Lecture 1 1. Malthusian and Neo-Malthusian Theories/ Ran Abramitzky and Fabio Braggion -The foundation of Malthus' theory relies on two assumptions that he views as fixed, namely that food and passion between sexes are both essential for human's existence. Malthus believed that the world's population tends to increase at a faster rate than its food supply. Whereas population grows at a geometric rate, the production capacity only grows arithmetically. Therefore, in the absence of consistent checks on population growth, Malthus made the gloomy prediction that in a short period of time, scarce resources will have to be shared among an increasing number of individuals. - We have two types of checks: -The preventive check consists of voluntary limitations of population growth. Individuals, before getting married and building a family, make rational decisions based on the income they expect to earn and the quality of life they anticipate to maintain in the future for themselves and their families - The positive check to the population is a direct consequence of the lack of a preventive check. When society does not limit population growth voluntarily, diseases, famines and wars reduce population size and establish the necessary balance with resources. According to Malthus, the positive check acts more intensively in lower classes, where infant mortality rates are higher and unhealthy conditions are more common - The preventive and positive checks, by controlling population growth, eventually close the mismatch between the level of population and the availability of resources, but the latter at a cost of creating misery and wickedness that cannot be avoided and are beyond the control of men - Under this perspective, technological improvements that contribute to the increase in agricultural yields will only produce a temporary increase in living standards, but will be offset in the long run by a corresponding increase in population size that will cancel the temporary relief. Migrations could alleviate the effects of the positive check, but Malthus considers this possibility unfeasible, as general conditions were too harsh in possible receiving countries. - Malthus was strongly opposed to monetary transfers from rich to poor individuals. According to him, increasing the welfare of the poor by giving them more money would eventually worsen their living conditions, as they would mistakenly be led to think that they can support a bigger family, which would in turn depress the preventive check and generate higher population growth. At the end of this process, the same amount of resources has to be split between a larger population, triggering the work of the positive check to populations. Moreover, immediately after such a transfer, people can afford buying more food, bidding its price up and decreasing real wages, which hurt poor individuals whose main income comes from their labor -Malthus realized that his model implied that real wages determined by the market would always be pinned down to the subsistence level. If real wages were above this level, population would begin to grow, inducing a decline in nominal wages as a result of firms having a larger supply of labor available. Moreover, the larger population would result in an increase in the demand for goods, which would force prices to go up and real wages to decrease to their subsistence level. This concept was known as the Iron Law of Wages - An immediate consequence is that population growth increases employment in the industrial sector more than it does in the agricultural sector and raises manufacturing supply more than it does agricultural supply. Therefore, population pressure, which increases both the supply and the demand for goods, induces prices of agriculture to move up relative to those of manufacturing, impoverishing factory workers. - Malthus’ model was a better description of agricultural societies that characterized antiquity and the Middle Ages than it was of the post-industrial revolution era. By the 19th century, however, things had begun to change. The modern period saw a substantial decline in fertility rates in industrialized countries, and even though population growth rates increased dramatically to almost 0.6% in 1950 and more than 1.8% in 1990 due to an increase in life expectancy, many countries experienced a dramatic growth in agricultural and industrial production. Living standards improved permanently without a subsequent increase in population growth rates. Malthus’ prediction, which sounded so logical and powerful at the time it was made, was refuted in large parts of the world. Neo-Malthusians -E.A. Wrigley's work has supported Malthus’ theory, focusing his research on British economic and population history. He has argued that Britain, before and immediately after the industrial revolution, displayed all the main features of a Malthusian economy, but by the end of the nineteenth century the relationship between population and income was broken. -He defines British economy before the industrial revolution as an “Organic Economic System”, characterized by decreasing returns to scale, where population movements set standards of living to the subsistence level. The use of wood and other organic materials as source of energy in production process tightened decreasing returns and narrowed production possibilities. -Wrigley shows that in modern Britain, from 1566 to 1871, prices and population were closely related: when population increased, for instance from 1781 to 1806, the price index also rose. On the other hand, downturns in population correspond to decline in prices - David Weir is also among the economists who empirically tested the existence of a Malthusian pressure. Using tax records of Rosny-Sous-Bois, a small village south of Paris, he is able to trace a demographic history of this locality for the year 1747. His findings suggest that Rosny was a classic Malthusian micro-system. In particular, under a Malthusian perspective, age at marriage is expected to fall with rise in income, and mortality rates are predicted to be negatively related with living standards. Indeed, Weir finds that, female age at marriage was lower, the higher the income of the husband, and mortality rates of children and adults were negatively related to income. Critics: -One kind of criticism emphasized potential positive consequences of population growth in the long run ignored by Malthus. Ester Boserup, for instance, suggested that Malthusians' arguments display a reverse causation. According to her, population growth is an autonomous factor, which affects agricultural productivity rather than being affected by it, as suggested by the Malthusian school. Boserup claimed that Malthus' assumption of diminishing returns to labor needs not hold in the long run, as higher population may lead to a more efficient division of labor as well as to improved agricultural practices (signaled by the frequency of cropping) -Gary S. Becker and Gregg H. Lewis were the first to formalize the idea that parents may be altruistic towards their children and when making fertility decisions, they will take into account both the number of children and the quality of each of them that is reflected in his consumption, education, health etc. They show that when altruism is present, the Malthusian prediction doesn't hold and higher living standards are consistent with lower fertility rates, as observed in the data. Becker, Kevin M. Murphy and Robert F. Tamura pointed out that Malthus' analysis is not suited to the modern era, as it ignores the importance of education and the higher cost of raising children in industrialized countries, a result of the higher value of time in such countries. These two factors induce parents in rich countries to invest in their children's quality rather than in their quantity, which can account for lower fertility rates than the ones suggested by Malthus Galor, together with David N. Weil, further analyze the relationship between population growth, technological change and living standards, and find that population growth gradually improved technology, which in turn increased investment in human capital, inducing households to substitute quality for quantity children. At the end of this process, fertility rates are permanently lower, and standards of living improve. This view implies that the Malthusian era was a necessary stage to reach sustained economic growth. -In spite of all the above critiques, Malthus’ theory still applies to many poor countries that are still struggling to get out of the Malthusian cycle. Even among richer countries, a Neo-Malthusian relationship between population growth and the environment has been argued for, based on the idea of the overuse of scarce natural resources. But this problem, too, is more severe in poor countries, which usually depend more on their natural resources. 