory reforms were introduced: in accordance with Decree No. 2240/1938 M. E., in all member institutions where the share capital was above 3 million pengős, the appointment of executives was subject to the prior consent of the CCBC and the Magyar Nemzeti Bank, and the appointment could only be authorised if it was approved. The increasing weight of the CCBC can be seen from the fact that after the Great Depression, almost all financial institutions in the — 756 —

10. Banking regulation and supervision

country were controlled by it. Decree No. 10/1939 P. M. abolished the existing capital limit on examinations, and member institutions were subject to mandatory annual reviews instead of the previous optional annual examinations.

10.2.3 Financial regulation and supervision after the Second World War

The Second World War was followed by centralisation and nationalisation in many countries, and thus also a change in supervisory duties. The issue of overregulation arising from the regulations introduced after the crisis and its effect potentially crippling competitiveness also appeared, along with calls for deregulation. In the United States, this era was marked by rising living standards, and consumer spending increased. Typically, no new banks were established, banks’ credit losses were usually low, bank failures were practically non-existent, banking activities were generally profitable, and the banking system’s stability seemed to be ensured. Against this backdrop, claims highlighting the dangers of overregulation appeared, arguing that the Glass–Steagall Act curbed growth and undermined competitiveness (Biedermann, 2012). The Comptroller of the Currency at that time, James J. Saxon, also spoke about general overregulation, which had a negative effect on the banking system. However, so-called financial service providers appeared to think that, as they were not commercial banks, were not subject to the Glass–Steagall Act. Moreover, firms and bank holding companies engaged in securities trading not as their main business but as a secondary activity, which was not less risky, and they, along with the deregulation measures, caused the next great crisis. In the Netherlands, substantial changes occurred after the Second World War with respect to the De Nederlandsche Bank (DNB). It was nationalised in 1948 and it was declared that it was responsible for the stability of the macroeconomy and the financial system. However, — 757 —

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the DNB formally received supervisory powers only later, in 1952. The supervisory function was manifested in three respects, namely monetary supervision (to assist monetary policy), business supervision (later called prudential supervision) and structural supervision (which aimed to create the conditions for a healthy and efficient banking sector). The law stipulated that the DNB had to decide alone how to act in cases where there was a conflict between these responsibilities and its objectives. However, the DNB did not have strong supervisory instruments, it mainly relied on negotiations with industry representatives and consultations with banks. Commercial banks could only start operating with the approval of the DNB, and the authorisation was granted only when the minimum capital requirement set by the finance ministry was met. At this time, no detailed requirements were specified for bank executives. The DNB’s prior agreement was needed for reducing banks’ share capital, large acquisitions or mergers with another bank. With respect to agricultural credit cooperatives, the law allowed the DNB to delegate their liquidity and solvency supervision to their professional associations, and the DNB did so. By 1956, it had become clear that the earlier, agreement-based procedures were inadequate; therefore the Supervisory Act was amended to provide statutory rights to the DNB for carrying out its supervisory duties. However, until 1978 smaller banks could operate without being subject to the DNB’s supervision. The prudential supervisory powers were mainly manifested in that the DNB published solvency and liquidity recommendations, and if banks did not comply, it warned them. If a bank did not follow the recommendations even after the warning, the last resort of the DNB was to disclose the warning and the measures it deemed necessary. The Supervisory Act introducing truly substantial changes was adopted only in 1978. The new Act was consistent with the EU’s bank harmonisation directive enacted at that time, and it expanded the group of banks subject to the DNB’s supervision. The conditions for establishing banks were considerably tightened, and minimum requirements for bank executives were also

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introduced. The DNB could now revoke licences if banks failed to meet the prudential requirements, and it also received further crisis management instruments (Mooij–Prast, 2012). In Germany, after the Second World War, the victorious Allied powers centralised banking supervision and regulation and set up the Special Banking Supervision Committee. From 1950, more and more proposals were put forward for reforming the Banking Act, many people demanded that the Act be thoroughly reviewed, which eventually led to the German Banking Act in 1961 that established the German prudential supervision framework and the Federal Banking Supervisory Office (Bundesaufsichtsamt für das Kreditwesen). When it commenced its activities, it supervised around 13,000 credit institutions with 18,000 branches. Although the German Banking Act was amended substantially several times since it entered into force, first to expand supervisory powers, then to transpose EU legislation, it still has extraordinary significance, as it continues to define supervision (Bokor–Tapaszti, 2015). In Belgium after the World War, deregulation started, and the activities of the Banking Committee continuously expanded. During this, it supervised so-called trusts from 1957 and then securities issues from 1964, and finally it assumed the role of OCPE in 1976 by supervising savings banks. At the start of the Second World War, supervision was in the background in Hungary and Austria, too. In Hungary, Act II of 1939 authorised the government to focus on national defence while controlling the operation of the CCBC, the activities of which therefore served planned economy objectives rather than supervisory policy, and due to the lack of a market economy, there was no real need for financial supervision. In Austria, the market situation changed dramatically after the 1938 Anschluss, resulting in supervision being relegated into the background.

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10.2.4 The necessity of international coordination and the appearance of regulatory hubs between 1970 and today

The need for cooperation and international coordination between financial supervisors is nothing new: the roots of today’s system go back to the 1970s when after the failure of Bankhaus Herstatt there were vocal calls demanding that supervisory authorities devise a system for forecasting credit institutions’ crises. The increasing globalisation of financial services highlighted the development of the related supervisory work, the international division of labour between banking supervisors and the common development of ideas on further enhancing requirements and methods. Although there had been bank failures with cross-border consequences before the bankruptcy of Herstatt (Franklin National Bank, the Israeli British Bank [IBB], Lloyds Lugano), still it was the case of Herstatt that made it clear that international cooperation was needed in banking regulation and supervision. Box 10-3 The failure of Bankhaus Herstatt

Bankhaus Herstatt was established in 1727, therefore it had been operating for nearly 250 years before its crisis. In 1974, it was the 80th largest bank in Germany, and even though it was relatively small, it was part of an extensive international network due to its large-scale foreign exchange transactions. Based on the rumour about the precarious financial situation of the bank and its excessive foreign exchange trading positions, the German banking supervisory authority carried out multiple audits and consulted with the bank executives, owner and auditor, yet it was unable to collect information that would have substantiated the negative opinion of the market. This was chiefly due to the fact that the executive in charge of foreign exchange trading was able to manipulate business reports, and many market transactions were not even included in the statements. This also enabled traders and the executive to considerably exceed the limits stipulated in internal regulations. Although the banking supervisory authority sent a letter to the banking association in May 1974 notifying

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them that foreign exchange trading entailed several risks, Herstatt was not mentioned by name, and its foreign exchange trading activities were not prohibited. Herstatt’s report for the 1973 financial year, published in April 1974, showed steadily growing profits and a sound financial situation, which was confirmed by the auditor. The dire financial situation became clear in June 1974, and Herstatt had to admit to the banking supervisory authority that it had previously unreported losses. Although there were attempts at rescuing the bank, the three large German banks asked to participate in crisis management withdrew from the bailout because the precise magnitude of the losses could not be assessed at that time. The bank was finally closed on 26 June 1974 (Emmanuel, 2015).

The failure of Herstatt showed not only that international cooperation was needed due to cross-border implications, but also that the banking supervision techniques mainly based on the market’s self-regulation and the agreements between the supervisory authorities and banks were inadequate for ensuring financial stability. The Basel Committee on Banking Supervision (Basel Committee) was established at the end of 1974 by the banking supervisory authorities of ten leading developed countries on account of the issues on international banking and foreign exchange markets caused by the failure of Bankhaus Herstatt. The Basel Committee continues to be hosted in the building of the Bank for International Settlements (BIS), and prepares reports for its members. The Basel Committee fulfils no supranational banking supervisory function, its methodologies and recommendations are not binding, not even for its members. Its role is simply to publish methodologies and possible supervisory requirements that the banking supervisory authorities in the various countries may incorporate into their systems in the version deemed best by themselves. This also entails that the regulations prepared along the same principles may still vary in international comparison, and they do. Of course, these recommendations greatly help in basing the work of different banking — 761 —

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supervisory authorities on similar principles, and in ensuring that banks are subject to very similar requirements even in the international arena.

10.2.5 The development of banking regulation and supervision in view of the Basel Committee’s standards and guidelines

Since the Basel Committee became the main hub of banking regulation and supervision in the 1970s, the development of supervisory instruments can be clearly demonstrated through the recommendations it has published. The summary also touches upon the issues related to the European Union and Hungarian implementation of the major recommendations. a) September 1975: the road towards the efficient supervision of crossborder banking groups (Report on the supervision of banks’ foreign establishments/Concordat) The first document published by the Basel Committee focused on the issue of the supervision of cross-border banking groups, in line with the crisis of Herstatt and other contemporary banks. One of the main requirements in the report was to ensure that no foreign-established bank could retreat from supervision, and that this supervision was adequate. Supervision was supposed to focus principally on liquidity, solvency and foreign exchange transactions. To ensure the effective supervision of the group members, the privacy requirements that prevented supervisory authorities from sharing data and conducting on-site examinations were supposed to be relaxed. The issue of international cooperation among financial supervisors has continued to be a priority for the Basel Committee ever since, and it has issued several recommendations on international cooperation practices, information sharing, the licensing of cross-border activities and the operation of supervisory colleges.

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The Basel Committee revised the Concordat several times, bearing in mind the main principle that no institution in another country should retreat from supervision, and that the nature of supervision with respect to establishments in another country should reflect the characteristics of the given establishment. The Concordat was fully reviewed in 1992, as the Basel Committee was forced to act due to the BCCI scandal. Box 10-4 The BCCI scandal

BCCI (Bank of Credit and Commerce International) was established in 1972 in Pakistan, and in its most active years it operated in 78 countries with over 400 branches and had a balance sheet total of over USD 25 billion. It was founded by a Pakistani businessman and it was registered in Luxembourg, but its seat was in London, and it was present in over 70 countries in the world. BCCI functioned for over 20 years without practically any supervision because the banking supervisors in Luxembourg and the UK were unable to agree whose task it was to examine the bank. The supervisory authorities of the US and the UK discovered in 1991 that BCCI was embroiled in money laundering, corruption, terrorist financing, smuggling and other illegal dealings. Losses amounted to USD 13 billion. This was a special case from the perspective of the cooperation among financial supervisory authorities because according to the findings of the supervisors, BCCI’s structure was developed specifically to retreat from central (consolidated) supervision, and conceal its actual risks and activities. BCCI’s case highlighted not only the shortcomings of supervisory cooperation, but also the responsibility of auditors and the difficulty of liquidating internationally active banks.

The failure of BCCI also showed that in the case of global financial groups, the host supervisors in themselves cannot adequately fulfil their functions, as there were subsidiaries of BCCI that operated prudently

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at the individual level, however, due to the insolvency of the group as a whole, their lenders also suffered losses. At the same time, the BCCI scandal revealed another weakness, namely, that during the consolidated supervision of financial groups present at several locations around the globe, the authorities need to clarify their responsibilities among each other, and they need to share the necessary information with each other. The fallout from the BCCI case forced supervisory authorities to cooperate much more closely, share more information with each other, and ultimately led to the system of supervisory colleges that are the cornerstones of today’s supervisory cooperation with respect to global financial groups. According to the recommendation entitled ‘Minimum standards for the supervision of international banking groups and their crossborder establishments’, published in July 1992 and intended to serve as a substantially extended revision of the Concordat, all international banking groups and banks need to have a supervisory authority that can provide adequate consolidated supervision. The creation of a crossborder banking establishment (in the form of a subsidiary or branch) should receive prior consent of both the host country supervisory authority and the bank or banking group’s home country supervisory authority. Supervisory authorities should possess the right to gather information from cross-border banking establishments of the banks or banking groups for which they are the home country supervisor. If a host country authority determines that any one of the foregoing minimum standards is not met to its satisfaction, that authority can impose restrictive measures necessary to satisfy its prudential concerns consistent with these minimum standards, including the prohibition of the creation of banking establishments. This recommendation of the Basel Committee laid the foundations for the supervisory principle evident today, that it is not enough to

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supervise banks in themselves, the group to which the bank belongs should be supervised on a consolidated basis. This recommendation also gave rise to the international network of financial supervisory authorities that relies on the mutual cooperation of home and host supervisory authorities (Seregdi, 2016). Box 10-5 Consolidated supervision

Consolidated supervision means the supervision of several institutions in the same group on a consolidated basis by a central authority. During this, the consolidated companies are treated by the consolidating authority from the perspective of compliance with the prudential regulations as if they formed a single institution together, irrespective of whether the companies are registered in one or more countries. The most important aspects of consolidated supervision include the scope of consolidation, the consolidation methods and the prudential requirements to be met at the consolidated level as well. In Hungary, consolidated supervision is governed by the Credit Institutions Act and the rules of the CRR. Pursuant to the CRR, the scope of consolidation includes the credit institutions, investment firms, financial institutions, ancillary services undertakings and asset management companies that are the subsidiaries of the credit institution in accordance with the laws. The consolidation methods are also defined in the CRR, and they are, just like in accounting, as follows: full consolidation, proportionate consolidation and equity consolidation. The CRR also determines the prudential regulations that need to be met at the consolidated level as well, such as the own funds requirement, the large exposure limit, minimum liquidity requirements and the leverage ratio. Prudential consolidation is similar to accounting consolidation, but there may be differences between the two types in the scope of consolidated companies and the methods used for consolidation.

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The significance of the international cooperation among financial supervisors is also shown by the fact that this issue was included in the Basel core principles for supervision, under which requirements pertaining to not only theoretical but also practical cooperation were specified. b) July 1988: capital, the central element of supervision (International convergence of capital measurement and capital standards/Basel I) Capital has not always been at the centre of regulation. Until the 1980s, banking regulation’s main rules were primarily manifested in barriers to entry, liquidity rules, reserve requirements, deposit rate ceilings and lending and investment restrictions (Kobrak–Troege, 2014). Capital started coming into focus after two banks failed in the US (National Bank of San Diego, Franklin National) in 1973 and one in Germany, Herstatt Bank, in 1974. These events showed regulators that commonly applicable rules are needed to prevent banks from becoming insolvent, or, at least, predict problems. In an interesting contradiction, these banks’ problems were caused by factors (fraud, irresponsible and uncontrolled foreign exchange and interest rate speculations) that even the later implemented Basel I would not have been able to prevent, since it mainly focused on credit risk, and its amendments on operational and market risks entered into force much later. Therefore, the main aim of Basel I was not to provide appropriate regulatory responses to the practical problems but to establish a system of rules applied uniformly at the international level that prescribes minimum requirements for banks’ operation based on capital. In this system, capital has at least two roles: safeguarding against unexpected losses and limiting banks’ risk-taking. The significance of these functions has changed over time, initially limiting risk-taking was more important, and the risk-taking limits relative to own funds were developed in connection with this. Later, as risk measurement developed, it forced the safeguarding role of capital to strengthen, where the coverage of risks with capital is based on highly sophisticated risk measurement.

