BUS614: International Finance

Although money lending and money changing are very old activities (there are records of loans by Babylonian temples as early as 2000 b. C.), the early beginnings of investment and commercial banking may be traced to twelfth century Italy. The weakening of church restrictions on economic activity during the Renaissance and the growth of maritime ties of coastal Italian cities with the Levant set the stage for the rise of Italian merchant banking houses. As these coastal cities grew to be an important conduit for trade with the European interior, some of the larger merchant banks extended their activities to other European countries and came to dominate international finance from the twelfth through the fifteenth centuries. These family-owned and managed firms are generally viewed as the predecessors of modem commercial banks. In addition to accepting deposits and financing foreign trade, these houses made a market in foreign exchange, extended short and medium-term loans to entrepreneurs, rulers, noblemen, and the clergy, and invested in industrial and commercial ventures.

Two of the largest banking houses in the early fourteenth century were those of the Bardi and the Peruzzi. Located in Florence, the leading banking center of this period, these banks handled extensive financial interests in key European centers. A more prominent bank, however was that of the Medici. Established in Florence, in 1397, the Medici bank grew both within and outside Italy; by the mid-fifteenth century it had branches in Rome, Venice, Milan, Pisa, Avignon, Bruges, London and Geneva. Each branch was separately capitalized, with the central partnership in Florence retaining the majority ownership stake and the local manager retaining the minority stake. However, based on performance, managers were compensated with a larger share in branch profits than was guarantied by their equity investment. Before any distribution of profits, it was a customary practice for managers to make due provisions for bad debts. Books were closed once a year and managers had to take them to Florence for a thorough audit.

Branches worked closely with each other in the conducting of the banking business; for example, they extended to each other credit facilities, provided for the transfer of funds and settled claims arising from bills of exchange and other loans. Credit policy was formulated and enforced by guidelines laid down at the headquarters in Florence. Loans were of short or medium-term maturity and were made to merchants and manufacturers as well as to various members of the clergy and European nobility. Clergy and nobility were generally perceived as high risks and credit was allowed only on a collateralized basis, e.g., the pledge of jewels and other personal assets, land and revenues from mines, customs or tax receipts. Credit limits were set for loans to other banks in Italy and for selected officials of the Church (e.g., cardinals and the Pope).

In addition to branches, the bank maintained a network of agents and correspondents in the leading business centers of Europe and the Levant. Operations were sizable and often quite profitable. In the first year of its operation, the bank earned a 10 per cent return on investment, which was by no means excessive considering that the current interest rate paid by banks on time deposits was between 7 and 8 per cent. However, as the bank expanded its geographic reach and scope of services, profitability was affected accordingly. The Rome branch, through its access to Papal deposits, was the principal supplier of liquidity for the Medici bank and produced more than 50 per cent of the bank's total profits during the early part of the fifteenth century. Two other profitable branches were those of Venice and Geneva; throughout the second quarter of the fifteenth century they averaged a rate of return on equity of 60 per cent and 30 per cent, respectively.

In seeking to employ its funds profitably the bank at times took high risks which ultimately undermined its soundness and viability. Indeed, in the course of business, the Medici bank had assumed extensive sovereign risk exposure through loans to such sovereigns as the Pope and Edward IV of England. When these loans went unpaid and had to be written-off, assets were no longer sufficient to meet depositors' claims. The Medici bank fell into insolvency much like its larger predecessors, the Bardi and the Peruzzi. Though bad loans made a major contribution to the collapse of the Medici bank in 1494, other causes included inadequate management and problems in coordinating foreign branches.

Source: Emmanuel N. Roussakis, http://www.fgv.br/rae/artigos/revista-rae-vol-37-num-4-ano-1997-nid-45445/
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