2. Аllen, Robert, 2009, “Why was the Industrial Revolution British?” - I argue that the explanation of the Industrial Revolution was fundamentally economic. The Industrial Revolution was Britain’s creative response to the challenges and opportunities created by the global economy that emerged after 1500. This was a two step process. In the late sixteenth and early seventeenth centuries a European-wide market emerged. England took a commanding position in this new order as her wool textile industry out competed the established producers in Italy and the Low Countries. England extended her lead in the late seventeenth and eighteenth centuries by creating an intercontinental trading network including the Americas and India. Intercontinental trade expansion depended on the acquisition of colonies, mercantilist trade promotion, and naval power. -The growth of British commerce had three important consequences. First, the growth of London created a shortage of wood fuel that was only relieved by the exploitation of coal. Figure 1 shows the real price per million BTUs of energy in London from wood and coal in this period. In the fifteenth century, the two fuels sold at the same price per million BTUs which meant that the market for coal was limited given its polluting character. As London grew after 1500, the price of wood fuels rose and by the end of the sixteenth century, charcoal and firewood were twice the price of coal per unit of energy. With that premium, consumers began to substitute coal for wood. Instead of a wood burning hearth in the middle of a large central room, houses were built with narrow fireplaces and chimneys to burn coal. The coal burning house was invented. It then paid to mine coal in Northumberland and ship it down the coast to London. The coal trade began. On the coal fields (in Newcastle, for instance), Britain had the cheapest energy in the world. Energy was more expensive on the European continent and particularly expensive in China -Second, the growth of cities and manufacturing increased the demand for labor with the result that British wages and living standards were the highest in the world. Figure 3 shows the wages of laborers in leading cities in Europe and Asia from 1375 to 1875. The wages have been deflated by a consumer price index so that they show the purchasing power across space as well as over time. A value of one means that a laborer employed full time, full year could earn just enough to keep his family at a subsistence standard of living of 1940 calories per adult male equivalent per day. The budget used to define the consumer price index is set so that most of the spending is on food and most of that is on the cheapest carbohydrate available (oatmeal in northwestern Europe, polenta in Florence, sorghum in Beijing, millet chapatis in Delhi). Only tiny quantities of meat, oil, cloth, fuel, and housing are included in the budget. After the Black Death in the midfourteenth century, the standard of living of workers everywhere was high; they typically earned three- or four-times subsistence. In the ensuing centuries, population growth in Europe and Asia led to falling real wages, so that most workers ended up in the eighteenth century earning just enough to purchase the subsistence standard of living.The only countries to avoid that fate were Britain and the Low Countries. -In the ensuing centuries, population growth in Europe and Asia led to falling real wages, so that most workers ended up in the eighteenth century earning just enough to purchase the subsistence standard of living. The only countries to avoid that fate were Britain and the Low Countries. Their populations, in fact, grew more rapidly than those elsewhere, but this effect was offset by the booms in their economies due to international trade. Workers in London and Amsterdam did not, however, buy four times as much oatmeal as they needed for subsistence. Instead they upgraded their diets to beef, beer, and bread, while their counterparts in much of Europe and Asia subsisted on quasi-vegetarian diets of boiled grains with a few peas or lentils. Workers in northwestern Europe also had surplus income to buy exotic imports like tea and sugar as well as domestic manufactures like books, pictures, watches, and better clothes. -Third, the growth of cities and the high wage economy stimulated agriculture. The strong demand for food and particularly meat, butter, and cheese led to the conversion of arable to pasture, convertible husbandry, and the production of fodder crops (beans, clover, turnips), most of which raised soil nitrogen levels and pushed up the yields of wheat and barley. The urban demand for labor led to the amalgamation of small holdings into large farms, which employed fewer people per acre, a development also entailed by the conversion of plowed land to grass. Agriculture was revolutionized because cities expanded, rather than the reverse as historians have often maintained. -Success in international trade created Britain’s high wage, cheap energy economy, and it was the springboard for the Industrial Revolution. High wages and cheap energy created a demand for technology that substituted capital and energy for labor. These incentives operated in many industries. Pottery, for instance, was manufactured in both England and China. The design of the kilns differed greatly, however. English kilns were cheap to build but very fuel inefficient; much of the energy from the burning fuel was lost through the vent hole on the top (Figure 4). The typical Chinese kiln, on the other hand, was more expensive to construct and, indeed, required more labor to operate. Figure 5 shows how heat was drawn into the chamber on the left and then forced out a hole at floor level into a second chamber. The process continued through many chambers until the air, by then denuded of most of its heat, finally exited up a chimney. In England, it was not worth spending a lot of money to build a thermally efficient kiln since energy was so cheap. In China, however, where energy was expensive, it was cost effective to build thermally efficient kilns. The technologies that were used reflected the relative prices of capital, labor, and energy. Since it was costly to invent technology, invention also responded to the same incentives. -The famous inventions of the Industrial Revolution were responses to the high wages and cheap energy of the British economy. These inventions also substituted capital and energy for labor. The steam engine increased the use of capital and coal to raise output per worker. The cotton mill used machines to raise labor productivity in spinning and weaving. New technologies of iron making substituted cheap coal for expensive charcoal and mechanized production to increase output per worker. -Since the technologies of the Industrial Revolution were only profitable to adopt in Britain, that was also the only country where it paid to invent them. The ideas embodied in the breakthrough technologies were simple; the difficult problem was the engineering challenge of making them work. Responding to that challenge required research and development, which emerged as an important business practice in the eighteenth century. It was accompanied by the appearance of venture capitalists to finance the R&D and a reliance on patents to recoup the benefits of successful development. The Industrial Revolution was invented in Britain in the eighteenth century because that was where it paid to invent it. The success of R&D programs in eighteenth century Britain depended on another characteristic of the high wage economy. In the seventeenth and eighteenth centuries, the growth of a manufacturing, commercial economy increased the demand for literacy, numeracy and trade skills. These were acquired through privately purchased education and apprenticeships. The high wage economy not only created a demand for these skills, but also gave parents the income to purchase them. As a result, the British population was highly skilled (by international standards), and those skills were necessary for the high tech revolution to unfold. Article 3 Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England (Tables) We see a supply - demand effect Because the institutions work better the supply of funds has increased and the interest rate went down Lecture 2 Chapter 1 (Book) -Banking crises have been a prominent feature of the financial landscape from the earliest days of commercial banking, of which the subprime the mortgage crisis is merely the most recent example. Banking crises have three primary causes: (1) “boom-bust” (or macroeconomic) fluctuations; (2) shocks to confidence; and (3) structural weakness. Boom-bust fluctutions have long been a feature of the modern industrialized economy. If banking growth is especially vigorous during a period of robust macroeconomic expansion, the subsequent contraction may strain the banking system to the point of crisis. Shocks to confidence arising from, for example, concerns about the continued convertibility of the currency— raising the specter that deposits may only be redeemable in devalued currency—or the anticipation of an impending war or other event that reduces