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10. Banking regulation and supervision

The Basel Committee most likely exerted the greatest impact on the operation of the banking system with the Basel I recommendation. Its significance is attested by the fact that although it appeared as a recommendation, therefore it is not binding, it was adopted by not only Basel Committee members, but practically all countries with a mature financial regulatory system based the regulation of their banking system on the recommendation. Even though the Basel Committee originally intended to create an early warning system, the result was a prudential indicator that determined the minimum level of capital required for banks’ operation. Such a common, globally applicable minimum requirement was necessary because on account of globalisation there was competition not only among banks but also among banking regulators. There was real danger of a country applying looser banking regulation principles out of short-term interests to gain a competitive edge on the global market against the banks from other countries with more stringent regulation. Accordingly, the Basel I recommendation determined the constituents of capital, which comprised core and supplementary capital. Core capital included equity capital and disclosed reserves. Supplementary capital included undisclosed reserves, revaluation reserves, general provisions, hybrid capital elements and subordinated debt. One major part of the recommendation was the definition of deductions from capital. According to the original recommendation, goodwill and investments in another bank or financial institution should be deducted. The latter was needed to ensure that banks’ own funds did not cover the risks assumed by the bank and its subsidiaries at the same time (to avoid double gearing). In addition to the constituents of capital, the recommendation defined risk weights for on- and off-balance sheet items at 0, 10, 20, 50 and 100 per cent, and it determined the credit conversion factors for offbalance sheet items.

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Banks in history: innovations and crises

The minimum level for the target standard ratio of capital, defined as the ratio of capital to the balance sheet total adjusted for risk weights, was set at 8 per cent. The analysis of the current prudential regulation of credit institutions clearly shows that it is centred around capital, as most prudential limits are based on the amount of capital (capital requirement, large exposure limit, investment limits). Although these basic rules have been recently supplemented by further elements that are not based on capital (liquidity minimum requirements, corporate governance rules, disclosure), this has not materially undermined the role of capital, which has become even more sophisticated and important in the CRD/ CRR framework regulating capital requirements. Even when it was introduced, the regulation was widely criticized for being based on capital, as it did not provide an adequate response to the reasons for the banking crises at that time, and empirical evidence showed that the losses incurred in bank failures could only have been covered by own funds if a substantially higher capital adequacy requirement had been in place. In the 30 years since then, it has become clear that putting capital at the heart of banking regulation was a fundamentally appropriate step. Nevertheless, it can fulfil its function adequately only if supplemented by additional quantitative requirements (e.g. liquidity requirements, leverage ratio) and qualitative requirements (risk management, remuneration, corporate governance rules), and, besides credit risk, it covers all other relevant risks that arise during banks’ operation (market risk, operational risk, legal risks etc.). Capital requirements first appeared in the EU in 1989 when the directives on capital requirements calculation and own funds calculation were published. These directives specified own funds calculation and capital requirements basically in line with the Basel I recommendation, but regularly cited the EU directive on the accounting of credit institutions during own funds calculation. — 768 —

10. Banking regulation and supervision

In Hungary, the regulation of own funds was first stipulated by law in Annex 2 of the Financial Institutions Act in 1991, essentially in accordance with the Basel I recommendation and the prevailing EU directive. Later these rules were adopted in Annex 5 of the Credit Institutions Act. The Hungarian regulation kept up with the EU’s regulatory developments with a small lag until EU accession, and has more or less observed the implementation deadlines since then. With a few smaller exceptions (e.g. the treatment of general provisions for risk, the general provisioning requirement, the 50-50 division of deductions between core and supplementary capital elements), the Hungarian regulations practically mirrored the EU requirements. Today, due to the directly applicable nature of the Capital Requirements Regulation, the rules on own funds and capital requirements calculation are completely identical in the EU and Hungary. It is interesting to note that Hungary had a minimum requirement only for the capital adequacy ratio (8 per cent) and not for own funds until 2013, although this followed from the Basel recommendations and it was used in several EU Member States. Certain Central and Eastern European countries (e.g. Bulgaria) typically prescribed a minimum capital requirement of over 8 per cent for all banks, but in Hungary this happened only in the case of specific banks, under special circumstances (Seregdi, 2015). c) January 1991: the emergence and development of large exposure rules (Measuring and controlling large credit exposures) Concentration risk attracted the attention of banking supervisors even before the 1980s, and different rules were developed for it in various countries. The Basel Committee sought to harmonise these rules, and it stipulated two important requirements in its guideline: banks’ total exposure to a single counterparty or a group of connected counterparties may not exceed 25 per cent of the capital, and exposures amounting to over 10 per cent of the capital should be reported to the supervisory authority. The risk weights can be taken into account only to a very limited extent while calculating the exposures. The

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Banks in history: innovations and crises

recommendation also details the exposures that may be exempt from the limit. Before issuing its recommendation in 1991, the Basel Committee examined the large exposure limits used by its members. These were identical in that they were set relative to banks’ capital, although there were some that used only core capital rather than total capital as a benchmark. The ratio relative to the capital was also different, with 10–40 per cent being established. The Basel Committee did not provide any detailed explanation, but it believed that the maximum amount of exposure should be 25 per cent. Although large exposure rules have changed in the past 25 years, the main elements of the system are still the same as in the Basel recommendation from 1991. The roots of large exposure limits in the European Union go back to 1987, when the EU Commission published a recommendation to make Member States formulate rules for curbing large exposures (EU Commission, 1986). This is all the more interesting because the EU usually follows the Basel Committee’s practices, which published its own recommendation on the regulation of large exposures only in 1991. Moreover, the Basel Committee cited the EU Commission’s 1987 recommendation in its own guideline as a positive example. The EU recommendation already contained the important definitions, reporting requirements, limits, exemptions and consolidation requirements on which the future directive was based. However, Member States did not strive sufficiently to implement the recommendation (Dragomir, 2010), and as a result the EU published its directive on large exposure limits in 1992. This was still obviously a minimum harmonisation directive, and made it clear in its introduction that Member States may apply stricter rules than those in the directive. According to the directive, monitoring and controlling credit institutions’ exposures is a vital element of supervisory activities, and the excessive concentration of exposures

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10. Banking regulation and supervision

to a client or a group of connected clients poses an unacceptable risk because it may be detrimental to the solvent functioning of the credit institution. The European Union’s large exposure limit directive basically adopted the Basel Committee’s recommendations but was much more specific about certain principles. The differences were mainly due to the fact that while the Basel requirements were set out in the form of a recommendation, the directive was law, therefore the requirements had to be formulated using official legal terminology and with concrete content. For example, the directive adopted the Zone A–Zone B distinction between countries, while the Basel recommendation stated merely that high-quality sovereign risks could be exempt from the limit, whereas the EU directive was much more concrete about this, making it possible for Zone A country exposures. Limiting the total amount of large exposures: The EU’s large exposure limit directive introduced an extra limit in addition to those in the Basel recommendation, namely, that the total amount of large exposures (amounting to over 10 per cent of own funds) may not exceed eight times a bank’s own funds. In 1991, this rule was adopted in Hungary in the prevailing Financial Institutions Act with the wording that the combined amount of a bank’s large loans outstanding may not exceed four times its own funds, and only later was this amount increased to eight times. This rule in the EU directive was applicable until the end of 2013, but it was not adopted in the CRR because experience showed that it did not present an actual limit, as there was no bank whose portfolio was this concentrated.

The directive did not determine the exemptions uniformly, Member States could pick from a long list of items they wished to exempt from the large exposure limit in their national laws. It is interesting to note that this system changed in the CRR in that certain exposures are exempt, while in other cases the exemption can be granted by the Member States or the competent supervisory authorities.

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Banks in history: innovations and crises

In Hungary, large exposure rules first appeared in the Council of Ministers Decree No. 106/1989. (X. 29.) on the Banking Supervision Requirements of Banking Activities and the National Banking Supervisor, which entered into force on 1 November 1989. d) January 1996: measuring market risks and defining the capital requirement (Amendment to the capital accord to incorporate market risks) While the Basel I recommendation defined capital requirement almost exclusively with respect to credit risk, the amendment that entered into force in 1996 incorporated the measurement of market risks and the calculation of the capital requirement. The recommendation introduced the concept of the trading book and determined the calculation of the capital requirement on equity and bond positions, currency and foreign exchange risk, interest rate risk and derivatives positions. The positions in the trading book were supposed to be assessed and recorded at daily market prices. The recommendation allowed a Tier 3 capital element to be included as coverage for capital requirements besides core and supplementary capital (although this opportunity is no longer available since Basel II). The calculation of the market risk capital requirement also represented a major change in that it allowed banks for the first time to use an internal model developed by them, rather than the universally accepted standardised approach, for establishing their capital requirement if they received authorisation from their supervisory authority to do so. Based on the experiences with the market risk models, later, in the Basel II recommendation, this option was extended to several other risks, especially credit risk and operational risk. e) September 1997: Core principles for effective banking supervision This document summarises the 25 basic principles that need to be in place for a supervisory system to be effective. The core principles are the preconditions for effective banking supervision, and they lay down requirements related to licensing conditions, prudential requirements, — 772 —

10. Banking regulation and supervision

banking supervision methods, access to information, supervisors’ enforcement instruments and cross-border activities. After the 25 core principles were published, the supervisory authorities in all countries could examine how closely they followed the principles and which areas required further development. The core principles have been amended and revised several times since 1997. The Basel Committee first published in September 1997 the core principles that need to be applied to make the activities of a given banking supervisory authority effective. Since then, the Basel Committee has amended and revised the principles several times, therefore the original 25 principles have been expanded to 29 (BCBS, 2012). The aim of the publication of the principles was to let all supervisory authorities assess which areas’ activities needed to be made more efficient. The principles are based on the Basel Committee’s recommendations, especially in the fields of corporate governance, risk management and prudential requirements, and further amendments were published in certain topics (e.g. treatment of troubled banks, financial conglomerates427). The latest version of the supervisory principles was published in September 2012. According to the principles, all supervisory authorities need to have predetermined and clear responsibilities, and they have to hold the necessary powers to carry out their tasks. They need to be independent but accountable and have sufficient funds for performing their duties. The laws have to provide an opportunity for maintaining ties to home and host supervisors. The regulation has to clearly determine the activities that are subject to licensing and supervision. Only those banks can be licensed that fulfil the minimum requirements, including the appropriate ownership structure, the executives, the analysis of corporate governance procedures, and a sound financial 427

ccording to the relevant EU directive, a financial conglomerate is a group of jointly A controlled firms whose operation includes a large share of banking/investment services and insurance activities.

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Banks in history: innovations and crises

basis. The ownership stake in the bank may only be transferred with the consent of the supervisory authority. Large acquisitions by banks, including foreign engagements, are also subject to the supervisors’ approval. The supervisory authority needs to use a forward-looking approach in assessing banks’ risks, and it should be able to intervene, if necessary. During banks’ supervision, their risks and systemic importance need to be taken into account. The supervisory authority needs to receive regular reports about banks’ situation on an individual and consolidated basis as well, and it has to stand ready to examine their veracity at on-site examinations. Supervisors need to have a broad range of instruments to ensure that larger crises can be prevented in the early stages of arising problems. Banks should be supervised not only on an individual basis, consolidated supervision also has to be performed for the banking group as a whole. In the case of cross-border banking groups, the home and host supervisory authorities need to cooperate effectively (Seregdi, 2016). Supervisors need to evaluate whether banks have corporate governance procedures commensurate with their risk profile and systemic importance. Banks have to measure, limit and manage all risks that are relevant from the perspective of their activities. Banks need to fulfil capital requirements in line with their risks, which is determined by the supervisory authority. The supervisory authority needs to ensure whether credit risk is managed appropriately in the bank. Banks need to have adequate policies for identifying and managing problem assets, including provisioning and the recognition of impairments. Banks have to measure concentrations of the individual risk types, and supervisory authorities need to set clear limits for them. Banks are expected to manage their exposures to related parties on an arm’s length basis. Banks need to have adequate processes for managing country and transfer risk, market risk, interest rate risk in the banking book, liquidity risk and operational risk. Supervisory authorities need to assess whether banks have adequate internal control and audit functions and that it ensures compliance. Banks need to develop adequate internal records — 774 —

10. Banking regulation and supervision

and accounting statements that fairly reflect banks’ actual financial situation and whose veracity is confirmed by external auditors. Banks need to regularly publish easily accessible and clear reports. Banks need to develop adequate processes that prevent them from being involved in criminal activities. These supervisory principles are supplemented by further detailed criteria whose evaluation shows to what extent a country’s supervisory framework and banking regulation are consistent with the core principles. f) September 1999: key corporate governance principles and their evaluation (Enhancing corporate governance for banking organisations) Although the Basel Committee has issued recommendations on corporate governance and risk management before, this document provides a detailed summary about the key corporate governance principles related to banking operation and how supervisory authorities can assess compliance. The Basel recommendation was based on the OECD’s corporate governance principles published around that time, modified to reflect the special features of banking. The recommendation is also important because it made clear that the prudent banking operation has to be based not only on quantifiable indicators manifested in limits, but taking into account qualitative aspects is also crucial. The recommendation provides a detailed overview about the expectations regarding corporate governance, including that banks need to set adequate strategic objectives and communicate them in an appropriate manner. The definition of responsibilities and accountability has to be enforced in the whole bank. The bank’s operation needs to be governed by managers who have the necessary expertise, understand the bank’s operation and have no conflict of interest that would hinder them in appropriately controlling the bank. The bank needs to have adequate internal control functions that also cooperate with external — 775 —

Banks in history: innovations and crises

auditors. The recommendation adds that supervisory authorities also have to take into account banks’ corporate governance and enforce its adequate functioning. The Basel corporate governance principles were revised and supplemented in 2006. The new recommendation’s requirements included in the principles were much more detailed than in the earlier version, and it also included additional requirements, such as that banks’ governing and supervisory bodies need to understand the bank’s or banking group’s architecture or structure. The new recommendation also has more detailed requirements for supervisory authorities. The currently effective Basel corporate governance recommendation was published in July 2015. The new recommendation reaffirmed the requirement that governing bodies should ensure the appropriate functioning of risk management systems, underlined the expectation that the professional competencies of the governing body as a whole should cover all important areas in the bank’s operation, and that these people should spend enough time on discharging their duties, and highlighted the importance of remuneration systems during the development of an adequate incentive scheme. All in all, the most important achievement of the Basel Committee’s corporate governance recommendations was that they clearly showed banks and supervisory authorities the significance of the efficient functioning of governing and supervisory bodies, risk management systems and internal control functions. Corporate governance is distinguished for banks from several perspectives. Banking is based on confidence; therefore it is especially important for banks to be led by reliable and expert managers, and that the control points in the process, executive control, the management information system and internal audit work adequately during operation. Banks need to continuously develop and keep up with changes in the market environment, and the owners and management need to find the appropriate business model and strategy for this. — 776 —

10. Banking regulation and supervision

The principles of the Basel recommendation later appeared in European Union directives and regulations, and the European Banking Authority (EBA) and its forerunner produced further detailed recommendations based on these. EBA’s guidelines on internal governance (EBA/ GL/2017/11) also build on the principles in the Basel recommendation when summarising the requirements pertaining to banks and supervisory authorities. For banks, having adequate external and internal safeguards is especially important, and their system is summarised in the chart below (Chart 10-2). Chart 10-2: Internal and external safeguards in banking operation Regulation (EU and Home)

Supervision (micro, macro, consumer protection, resolution, home supervisor)

Ownership control, Shareholders meeting, Supervisory Board, Nomination of executives Management control, Management Board Operation: Operational structure, Committees, IT, Risk management and control, Internal procedures, Activity controls, outsourcing, BCM, Conflict of interest procedures, Group management, Operational culture Compliance Officer Independent Internal Control Other Control Points: Tax Authority, Public Administration, Market Independent External Auditor

Participants, Clients, Public Disclosures

Source: MNB.

