EC120 week 10, topic 9, slide 0 Innovations and Crises in Finance Topics: Monetary Standards and Systems Varieties of Financial Instruments and their Purposes Banks: their evolving role Financing Trade Long-term Finance Financial Crises and Economic Fluctuations Finance and capital: evolution of the banking system Finance and capital: expansion of long-term capital markets

Monetary systems and standards What is `money’? Coinage of precious metals, antiquity onwards Governments have always intervened –Temptation to debase the currency Multiple monies –Different states (typically) have different currencies EC120 week 10, topic 9, slide 1

Financial Instruments and their purposes Apart from money: Debt contracts –Long-term debt, e.g. mortgages, or bonds –Short-term debt, e.g. Bills of Exchange, or bank loans Equity, conferring ownership, e.g. shares in a partnership, or in a corporation Important distinctions: Marketable: may the instrument be traded among holders? Liability: equity often imposes unlimited liability EC120 week 10, topic 9, slide 2

More Money Matters EC120 week 10, topic 9, slide 3

The Role of Banks Banks link money and credit How? Through borrowing and lending Borrowing (banks’ liabilities)? –Owners equity, debt, deposits, “money” Do banks “create” money? –Some, not all, banks issued notes Lend to firms, individuals, governments –Key role: to finance trade EC120 week 10, topic 9, slide 4

Financing Trade Credit becomes vital to support trade expansion –Long-distance trade → time in transit –Work in progress → time to produce Specialist institutions evolve to lend to buyer or seller, or both –“Banks” obtain funds, from partners or borrowing –And lend, at interest, to those who can provide collateral Bill of Exchange − a trade contract, facilitating trade credit –Banks made loans by “discounting”, i.e. buying, Bills of Exchange Banks also arranged settlement of debts –Especially important for widely separated borrowers and lenders EC120 week 10, topic 9, slide 5

Bills of Exchange The Bill of Exchange – an instrument for short term credit `bill’ = contract between `buyer’ and `seller’ for cash settlement at a specified future date `bill’ is typically guaranteed by an `acceptor’ (bank) `bill’ can then be traded for cash before settlement EC120 week 10, topic 9, slide 6

EC120 week 10, topic 9, slide 7 Long-term Finance Long-term debt supported markets in land – Mortgages Capital markets for long-term securities expand in 18C Vulnerable to mania and crises –Prospect of Govt. default with onset of war –Bubble Act, 1720, restricted joint-stock companies Corporate finance (for business) –Finance trade (trade credit, working or circulating capital) –Long-term, fixed capital demanded only in a few sectors

Financial Crises Role of banks in credit crises: –Highly fragmented system, vulnerable to crises –Little central (national) supervision until 19C Crises in long-term capital markets –Narrow impact until expansion of equity markets in 19C –Most involve government debt EC120 week 10, topic 9, slide 8

Economic Fluctuations Pervasive, irregular fluctuations and crises –More regular Trade Cycle appears later, from mid-19C Economic fluctuations driven by harvests Credit crises associated with fluctuations in trade EC120 week 10, topic 9, slide 9

EC120 week 10, topic 9, slide 10 Finance and capital: banking system Restoration of gold parity, 1819/20 Restrictions on private issues of bank-notes Trend to banks’ amalgamation, branch banking in UK Recurrent credit crises result in financial distress Bank Charter Act, 1844 – confirmed Bank of England’s role in UK monetary system Emergence of central banks: `Lender of last resort’

EC120 week 10, topic 9, slide 11 Expansion of long-term capital markets Capital markets: Bubble Act repealed in 1825 Railways required large scale investment Limited liability became widespread from 1856 Recurrent speculative investment mania

Joining it all up Themes: Governments always need revenue, partly from borrowing Trade requires credit and a payments mechanism Modern industry requires long-term capital What drives financial performance? Fragility or stability of banks (and other financial institutions) State capacity – Gov’t borrowing/taxation to support finance Democratic accountability International co-operation (or lack of it) EC120 week 10, topic 9, slide 12