confidence in the stability of the banking system, may generate panic withdrawals and precipitate a crisis. Finally, the likelihood of crises can be affected by the structure of the banking system. A banking system composed of many small banks or governed by one set of regulations may be more prone to crisis, no matter what the source of disturbance, than one characterized by fewer, larger institutions or governed by a different regulatory framework. -Because crises are costly and may spread if not controlled, private and public actors have incentives to engage in rescue operations. Rescues may be confined to bailing out one troubled institution or may extend to the banking system more generally through lender of last resort operations; they may be of limited scope or may consist of relatively extreme measures, such as wholesale bank nationalization. The consequences of the type of rescue undertaken can have long-lasting effects on the banking system. If a rescue entail sustaining weaker banks, it may encourage other banks to undertake riskier activities secure in the knowledge that they too will be rescued in case of distress, a phenomenon known as “moral hazard.” Thus, rescues may contribute to yet another boom-bust cycle marked by overexpansion and ending in crisis. -Crises typically leave a number of devastated banks in their wake. One consequence of this may be an increase in bank merger activity, as healthy banks absorb troubled institutions. Yet merger movements are not solely the creatures of economic downturns: economic expansion can also stimulate mergers if increased financing requirements are better met by larger financial institutions. The wealth effects of rising equity prices during an economic boom may also increase the willingness of potential acquirers to initiate mergers while rising share prices may make potential targets more willing to be acquired. -Efforts at stability-promoting reform typically take one of two paths. Stricter regulation, including measures that strengthen safety and soundness requirements, curtail bank powers, and increase the reach and authority of regulators, constraints banks and makes it more difficult for them to get into trouble. An alternative regulatory approach takes a seemingly opposite course: expanding the powers of existing institutions—possibly combined with competition-reducing measures— in an effort to strengthen banks and render them less vulnerable to shocks. These paths have very different consequences for the banking system and will find support among different private interest groups. Reforms aimed at restricting competition can lead to an excessively constrained banking system, although such reforms may be supported by financial incumbents protecting their private interests (Rajan and Zingales 2003b). Such constraints may eventually render the banking system less able to contribute to economic growth and lead to calls for deregulation. Reforms that allow an expansion of banking powers will have different consequences and will have different advocates. If such regulations are anticompetitive, they may lead to increased—perhaps to an uncomfortably high level—banking concentration. By granting wide-ranging powers, such reforms allow banks to increase risk-taking and may thus lead to greater instability. - John Hicks (1969: 78, 94–97) juxtaposes the above approaches by describing three stages through which banking develops. In the first stage,banks operate solely as trusted middlemen: borrowing, re-lending, and profiting on the spread between borrowing and lending rates. In the second stage, the banker begins to accept deposits that can be withdrawn on demand. At this point, the banker becomes a principal in the transaction,accepting the risk of a bank run if liquid assets are not sufficient to redeem demand liabilities. In the third stage, deposits subject to withdrawal become transferable, either by check or note. According to Hicks, “. . . it is at this point that the bank becomes able to create what is in effect money.” -A related strand of literature focuses not directly on the credit-creating powers of banks, but on banks more generally in the realm of firm finance. Gurley and Shaw (1955) characterize earlier forms of firm finance as “self-finance,” in which firms finance investment projects from undistributed profits, and “direct finance,” in which firms borrow directly from savers. The next stage of financial development, termed “indirect finance,” occurs when banks issue their own debt and use the proceeds to finance investment projects. Gurley and Shaw argue that failure to develop this type of indirect finance through financial intermediators can retard economic development. -Alexander Gerschenkron (1962) also takes up the idea of investment finance, arguing that the importance of financial intermediators rose with the level of economic “backwardness.” He asserts that in Britain, the most developed economy of the eighteenth and nineteenth centuries, industrialization was financed primarily with the retained earnings of industrialists. In moderately backwards economies, exemplified by Germany, banks played a crucial role in mobilizing savings during industrialization—a role that had not been necessary in economically developed Britain. In the most backwards of countries, exemplified by Russia, he argues that financing industrialization was too great a task for banks to accomplish, and so the leading role had to be undertaken by the state. - Economists ascribe a variety of functions to the financial system that are important in economic development (Levine 1997). These include facilitating trade in goods and services, providing liquidity services, mobilizing savings, allocating resources, facilitating the trading of risk, collecting and communicating information, and providing a means for monitoring managers and exerting corporate control. Functions of a financial system: -Among the most basic services provided by the financial system are those that enable trade. As the use of coins spread from Lydia and Ionia throughout the ancient Mediterranean world, one of the earliest banking functions to develop was money changing, that is, the trading of moneys of different realms, or what we would today call the foreign exchange business. Another early banking function involved facilitating the transfer of funds from one individual to another—possibly separated by some distance—via book transfers and bills of exchange. - A second function of the financial system is the provision of liquidity services. Liquidity is “the ease and speed with which agents can convert assets into purchasing power at agreed prices” -A further function of the financial system is to accumulate the aggregate savings of an economy and channel it to areas where it can be put to productive use. This is particularly important if large quantities of capital are required, as is generally the case in industrialized and industrializing economies. - The financial system also provides a mechanism for the trading and pooling of risk. For example, the owner of a company who sells shares on the stock exchange is effectively selling some of the accompanying risk to investors. Since individual investors can each purchase a small proportion of the shares offered, they are able to diversify their portfolios by purchasing a variety of assets with different risk characteristics. Similarly, banks pool risk by lending accumulated depositor funds to a variety of projects, hence reducing the risk to depositors from the failure of any one project. - Financial intermediators also provide information services and a mechanism for monitoring managers and exerting corporate control. Banks acquire information on the credit-worthiness of borrowers, the soundness of the collateral, and the likelihood of success of proposed projects prior to making loans. -The up- or downwards movement of securities prices reflect the flow of information about the prospects for a given private or public debt or equity issuer. -In a theoretical economic sense, securities markets provide the optimal form of intermediation: those who need funds for investment projects can offer their wares in the financial marketplace and savers can shop for the financial product with the attributes (e.g., maturity, risk, return, collateral) that suit their preferences (Rajan and Zingales 2003a,c). If the market is active, transaction costs are low, and all parties have sufficient information, buyers and sellers will get the best price possible. Market prices will continuously adjust to reflect changes in supply and demand for securities which, in turn, reflect new information about the underlying investments. If circumstances warrant, adjustments can take place through the market: firms and other demanders of funds can purchase their own debt or equity if the funds are no longer needed; savers can sell securities at any time and gain access to their funds. -Commercial banks were not the only institutions to make loans financed by the issuance of