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Banks in history: innovations and crises

g) June 2004: Basel II or revising the Basel I capital requirements system (International Convergence of Capital Measurement and Capital Standards: A Revised Framework) From the late 1990s, the Basel Committee was under increasing pressure by banks who criticised the Basel I framework for not being risk-sensitive enough, while they used sophisticated risk measurement techniques and models that were able to estimate risks much more precisely than the vastly simplified risk weight categories used in Basel I. The more advanced banks also complained that they had to calculate their capital requirement using the same methodology as small banks, while their internal risk management had abandoned that method a long time before. The Basel Committee accepted this criticism but believed that the option for choosing between capital requirements calculation methods and the use of internal models for capital requirements calculation could only be possible under adequate controls. Therefore, the Basel II recommendation considerably revised the Basel I capital requirement system. It allows banks to calculate their credit, operational and market risk capital requirement using the internal models approved by the supervisory authority. The freedom of choice between the capital requirements calculation methods entailed not only supervisory approval but also the use of further control points. Besides the capital requirement prescribed by the regulation, banks themselves also develop capital requirements calculation methods (ICAAP428) and the supervisory authorities also determine additional capital requirements for banks (SREP429). These I CAAP: Internal Capital Adequacy Assessment Process, which seeks to ensure that institutions have a risk management framework that adequately identifies, measures, compiles and monitors all relevant risks of the institution and that sufficient funds are available for covering these. 429 SREP: Supervisory Review and Evaluation Process pertaining to institutions subject to CRD IV, during which the competent supervisory authority assesses the operation of institutions’ internal management and control functions. 428

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10. Banking regulation and supervision

procedures are necessary because the capital requirement calculated based on the regulation (Pillar I430) does not always show an accurate picture about banks’ risks. Banks’ activities may include additional risks that capital requirements calculation methods developed for credit, market and operational risk do not adequately cover (e.g. there are credit concentration risks that the credit risk standardised approach does not take into account). Furthermore, during a banks operation, besides the credit, market and operational risks, other risk types may also be relevant (e.g. liquidity risk, interest rate risk in the banking book). The ICAAP and SREP recommendations together form Pillar II431 of the Basel II recommendation, and their main aim is to clarify the Pillar I capital requirement so that it covers all relevant risks in a bank’s activities, and to supplement any shortcomings in the Pillar I methods. Pillar III432 of the Basel II recommendation is based on the fact that if banks need to disclose detailed information about themselves, that by itself enforces prudent operation (market discipline), because data on poor financial management could prompt customers to lose confidence in them. Therefore, the recommendation details the information banks need to disclose as well as the method of disclosure. In addition to the above, the Basel II recommendation was also novel in that it introduced capital requirements calculation for operational risk.

illar I: minimum capital requirement calculated based on the regulation, during P which it is determined mainly for credit, market and operational risks. 431 Pillar II: the capital requirement calculated with institutions’ own internal process for covering all relevant risks and building additional capital, if necessary (this pillar has detailed rules on liquidity risk, large exposure risk, interest rate risk in the banking book, excessive leverage risk); Pillar II also includes provisions on the supervisory review process of the capital position to assess whether institutions have sufficient capital based on the methods used by them to cover the risks they assume. 432 Pillar III: public disclosure requirements, including on capital, risks and risk management. 430

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Banks in history: innovations and crises

The Basel II recommendation was implemented by the European Union in 2006 with the CRD.433 The main difference was that while the Basel Committee prepared its recommendation for global, large, internationally significant banks, the European Union applied the Basel II recommendation for all credit institutions and investment firms registered in the EU. And recommendations can be more colloquial, while a directive has to use the proper legal terminology in a way that all enforcement authorities interpret it uniformly. In accordance with the Basel II recommendation, the EU rules also allowed the use of internal models. The capital requirements calculation methods that can be used pursuant to the currently effective provisions of the CRR are presented in Table 10-3. The CRD was implemented in Hungary in the Credit Institutions Act. h) December 2010: Basel III – tightening rules on own funds calculation and changes to the measurement of liquidity (A global regulatory framework for more resilient banks and banking systems, International framework for liquidity risk measurement, standards and monitoring) Basel III contains two important standards, one is the considerably tighter rules of capital requirements, and the introduction of new indicators for measuring liquidity. These will be presented in detail in Subchapter 10.2.8, during the discussion of regulatory responses to the 2008 global financial crisis. The most important Basel Committee recommendations are summarised in Table 10-4.

433

RD: Directive 2006/48/EC relating to the initiating and continuation of the C business of credit institutions (Capital Requirements Directive).

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Basic Indicator Approach (BIA) Standardised Approach (SA) Advanced Measurement Approach (AMA)

Standardised Foundation IRB (based on internal rating but without own LGD calculation) Advanced IRB (based on internal rating with own LGD calculation) Additional models: — Capital requirement for securitisation (IAA) — Capital requirement for counterparty credit risk (IMM) — Capital requirement for equity

Source: MNB.

Operational risk

Credit risk Standardised Approach Additional models for particular sub-elements: — General and specific risk of equity — General and specific risk of debt instruments — Foreign exchange risk — Commodities risk — Incremental default and migration risk (IRC) model — Internal model for correlation trading — Calculation of delta for evaluation of options — Sensitivity models for interest rate contracts, options and swaps

Market risk

ICAAP The institution’s own internal capital requirements calculation system

Table 10-3: Capital requirements calculation methods in CRR

10. Banking regulation and supervision

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Measuring and controlling large credit exposures

Minimum standards for the supervision of international banking groups and their crossborder establishments

Amendment to the capital accord to incorporate market risks

January 1991

July 1992

January 1996

— 782 —

While the Basel I defined the capital requirement only for credit risk, this amendment incorporated the measurement of market risks and the calculation of the capital requirement. The recommendation introduced the concept of the trading book and determined the calculation of the capital requirement on equity and bond positions, currency and foreign exchange risk, interest rate risk and derivatives positions. It allowed a Tier 3 capital element to be included as coverage for capital requirements besides core and supplementary capital.

All international banking groups and international banks should be supervised by a home country authority that capably performs consolidated supervision. The creation of a cross-border banking establishment (in the form of a subsidiary or branch) should receive the prior consent of both the host country supervisory authority and the bank or banking group’s home country supervisory authority. Supervisory authorities should possess the right to gather information from the cross-border banking establishments of the banks or banking groups for which they are the home country supervisor. If a host country authority determines that any one of the foregoing minimum standards is not met to its satisfaction, that authority could impose restrictive measures necessary to satisfy its prudential concerns consistent with these minimum standards, including the prohibition of the creation of banking establishments.

Banks’ total exposure to a single counterparty or a group of related counterparties may not exceed 25% of the capital, and exposures amounting to over 10% of the capital should be reported to the supervisory authority. The risk weights can be taken into account only to a very limited extent while calculating the exposures. The recommendation defines the exposures that may be exempt from the limit.

Defined the constituents of capital (core capital and supplementary capital, deductions from capital), risk weights for on- and off-balance sheet items (0, 10, 20, 50 and 100%), credit conversion factors for off-balance sheet items, and minimum 8% target standard ratio of capital.

International convergence of capital measurement and capital standards (Basel I)

July 1988

Main elements

Report on the supervision of banks’ No foreign-established bank should escape supervision, and supervision should be foreign establishments – Concordat adequate.

Title

September 1975

Date

Table 10-4: Key documents published by the Basel Committee

Banks in history: innovations and crises

— 783 —

Source: MNB.

Basel III: A global regulatory Basel III contains two important recommendations, one is the considerably tighter framework for more resilient banks rules of capital requirements, and the introduction of new indicators for measuring and banking systems liquidity. The capital requirements part tightened the conditions for the inclusion International framework for of capital elements, extended the list of items to be deducted from capital and liquidity risk measurement, defined the minimum capital adequacy requirements at all three tiers of capital. standards and monitoring The liquidity part introduced the 30-day LCR that is supposed to offset money inflows against outflows, as well as the NSFR, which does the same over a 1-year horizon. The final rules were later amended several times by the Committee.

December 2010

Although the Committee issued recommendations on corporate governance and risk management before, this document provides a detailed summary about the key corporate governance principles related banking operation and how supervisory authorities can assess compliance.

The recommendation considerably revised the Basel I capital requirement system. It introduced capital requirements calculation for operational risk. It allows banks to calculate their credit, operational and market risk capital requirement using the internal models approved by the supervisory authority. Besides the capital requirement prescribed by the regulation, banks themselves also develop capital requirements calculation methods (ICAAP) and the supervisory authorities also determine additional capital requirements for banks (SREP). The recommendation details the information banks need to disclose, based on the principle that market discipline enforces prudent operation.

Enhancing corporate governance for banking organisations

Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework

June 2004

This document summarises the 25 basic principles that need to be observed for a supervisory system to be effective. The core principles define the requirements based on the preconditions for effective banking supervision, such as licensing conditions, prudential requirements, banking supervision methods, access to information, supervisors’ enforcement instruments and cross-border activities. After the 25 core principles were published, the supervisory authorities in all countries could examine how closely they followed the principles and which areas required further development. The core principles have been amended and revised several times since 1997.

February 2006

Core principles for effective banking supervision

September 1997

10. Banking regulation and supervision

Banks in history: innovations and crises

10.2.6 The role of the Financial Stability Board in banking regulation

The forerunner to the Financial Stability Board (FSB) was the Financial Stability Forum, established in 1999 by the G7 countries’ finance ministers and central bank governors. The organisation created to foster global cooperation in maintaining financial stability was transformed in 2009 into the FSB with an extended range of responsibilities. The FSB’s aims included the development of common standards in the topics determined by the most advanced countries that facilitate the preservation of financial stability. The FSB cooperates closely with the Basel Committee. The most important standards published by the FSB on banking supervision and regulation were the following. a) FSF Principles for Sound Compensation Practices, April 2009 The document published by the FSF already included the main principles used by the CRD to determine compensation rules in the European Union. The principles include that those performing control functions should be compensated independent from business areas, the bonus amounts need to be adjusted based on long-term risks, and compensation has to be paid not only in cash but also in assets. b) Shadow Banking: Strengthening Oversight and Regulation, October 2011 The FSB’s recommendation points out that organisations that do not fit into the traditional banking system and are not part of the same regulatory environment as banks, but nevertheless perform similar activities have grown to a size that they represent systemic risk. Therefore, their activities need to be regulated in more depth, and banks’ exposures to shadow banking organisations should be limited to prevent the risks from spreading to the banking sector.

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10. Banking regulation and supervision

c) Policy Measures to Address Systemically Important Financial Institutions, November 2011 This was the document in which the FSB determined that more attention should be paid to the globally systemically important institutions that had grown too big, mainly through the enhanced resolution framework, the additional capital buffer requirement and tighter supervisory procedures. d) Total Loss-Absorbing Capacity standard for global systemically important banks, November 2015 The central element of the recommendation is that the systemically important banks should hold liabilities in addition to the own funds prescribed by regulators and supervisors that can absorb losses in resolution proceedings. A unique minimum TLAC (Total Loss Absorbing Capacity) level has to be set for all institutions by the designated authority (usually the resolution authority). TLAC instruments can only include long-term liabilities and those whose bail-in during resolution is not hampered by legal obstacles. The FSB’s recommendation is being adopted by the European Union, the rules will be completed when the ongoing amendment of the CRD and the bank recovery and resolution directive (BRRD)434 will be finalised.

434

The provisions of the directive were to be transposed by Member States until 31 December 2014, but the European Commission published several recommendations on amending the directive in November 2016.

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Banks in history: innovations and crises

10.2.7 The European Union’s role in harmonising banking regulation and supervision

The Basel Committee is pivotal in the global harmonisation of banking regulation and supervision, however, its opportunities are practically limited to publishing recommendations, as it has no tools for enforcing them. However, in the European Union the single internal market and the freedom to provide services and goods make it absolutely necessary that banks operate on a level playing field. This has to adapt to the continuous evolution of financial markets and be based on the most efficient regulatory and supervisory instruments at all times that can guarantee long-term safe functioning to market participants, but not unnecessarily make banks’ activities more expensive. The EU’s convergence efforts in regulation and supervision are also helped by the fact that the Union’s regulatory and institutional system provide adequate instruments for convergence. All in all, the EU’s banking regulation and supervision system is based on the standard and guidelines published by the Basel Committee and the FSB, but it is much more detailed and concrete. The EU has several legal instruments at its disposal at the same time. Currently, banks’ regulation can be found in the following types of EU legal acts (Table 10-5).

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10. Banking regulation and supervision

Table 10-5: The legal instruments of banking regulation in the European Union Title

Characteristics

Example

Short name

Directive of the EU Parliament and of the Council

Approved by the EU Parliament and the Council based on the proposal of the Commission; has to be implemented in national laws

CRD

Directive

Regulation of the EU Parliament and of the Council

Approved by the EU Parliament and the Council based on the proposal of the Commission

CRR

Regulation

EU Commission Delegated Regulation

Modifies the text of the CRR, EU Parliament and Council have a veto right

No. 2015/61 on liquidity, No. 2015/62 on the leverage ratio

Delegated Act, DA

Regulatory Technical Standard of the EU Commission

Details some provisions of the CRD IV and the CRR

No. 241/2014 on the calculation of own funds

Regulatory Technical Standard, RTS

Implementing Technical Standard of the EU Commission

Details the implementation of some provisions of the CRD IV and the CRR

No. 680/2014 on supervisory reporting

Implementing Technical Standard, ITS

Implementing Decisions of the EU Commission

Gives practical guidance to the application of laws

No. 2016/230 on countries with an equivalent supervision

Implementing Decisions

Source: MNB.

