Financial institutions

Banks are institutions that accept and manage deposits of money from people and also offer credit—or loans—to clients. The term bank comes from the medieval Italian word banca—bench or table in English. The term came to be used because early financial transactions were conducted at a table or bench.

Even though the practice of banking as we know it today originated in medieval Italian city-states, these practices didn’t appear out of nowhere. They were the culmination of many centuries of development. Italy became the birthplace of banking in the twelfth and thirteenth centuries because it was at the center of a global trading network that exposed Italian traders and their financiers to various methods of money management. Italians then built on this knowledge to create new and better methods of handling financial exchanges.

In 1202, Leonardo Fibonacci published a book called the Liber Abaci—The Book of Calculation. Famous today for the Fibonacci sequence, Fibonacci was the son of a customs official—someone who collects taxes on imported goods—so he had a lifetime of experience with trade and finance. In his book, Fibonacci explained how to use mathematical concepts that had been developed in India and the Middle East and apply them to the business of trade and money management. While finance and commerce were not new to Europe, the methods that Fibonacci introduced made much more complex financial calculations possible.${}^1$‍

In the medieval period, long-distance trade was risky because of high upfront costs and the possibility of a failed venture. Paying for a medieval trading voyage required several steps: buying goods that could be exchanged at the destination, fitting out a ship or pack animals, and hiring people to actually make the trip.

Because a successful trading voyage could yield large profits, the expense of launching a trading voyage was considered a worthwhile investment. But trade took a long time. The delay between funding the voyage and collecting the profits—assuming the voyage was successful—was considerable. A single trading voyage might take months or even years to return to its place of origin with new goods to sell.

Credit helped to fill the gap between paying for the voyage and collecting the profits. Credit refers to the lending and borrowing of money with a promise that it will be repaid at some future date. The idea of lending money to traders in return for a share of the venture’s profit existed in many societies. For example, partnerships where an investor funded a trader’s venture in return for a share of the profits were common throughout the Abbasid Caliphate, Song China, and in European trading cities.

In any of these settings, a trader might have needed to borrow money up front to finance his voyage. Knowing that he—almost all medieval traders were men—would be able to pay off the debt once he had sold his goods, he would obtain a loan with a promise to pay the lender a share of the profit if the trading venture was successful.

This practice of lending money to traders in exchange for a share of potential profit was a well-established practice by the time banking appeared in Italy. Lending out money and collecting interest—a charge to borrow money on top of the principal loan amount—was the simplest way to make money from loans, but religious prohibitions kept most people from doing it. Interest was considered usury by the Catholic Church and riba in Islamic law. In Judaism, charging interest to fellow Jews was forbidden, but charging interest to others was acceptable. In all of these cases, the prohibition on charging interest was driven by a combination of concerns over which ways of making money were ethical, particularly since these practices tended to be most damaging to the poor.

The change that occurred in thirteenth century Italy with regard to banking and finance was not the invention of credit. Rather, the new idea was that a person could make money from buying and selling financial instruments—essentially monetary contracts—such as a bill of exchange. Profits earned on legitimate trade, or through natural increases in value of an item, avoided the potential charge of usury.

Bills of exchange were written agreements that entitled the holder of the bill to a specified payment from a third party. You can think of a bill of exchange as having value because it promises a future payment. Rather than just loaning money to traders and waiting for them to return to share the profits, bankers began buying and selling these bills of exchange as objects of value in and of themselves.

For example, imagine an investor had lent money to a trader but needed that money before the trader returned. The investor could write a bill of exchange that entitled the holder to the investor’s share of the profit. He could then sell that bill, probably at a slightly discounted price, in order to get money now. The buyer of the bill could then collect the original investor’s share from the trader when he returned.

The Medici of Florence were not the first Italian family to take up banking, but they were the most successful. From the late fourteenth century until the end of the fifteenth century, the Medici established branches of their bank in major cities throughout Europe. Having branches in different cities allowed the Medici to make money by taking advantage of changing exchange rates and therefore avoiding committing the sin of usury.${}^2$‍

Having banks in many cities that were willing to honor bills of exchange also made it possible to transfer large sums of money across the continent. Since a Medici Bank bill of exchange could be redeemed at any branch, a person could move money without taking the risk of physically transporting coins. Not only merchants and traders, but kings and Popes borrowed from the Medici and other major banking families. This was in part because no one else was able to lend the amount of money needed to fund a war, for example. This made banking families very powerful and important players in politics as well as economics.

Although various financial tools and practices developed in China and the Middle East, it was only in Europe that a full-blown banking industry arose. Historians have puzzled over why this was the case, particularly since China and the Middle East both had far more developed economies than Europe prior to the emergence of large-scale banking. Europe’s development of financial institutions certainly drew heavily on information gained through commercial interactions with these places.

So why did Europe develop a banking industry so long before China or the Middle East? One theory is that both the Song Dynasty and the Abbasid Caliphate were toppled by the Mongols at about the time that Italian banking was starting to develop, which could have stalled economic development in those regions. In addition, some historians have argued that the fractured political organization of Europe actually helped in the development of banking. The idea has some merit, since the Medici made much of their fortune by exploiting exchange rates between the large variety of local currencies throughout Europe. Large imperial structures, such as those in Song China and the Abbasid Caliphate, meant a common currency with no opportunity to exploit exchange rates.