money-like instruments: government banks and private banks frequently undertook these tasks long before commercial banks emerged. Government banks, however, were a special case of commercial bank: although frequently created as ordinary commercial banks, they typically had a special relationship with the state—both in terms of rights and responsibilities—that distinguished them from other commercial banks. Lifecycle of the banking system - Banking systems experience a period of expanding population, followed by a peak, followed by a more or less rapid decline. -Although the relationship between economic growth and financial development is not precisely understood, the data suggest that banking and economic development move together in the early phase of the banking life cycle. As noted above, the initial growth in banking depends positively on the demand for increased banking services brought about by economic growth, the rapidity with which commercial banking takes over the functions of preexisting financial institutions, and negatively on the restraining hand of regulation and the presence of competing intermediators that retard the development of commercial banking. -The number of institutions provides a good measure of the spread of banking during the early phase of commercial banking development, since most of the increase results from the entry of new firms. As banking becomes more established, however, a larger proportion of the growth comes through the growth of existing institutions, rather than from new entrants. Hence, in considering the later expansion, it will be useful to also consider measures of the size, as well as the number, of banks. Unfortunately, information on aggregate bank assets is even more fragmentary than data on bank population. - In each of these countries, aggregate banking assets grew despite a decline in the number of banks, indicating that the continued growth resulted in part from an increase in bank merger activity. Heightened merger activity also led to the growth of branch networks, as newly acquired banks became part of the branch networks of the banks that purchased them. - Chapter 2 (The origins of Banking) 1. Early Banking Functions -Banking is hardly a novel endeavor. Tasks which we recognize as those of bankers— taking deposits and making loans—have been undertaken by human society for at least four millennia, although banking firms per se, did not emerge until about 2,600 years ago in Mesopotamia and Greece. -The ancient world was also familiar with deposit-taking. An early form of deposit was the “closed deposit,” which resembled a safe deposit box more than a modern bank deposit. In classical Greece, these deposits, which may have included documents in addition to money, were frequently left in sealed containers in temples. Depositors paid a fee at the time of the deposit, and their containers were labeled with a record of the contents and instructions as to how to recognize, by means of a symbol, a legitimate claimant to the contents -A so-called “irregular deposit,” the proceeds of which could be loaned out by the banker, consisted of money placed on deposit with a person or institution. In redeeming such a deposit, the banker needed only to return an equivalent amount of money—not the identical coins—as had been placed on deposit 2. Credit Creation -Credit creation consists of issuing notes or creating deposits beyond the amount of money deposited -Credit-creating loans (i.e., loans over and beyond the amount of gold reserves held) need not be extended in receipts, but could take the form of deposits, as long as those deposits are somehow spendable, either via written order to a third party or via a transfer on the books of a banker. -Table 2.1 presents an approximation of the balance sheet of Francis Child, a prominent London goldsmith banker in the mid-1680s. Assets, what the bank owns or is owed, consist of vault cash, outstanding loans, and the precious metals and stones that constituted the goldsmith’s working capital. Liabilities, or what the bank owes, consist of the receipts that circulate or, equivalently, of the evidence of deposits at the bank. The amount by which receipts exceed the vault cash, or just over £42,000, is the extent of credit creation. Credit-creating, fractional reserve banking presents the banker with conflicting goals. On the one hand, by lending as many receipts as possible, the banker can earn a greater return. On the other hand, by is-suing too many notes the banker runs the risk that depositors with claims representing greater sums than the banker has in the vault will request payment. When this occurs, unless the banker is able to call in or sell loans, or borrow money elsewhere, the bank will be forced to close. -Bill of exchange -Unlike the cambium, which involved only two parties, the bill of ex-change typically involved four: two principals (e.g., importer and ex-porter) and two corresponding merchants who effected payment. A bill of exchange consisted of a brief letter from one merchant to the other, requesting that funds on behalf of the importer be paid to the exporter in a distant city (in the distant city’s local currency) at a particular future date. A bill of exchange could have arisen as a consequence of a commercial transaction or, alternatively, could have been used to pay off a debtor transfer money. The bill of exchange was composed of two different transactions. First, the bill was a foreign exchange transaction, since the exporter was typically paid in a currency other than that of the importer. Second, the bill was a loan, since the funds were not paid until sometime in the future. Because of the Catholic Church’s prohibition against usury, the interest component of these transactions during the Middle Ages was usually disguised within the exchange component 3. Government Debt and the Beginnings of Government Banks -From the point of view of banking, the development of public debt led to two important innovations. First, public debt was among the first examples of long-term debt. Commercial loans had, for the most part, been of short duration, usually no more than several months, in order to fund a specific commercial venture.12 Second, these debts led some governments to found public banks to manage their obligations. -Among the most important of these intermediators were “cashiers” or “cash-keepers” (kassiers). Cashiers were merchants’ agents who were authorized to pay their creditors and collect debts owed. This class of intermediator grew rapidly, as did the wide circulation of their written orders of payment, which were endorsable 4. Government Banks -Palmstruch’s plan was to create a bank with two departments: an Exchange Bank (Wexelbank, a literal translation of the Dutch Wisselbank), to take deposits and make transfers, and a Lending Bank (Länebank, from Amsterdam’s Huys van Leening), to make loans for a term of one year and six weeks. -The widespread acceptance of notes was an important milestone in the development of credit-creating banking for two reasons. First, it al-lowed banks to create credit in the form of banknotes, without which the only effective means for a bank to extend credit was via deposit creation. Deposit creation could only have been effective if the use of deposit accounts, written orders of payment, and book transfers was widespread. The use of notes allowed credit creation even where deposit banking was not well developed. Second, unlike bills of exchange, banknotes had no maturity date, and hence could circulate indefinitely. The longer a given quantity of notes circulated outside of the issuing institution, the more notes the institution could put in circulation and the greater the net credit creation. 5. Private Banks - Private bank, in this case, refers to an entity that operated as a partnership (i.e., unincorporated) and without the explicit sanction of the government in the form of a charter. A private bank was an association of individuals that were governed by the terms of their partnership agreement and were not bound bylaws beyond those that applied to individuals. -Because private banks were unchartered, they were not restricted to specific fields of endeavor and hence could engage in a variety of banking and non-banking activities. These included money changing, pawn-broking, cash-keeping, and, most importantly, providing domestic and international trade credit. In discussing private banking in the Rhineland during the first half of the nineteenth century. -Frequently, private banks started out as purely commercial—and often family-based— firms and, because of the need to extend credit for trade finance, evolved into institutions where banking soon overshadowed the non-financial side of the business. -Usually, government banks were authorized to make loans, take deposits, discount bills of exchange, and deal in gold, silver, and other monies; they were typically prohibited from dealing in goods and real estate beyond what was needed for banking premises. 