The first common regulation on banks in the European Union was issued in 1973, and it defined the freedom of establishment and freedom to provide services as well as the minimum requirements of the provision of services. This directive did not stipulate prudential requirements but listed the measures each Member State had to implement to ensure the freedom of establishment. However, this was far from the current system of the freedom to provide services, because, for example, the directive did not prohibit Member State’s practice of prescribing a dotation capital requirement for credit institutions from another Member State when opening a branch in their country (EU Council, 1973). — 787 —

Banks in history: innovations and crises

The first directive that contained commonly applicable prudential regulations appeared in 1977. Its main requirements included that all banks should have a minimum share capital, and that they be governed by two individuals with an adequate business reputation and professional experience. The directive also sought to facilitate the opening of branches in another Member State and improve cooperation among supervisory authorities, but did not include too many detailed rules. From the 1980s, the prudential rules on the EU’s banks largely followed the recommendations published by the Basel Committee. The directives issued by the EU usually differed from the Basel recommendations so that the rules could be applied not only to internationally active banks but to any credit institution registered in the EU, and the Basel requirements had to be transformed into concrete legal terminology. Chart 10-3 provides an overview of the main milestones in the development of the EU’s banking regulation. Chart 10-3: Milestones in the evolution of banking regulation in the EU

1977 1989 1992 2000 2002 2006 2013

First Banking Directive, harmonization of licencing conditions Calculation of own funds and own funds requirements Consolidated supervision Consolidated version of previous directives Financial Conglomerates CRD, EU implementation of Basel II, followed by CRD II and III CRDIV/CRR framework, RTSs and ITSs

Source: MNB.

— 788 —

10. Banking regulation and supervision

Two main trends could be observed during the evolution of banking regulation in the EU. First, banking regulation developed tremendously in quantitative terms, as the original directives described on a couple of pages have expanded to highly complex legislation running for hundreds of pages. Second, while the first directives followed the minimum harmonisation principle, so Member States could apply stricter rules than those in the directive, in the 2000s more and more maximum harmonisation directives appeared, i.e. Member States could not deviate from the rules in either direction. In 2013, during the adoption of the CRR,435 common regulation was further bolstered by the fact that the CRR and the corresponding implementing rules did appear as regulations, i.e. they were directly applicable in the Member States without having separate national laws. This considerably reduced Member States’ leeway in derogating from the rules prescribed in EU legislation. This qualitative change was necessary because previously many Member States used the loopholes in minimum harmonisation, which did not help the establishment of a level playing field. The European Communities also quickly realised that it was not enough to harmonise banking regulation, the convergence had to cover banking supervision methods as well. The Groupe de Contact (GdC) was established back in 1972, and this was basically the first European initiative for the international cooperation between banking supervisors. The GdC members primarily comprised of mid-level managers of banking supervisory authorities, and the group held three or four meetings a year where questions regarding individual banking groups could be discussed besides the general topical supervisory issues. The members regularly notified each other if they saw risks in their own countries that could impact other Member States (e.g. 435

RR: Regulation (EU) No 575/2013 of the European Parliament and of the Council C on prudential requirements for credit institutions and investment firms (Capital Requirements Regulation), which has been in effect since January 2014, and it mainly contains rules on capital adequacy, large exposures, liquidity, disclosure and leverage.

— 789 —

Banks in history: innovations and crises

individuals with shady business activities). In the 1970s, the GdC’s agenda included several issues that are also hot topics today (home– host supervisory cooperation, liquidity, capital requirements). One of the great advantages of the GdC’s functioning was that it was not completely formalised, and it could focus on very practical issues, too. The GdC already did what later characterised supervisory institutions, i.e. it formulated recommendations in the spirit of convergence that members adopted for themselves, and despite not having any legally binding force, the recommendations were also applied. The Committee of European Banking Supervisors (CEBS) was set up in 2004, with a twofold aim: first, to expedite the development of the rules on credit institutions, and second, to devise commonly accepted supervisory methods that would later be applied commonly by Member States’ supervisory authorities. The CEBS successfully adopted several important methodological documents, although its role in the evolution of regulations remained limited, and it had few concrete instruments for achieving regulatory and supervisory convergence. All in all, in the past 40 years substantial harmonisation and convergence could be observed in the European Union with respect to banking regulation and supervision. However, this process has not been completed, as continuous evolution can still be observed today. For example, in November 2016 the EU Commission published its comprehensive amendment package for increasing banks’ resilience and mitigating the existing risks in the banking sector (CRD V/CRR2), which proposes to modify several currently effective provisions and expand them with many new elements.

— 790 —

10. Banking regulation and supervision

10.2.8 The impact of the 2008 global financial crisis on banking regulation and supervision

The 2008 global financial crisis provided a huge impulse to the evolution of banking regulation and supervision. It took lengthy discussions in professional circles to summarise the reasons of the financial crisis, and outline the potential regulatory and supervisory changes aimed at increasing the efficiency of preventing the occurrence of similar crises in the future. In its report to the G20 in October 2010, the Basel Committee summarised the main reasons behind the crisis and the steps it considered necessary for preventing future downturns (BCBS, 2010). According to the Committee, the lessons of the crisis have shown that the following main areas need to be enhanced in regulation and supervision: a) raising the quality of capital to ensure that it can be used to absorb losses on both a going concern basis and in the event of a potential liquidation, b) increasing the range of risks that are considered during capital requirements calculations, in particular more attention has to be paid to trading activities, securitisation and the counterparty risks arising from derivatives, c) raising the Common Equity Tier 1 capital requirement, and additional capital buffers need to be introduced to make the operation of banks safer, d) introducing an internationally harmonised leverage ratio that would serve as an additional backstop to excessive leverage in addition to the risk-based capital requirements,

— 791 —

Banks in history: innovations and crises

e) strengthening the role of the supervisory review process and disclosures, and further requirements are necessary in sound valuation processes, stress testing, the treatment of liquidity, corporate governance and compensation, f) introducing new, short- and long-term, internationally accepted liquidity requirements, g) introducing capital buffers that build up in a boom and can be reduced in a downturn to mitigate the procyclicality of regulation. The Basel Committee’s recommendations were laid down in the Basel III package. The Committee also considered it important to make headway in several other issues, including the following: a) fundamentally reviewing the trading book, b) the use and impact of external ratings in the securitisation capital requirement, c) addressing the issue of systemically important institutions, d) reviewing large exposure rules, e) enhancing the resolution methods of cross-border banks, f) reviewing the Core Principles for Effective Banking Supervision based on the lessons from the crisis, g) improving cooperation among supervisory authorities. Similar to the Basel Committee, the European Union also looked at the possibility of further enhancing the regulation. The results were summarised in the de Larosière report published in February 2009 (de Larosière, 2009). It was largely consistent with the Basel Committee’s — 792 —

10. Banking regulation and supervision

experiences, although there were several differences with respect to emphasis, which are attributable to the characteristics of the European Union. The de Larosière report focuses more on the importance of cooperation among macroprudential and microprudential supervisory authorities, the shortcomings of risk management processes, the role of external credit rating agencies, corporate governance issues in banks and the difficulties of the crisis management procedures. The de Larosière report served as the basis for several measures that the European Union implemented in addition to internationally accepted standards to prevent future crises. These include specifically the establishment of the European Systemic Risk Board (ESRB) to coordinate the operation of macroprudential supervisory authorities, the creation and operation of the EU’s supervisory authorities (EBA, ESMA, EIOPA), the shift from directives to regulations in the case of prudential requirements and the setting-up of the banking union’s institutional system. Accordingly, the most important regulatory responses in the aftermath of the global financial crisis can be summarised as follows. Macroprudential supervisory authorities: One of the main reasons for the crisis was found to be the lack of cooperation among macroprudential and microprudential supervisory authorities. Therefore, regulatory measures were introduced that established the institutional system of macroprudential supervisory authorities, determined their responsibilities, created the available instruments and devised the methods for cooperation with microprudential supervisory authorities. The fundamental aim of macroprudential supervisors is to identify systemic risks, prevent risks from becoming damaging, uncover market bubbles, reduce the procyclicality of banking regulation and the banking system’s operation, and manage systemically important institutions. They do this mainly by determining capital buffers (countercyclical, systemically important institutions, systemic risk), but they have several other regulatory instruments for preventing excessive risks.

— 793 —

Banks in history: innovations and crises

Tightening capital requirements: The Basel II recommendation published in 2004 only clarified the range of risks taken into account during capital requirements calculation and the methods for taking them into account, however, it did not include details on tightening capital requirement calculations. At the time of its publication, banking regulation was mainly characterised by rules that eased prudential requirements to boost banking activities and jumpstart the economy (e.g. relaxing the conditions for taking into account capital, the option of using internal models to achieve a lower capital requirement). Although the work on capital began in the Basel Committee before the crisis, the downturn revised the original plans and a much stricter framework was set up. It became clear during the crisis that not all constituents of capital were able to adequately absorb losses. The Basel III recommendations on capital requirements considerably tightened the conditions for the inclusion of capital elements and extended the list of items to be deducted from capital. The Basel III recommendation distinguishes three levels of capital: – Common Equity Tier 1 capital (CET1), – Tier 1 capital (T1) consisting of CET1 plus the Additional Tier 1 capital (AT1), and – the Total Capital consisting of T1 plus Tier 2 capital. The recommendation determines the capital adequacy requirements for all three levels of capital: CET1 must be at least 4.5 per cent of risk-weighted assets, while T1 and Total Capital must be at least 6 and 8 per cent of risk-weighted assets, respectively. By setting the capital requirement for each level of capital, the Basel Committee sought to force banks to mainly hold capital that is high-quality, steadily available

— 794 —

10. Banking regulation and supervision

and can be used to cover losses without restrictions. While according to earlier requirements, basically all ordinary shares could be part of Tier 1 capital, Basel III had a very detailed, 14-point framework for classifying shares as CET1 capital elements. Such conditions include that the dividend payment for the share should not be fixed in advance, and no condition should be attached to it that would suggest that the bank would repurchase or redeem the share after a while. Tier 1 capital can only contain elements that are able to absorb losses on a going concern basis (going concern principle). The rules on the deductions from capital were also tightened: most deductible items should now be deducted from CET1 rather than Total Capital. The conditions equity instruments need to satisfy for being taken into consideration as capital have considerably tightened. These are based on three main aspects: – yield payments on equity instruments should be flexible, i.e. the equity instrument’s conditions enable the bank to pay low yields (dividend or interest) to the holders or completely suspend payments in a crisis, – equity instruments need to be available for a long time, therefore only perpetual instruments can be taken into account in CET1, and even lower-quality capital elements cannot have maturities of under 5 years, – the paid-in capital has to be fully adequate for absorbing losses, in the case of core capital elements, this has to be ensured on a going concern basis, but in the case of supplementary capital elements, it is acceptable to use them for absorbing losses on a gone concern basis. The significance of the best-quality, Common Equity Tier 1 capital element, which can be used best to absorb losses, has increased dramatically in fulfilling capital requirements. While earlier banks merely had to hold CET1 amounting to 2 per cent of their risk-weighted

— 795 —

Banks in history: innovations and crises

assets, this rose to 4.5 per cent in the wake of the crisis, and the capital buffer requirements stipulated by the macroprudential authority also need to be met with CET1. The capital requirements are supplemented with a new, leverage ratio requirement, which is an additional instrument in limiting the increase in leverage. Pursuant to Basel III, Tier 1 capital has to amount to at least 3 per cent of the sum of a bank’s non-risk-weighted assets (with only a few exceptions) and its off-balance sheet items. The leverage ratio minimum requirements were determined because of the negative experiences from the global financial crisis. After the Lehman shock, distressed credit institutions were mostly those that fulfilled the capital requirements but were able to excessively increase their leverage through various means. Although the leverage requirement is much simpler and less thorough than capital requirements, the Basel Committee believes that determining the maximum leverage should also be introduced as a backstop measure. The detailed rules on the leverage ratio have not been finalised in the European Union, and its introduction is expected in 2019 at the earliest. Tighter regulation of systemically important institutions: During the global financial crisis, a so-called vicious circle could be observed (see Chart 10-4) that started with cashflow difficulties of systemically important banks. To preserve economic stability, governments had to intervene and perform a capital injection from taxpayers’ money. However, this increased public indebtedness, and market investors considered the given country riskier. This eventually led to a situation where the funding costs of the bank that had already been assisted by the state spiked, it suffered further losses, which could again only be covered by the state.

— 796 —

10. Banking regulation and supervision

Chart 10-4: The process of the deepening of the crisis

2. Banks need support by national government

1. Crisis deepens

3. Fiscal position of government weakened

5. Weaker bank balance sheets

4. Refinancing costs rise; higher debt yields Source: European Commission.

Moreover, as attested by the example of Iceland, some governments lacked the sufficient funds to bail out an excessively large bank. Icelandic banking crisis: The dangers of banks growing too large in size were exhibited in practice by the crisis of Icelandic banks. In October 2008, the three largest Icelandic banks, comprising 85 per cent of the country’s banking system in total, failed at the same time. However, the three large banks did not only operate in Iceland but also in several EU Member States, especially in the Netherlands and the United Kingdom. By the end of 2007, the balance sheet total of the three banks amounted to 880 per cent of Iceland’s GDP. Therefore, it was well beyond the means of the Icelandic government to save the banks or compensate depositors.

To halt the deepening of the crisis (‘vicious circle’), regulatory efforts aimed to reduce the close interconnectedness of the state and the banks and to constrain the activities of too large banks (Table 10-6). The Basel — 797 —

Banks in history: innovations and crises

Committee also originally intended to restrict the banks’ sovereign risk exposure by raising the capital requirement or tightening the large exposure limit, but it has only published discussion papers on this issue, and no concrete regulatory steps have been taken. However, with respect to systemically important institutions, capital buffers were introduced that, depending on the size of banks, global systemically important institutions need to meet, and the individual countries may determine capital buffers for other systemically important institutions at their own discretion. The measures tightening the rules on the activities of systemically important banks are due to two reasons: first, this is sought to urge banks that currently are not considered systemically important not to continue growing, and second, the capital add-on for the already systemically important banks ensures that these banks’ resilience to crisis will be greater due to the larger amount of capital. Table 10-6: Summary of the regulatory responses to the financial crisis at global and EU level Topic

G L O B A L

E U

Global

Establishment of macroprudential supervisory framework

FSB, Basel Committee documents

ESRB, EBA regulations, CRD

Strengthening capital requirements, leverage ratio

Basel III

CRD, CRR

G-SII and O-SII banks

FSB, Basel Committee documents

CRD, banking union

Liquidity

Basel III

CRD, CRR

Resolution tools

FSB, Basel Committee documents

BRRD

Expansion of disclosure requirements

Basel III

CRR

Qualitative and quantitative developments in EU legislation

CRD, CRR, implementing regulations

Strengthening the role of EBA

CRR

Central EU supervision

Banking union

Source: MNB.

