Treasury Today Country Profiles in association with Citi

Financial innovation (part one): Lessons will be learned

Vintage photo of a Man Working On Complex Machine

Since mankind has been trading, there have been many attempts to steer the financial processes involved in new and interesting ways, and not always for the good of the people. In the first part of this two-part Insight, we take a brief historical trip into the world of financial innovation in the company of a distinguished financial expert.

Financial innovation is nothing new. That is, the creative force has sought to become part of financial exchange almost as long as people have been trading. And yet some of the financial products of antiquity bear a remarkable resemblance to today’s offerings. For example, archaeologists working in what was Mesopotamia (modern-day Iraq and parts of Syria and Turkey) uncovered tablets from around 4,000 years ago which were written (in cuneiform script) as loan contracts. Each typically shows the recipient of the loan, the amount loaned, the term of the loan and the ‘interest rate’ agreed (i.e. what extra would be paid). When the loan was repaid, the tablet was usually broken (so presumably those tablets found intact were defaulted loans). A number of these tablets record the loan of a weight of silver (typically around 8 grams) to farmers to buy seeds for crops, with the promise that the loan would be repaid with interest following the harvest.

Around 1800 BC, under the reign of Hammurabi, the sixth king of Babylon, Mesopotamian temples which had accrued vast sums through local taxation began lending at favourable rates to poor citizens. The idea was to help them start small businesses as a means of climbing out of poverty. This surely pre-empted modern microfinance institutions, such as Grameen Bank, by about 3800 years.

By around 500 BC, financial practice had developed. It is known that in the Babylonian city of Borsippa (now in central Iraq) one of the most powerful ‘institutions’ engaged in proto-banking activity, the Ea-iluta-bani family, were carrying out risk assessment and taking collateral in lieu of interest on higher risks. The family is also understood to have established structured financial products around the supply-and-demand pricing of food.

Moving forward

Ancient history reveals much about how we live today and Sir Richard Lambert, a Senior Independent Advisor at Deutsche Bank, Chancellor of the University of Warwick, former CBI Director-General and editor of the Financial Times, believes that financial innovation is “absolutely a force for good”. Speaking at the ACT annual conference earlier this year, Lambert feels that the creative process applied to finance has “driven the engine that has lifted living standards and well-being around the world”. 

He cites the printing of paper money in China in 1214 AD as representing a “huge advance” on the often impractical iron currency that it replaced. He also points to the country’s various assertions about the fate of those who tried to forge these notes (typically the death penalty for the individual and all known acquaintances), so taking financial fraud measures right from the start. Lambert fetes Italian mathematical genius, Leonardo Pisano Bigollo and his publication of Liber Abaci (Book of Calculation) in 1202 as “playing a huge role in the development of Europe’s capital markets and trade”. Although it is suggested that the work borrows extensively from earlier Arab scholars, it still brings to the fore a range of today’s essential financial processes such as how to calculate present value and compound interest, how to divide profits from business ventures and work out the price goods in a variety of weights, measures and currencies. “It laid the economic foundation for the Italian city states that prospered throughout the Renaissance period, shaping Western culture forever,” comments Lambert.

In the trade space risk is always in attendance. In the 17th century, when trade routes were rapidly expanding, the level of exposure to risk increased. The negotiable foreign bill of exchange was the big innovation of the time which went a long way to making London the trading capital of the world.

In 1693, astronomer and mathematician, Edmund Halley, presented his table for calculation of present value of annuity payments, kick-starting the life annuity contract industry and that of the private insurance market and friendly societies (the world’s first form of social insurance). Around 170 years later, inflation-linked securities came into being during the American civil war when bonds issued by Confederate states had a redemption value based on the price of cotton, which was “a great way to protect consumers against the inflationary policies of their government,” comments Lambert. The first Eurobond was not, he believes, the $15m six-year ‘Autostrada bond’ arranged for the Italian government by London bankers, S. G. Warburg in 1963, but sterling-denominated foreign government bonds issued by N.M.Rothschild for the Russian and Prussian governments (in 1822 it managed a 5%, £3.5m loan to the Prussian government and a 5% £6.6m loan to the Russian government).

“Finance has always had three common features: the inter-temporal transfer of value; the ability to contract on future outcomes; and the negotiability of claims,” states Lambert. Advances in human understanding over thousands of years have made “enormous differences and huge breakthroughs”. But he acknowledges that the creative imperative has, from time to time, “made the wheels fall off”. A brief delve into the darker side of finance reveals some spectacular errors of judgement.

The dark side of innovation

As the world’s first major debt/equity swap, the formation of the British South Sea Company (SSC) was set up in 1711 as a purpose-built vehicle. It was intended as a public-private partnership for the consolidation and cost-reduction of Britain’s national debt. It was also a disaster waiting to happen. And it did.

The £10m debt was bought at a discount and issued as stock in this new company which had been granted a monopoly on trade in South America. There was a feeding frenzy as the citizens of this prospering nation bought into the scheme with their new-found wealth (Sir Isaac Newton said: “I can calculate the movement of the stars, but not the madness of men”, although he himself lost a large sum). Many other initial public offerings (IPOs) were issued on the back of the insatiable appetite for stock, including one lunatic scheme to reclaim sunshine from vegetables – but people wanted to invest and invest they did (rather as tulip-mania hit Holland in the 1630s and the bubble expanded in the 1990s).

From a start of £100, SSC’s share price very quickly peaked at £1,000. But the company was badly run (and in any case the Spanish controlled most of South America so trade was almost impossible), and so by the end of 1720 it had crashed, precipitated by the rapid selling by SSC’s management of their own stock (hoping no one would notice) when they realised that the company was massively over-valued.

Bankruptcies were plentiful, many having taken loans to buy expensive shares they could not then sell. As other stock prices followed rapidly downwards, a complete collapse of the financial system was narrowly avoided when the government stepped in to bail out the banks (another familiar scene).

Such falls from grace can also befall a hitherto well-run business if new financial measures get the better of it. The Dutch East India Company, often considered the first multinational corporation (MNC) in the world (and the first company to issue stock), found ways to take the concept of leverage to new heights. It started trading in 1602 and did exceptionally well. But the rot started to set in during the mid to latter part of the 18th century as shareholders wanted it to go on paying big dividends (18%). Towards the end of the century the company had raised its debt/equity ratio ever-upwards when, having faced various supply-chain problems (including war and uprisings) which depleted its capital, its directors were forced to replenish liquidity by resorting to short-term financing backed by expected (but over-ambitious) revenues from home-bound fleets. The loans to keep the company operating reduced its net assets to zero and it was wound up in 1798 with some spectacular individual losses.

History reveals some ingenious financial models and some absolute disasters and from these lessons should be learnt, but often they are not. The actual cost of current financial crisis is unknown but in assessing the damage, Lambert quotes the economist, John Maynard Keynes, who, writing in the 1936 (after the 1933 collapse) said: “When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done”. For Lambert then, “financial innovation is always good, except on the occasions when it isn’t.”