6. Commercial Banks -Starting in the eighteenth century, the growth and increasing complexity of economic activity raised the demand for financial services. The sources of the increased demand included the growth and commercialization of agriculture, greater urbanization, industrialization, and a substantial in-crease in the quantity of trade and commerce. This increased demand for financing was met in part by the growth of debt and equity markets and in part by an increase in the facilities provided by banks. Private banks – limited resources, not limited liability - The data suggest a positive relationship between demand factors and the emergence of commercial banking. Belgium and the Netherlands were the first countries in Europe to experiment with this type of banking and, in both cases, the sources of demand are apparent. Belgium, with its ample supplies of iron ore and coal, was the first country on the continent to develop capital-intensive heavy industry, increasing the demands for banking services -Incorporated commercial banking emerged as the culmination of several centuries—even millennia—of development. Starting with the first moneylenders and deposit takers in the ancient world, banking evolved through the development of money, trade credit, medieval fairs, and—with the beginnings of the nation-state—through the evolution of government banks, and finally private banks. The eighteenth and nineteenth centuries saw the evolution of incorporated commercial banks. Although similar to their predecessors in many of the functions they undertook, the adoption of the corporate form and limited liability allowed commercial banks to become larger, more active players in the growing economies of the eighteenth and nineteenth centuries. There is a clear correlation between economic development and the emergence of commercial banking. Although the association is clear, it need not imply causality: the correlation could be merely coincidental, although there are good reasons to believe that it is not. Each stage of banking development was accompanied by some important advance in political and economic development: public banks and the growth of the nation state, exchange banks, like the Wisselbank, and the growth of domestic trade, and private banks and the growth of interregional and international trade. Nonetheless, determining definitively the existence of a causal relationship, and the direction of causation, is a difficult task, and one beyond the scope of this Chapter 5 (Merger Movements) 1. Consequences of Mergers -Mergers, in the absence of contemporaneous entries into banking, result in greater concentration, in other words, a smaller number of, on average, larger banking firms. The possible benefits of concentration, previously discussed, include: (1) greater geographic and sectoral diversification, which may increase stability; (2) greater economies of scale, through ability to service larger borrowers and develop more professional management and control systems; and (3) fewer institutions, leading to greater profitability and greater scope for coordination in times of crisis. -Although banking consolidation may lead to economies of scale and have some stabilityenhancing benefits, high concentration may prove problematic in other ways. The failure of large banks may be more likely to lead to a contagion of fear and banking crisis than that of smaller banks. Thus, the Depression-era failures of the Credit Anstalt in Austria, the Danat-Bank in Germany, the Bank of United States, and France’s Banque nationale pour le Commerce et l’Industrie each proved more dangerous for financial stability than the contemporary failures of smaller institutions. A banking system composed of a smaller number of banks may also prove to be inefficient because it is less competitive: banks that face less competition have an incentive to limit the quantity and raise the price of loans they offer, charge higher fees, and pay lower interest rates on depos-its than they would in a more competitive banking environment. If there are no legal or other barriers to the formation of new banks, the higher profitability brought about by mergers might encourage the entry of new banks and reduce these competition-stifling effects. 2. The Urge to Merge -One motive facing potential acquirers is economies of scale and scope. Large banks may have efficiency advantages over smaller banks. First, by conducting more business, they may be able to do so at a lower average cost (i.e., economies of scale), giving them a competitive advantage over smaller rivals. Second, merely by having more resources at their disposal, they are maybe better able to service the borrowing needs of larger firms. Third, larger banks may be better able to diversify, both geographically (through branch networks) and functionally (across product lines), than smaller banks. -Economic growth, in particular the kind that accompanies industrialization, and that often involves an increase in average firm size, may increase the returns to economies of scale. Larger firms usually have greater financing requirements than smaller ones, since they involve higher concentrations of capital. Thus, industrialization—or any other development that leads to an increase in average firm size, such as mergers among industrial firms— could encourage combinations among banks -Another potential fac-tor encouraging mergers is a change in the geographic distribution of the population and therefore the demand for financial services. As new areas become settled, banks in more established areas might have reason to expand into these areas by acquiring local banks as a cheaper alternative to establishing new branches. Finally, as an economy develops it demands more sophisticated banking services, such as trade credit, short-term business finance, and securities underwriting, and therefore the variety of services demanded of banks may grow as well. Greater functional and geographic diversification also can be attained through internal growth and the establishment of new branches and new products. It is, of course, quicker to achieve these ends through mergers, although it is not obvious where the cost advantage lies. -The decision to undertake acquisitions can be thought of in terms of a threshold model: when the optimal size of banks exceeds the actual bank size (i.e., when the actual bank size is below the diagonal line), the urge to merge is high; the larger the gap, the greater the incentive to merge. -Failure to develop limited liability company law and to apply that law to banks could limit bank size: unlimited liability would discourage banks from growing too large since failure could mean personal ruin for the partners. Strict regulation of entry, merger, and branching could also impair bank efforts to achieve optimal size through mergers, as could tax and antitrust policies. Aspects of the financial infrastructure could also present obstacles to mergers. For example, the absence of liquid and deep capital markets would make it more difficult to amass the required capital to carry out acquisitions. On the other hand, the existence of effective alternative intermediators—either institutions or securities markets— might reduce the incentive for commercial bank mergers. Finally, mergers might be infeasible for technological reasons: lack of the necessary communication and transportation infrastructure may make the creation of large or geographically far-flung organizations impossible. In each of the above cases loosening the constraint through legal changes, regulatory easing, or technological improvement could lead to a sudden increase in merger activity. -A second motive for bank mergers is the desire for market power. More concentrated banks should yield their owners greater influence over market conditions, such as interest rates and fees paid by borrowers and interest rates paid and services provided to depositors. - Predatory instinct = monopoly profits -On the other hand, such market share-induced mergers could be a defensive reaction to other mergers and an effort not to lose market share to a growing competitor. Finally, such actions could be opportunistic. If a bank is weakened, either due to poor management orto circumstances beyond the management’s control, it might become an attractive takeover target. -On the seller’s side, there are several reasons to favor being acquired. First, banks facing an increasingly competitive environment or an eco-nomic slowdown might be more inclined to merge out of fear that they are not large enough to survive the changes on their own. Hence, sellers might wish to merge for purely defensive reasons. An extreme version of this scenario would be a bank on the point of failure that is prepared to be acquired rather than to fail. -Another reason for mergers, frequently cited in connection with those in non-financial sectors, includes the growth of and fluctuations in capital markets (White 1985). The development of equities markets enables firm owners to realize profits more easily through the sale of some or all of their shares. Thus, the evolution of equities markets should increase the likelihood of bank owners cashing in by selling their equity. In addition to the evolution of the markets themselves, fluctuations in those markets will affect the willingness of sellers and potential buyers to engage in a merger transaction. Rising share values should increase the willingness of bank owners who are considering selling to sell. Increases in share values of potential buyers may make them more willing and able to acquire new enterprises, either for cash or for appreciated shares. Declines in market interest rates reduce the cost of borrowing and, to the extent that purchases are made with borrowed funds, will increase the willingness of potential buyers to engage in a merger. Finally, the development of new types of instruments (e.g., options, different classes of shares) and the entry of new types of investors (e.g., foreign, institutional) may make more money available for—and stimulate—merger activity. 