— 798 —

10. Banking regulation and supervision

Liquidity: Although analysing the liquidity of banks is essential in banking supervision, there were practically no internationally accepted and uniformly applied minimum liquidity requirements before 2010 that would have determined limits in a quantifiable manner. During the crisis, banks with healthy capital adequacy turned illiquid on account of changed market conditions and their business models. As a result of the global financial crisis, regulators’ first response was to set up requirements on the quality of liquidity management that sought to prompt the governing bodies of banks to devote much more attention than before to the management of liquidity risks and to keep banks liquid in a potential stress. In 2008, the lack of confidence in the market resulted in unexpected stress, however, at that time, neither the shortterm, nor the long-term liquidity rules had been harmonised. Therefore, the part of the Basel III recommendation that deals with liquidity introduced not only qualitative requirements but also quantitative limits in the form of the 30-day LCR (liquidity coverage ratio)436 that is supposed to offset money inflows against outflows, as well as the NSFR (net stable funding ratio),437 which does the same over a 1-year horizon. The final rules were later amended by the Basel Committee multiple times, and a long interim period was granted for compliance. Resolution: The global financial crisis also highlighted the issue that certain countries did not have adequate reserves for bailing out distressed banks or instruments that would have made bank crisis management rapid and efficient. Therefore, the FSB and the Basel Committee developed a resolution framework that enables banks’ crisis management to be performed without taxpayers’ money, whenever possible. The essence of the framework is that credit institutions’ crisis management should be performed by an authority with the appropriate expertise, funds and instruments. The resolution authority creates resolution plans during the preparation for banks’ CR: it aims to ensure that banks have liquidity of sufficient quantity and quality L in the short run for a potential liquidity shock. 437 NSFR: it aims to ensure the balance between assets and liabilities with a maturity of over one year. 436

— 799 —

Banks in history: innovations and crises

resolution, and, depending on banks’ riskiness and capital adequacy, determines the minimum level of liabilities that can be written down or converted. This is necessary so that credit institutions have liabilities besides their own funds that can be used to absorb some of the losses in a crisis. The costs of resolution are covered by resolution funds that are set up in the individual countries that, similar to deposit insurance funds, accumulate reserves in calmer times so that banks can be bailed out in a crisis. If a credit institution experiences a crisis, initially the microprudential authority attempts to use instruments that ensure the further functioning of the bank (e.g. appointment of a supervisory commissioner, replacement of executives), but the powers of the microprudential authority are heavily limited because even with the appointment of a supervisory commissioner it can assume the powers of the management body with governing powers (board of directors) and not the decisionmaking rights of the owners. The resolution is launched when the supervisory authority concludes that the bank is unable to manage the bank’s distress with its own instruments and finds that the institution is failing or likely to fail, and the resolution authority believes that resolution proceedings are warranted. The resolution may include the write-down or conversion of a bank’s certain capital elements, the use of the sale of business tool, the creation of a bridge institution, asset separation or a bail-in, depending on which of these the resolution authority deems to be the most appropriate. If resolution cannot be performed efficiently in any other way, state stabilisation instruments may also be used (e.g. capital increase). In the case of institutions in a group, resolution colleges similar to supervisory colleges are also involved. Disclosure requirements: The Basel Committee has treated disclosure as a priority since 2004, and it has played a major role as a cornerstone of the Basel II and Basel III recommendations for a long time. The global financial crisis also showed that disclosure requirements need

— 800 —

10. Banking regulation and supervision

to be further expanded, especially with respect to the constituents of capital and the calculation of capital requirements. There are several new regulatory areas (e.g. liquidity and leverage ratio) where the Basel Committee expects detailed disclosures even when the specific prudential requirements are not even in effect (e.g. LCR, NSFR, leverage ratio). Nowadays, the Basel Committee always expands the disclosure requirements related to new regulations in all new regulatory areas.

10.2.9 The European Union’s responses to the global financial crisis

In the European Union, the above-mentioned regulatory recommendations have been implemented in directives and regulations, or their implementation is under way. However, the European Union’s single internal market, the freedom to provide services and the efforts to establish a level playing field required further measures that are summarised below. Deepening harmonised regulation: Since the 1970s, banking regulation has traditionally been harmonised in the European Union in directives. This seemed to be appropriate when the most important core rules had to be harmonised, because Member States were required to implement the text of the directives in their own laws. As regulations got increasingly complex and competition among countries on the banking services market intensified, this form proved less and less adequate. Initially, there were minimum harmonisation directives, i.e. Member States could apply stricter rules than those it adhered to, which hampered the creation of a level playing field. Member States often transposed certain rules into their regulations with an interpretation favourable to them. The European Union’s first response to this problem was to use maximum harmonisation directives instead, where Member States must

— 801 —

Banks in history: innovations and crises

adopt the directive word for word, and they could not deviate from the rules in either direction. This procedure was better for establishing a level playing field, however, the increasing length of the directives placed ever more burden on national legislators. The CRR became the first major EU-level requirement that appeared not in the form of a directive but as a directly applicable regulation. The regulation form reduces national derogations to a minimum, which makes it optimal from the perspective of the level playing field. Therefore, the European Union’s banking regulation legislation has evolved in terms of not only quantity but also quality over the decades. The role of the European Banking Authority (EBA) in regulation: The EBA was established in 2011 to replace the CEBS with a separate status regulation, similar to other EU supervisory authorities. The core functions of EBA determined in the regulation include improving the functioning of the internal market, including in particular a sound, effective and consistent level of regulation and supervision, as well as strengthening international supervisory coordination. The EBA is part of the European System of Financial Supervision whose main aim is to ensure that the rules applicable to the financial sector are appropriately implemented to preserve financial stability, and to safeguard confidence in the financial system as a whole and the appropriate protection of the consumers of financial services. Besides the EBA, the System also includes the ESRB, EIOPA, ESMA, a Joint Committee and national supervisory authorities. Chart 10-5 shows how the System is structured.

— 802 —

10. Banking regulation and supervision

Chart 10-5: The European System of Financial Supervision

European System of Financial Supervision

EU Supervisory Authorities

Microprudential supervision

Macroprudential supervision

European Security and Markets Authority (ESMA) European Systemic Risk Board (ESRB)

European Banking Authority (EBA) European Insurance and Occupational Pensions Authority (EIOPA) Joint Committee (EBA, ESMA, EIOPA) National supervisory authorities (e.g. MNB)

Central banks

Single Rulebook Supervisory Convergence Source: MNB.

The EBA’s significance has considerably increased as compared to the CEBS. The largest change is that the CRD and the CRR tasked the EBA to prepare a large number of implementing regulations. Even though in their final form these implementing regulations are published as EU Commission regulations, they are prepared by the EBA that also consults with the financial sector regarding them.

— 803 —

Banks in history: innovations and crises

Therefore, the EBA contributes much to the establishment of the regulatory framework, publishes guidelines that harmonise regulatory approaches, and operates a Q&A system that makes the application of the laws consistent across supervisory authorities and market participants. Banking union: The European Unionâ&#x20AC;&#x2122;s response to the calls for reducing the interdependence between banks and the state was the creation of the banking union. It includes euro area members, but EU Member States outside the euro area may also decide to join. The main elements of the banking union are the Single Supervisory Mechanism, the Single Resolution Mechanism and the single deposit insurance scheme, which are based on a common Single Rulebook for banks. Within the framework of the Single Supervisory Mechanism, since 2015, the European Central Bank has been supervising the largest banks registered in the banking union, which helps avoid national supervisory authorities concealing a crisis at the most important institutions, and it guarantees that in the case of the largest banks not only regulation but also the methodology of supervision is harmonised. The central element of the Single Resolution Mechanism is that a Single Resolution Fund is established for the banks in the banking union, whereby they do not have a national safety net but a European one, which is much stronger. And similar to the Single Resolution Fund, the aim of the single deposit insurance scheme is to ensure that depositors enjoy deposit insurance not only at the national but also at the European level, thereby increasing the safety of bank deposits. In the European Union, the rules on own funds, capital requirements, liquidity requirements and the leverage ratio are stipulated in the CRR, therefore they are directly applicable in Hungary. The capital buffer requirements were laid down in the CRD by the EU, and these rules were implemented in Hungary in the Credit Institutions Act.

â&#x20AC;&#x201D; 804 â&#x20AC;&#x201D;

10. Banking regulation and supervision

10.3 Conceptual matters in determining the development roadmap for banking supervision 10.3.1 Supervisory structure 10.3.1.1 Supervisory structures in the European Union

Even though the European Union has created the Single Market for money and capital markets, the structure of supervisory authorities still reflects the historical traditions of the individual Member States. There is no common practice, guidance or regulation in the European Union on the structure of financial supervisory authorities. This is largely attributable to the fact that the evolution of these supervisory authorities has a long history in Western European countries, while Eastern European countries chose different models as benchmarks when reforming their financial systems. Although there has been some harmonisation recently because countries increasingly shift towards creating an integrated financial supervisory authority, the situation is still highly complex today. In the European Union Member States, the authorities function using the following basic supervisory structures. Mainly in the 1990s, Eastern European countries typically a) established banking supervision within the central bank, as a sort of a directorate within the central bank. Besides the central bank, the capital market, insurance and pension fund supervisors usually functioned within the finance ministry (the latter sometimes did so in a separate ministry of welfare or health). This entailed a situation in which the banking supervisors enjoyed the independence characteristic of central banks, and, thanks to the central bank, they had the appropriate infrastructure, IT systems, data and regulatory powers. However, the other supervisors were in a much less favourable position, tied closely to the central administration.

â&#x20AC;&#x201D; 805 â&#x20AC;&#x201D;

Banks in history: innovations and crises

b) In another widely used structure, banking supervision is independent, while the other supervisors are also independent or part of a ministry. If several or all supervisory authorities are independent, a superior organisation (committee) can be set up that ensures information exchange and cooperation between the otherwise independent authorities. In this case, cooperation can still face substantial obstacles in the form of confidentiality policies, however, this can be surmounted by a legal authorisation. c) The transformation that today defines the structure of most financial supervisory authorities started in the 1990s, primarily in Nordic countries. The need for the transformation is due to the realisation that prudential supervision of the groups established within the country is much more efficient if performed by a single supervisory authority, as that best ensures the appropriate sharing and use of information. The supervision of financial groups usually requires that the group members, for example banks, insurers, investment firms and pension funds, be examined at the same time, along uniform criteria on site, with a special focus on the examination and assessment of intra-group transactions and risk transfers. Single supervision can coordinate these activities much better, the information gained by the supervisory authority can be evaluated much more efficiently, and the appropriate supervisory measures can be selected in an optimal framework. Another argument for integrating supervisory authorities is that this could harmonise the regulations on the supervised sectors and the corresponding supervisory methodology, and the supervisors working in different fields can learn from each other the most efficient methods used in other sectors. d) S upervisory authorities can be unified within or outside the central bank. If supervisory powers are exercised within the central bank, supervisory authorities share the independence enjoyed by the national bank. After the global financial crisis, ties between the macroprudential and microprudential supervisors should be as â&#x20AC;&#x201D; 806 â&#x20AC;&#x201D;

10. Banking regulation and supervision

strong as possible. For example, in Hungary, the MNB performs microprudential and macroprudential supervision as well as resolution as a single authority, although these functions must be separated from each other within the MNB. With respect to central banks, the ECB is vigilant about the appropriate regulation of their independence. e) Some countries use a supervisory structure where supervisory activities are divided functionally rather than by sectors, between an authority responsible for the prudential supervision of institutions and another responsible for the legal operation of markets (twin peaks). This method was first used in New Zealand, and although it is not widely used, the principle has been adopted by many other supervisory authorities by clearly distinguishing the consumer protection function within the organisation, even if it is not placed at a separate institution. The sharing of duties along these principles is attributable to the conflict of interest that on the one hand, the supervisory authority needs to act for the safe functioning of the institution (which entails ensuring that the institution is profitable because that way it can increase its capital, which serves as the collateral for the customersâ&#x20AC;&#x2122; money deposited with it). On the other hand, it has to act in consumer protection issues and undertake measures that lead to huge amounts of compensation being paid by the bank, which may undermine safe operation and customer confidence. Currently, the greatest user of the twin peaks model is the United Kingdom, where the Prudential Regulation Authority (PRA) established within the Bank of England in 2012 is in charge of prudential supervision, while the consumer protection and market surveillance functions are performed by the Financial Conduct Authority (FCA), which is independent from the central bank. 10.3.1.2 Supervisory structures in Hungary

From a structural perspective, the Hungarian financial supervisory authority has clearly tried almost all of the above-mentioned arrangements. Banking supervision started functioning within the â&#x20AC;&#x201D; 807 â&#x20AC;&#x201D;

Banks in history: innovations and crises

Ministry of Finance after the creation of the two-tier banking system, then it was established as an independent budgetary organ (State Banking Supervisory Authority) in 1991, while capital market, insurance and pension fund supervision remained within the Ministry of Finance. In 1997, the banking supervision and capital market authorities merged (State Banking and Capital Market Supervisory Authority), and in 2000 the institution supervising all four financial sectors (Hungarian Financial Supervisory Authority, HFSA) was established. Therefore, the HFSA was established through the merger of the State Banking and Capital Market Supervisory Authority, the State Insurance Supervisory Authority and the State Pension Fund Supervisory Authority, and it functioned between 2000 and 2013 with supervisory, control, consumer protection and regulatory powers. In 2013, the Hungarian Financial Supervisory Authority ceased operation, and its functions were transferred to the Magyar Nemzeti Bank. As a result, all financial sectors in Hungary are supervised by the central bank, which also has consumer protection functions. Within this framework, the MNB continuously monitors the activities of money and capital market institutions, pension funds, insurers and institutions of the financial infrastructure (regulated market, clearing house and central depository), using the tools of prudential supervision, as well as market surveillance and consumer protection, and, if necessary, it takes measures.

10.3.2 Risk-based supervision

In the 1990s, risk-based supervision increasingly appeared within the banking supervision methodologies of various countries. Formerly, banking supervisory authorities mainly strove to ensure that rules facilitating prudent operation were established for banking activities, and examinations principally targeted if banks complied with all legislative requirements (compliance-based supervision). From the 1990s, the supervisory approach examining the requirements prescribed by the rules was not simply supplemented by the preventive and proactive supervisory behaviour aimed at risk monitoring â&#x20AC;&#x201D; 808 â&#x20AC;&#x201D;

10. Banking regulation and supervision

and measurement, internal decision-making and limit systems and monitoring, it became the primary focus for the authority (BdE, 2002). Risk-based supervision injects more supervisory discretion and thus also subjectivity into the supervisory framework, which makes comparisons difficult. Experience has shown that not even risk-based supervision can always appropriately prevent huge losses. Viñals and Fiechter found in their study on the supervisory reasons behind the global financial crisis that financial supervisory authorities trusted banks’ internal risk management and control mechanisms and failed to act proactively even when too large risks could be identified (Viñals–Fiechter, 2010). By the 2000s, this was supplemented by another new concept, this time characterised by the difference between the rule-based vs principlebased supervisory approach (Quintyn, 2013). The different philosophy behind the two approaches is manifested in that while the rule-based approach seeks to limit banks’ activities with a detailed set of rules, the principle-based approach is a much more flexible system that prescribes the principles whose observance is expected from the banks by the supervisory authority. This approach defines a flexible framework for banks and the supervisory authority as well, and both parties have some leeway for taking into account banks’ unique features, such as their size, the complexity of their activities, or the quality of their internal controls and risk management, and the same detailed rules do not necessarily have to be forced on all banks. While earlier principle-based regulation was almost exclusively in Anglo-Saxon legislation, today this approach plays a role in EU directives and the CRR, and it was pivotal in the standards developed by CEBS and later EBA, and, as a result countries using Germantype law were also forced to adopt certain elements of the principlebased regulation. Due to the inflexible legal system, this change was not discernible in Hungary for a long time, because previously, during the implementation of EU directives, the ministry in charge of — 809 —

Banks in history: innovations and crises

justice demanded that certain concepts not detailed in the directives (e.g. appropriate, high-level, sufficient number etc.) be stipulated specifically in Hungarian laws. As a result, Hungarian legislators had to solve, in a very short time frame, regulatory issues that the drafters of the directives spent years and years pondering without agreeing on a common formulation. While today the capital requirements are contained in the directly applicable CRR, which often uses the principlebased approach, the MNB, acting in the capacity of the supervisory authority, needs to determine in its methodology or statements how these rules previously detailed in Hungarian law will be enforced. However, the shift towards principle-based regulation does not necessarily foster supervisory convergence, or only by the fact that supervisory authorities agree on the principles they use. However, the practical ways of implementing the principle may differ widely, which work precisely against convergence. Although supervisory authorities like to proclaim that their practices are based on the principle-based approach, the appropriate practice may be to use the two approaches in conjunction. For example, FSA (Financial Services Authority) in the UK determined 11 supervisory principles for itself, but these are reflected in practice in a constantly expanded rulebook, which is already over 8,000 pages long. However, Black notes that the FSA was also forced to adjust the principle-based approach and lay down much more concrete rules for supervised institutions (Black, 2010), and the very detailed requirements in the CRR also attest that the EU has also relaxed its stance towards principle-based regulation. Risk-based supervision is hampered by the fact that banks need to face several different risk types during their operation, which are intertwined at various levels.