3. Matching Evidence with Explanations -First, merger waves may occur—or not occur—for multiple reasons. Economic growth that leads to an increase in optimal bank size may not lead to mergers if the regulatory environment restricts banking combinations. A regulatory easing on mergers may not lead to an increase in merger activity if average bank size equals or exceeds optimal bank size. Second, the causes of merger movements may be correlated. Because macroeconomic and securities market fluctuations often go hand in hand, it is difficult to determine whether economic growth or rising equity values were responsible for a particular merger movement. -It is more difficult to assess the importance of the market power hypothesis. We know that one of the consequences of merger movement scan be reduced competition. It is not clear, however, why there is a greater inducement to merger movements at some times rather than at others. According to Britain’s Treasury Committee on Bank Amalgamations (the Colwyn Committee), appointed in 1917, one of the consequences of bank mergers leading to a relatively consolidated banking market was competitive pressure on banks to merge. Their report stated: “Experience shows that, in order to preserve an approximate equality of resources and of competitive power, the larger English banks consider it necessary to meet each important amalgamation, sooner or later, by another” -In attempting to explain where merger movements took place, it may also be useful to consider where they did not take place. France experienced considerable growth in its bank branch networks during the late nineteenth and early twentieth centuries; however, this growth was accomplished primarily via the creation of new bank branches, rather than through acquisitions. The absence of a merger movement may be explained by the fact that France’s large industrial firms were well served by the investment banking houses (i.e., the haute banque), leaving the optimal bank size of French commercial banks relatively small. There were less than 150 joint stock banks in all of France by 1870, a lower level of bank density than in Scotland one hundred years earlier -The greater the gap between the optimal and actual bank size, the greater the incentive to merge. Of course, banks could grow in more conventional ways—raising more capital, opening new branches, establishing new product lines, and expanding more gradually— however, where the gap was large, the incentive to grow quickly through mergers was more urgent. Chapter 6 (Regulation) 1. Motives for Regulation -In the presence of market imperfections, such as monopolies or incomplete information, government regulation can result in superior (i.e., more efficient) outcomes (Scherer 1980). Thus, regulation is merely a response by the authorities to an imperfect world. For banking, the purely economic motives for regulation center on promoting stability and efficiency. Because of the unique role that banks play in money creation, regulation may also be motivated by the government’s desire to exert monetary control. -Government responses to banking crises include bailouts, lender of last resort operations, and more extreme measures. These are the most direct means of stopping a systemic crisis in its tracks. In addition to these tools, a variety of regulations are aimed at strengthening individual institutions in order to render them less likely to fail. These include capital and reserve requirements. Reserve requirements mandate that banks hold a certain minimum level of liquid reserves, making it less likely, other things being equal, that the bank will be forced to close due to an unexpected withdrawal of demand liabilities. Capital requirements provide enhanced assurance that if a bank’s assets are impaired, sufficient share-holder equity will be available to redeem deposits, as well as other benefits. Other regulations that might enhance bank stability include balance sheet restrictions, such as those that limit the type of assets a bank might hold (e.g., prohibiting certain categories of risky investments), regulate the composition of assets (e.g., restricting the percentage of assets that might be loaned to an individual borrower), or impose restrictions on permitted liabilities (e.g., restricting certain types of bank borrowing). -Regulatory policy might also enhance banking stability by reducing competition. This can be achieved by limiting entry into banking, fostering mergers among existing banks, or by establishing capital requirements that are so high that they can be satisfied by only a small number of institutions. By preventing competition, regulators can reduce the likelihood of failure by fostering large, profitable institutions (Guiso, Sapienza, and Zingales 2007). Such measures could include exemptions from antitrust legislation, legal inducements to merge, and government-sanctioned or government-sponsored agreements to limit interest paid on deposits. -Although a desire for stability might motivate regulations to stifle competition, the goal of an efficient banking system is best achieved with regulations that promote competition. 2. Entry Regulation -The earliest form of financial regulation was not banking regulation perse, but monetary regulation, specifying the weight and fineness of metallic coins -As bank deposits grew in importance relative to banknotes, both as a store of value and as a means of payment, the focus of regulation shifted from notes to bank deposits, and therefore to the regulation of commercial banks (Allen et al. 1938: 3ff.). Among the most basic, and earliest, banking regulations were those on entry, which typically took on one of three forms: charters, banking codes, and corporation law. -The earliest form of entry regulation was through charters, explicit per-mission given by the legislature or sovereign for a firm to undertake banking business. Such charters sometimes provided the new company with limited liability; they typically set general conditions under which it could do business, such as setting minimum share capital and authorizing the bank to conduct certain types of business. -The first banking codes were introduced in England (1844) and in Sweden (1846). These represented relatively detailed banking codes, which spelled out conditions of entry, form of charter, minimum capital standards, and requirements to publish balance sheets. -In the United States, Canada, and Japan, the initial shift away from individually granted charters came in the form of free banking laws. Un-der free banking, which was introduced in Michigan in 1837 and in New York in 1838, rather than apply to the state legislature for a charter, individuals could obtain a charter by completing paperwork and depositing a prescribed amount of specified bonds with the state authorities. 3. Banking Codes versus Corporation Law -Entry regulation passed through several stages from the earliest banking charters in the seventeenth century through World War II. At first, bank charters were granted on a caseby-case basis. These charters were usually given to government banks, which both provided public services and compensation to the chartering authority. To the extent that charter values—and the disparity between them—remained high, governments and legislators had an incentive to parcel out charters on a case-by-case basis. Declines in charter values and the disparity between them, changes in corporation law, and hardening of public attitudes toward banking encouraged the authorities to regularize the manner in which charters were granted. Once it was clear that the way in which charters were issued was to be changed, two options were available: banking codes and corporation law. For the most part, countries enacted banking codes when issuing money was the responsibility of private commercial banks. In countries where the central bank had been granted a monopoly on note issue relatively early, the need for a detailed banking code was less pressing and entry regulation was left to corporation laws. Although other factors may have played a part, monetary control was the dominant motive for entry regulation. 