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10. Banking regulation and supervision

10.3.3 Separation of banking and investment services

The separation of investment and financial services and the efforts to curb banks’ proprietary trading is nothing new, as the Glass–Stegall Act stipulated this in the United States in the wake of the 1929 to 1933 Great Depression. While the lessons from the crisis were being learnt, proposals were put forward in both the US (Volcker Rule) and the UK (Vickers Report) to introduce restrictions. At the same time, the EU tasked an expert working group to draft proposals on the structural reform of the EU’s banking system. The working group published its report in October 2012, and its proposals included that if the ratio of a bank’s trading assets plus the assets held for sale to total assets is above a given limit, the bank should be compelled to reallocate that activity to a separate company. This proposal would not prohibit banks from owning a company engaged in such activities, but the isolation of these activities would separate the bank, which may be worth saving for social reasons if problems arise, and the company where the state has no such social responsibility. Based on the Liikanen report, the European Commission published its concrete proposal for the regulation to be published by the European Parliament and the Council on 29 January 2014, after two public consultations. The regulation would apply to global systemically important banks and those exceeding the limit stipulated in the regulation (covering around 30 banks in the EU). Its main elements are as follows: –P rohibition of high-risk activities. Banks are prohibited from engaging in proprietary trading for profit, by any unit or trader, without any connection to client activity or hedging the entity’s risk, and they may not invest or hold shares in hedge funds or entities that engage in proprietary trading or sponsor hedge funds. Exceptions include money market operations conducted for money — 811 —

Banks in history: innovations and crises

flow purposes, trading in EU government securities and unleveraged, closed-ended EU funds. – Supervisory authorities are permitted to compel banks to separate certain activities if the authorised trading activity exceeds a specific limit. The decision on the separation is made by the consolidating supervisor after consulting with the host authorities supervising the other members of the group. As an ancillary impact of the proposal, the structural regulation may lead to a more favourable distribution of capital for the national economy, since it guides the credit institutions concerned from highrisk, speculative transactions towards traditional bank lending. However, this package is among the proposals to be withdrawn in the European Commission’s 2018 work programme, since there has been no progress in this regard since 2015.

10.3.4 Digitalisation and supervision in Hungary

As has been shown, the supervision of the financial intermediary system in Hungary was conducted within the framework of three separate institutions, namely the National Monetary and Capital Market Supervisory Authority, the National Insurer Supervisory Authority and the National Pension Fund Supervisory Authority, until 1 April 2000. IT supervision gained prominence with the establishment of the Hungarian Financial Supervisory Authority. In the early 2000s, on-site examinations dominated the work, then survey based offsite examination came in the focus. Requirements were typically based on the COBIT methodology,438 supervisors held international 438

he COBIT methodology created by ISACA set IT governance objectives with T respect to different fields of IT and provides reference processes for these, the existence and operation of which can be assessed during audits.

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10. Banking regulation and supervision

CISA439 certification issued by ISACA,440 which is still an important criterion of employment besides other professional qualifications. In 2007, the Hungarian Financial Supervisory Authority also published a recommendation for determining IT audit criteria441 about the protection of IT systems, which was revised in content and form in 2013442 to reflect the changes in IT and security requirements. In October 2013, the Magyar Nemzeti Bank (MNB) took over the supervisory duties of the financial intermediary system. The IT supervision, first functioning as an independent team, then becoming a department, played a central role in examinations due to transforming IT trends, legislative changes and the spread of security awareness. The department assessed the experience from the on-site and off-site supervision and developed a new supervisory methodology from a blend of the two methods for the more efficient supervision of the institutions in the financial intermediary system, enhancing the onsite examinations with analysis of data from regulatory reporting and data stored in IT systems and requested during audits. In addition to the former, mainly security governance focused methods, the new examination methodology was supplemented with IT security examinations based on technology and business processes, and the functional review of IT systems also gained importance. Together with the functional review, so-called whole-population data analysis evaluations were also conducted from time to time, which sought to identify the differences and opportunities for fraud in institutions’ data using special data analysis tools and methodology.

ertified Information Systems Auditor http://www.isaca.org/Certification/CISAC Certified-Information-Systems-Auditor/Pages/default.aspx 440 Information Systems Audit and Control Association http://isaca.org 441 Methodological Manual No. 1/2007 of the Hungarian Financial Supervisory Authority on the Protection of IT Systems of Financial Organisations, Budapest, October 2007. 442 Guideline No. 1/2013 of the Hungarian Financial Supervisory Authority on the Protection of the IT System, Budapest, May 2013. 439

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Banks in history: innovations and crises

The new IT solutions appearing on account of the digitalisation efforts on the money market, such as FinTech, cloud services, remote identification or the payment transactions over various electronic channels, triggered substantial changes in the IT supervision methodology as well. Due to the increasingly widespread use of electronic channels, besides its revised recommendation on the protection of the IT system,443 the MNB published a recommendation specifically on electronic channels,444 which also incorporated the implementation of the experience in the EBA recommendation445 based on international efforts. The IT solutions of the financial intermediary system are increasingly sought to be outsourced to public cloud services due to cost effectiveness and economies of scale. The supervisory authority believed that in contrast to the IT cost, the enforceability and auditability of the confidentiality and integrity of the data uploaded to cloud services, and of the availability of the data and systems posed a high risk. While balancing the interests, MNB replaced the earlier executive circular446 with a strict recommendation,447 in which it determined the framework

revious Recommendation No. 1/2015 on the Protection of the IT System, then the P currently effective Recommendation No. 7/2017 (VII. 5.) of the Magyar Nemzeti Bank on the Protection of the IT System, which was extensively revised not only in terms of content but also in terms of its approach. https://www.mnb.hu/ letoltes/7-2017-informatikai-rendsz-ved.pdf 444 Recommendation No. 15/2015 of the Magyar Nemzeti Bank on the Security of Financial Services Provided over the Internet, https://www.mnb.hu/letoltes/amagyar-nemzeti-bank-15-2015-szamu-ajanlasa-az-interneten-keresztul-nyujtottpenzugyi-szolgaltatasok-biztonsagarol.pdf 445 European Banking Authority: Final guidelines on the security of internet payments, London UK, 19 December 2014, https://www.eba.europa.eu/ documents/10180/934179/EBA-GL-2014-12+%28Guidelines+on+the+security+o f+internet+payments%29_Rev1 446 Executive Circular No. 4/2012 of the Hungarian Financial Supervisory Authority on the Risks Arising from Using Social and Public Cloud Services. 447 Recommendation No. 2/2017 (I. 12.) of the Magyar Nemzeti Bank on Using Social and Public Cloud Services https://www.mnb.hu/letoltes/2-2017-felho-szolg.pdf 443

— 814 —

10. Banking regulation and supervision

where the data security of the financial intermediary system and its customers using its services can be ensured. Due to changes in customers’ payment habits and the digitalisation of their payment services’ needs, so-called FinTech and InsurTech solutions are increasingly popular. The supervision of the service providers typically wedged between banks or insurers and customers and providing convenience services is expected to undergo serious changes. During the implementation of the relevant European Union directive,448 the MNB continuously strives to ensure easier access to such services. It also examines the possibility of creating a so-called Regulatory Sandbox449 in Hungary. Moreover, the MNB Innovation Hub450 wishes to facilitate the identification of the arising legal obstacles and the feasibility of innovative ideas by functioning as an information repository, communication hub and regulatory support platform. During the digitalisation efforts of the financial intermediary system, there were loud calls for the introduction of remote customer identification processes. The law451 on combating money laundering and terrorist financing enabled remote customer identification; however, it empowered the MNB’s governor to create regulations for determining the corresponding technical and security framework. The relevant MNB

irective (EU) 2015/2366 of the European Parliament and of the Council of 25 D November 2015 on payment services in the internal market, amending Directives 2002/65/EC, 2009/110/EC and 2013/36/EU and Regulation (EU) No 1093/2010, and repealing Directive 2007/64/EC https://eur-lex.europa.eu/legal-content/ EN/TXT/?uri=celex%3A32015L2366 449 MNB: Innovation and Stability – Overview of FinTech in Hungary https://www. mnb.hu/letoltes/consultation-document.pdf Budapest, December 2017. 450 MNB: Innovation Hub: https://www.mnb.hu/en/innovation-hub 451 Act LIII of 2017 on the Prevention and Combating of Money Laundering and Terrorist Financing. 448

— 815 —

Banks in history: innovations and crises

decree452 was formulated after an extensive public consultation, and it specifies detailed rules on the closed system and the audit of remote identification and authentication, as well as on taking the appropriate security measures. Within the framework of IT supervision, the MNB pays special attention to the IT security of the financial intermediary system, which helps it ensure the uninterrupted, transparent and efficient functioning of the system, foster the prudent operation of individuals and organisations comprising the system, monitor ownersâ&#x20AC;&#x2122; careful observance of the law, identify the undesired business and economic risks threatening individual financial organisations and certain sectors of financial organisations, mitigate or eliminate the existing unique or sectoral risks, implement preventive measures to ensure the prudent functioning of financial organisations, and protect the interests of those using the services provided by financial organisations in order to strengthen public confidence in the financial intermediary system.453

MNB Decree No. 19/2017 (VII. 19) on the Detailed Rules Concerning the Implementation of the Act on the Prevention and Combating of Money Laundering and Terrorist Financing, as Applicable to Service Providers Supervised by the MNB, and Concerning the Minimum Requirements for the Development and Operation of the Screening System under the Act on the Implementation of Financial and Asset-related Restrictive Measures Imposed by the European Union and the UN Security Council. 453 Pursuant to Article 4(9) of Act CXXXIX of 2013 on the Magyar Nemzeti Bank. 452

â&#x20AC;&#x201D; 816 â&#x20AC;&#x201D;

10. Banking regulation and supervision

Key terms banking supervision Basel Committee Basel I, II, III consolidated supervision CRR/CRD directives and regulations financial crisis

home and host authority Pillar I, II, III prudential requirements risk-based supervision supervisory fields supervisory principles supervisory structure

References Bafin (2018): Banking supervision, www.bafin.de Downloaded: 31 January 2018. BCBS (2010): The Basel Committee’s response to the financial crisis: report to the G20., https://www. bis.org/publ/bcbs179.pdf Downloaded: 31 January 2018. BCBS (2012): Core principles for effective banking supervision. http://www.bis.org/publ/bcbs230. htm Downloaded: 31 January 2018. BdE (2002): Development of the risk-based approach to banking supervision, Report on Banking Supervision in Spain. 2002. Chap. II.5, pp. 92–98, Banco de Espana, http://www.bde.es/f/ webbde/COM/supervision/politica/SABER_INGLES.pdf Downloaded: 31 January 2018. Biedermann, Zs. (2012): Az amerikai pénzügyi szabályozás története (The history of American financial regulation). Public Finance Quarterly, Volume 57, Issue 3, 2012, pp. 337–354. Black, J. (2010): The Rise, Fall and Fate of Principles Based Regulation, LSE Law, Society and Economy Working Papers 17/2010, 26 p. https://core.ac.uk/download/pdf/17332.pdf Downloaded: 31 January 2018. Bokor, Cs. – Lányi, B. – Tapaszti, A. (2015): A német bankrendszer három pillére (The three pillars of the German banking system). Financial and Economic Review, Vol. 14, Special issue, pp. 172–190. Botos, J. (1994): A magyarországi pénzintézetek együttműködésének formái és keretei (Forms and Framework of Cooperation Among Financial Institutions in Hungary). Közgazdasági és Jogi Könyvkiadó, Budapest. Botos, K. (1996): Elvesz(t)ett illúziók. A magyar bankrendszer helyzete és távlatai (Lost Illusions. The Situation and Prospects of the Hungarian Banking System). Közgazdasági és Jogi Könyvkiadó, Budapest. Bundesbank (2018): Banking Supervision, https://www.bundesbank.de/Redaktion/EN/ Standardartikel/Tasks/Banking_supervision/banking_supervision.html Downloaded: 31 January 2018.

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Banks in history: innovations and crises Bundesministerium der Justiz und für Verbraucherschutz (1961): Gesetz über das Kreditwesen, https:// www.gesetze-im-internet.de/kredwg/BJNR008810961.html Downloaded: 31 January 2018. Clavin, P. (2000): The Great Depression in Europe, 1929–1939. St. Martin’s Press, United States of America. de Larosière, J. (2009): Report of the High-Level Group on Financial Supervision in the EU., http:// ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf Downloaded: 31 January 2018. Dragomir, L. (2010): European banking prudential regulation and supervision: a legal dimension, Routledge Research in Finance and Banking Law. Emmanuel, M.-D. (2015): ‘Trust is good, control is better’: The 1974 Herstatt Bank Crisis and its Implications for International Regulatory Reform, Adam Smith Business School, University of Glasgow, Glasgow, UK, http://eprints.gla.ac.uk/95628/1/95628.pdf Downloaded: 31 January 2018. Erik, B. – Ivo, M. (2008): The regulation and supervision of the Belgian financial system (1830 - 2005), Bank of Greece Working Paper. EU Commission (1986): COMMISSION RECOMMENDATION of 22 December 1986 on monitoring and controlling large exposures of credit institutions (87/62/EEC), https://publications.europa.eu/ en/publication-detail/-/publication/42d8add2-8943-4580-b792-d8a3a89b95d5 Downloaded: 31 January 2018. EU Council (1973): Directive 73/183/EEC of 28 June 1973 on the abolition of restrictions on freedom of establishment and freedom to provide services in respect of self- employed activities of banks and other financial institutions, http://eur-lex.europa.eu/legal-content/GA/TXT/?uri=CELEX:31973L0183 Downloaded: 31 January 2018. Hantos, E. (1916): A pénzintézeti reform: A Pénzintézeti Központ törvényének és alapszabályainak jegyzetes szövegével (The financial institution reform: With the annotated text of the Pénzintézeti Központ’s law and statutes) (2nd extended edition). Pénzintézetek Országos Egyesülése, Budapest. Jakabb, O. – Reményi-Schneller, L. – Szabó, I. (1941): A Pénzintézeti Központ első huszonöt éve (1916–1941) (The first twenty-five years of the Pénzintézeti Központ [1916–1941]). Királyi Magyar Egyetemi Nyomda, Budapest. Kobrak, C. – Troege, M. (2014): From Basel to Bailouts: Forty Years of International Attempts to Bolster Bank Safety, http://www.labex-refi.com/wp-content/uploads/2013/04/Working_paper_ FromBaselto-Bailouts_Troege_2014.pdf Downloaded: 31 January 2018. Kovács, Gy. (2013): A Dessewffyek a gazdaságelméletben és a gazdaságpolitikában (The Dessewffy Family in Economic Theory and Economic Policy). JATEPress Kiadó, Szeged. Kövér, Gy. (1993): Az Osztrák-Magyar Bank, 1878–1914 (The Austro-Hungarian Bank, 1878–1914). In: Bácskai, T. (ed.): A Magyar Nemzeti Bank története I: Az Osztrák Nemzeti Banktól a Magyar Nemzeti Bankig (1816–1924) (History of the Magyar Nemzeti Bank I: From the Austrian National Bank to the Magyar Nemzeti Bank [1816–1924]). Budapest, Közgazdasági és Jogi Könyvkiadó, pp. 259–342. Mitchener, J. K. – Jaremski, M. (2012): The Evolution of Bank Supervision: Evidence from U. S. States. NBER Working Paper Series. No. 20603, http://histoireeconomique.ca/pdfs/2012/mitchenerjaremski.pdf Downloaded: 31 January 2018.

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10. Banking regulation and supervision Mooij, J. – Prast, H. M. (2002): A Brief History of the Institutional Design of Banking Supervision in the Netherlands., https://www.dnb.nl/binaries/ot048_tcm46-146058.pdf Downloaded: 31 January 2018. Office of the Comptroller of the Currency (2011a): A Short History. Comptroller of the Currency, Administrator of National Banks, US Department of the Treasury. https://www.occ.treas.gov/ about/what-we-do/history/OCC%20history%20final.pdf Downloaded: 31 January 2018. Office of the Comptroller of the Currency (2011b): The OCC in Challenging Times. Comptroller of the Currency, Administrator of National Banks, US Department of the Treasury. https://www. occ.gov/about/what-we-do/history/The%20OCC%20in%20Challenging%20Times%20Exalt_5. pdf Downloaded: 31 January 2018. Quintyn, M. (2013): Principles versus Rules in Financial Supervision—Is There One Superior Approach? QFinance Newsletter, http://www.financepractitioner.com/regulation-best-practice/principlesversus-rules-in-financial-supervisionis-there-one-superior-approach?page=1 Downloaded: 31 January 2018. Reserve Bank of Australia (1995): Implications of the Barings Collapse for Bank Supervisors, Reserve Bank of Australia Bulletin. Seregdi, L. (2015): A szavatoló tőke szerepe a hitelintézetek prudenciális szabályozásában (The role of own funds in the prudential regulation of credit institutions), https://www.mnb.hu/letoltes/a-szavatolotoke-szerepe-a-hitelintezetek-prudencialis-szabalyozasaban-1.pdf Downloaded: 31 January 2018. Seregdi, L. (2016): A pénzügyi felügyeletek közötti nemzetközi együttműködés gyakorlata, a továbbfejlesztés szükségessége és lehetséges irányai (The practice of the international cooperation among financial supervisory authorities, the necessity of further development and its possible directions). PhD thesis, Kaposvár University, 2016. Tomka, B. (2000): A magyarországi pénzintézetek rövid története (1836–1947). (A short history of financial institutions in Hungary [1836–1947]). Aula Kiadó Kft., Budapest. Varga, B. (2016a): 100 éve alakult a Pénzintézeti Központ (The Pénzintézeti Központ was established 100 years ago). Financial and Economic Review, Budapest. Volume XV, Issue 1, pp. 124–144. Varga, B. (2016b): A magyar bankfelügyelés megszervezése (19. század második fele – 20. század eleje) (The organisation of Hungary’s banking supervision [From the second half of the 19th century until the early 20th century]). Economy and Finance, Budapest. Volume III, Issue 1, pp. 61–80. Varga, B. (2017): Pénzügyi felügyelés a két világháború közötti Magyarországon (Financial supervision in Hungary between the two world wars). Financial and Economic Review, Budapest. Volume XVI, Issue 1, pp. 143–161. Viñals, J. – Fiechter, J. (2010): The Making of Good Supervision: Learning to Say ‘No’, IMF, 22 p., https://www.imf.org/external/pubs/ft/spn/2010/spn1008.pdf Downloaded: 31 January 2018. Walder, Gy. (1939): Bankellenőrzés és bankpolitika (Bank control and bank policy). Közgazdasági Szemle, Budapest. Volume LXIII, pp. 443–476.

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11.

Acknowledgements The latest volume in the MNB Book Series was primarily inspired by the desire to enhance our knowledge about bank crises and innovations. The editors believe that in order to better understand financial crises, one has to be familiar with the history of banking crises, the reasons behind their emergence and the possible ways of addressing them. The studies in this book trace the changes in the role of money and banks from the first written documents to our present time, presenting the innovations that fostered financial development and those that ended in failure. The book presents not only the history of the emergence and evolution of banks, but also provides guidance in the current challenges faced by the financial sector and the responses that are being shaped today. The studies concerned with the latter draw on the decisions of the Monetary Council of the Magyar Nemzeti Bank, the analyses and workshops based on which they were taken, as well as the results of the discussions at various professional forums. The editors are indebted to György Matolcsy, Márton Nagy, Ferenc Gerhardt and László Windisch for their stimulating support, and all the members of the Monetary Council for their professional comments. Special thanks are due to the authors of the studies in this book, namely: Ádám Banai, Szilárd Benk, Zoltán Eperjesi, Dorottya Eszes, Réka Fenyvesi, László Kajdi, Dr Csaba Kandrács, Attila Kiss, András Kollarik, Zoltán Mamira, Balázs Mladonyiczki, István Papp, Péter Sajtos, László Seregdi, Beáta Szabó, János Szakács, Miklós Szebeny, László Péter Szegfű, Gergő Török, Ágnes Tőrös, Ákos Urbán, Bence Varga and Lóránt Varga. The authors of the boxes also deserve recognition. They are: Lajos Berkó, Zoltán Bögöthy, Zoltán Eperjesi, Balázs Mladonyiczki, Ágnes Nagy and Bertalan Vajda. The authors are also grateful to those who helped prepare the book by processing certain topics. Dr Gábor — 820 —

11. Acknowledgements

Izsák contributed to the project by drafting the part on the development of the deposit insurance system in the United States, while Zoltán Andrási collected the milestones in the evolution of the IT solutions in Hungarian banking. We would like to thank Eszter Hergár for assisting in the communication activities about the book, similar to her work on previous volumes in the MNB Book Series. The authors and editors are much obliged to Réka Egervári, István Papp and István Schindler for their editing and coordination activities, and Ákos Vajas for his useful comments on the book’s design. Thanks go to Soma Szabó and Károly Pavela for their work on graphic design and page layout in this book, as well as to Bence Gáspár, Csaba Horváth, András Vass and Kendall Logan for their valuable contribution to preparing this book. The authors and editors are also beholden to István Csonka, Maja Bajcsy, Sándor Balogh and all other colleagues who took part in any stage of the book’s preparation, for their thorough and devoted efforts without which this work could not have been published.

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List of acronyms ABC

Agricultural Bank of China

Artificial Intelligence

ALM

Asset and Liability Management

API

Application programming interface

ASEAN

Association of Southeast Asian Nations

ASIC

Australian Securities and Investments Commission

ATM

Automated Teller Machine

BCB

Banco Central do Brazil

BCBS

Basel Committee on Banking Supervision

BCCI

Bank of Credit and Commerce International

BHG

Berliner Handels-Gesellschaft

BIBF

Bangkok International Banking Facilities

BIS

Bank for International Settlements

BOC

Bank of China

BoE

Bank of England

BoJ

Bank of Japan

BOT

Bank of Thailand

BRRD

Bank Recovery and Resolution Directive

BSA

Bank Secrecy Act

CBDC

Central Bank Digital Currency

CCB

China Construction Bank

CCBC

Central Corporation of Banking Companies

CCP

Central Counterparty

CEBS

Committee of European Banking Supervisors

CEE

Central and Eastern Europe

CISA

Certified Information Systems Auditor

COBIT

Control Objectives for Information and Related Technology

CRD

Capital Requirement Directives

CRR

Capital Requirements Regulation

— 822 —

List of acronyms

CTR

Currency Transaction Report

Delegated Act

DCA

Deposited Currency Account

DLT

Distributed Ledger Technology

DNB

De Nederlandsche Bank

DSR

Debt service ratio

EBA

European Banking Authority

European Commission

ECB

European Central Bank

EFR

European Financial Services Round Table

EIOPA

European Insurance and Occupational Pensions Authority

ELB

Effective lower bound

ESMA

European Securities and Markets Authority

ESRB

European Systemic Risk Board

European Union

EUR

Euro

Ernst&Young

FASAB

Federal Accounting Standards Advisory Board

FATF

Financial Action Task Force

FCA

Financial Conduct Authority

FDI

Foreign Direct Investment

FDIC

Federal Deposit Insurance Corporation

Fed

Federal Reserve Bank

FinTech

Financial Technology

FSB

Financial Stability Board

foreign exchange

GdC

Groupe de Contact

GDP

Gross domestic product

G-SIFI

Global Systemically Important Financial Institutions

HFSA

Hungarian Financial Supervisory Authority

HKMA

Hong Kong Monetary Authority

HSBC

The Hongkong and Shanghai Banking Corporation

HUF

Hungarian forint

— 823 —

Banks in history: innovations and crises

IAA

Internal Assessment Approach

IBFC

International Business and Financial Centre

IBM

International Business Machines

ICAAP

Internal capital adequacy assessment process

ICBC

Industrial and Commercial Bank of China

IFC

International Finance Corporation

IFRS

International Financial Reporting Standards

IMF

International Monetary Fund

IMM

Internal Model Method

InsurTech

Insurance Technology

IoT

Internet of Things

IRB

Internal Ratings-Based

IRCJ

Industrial Revitalization Corporation of Japan

ISACA

Information Systems Audit and Control Association

ISMS

Information security management system

ITS

Implementing technical standard

KfW

Kreditanstalt für Wiederaufbau

LCR

Liquidity Coverage Ratio

LGD

Loss Given Default

LIBOR

London Inter-bank Offered Rate

LTCM

Long-Term Capital Management

MAS

Monetary Authority of Singapore

MBS

Mortgage-Backed Security

MNB

Magyar Nemzeti Bank

MPOSZ

Magyarországi Pénzintézetek Országos Szövetsége (National Association of Hungarian Financial Institutions)

MREL

Minimum requirement for own funds and eligible liabilities

NAL

No enforcement action letters

NBB

National Bank of Belgium

NCD

Negotiable Certificate of Deposit

NCTA

National Cable and Telecommunications Association

NPL

non-performing loan

NSFR

Net Stable Funding Requirement

OCC

Office of the Comptroller of the Currency — 824 —

List of acronyms

OCPE

Office Central de la Petite Épargne

OECD

Organisation for Economic Co-operation and Development

OKH

Országos Központi Hitelszövetkezet (National Central Credit Union)

P2P

peer-to-peer

PAD

Payment Account Directive

PBOC

People’s Bank of China

PCBC

People’s Construction Bank of China

Personal Identification Number

PKO

Powszechna Kasa Oszczędności (General Savings Bank)

PoS

proof-of-stake

PoW PRA

proof-of-work Prudential Regulation Authority

PSD

Payment Services Directive

RCC

Resolution and Collection Corporation

RFC

Reconstruction Finance Corporation

RKG

Reichs-Kredit-Gesellschaft

Rt.

Részvénytársaság (joint-stock company)

RTGS

Real-time Gross Settlement System

RTS

Regulatory Technical Standard

SDR

Special Drawing Rights

SREP

Supervisory Review and Evaluation Process

SWIFT

Society for Worldwide Interbank Financial Telecommunication

TLAC

Total Loss Absorbing Capacity

TRIS

Thai Rating and Information Service

UFJ

United Financial of Japan

United Kingdom

United Nations

UNODC

United Nations Office on Drugs and Crime

USA

United States of America

USD

United States Dollar

WWI

World War I

WWII

World War II

— 825 —

List of boxes, charts and tables List of boxes Box 3-1: Monetary transactions of Byzantium and the Arab world of the Middle Ages

Box 3-2: Ecclesiastical views on interest in the Middle Ages

Box 3-3: The Silk Road

Box 3-4: The Fuggers and their connections in Hungary

Box 3-5: Establishment of Amsterdamsche Wisselbank

107

Box 3-6: The Dutch tulip mania

113

Box 4-1: Credit, Light, Stage – works of István Széchenyi

141

Box 4-2: Rothschilds, Sinas

150

Box 4-3: The emergence of the two-tier banking system

171

Box 4-4: The classic era of gold standard and the further diffusion of central banks

176

Box 4-5: Agricultural cooperative model on Crédit Agricole’s example

185

Box 4-6: The process of making money and the importance of interest

192

Box 4-7: Banknotes in Scotland

199

Box 4-8: The South Sea Bubble

212

Box 4-9: The first issue of banknotes in the Habsburg countries

244

Box 4-10: The temporary Hungarian bank of issue

265

Box 4-11: The first global crisis – stock market, trade and credit crisis of 1857

271

Box 5-1: Industrial espionage in Great Britain in the 19th century

295

Box 5-2: The Holy Roman Empire, German Confederation, German Empire and the unification of Germany

304

Box 5-3: Private banks

306

Box 5-4: The first ‘bank resolution’ in Germany

309

Box 5-5: The first decades of Deutsche Bank

312

— 826 —

List of boxes, charts and tables Box 5-6: The savings banks of Saxony

334

Box 5-7: Landschafts, the first German mortgage credit institutions

344

Box 5-8: The system of German credit institutions today

351

Box 5-9: The failure of the City of Glasgow Bank

352

Box 5-10: The first and the second American banks that failed

369

Box 5-11: The Gold Rush in the USA

376

Box 5-12: Origins and development of clearing houses

401

Box 5-13: Parties and party systems before and after the Compromise

405

Box 5-14: Foundation of the First Hungarian General Insurance Company (Első Magyar Általános Biztosító Társaság) in the year of the crisis

410

Box 5-15: Guilds and chambers

419

Box 5-16: 1873 – the second global crisis

426

Box 5-17: Birth and spread of universal banks

447

Box 5-18: Mortgage loans in the period of the Compromise

456

Box 5-19: Latin Monetary Union (LMU)

466

Box 6-1: State assistance during the pre-World War II banking crises

507

Box 6-2: History of bank robberies

530

Box 7-1: Fiscal costs of banking crises after WWII

574

Box 7-2: Fiscal cost of banking crises during the global financial crisis

604

Box 7-3: Historical overview of money laundering and the fight against it

605

Box 8-1: The hype cycle in technological innovations

629

Box 8-2: Traditional payment systems challenged? – Bitcoin and other altcoins

634

Box 8-3: Comparison – FinTech innovations in the past and today

638

Box 8-4: ‘Data is the gold of the future’ – Old players with new activities

643

Box 9-1: Types of virtual currencies

691

Box 9-2: Various cases of CBDC implementation

703

Box 9-3: Where are the profits of money issuance realised?