4. Capital requirements -Capital requirements have been a key feature of banking regulation from the enactment of the first commercial banking codes in England and Sweden in the nineteenth century through the establishment of the Basel and Basel II accords in recent years. Policy makers emphasize the role of adequate capital in promoting bank “soundness and stability” (Basel Committee on Banking Supervision 1988, 2004). 5.The Role of Capital -New firms, which cannot tap into retained earnings, have two sources: (1) borrowed funds (i.e., debt); and (2) funds invested by the owners/shareholders (i.e., equity, capital). Firm managers seek the optimal mix of debt and equity financing to maximize a firm’s value. Modigliani and Miller’s (1958) classic work concludes that in a world with an efficient capital market, no tax distortions, and no bankruptcy costs, firms should be indifferent to the debt-equity mix -Bank capital, then, serves several roles. First, it provides a buffer against a shortfall in cash flow. As noted above, dividends can be suspended without catastrophic consequences, freeing up money to pay depositors and other creditors. Second, if a bank is forced to close, capital serves as a reserve that can be called on to liquidate unpaid debts. Third, higher holdings of capital can encourage banks to undertake less risk: because capital is at risk in case of failure, banks have an incentive to avoid risks that might put them out of business. Fourth, because banks know more about the soundness of their operations than investors (i.e., information asymmetry), the decision to hold more capital and to subject owners to a greater loss in case of failure signals to depositors and potential investors that the bank will undertake less risk than it otherwise might. Finally, banks hold capital because government regulations force them to do so. 6. Market Capital Requirements -Even in the absence of government mandates, banks will hold capital for all the reasons outlined above: to reduce cash-flow needs, serve as a reserve of funds to pay creditors in case of failure, encourage more riskaverse behavior, and reassure depositors and investors.8 Berger, Herring, and Szego(1995) refer to the amount of capital required for these purposes as “market capital requirements,” the amount of capital that banks will hold in order to maximize the value of their institutions. Holding less capital calls the bank’s safety into question and will reduce its value; holding higher amounts of capital will be costly, since it dilutes the returns to shareholders, and will therefore also reduce its value. -Market capital requirements decline as a country’s financial system matures for two reasons. First, as information about financial institutions becomes more widely available through the publication of balance sheets, and as reputations become established, depositors and shareholders will require banks, on average, to hold less capital. In other words, since banks hold capital in part to mitigate the information asymmetry, as information flows improve less capital will be necessary. Second, since the role of capital is largely tied to reducing the likelihood of bank failure and mitigating the effects of bank failures once they happen, as the risk of bank failure declines, market capital requirements will fall. Berger, Herring, and Szego˝ (1995: 402) document the decline in bank capital-toasset ratios in the United States during the century-and-a-half following 1840, which they ascribe largely to a decline in the risk of bank failure. The risk of failure declines with economic development for a variety of reasons. First, as money markets develop, banks are able to hold some fraction of their assets in liquid securities, rather than choosing between liquid cash and illiquid loans. This allows banks to hold lower levels of nonearning assets, which boosts cash-flow, while maintaining protection against sudden deposit withdrawals which can lead to failure. Second, as banking systems grow and individual banks increase in size and geographic spread, their ability to diversify increases and the risk of failure falls (Demsetz and Strahan 1997). Third, as financial systems prosper the stakes rise for all parties: managers, shareholders, depositors, and the public. 7. Explaining Government Capital Requirements - Promoting stability has been by far the most frequently stated rationale for governmentimposed capital requirements among contemporary policy makers and their predecessors. Although the market does impose capital requirements, if governments are more wary of financial crises than the private market—due to their concerns about bearing the political and economic costs of them—they may wish banks to be even more risk averse than the market requires and hence might enact higher capital requirements. 8. The Impact of Government Capital Requirements -First, if government regulations were more likely to be established in countries which were perceived as having more stable banking systems— perhaps because of well-established conservative banking practices or a proven lender of last resort—the market might not have required banks to hold as high a proportion of their assets in capital as in countries perceived as being more susceptible to crisis. Second, because the market viewed smaller banks as more susceptible to failure, it required them to hold higher capital-to-asset ratios than large banks. Therefore, countries with high capital requirements, populated by large banks, would have had lower average capital-to-asset ratios. It is therefore possible that high minimum capital requirements did not result in higher capital-to-asset ratios, but instead discouraged entry, leading to banking systems characterized by fewer and larger banks with lower capital-to-asset ratios. Third, it is possible that in countries where parallel sets of institutions had different regulatory requirements (e.g., state and national banks in the United States, banks and savings banks, and private and chartered banks in many other countries), capital-to-asset ratios may merely reflect the presence or absence of alternative regulatory regimes - Government capital requirements had a less important impact on capital-to-asset ratios, per se: banks in countries without capital regulation typically held more capital than those with capital regulation, and changes in capital requirements rarely led to substantial changes in capitalto-asset ratios (Grossman 2007b). There is, however, robust evidence that government-imposed capital requirements did have an important effect on the structure of the banking system. Higher capital requirements acted as a barrier to entry, slowing the increase—or leading to a decrease—in the number of banks in operation. -As a stability-promoting measure: reducing the population of banks may promote stability if it leads to a banking system composed of larger, stronger, more profitable banks. Second, political economy motives were at work. Making entry more difficult was in the interest of incumbents, as well as those of competing regulatory systems (e.g., state versus national banks, commercial versus savings banks), although it was detrimental to the interest of trade, industry, and consumers 9. Other Regulations -Arguments against universal banking emphasized three main points: (1) the potential conflict of interest between universal banks in their role as protectors of depositor’s interests and in their desire to place new equity with investors (Crockett et al. 2003); (2) the retardation of the development of liquid securities markets, arguably a more efficient capital allocation mechanism, due to the dominance of universal banks; and (3) increased instability, since the equity held by universal banks is inherently more risky than short-term loans which make up the a larger proportion of commercial bank loans in non-universal banks. -The data support two conclusions. First, younger central banks were more likely to be called on to become banking supervisors than their older counterparts. Second, among central banks that were entrusted with banking supervision, younger central banks were typically given this task earlier than older ones. These results can be explained by the fact that younger central banks were less entrenched in their means of operation, and were flexible enough to adapt to the dual role of monetary policy maker and banking supervisor. Because younger central banks were more likely established in response to financial instability, they may have acquired supervisory oversight as a result. Older central banks were less adaptable and required more time to be brought into this new role—indeed, a number were not brought in at all Chapter 7 In 1708, during the War of Spanish Succession and again in exchange for a fresh loan, the bank obtained from Parliament its most significant protection