715

Box 10-1: Banking operational risks

743

Box 10-2: The separation of investment and commercial banking in the US

752

Box 10-3: The failure of Bankhaus Herstatt

760

— 827 —

Banks in history: innovations and crises Box 10-4: The BCCI scandal

763

Box 10-5: Consolidated supervision

765

List of charts Chart 3-1: Law Code Stele of King Hammurabi (18th century BC)

Chart 3-2: Gold rings being weighed on an Egyptian mural painting (14th century BC)

Chart 3-3: Lydian coin (6th century BC)

Chart 3-4: Athens dekadrachm (467–465 BC)

Chart 3-5: Business letter written on wooden tablets from the fort of Vindolandain northern England (1st-2nd century AD)

Chart 3-6: Tuscan banker at work (14–15th century)

Chart 3-7: Chinese 1 kuan note from 1375

Chart 3-8: Gold florin of Florence (1347)

Chart 3-9: Minting coins

Chart 3-10: The Beurs in Amsterdam (1653)

Chart 3-11: Jacob Fugger in his office with his clerk – the volumes behind them are labelled with the names of the cities with which the banker did business

102

Chart 3-12: Dutch fluyt

104

Chart 3-13: Bruges harbour crane in the Middle Ages

104

Chart 3-14: Wisselbank started its operations at the old mediaeval town hall of Amsterdam 108 Chart 3-15: Black tulips

115

Chart 4-1: Europe in 1815

130

Chart 4-2: Revolutions in 1848 in Europe

133

Chart 4-3: Colonial empires in 1800

136

Chart 4-4: Countries and regions under Habsburg sovereignty between 1816 and 1867

138

Chart 4-5: Monarchs of Hungary between 1740 and 1916

139

Chart 4-6: István Széchenyi

142

Chart 4-7: Date of the first relevant railway line by country in Europe

148

Chart 4-8: Mayer Amschel Rothschild

151

— 828 —

List of boxes, charts and tables Chart 4-9: The old building of the Bank of England, from Mansion House (from an illustration of 1730)

157

Chart 4-10: Five pounds banknote from 1729 which was valid in Wales and England

161

Chart 4-11: Cheque from London (1725)

162

Chart 4-12: Five pounds banknote issued by York Union Banking Co. Ltd. in the 1870s

168

Chart 4-13: Hugh McCulloch (1808–1895), the successful implementer of the National Bank Act of 1863

175

Chart 4-14: The exchange rate of gold and silver

178

Chart 4-15: The United Kingdom’s inflation index between 1750 and 2001

184

Chart 4-16: The first Crédit Agricole headquarters in Salins

186

Chart 4-17: The stock of the South Sea Company

217

Chart 4-18: Countries and regions under Habsburg rulership between 1816 and 1867

241

Chart 4-19: Anticipation note (Antizipationsschein) from 1813 (value: 5 guilders)

245

umber of savings banks in Austria and in Hungary 1845, 1848 Chart 4-20: N

251

ór (Móricz) Ullmann, one of the founders of the Hungarian Commercial Chart 4-21: M Bank of Pest

257

Chart 4-22: T he deposit turnover of the Hungarian savings banks and the Hungarian Commercial Bank of Pest between 1843 and 1847

260

andwritten Kossuth-bankó (by Károly Conlegner) Chart 4-23: H

266

eamen’s Savings Bank attack in 1857 Chart 4-24: S

272

Chart 5-1: E stimated GDP per capita in selected countries between 1700 and 1913 (calculated in USD 1990)

289

Chart 5-2: T he silk processing mill founded by Lombe

297

he German Confederation between 1815 and 1866 Chart 5-3: T

303

Chart 5-4: T he headquarters of Metzler Bank around 1849

307

Chart 5-5: H eadquarters of the Schaaffhausen’sche Bank in Cologne

310

Chart 5-6: T he Berlin building of Deutsche Bank with the famous connecting bridge

313

Chart 5-7: T he German Empire between 1871 and 1918

316

Chart 5-8: L ocomotive factory of August Borsig (1847)

317

Chart 5-9: S hare of different types of financial institutions in the total assets of German financial institution between 1860 and 1913, in per cent

322

— 829 —

Banks in history: innovations and crises Chart 5-10: Number of private banks and joint-stock banks in the German Empire 1891, 1902 and 1911

329

Chart 5-11: Customer reception room of a savings bank of Berlin in 1894

330

Chart 5-12: Number of savings banks in Prussia between 1839 and 1913

333

Chart 5-13: Hermann Schulze-Delitsch

339

Chart 5-14: Friedrich Wilhelm Raiffeisen

341

Chart 5-15: Roof ornaments resembling the Raiffeisen emblem

342

Chart 5-16: The Reichsbank building around 1905

348

Chart 5-17: 100-mark note issued by the Reichsbank in 1908

350

Chart 5-18: Map of the province of Massachusetts Bay

356

Chart 5-19: War campaigns of King William

357

Chart 5-20: One of the first banknotes in America from 1690, value: 20 shillings

360

Chart 5-21: 15-shilling banknote printed for Pennsylvania by Benjamin Franklin

363

Chart 5-22: Continental one-third dollar bill

365

Chart 5-23: First Bank of the United States

368

Chart 5-24: Farmers’ Exchange Bank 10-dollar bill from 1808

370

Chart 5-25: One-dollar banknote from the Tiverton Bank

372

Chart 5-26: Second Bank of the United States

374

Chart 5-27: The original United States Mint in San Francisco

378

Chart 5-28: Gold panner at the Mokelumne River (1860)

380

Chart 5-29: Gold miners working in a river bed with the water diverted

381

Chart 5-30: Quartz Stamp Mill in Grass Valley

381

Chart 5-31: Completion of the first American transcontinental railway

392

Chart 5-32: First 100-dollar banknote of the Federal Reserve (1914)

397

Chart 5-33: Three key entities influencing the functioning of the Federal Reserve

399

Chart 5-34: Structural and organisational structure of the decentralised Federal Reserve system

400

Chart 5-35: Development of Hungarian party relations in the era of dualism

408

Chart 5-36: Common finances of Austria-Hungary

413

Chart 5-37: The Hungarian economy in the era of Dualism, 1867–1918

415

— 830 —

List of boxes, charts and tables Chart 5-38: Change in the distribution of industrial capital stock between 1900 and 1913

418

Chart 5-39: Roller mill, the world-famous invention of András Mechwart

422

Chart 5-40: Contemporary steam mill stock

423

Chart 5-41: The distribution of steam engines in different sectors of industry

424

Chart 5-42: Roller mill in Budapest

426

Chart 5-43: 9 May 1873, Black Friday at the Vienna Stock Exchange (panic)

427

Chart 5-44: Opening ceremony of the Pest—Vác railway line in 1846

432

Chart 5-45: Development of the railway network between 1867 and 1914

433

Chart 5-46: MÁV (Hungarian State Railway) express train engine from 1874

434

Chart 5-47: Branches and personal loan districts of the Austro-Hungarian National Bank (1886)

455

Chart 5-48: The Kaposvár branch of the Austro-Hungarian National Bank

464

Chart 5-49: Services of the Kaposvár branch of Austro-Hungarian National Bank

465

Chart 5-50: Hungarian side of a 5-forint banknote

468

Chart 5-51: Austrian side of the same banknote from 1881

468

Chart 5-52: Austro-Hungarian 100-crown coin from 1908

471

Chart 5-53: 100-crown banknote

471

Chart 6-1: Financial dependencies after the World War I

491

Chart 6-2: Development of the Dow Jones stock index

493

Chart 6-3: Number of bank suspensions between 1921 and 1933

497

Chart 6-4: Number of countries using the gold standard

506

Chart 6-5: Monthly average price of gold expressed in paper mark

520

Chart 6-6: Number of bank robberies in the USA

532

Chart 6-7: View of Szabadság tér (Liberty Square)

533

Chart 7-1: Functions of financial innovations

548

Chart 7-2: ATM machines in the USA

549

Chart 7-3: Historical growth of Asian local bond markets

564

Chart 7-4: Credit provided by the banking sector, percentage of GDP

565

Chart 7-5: G ross domestic savings, percentage of GDP

566

— 831 —

Banks in history: innovations and crises Chart 7-6: Number of systemic banking crises starting in a given year

574

Chart 7-7: Channels of the fiscal impacts of banking crises

575

Chart 7-8: Changes in outstanding loans by sector in Japan

586

Chart 7-9: Emergence of Japanese mega-banking groups

589

Chart 7-10: Chinese banks’ foreign claims

592

Chart 7-11: Shadow assets as a percentage of capital buffers

596

Chart 7-12: Private sector credit as a percentage of GDP in China

597

Chart 7-13: Flow chart for the expansion of foreign currency lending

603

Chart 7-14: Costliest banking crises during the recession of 2008

605

Chart 7-15: Stages of money laundering

607

Chart 8-1: Return on equity and assets in the USA and the eurozone

620

Chart 8-2: Proportion of non-performing loans as a percentage of the gross loan stock

621

Chart 8-3: Impact of the economic crisis and subsequent developments on banks’ operation 623 Chart 8-4: Number of Internet users and connected devices

624

Chart 8-5: Expectations of FinTech innovation efforts in the next 3–5 years (2017)

629

Chart 8-6: The hype cycle depending on time and expectations

630

Chart 8-7: The role of FinTech innovations in the value chain of financial services

633

Chart 8-8: Evolution of the number and average price of bitcoins

635

Chart 8-9: Net interest income and operating expenses as a proportion of total assets in EU Member States

642

Chart 8-10: Regulatory dilemma linked to FinTech solutions

655

Chart 8-11: Schematic flowchart of the operation of an Innovation Hub

658

Chart 8-12: Schematic flowchart of the operation of a Regulatory Sandbox

660

Chart 8-13: International examples of Regulatory Sandboxes and the date of introduction 662 Chart 8-14: Possible development paths for FinTech companies

664

Chart 8-15: Development level of financial and mobile service infrastructure by regions 665 Chart 8-16: Share of those using at least one non-traditional financial service

668

Chart 9-1: Number of bitcoins since the currency’s creation

680

— 832 —

List of boxes, charts and tables Chart 9-2: Standard deviation of daily yields of asset classes in 2017

683

Chart 9-3: Percentage change in the exchange rates of virtual currencies in 2017

693

Chart 9-4: Bitcoin’s offered advantages to users and its disadvantages

694

Chart 9-5: Stylised balance sheet of commercial banks during the build-up of the Bitcoin stock (A) and in the case of a central bank interest rate hike (B)

699

Chart 9-6: The money market in the case when there is only CBDC in the economy

703

Chart 9-7: The financial system as a function of the popularity of the CBDC and of the central bank standing facility

705

Chart 9-8: Comparison of market capitalisation of virtual currencies with that of other assets

721

Chart 10-1: The main risks and regulatory areas of banking operation

742

Chart 10-2: Internal and external safeguards in banking operation

777

Chart 10-3: Milestones in the evolution of banking regulation in the EU

788

Chart 10-4: The process of the deepening of the crisis

797

Chart 10-5: The European System of Financial Supervision

803

List of tables Table 3-1: List of products that could be bought for a Viceroy tulip bulb worth 2,500 guilders

115

Table 4-1: Early provincial banks in the United Kingdom

163

Table 4-2: The first joint-stock banks in England

164

Table 4-3: The banking system of the United Kingdom in 1844

165

Table 4-4: The banking system of the United Kingdom in 1884

168

Table 4-5: Differences between the rules of the Ordinance and the characteristics of Hungarian joint-stock savings banks

263

Table 5-1: Length of railroads between 1840 and 1910 by country (km)

290

Table 5-2: Coal and iron mining (in million tons)

291

Table 5-3: Importance and rate of growth of selected industry branches in Great Britain and Germany between 1880 and 1913

295

Table 5-4: Importance of exports and structural changes in selected countries and regions between 1840 and 1910

301

— 833 —

Banks in history: innovations and crises Table 5-5: Rate of growth of export and GDP per capita in European countries between 1860 and 1910 (calculated in USD, 1960)

301

Table 5-6: Number of credit cooperatives in Germany between 1860 and 1914

340

Table 5-7: Number of credit institutions in Hungary between 1866 and 1895

439

Table 5-8: Issue of securities and investments in Hungary between 1860 and 1873 (increase in capital stock in million forints)

440

Table 5-9: Capital investments in Hungary between 1867 and 1900 (annual average, million forints)

441

Table 5-10: The banks of Budapest on the path of becoming ‘big banks’ between 1869 and 1904

442

Table 5-11: Percentage of foreign and domestic capital concerning investments in Hungary

452

Table 5-12: Mortgage loans and mortgage bond transactions (year’s end data, in million Austrian forints)

456

Table 5-13: Models concerning mortgage banks

459

Table 6-1: Selected indicators of the US economic crisis

495

Table 6-2: Midland Bank: Numbers of branches and sub-branches between 1910 and 1940 516 Table 6-3: Percentage reduction of aggregated value of various classes of liquid assets of the Berlin big banks during three episodes of deposit loss

522

Table 6-4: Main balance sheet items of the Hungarian credit institutions between 1925 and 1938 (in million pengős)

529

Table 7-1: Banking crises dates and costs in Asian and Latin American countries between 1970 and 2011

554

Table 7-2: Chronology of major financial liberalisation measures in Thailand

558

Table 7-3: Latin America – First-generation reforms of the financial system

568

Table 7-4: Foreign bank ownership in selected emerging markets

571

Table 7-5: Classification of financial innovations

581

Table 7-6: Early warning indicators for stress in domestic banking systems

594

Table 8-1: Characteristics of FinTech eras

640

Table 8-2: Potential positive effects of technological innovations on financial intermediation 650 Table 8-3: Potential negative effects of technological innovations on financial intermediation 652

— 834 —

List of boxes, charts and tables Table 9-1: Classification of the different types of money

677

Table 9-2: Comparison of virtual currencies and CBDC

678

Table 9-3: Classification of the financial system with CBDC with respect to banking system tiers

725

Table 9-4: Advantages and risks of the CBDC system according to different central bank points of view and realisation methods

728

Table 10-1: The main activities of microprudential supervision

741

Table 10-2: The distribution of home and host supervisory roles in the EU

745

Table 10-3: Capital requirements calculation methods in CRR

781

Table 10-4: Key documents published by the Basel Committee

782

Table 10-5: The legal instruments of banking regulation in the European Union

787

Table 10-6: Summary of the regulatory responses to the financial crisis at global and EU level

798

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