from competition: the legal prohibition of associations of more than six individuals from conducting a banking business (i.e., issuing banknotes) in England. This was a crucial component of restricting competition, since issuing banknotes was the major source of banks’ funds in this era (White 1989: 73). The Act of 1708 thus gave the bank monopoly on note issues by joint stock banks. Although the act did not explicitly ban joint stock deposit banking, “the intention was to give the Bank of England a monopoly of jointstock banking, and had any other institution of more than six partners attempted to carry on a banking business in England . . . it would have been suppressed” The period 1826 through 1857 saw dramatic changes in English banking law. Prior to 1826, largely due to the government’s fiscal position, the Bank of England maintained a monopoly on joint stock banking in England and Wales. As the demands of industry increased and the government’s dependence on the bank decreased, the acts of 1826 and 1833 gradually eroded the bank’s monopoly position. More detailed regulations were passed in 1844. These had a stultifying effect on banking and, by the end of the 1850s, in parallel with developments in corporation law, the banking code of 1844 was scrapped and replaced with corporation law. This legal framework would govern English banking into the twentieth century. Nothing Special about Banks: Competition and Bank Lending in Britain, 1885-1925 BRAGGION, FABIO, NARLY DWARKASING, and LYNDON MOORE* Borrowers in counties with high bank concentration received smaller loans and posted more collateral than borrowers in low concentration counties. In high concentration counties, the quality of loan applicants had improved, which suggests that banks restricted credit, rather than that the quality of loan applicants had worsened. The high, and changing, degree of regulation in contemporary financial markets makes empirical conclusions about the effect of concentration on the economy hard to interpret, as regulation can affect both the degree of banking concentration and the behavior of banks and borrowers. Regulation may impact the workings of the financial system directly (e.g., a minimum capital ratio must be adhered to) or indirectly (e.g., managers, borrowers, and depositors may adjust their behavior following a change to minimum capital ratios). Hence, any contemporary study of bank competition and lending runs the risk that the results will be influenced by regulatory issues. In the little regulated British market, we find results consistent with the traditional view of bank concentration, whereby a decrease in competition is harmful for borrowers and leads banks to pursue safer investment strategies. In counties characterized by high banking concentration, banks granted smaller loans and demanded higher collateral. A one standard deviation increase in the county Herfindahl index of banking concentration leads to a 15-25% decrease in the value of loans granted to a customer, and a 25% increase in the collateral to loan ratio. As bank concentration increased in a county, the quality (as internally assessed by the bank) of successful loan applicants also improved, which suggests that the banking oligopoly restricted credit to marginal loan applicants, rather than the oligopoly induced riskier borrowers to take out loans. Contrast, theories of information asymmetry indicate that a more concentrated banking market may be good, at least for younger firms, or firms that operate with new technologies (see Petersen and Rajan (1995)). Marquez (2002) finds that in a more concentrated banking market the interest rate charged on loans is lower since larger banks are more effective at screening borrowers.5 Our environment also helps to test these theories since we study banking in a period of technological change, the so-called Second Industrial Revolution (see Mokyr (1992), pp. 113- 148, and Braggion and Moore (2013)) Our conclusion, that borrowers in more concentrated markets receive worse loan terms, is consistent with two competing theories. On the one hand, loan applicants with riskier projects could be those who are more likely take loans in more concentrated markets, with the result that banks rationally charge higher interest rates and demand more collateral as protection (see Boyd and De Nicoló (2005)). On the other hand, banks may use their market power to restrict the supply of loans, which cuts off the funding to marginally profitable borrowers, and leaves only To sum, our results provide support for the classical view of banking concentration whereby banks offer tougher lending terms when they face higher market concentration. At the same time, the increased concentration in the U.K. market led to banks holding a less risky portfolio of assets. Making a full welfare statement about whether the benefits of increased financial stability more than offset the costs of oligopoly pricing is beyond the scope of this study. Our work can however provide a basis to understand the behavior of large financial institutions. Merger waves in the 1980s and 1990s created very large financial institutions and less competitive banking systems in many developed countries. The experience of the 2007-08 financial crisis has led various policy makers to advocate the breakup large banks. The main reason for this is that greater market power increases the value of a bank franchise (or the “charter value”). This increases the cost to a bank of failing and leads it to act more prudently. On the other hand, other studies emphasize that banks in uncompetitive markets are more likely to originate risky loans. For instance, Mishkin (1999) argues that banks in concentrated systems are more likely to be subject to “too big to fail” policies that encourage risk-taking behavior by bank managers. Boyd and De Nicolό (2005) argue that by increasing lending rates, banks in less competitive markets exacerbate moral hazard problems with their borrowers, which induces borrowers to undertake riskier projects. As a result, banks that face less competition hold riskier loans in their portfolios. We present a suite of results that strongly supports the idea that a more concentrated banking sector may lead banks to pursue safer investment strategies, while offering tougher lending terms to borrowers. Counties that experience higher bank concentration tend to be those with lower loan sizes, alongside higher interest rates and more demands for collateral. Banks respond to increasing concentration by holding more marketable securities, which are typically low risk government bonds, and holding fewer of their assets as loans. The turn of the twentieth century merger wave, which drove banking concentration substantially higher in England and Wales, made banks safer, but at the same time, it resulted in bad outcomes for the clients of banks. In aggregate, the results indicate that increasing local market concentration in banking is associated with smaller loan sizes and tighter collateral requirements, although loan durations for business borrowers are slightly relaxed. Together these results lend support to the traditional argument that higher levels of bank concentration are bad for borrowers. Table V(c) shows that in-market mergers in the county are associated with smaller loan amounts. The result is statistically and economically significant. At least one inmarket merger in the county during the previous five years leads to a 13% reduction in the loan size for the same borrower (column (3)). In-market mergers are also associated with a 9% higher collateral ratio and a 5% shorter duration for the same borrower. MERCHANT BANKING IN THE MEDIEVAL AND EARLY MODERN ECONOMY* Meir Kohn In their lending, merchant banks relied on two sources of funds–their own capital and the funds they borrowed from others. Merchant banking firms were generally partnerships. At the creation of the partnership, each partner subscribed to the ‘official’ capital–the corpo. In addition to the corpo was the sopracorpo–normally, a much larger amount. Some of the sopracorpo came from additional funds contributed by the partners beyond their required subscription (good investment opportunities were scarce). These additional funds were a form of subordinated debt: the partners earned interest on them rather than profits, and then only after other debts had been settled. The remainder of the sopracorpo–the majority of it–came from retained profits. Profits were often substantial, and they were generally retained until the partnership was wound up and the accumulated profits were divided up among the partners. Merchant banks were financial intermediaries: they borrowed in their own name to re-lend to others. The borrowed funds, by increasing leverage, greatly increased the returns on their owners’ capital and, of course, greatly increased the risk to which they were exposed Merchant banks used the funds they raised in three principal activities–exchange trading, commercial credit, and sovereign lending.
