I.

HISTORY OF FINANCE
IN A NUTSHELL.

Imstudies,
Class#09
 THE BIRTH OF FINANCE

3000 BC: Banking originated in Babylonia: Temples

and palaces were used as safe places for the
storage of valuables. Initially the valuable that can
be deposited was only grain, but later cattle and
precious materials are also included.

In the Sumerian city Uruk in Mesopotamia

(population 10.000) trade was supported by lending.
Interest was paid.
 INTEREST AND FINANCE IN ANCIENT
GREECE
• 350 BC: According to Demosthenes in Greece
the interest rate was 10% for ordinary business.
For risky business, such as shipping, lending
rates were between 20-30%.
• 200 BC: The Greek island Delos became the
first financial center.
 EARLY MODERN BANKING IN EUROPE

• Banking in the modern sense of the word can be

traced to medieval and early Renaissance Italy, to
the rich cities in the north like Florence, Venice and
Genoa.
• The Bardi and Peruzzi families dominated banking
in 14th century Florence, establishing branches in
many other parts of Europe.
 XVth CENTURY DEVELOPMENTS IN
FINANCE (1)

• 1401: Bank of Barcelona founded.

• 1403: The lawyer and theologian Lorenzo di
Antonio Ridolfi won a legal case which led to
legalization of the interest payments by the
Florentine government.
• 1407: Fugars Bank is founded in Augsburg.
• 1407 The earliest known state deposit bank,
Ufficio di San Giorgio in Genoa (Casa di San
Giorgio) was established as a financial institution of
the Republic of Genoa.
 XVth CENTURY DEVELOPMENTS IN
FINANCE (2)
• 1444: Fatih Sultan Mehmet’s debasement of
“akçe”. He was the first Ottoman Sultan who used
debasement to raise public revenue. [see Pamuk
(1999; Chapter III)]
• 1472 Monte dei Paschi di Siena was established in
Siena, Italy. (Still Operating)
• 1494: First book on double entry bookkeeping is
published in Italy: It is Friar Luca Pacioli’s Summa
di Arithmetica, Geometrica, Proportioni et
Proportionalita…
 XVIth CENTURY THOUGHT
ON FINANCE-1
• 1515: John Egk from Bologna University published a
thesis that advocated the freeing certain types of
interest. His research financed by the rulers of Augsburg.
Augsburg was competing with Florence in controlling
trade in that region. Egk was a student of Conrad
Summenhart who advocated the abandonment of
Aristotoles’ views on interest.
• 1526: Nicholas Copernicus published his Treatise on
Debasement. He argued that the buying power of
currency depends on the total number of coins in
circulation rather than the weight of metal they contain.
 XVIth CENTURY DEVELOPMENTS

• 1542-1551: Henry VIII debases the coinage of

England
• 1545: Henry VIII legalizes interest charges on loans
(An upper limit of 10% per annum is set)
• The first English joint stock company is founded
• Queen Elisabeth I recalled the debased coins.
• 1585: Bank of Genoa founded
• 1587: Banco della Piazza del Rialto, first
government bank in Europe, founded
• 1590 Barenbank was established in Hamburg (Still
operating)
 XVIIth CENTURY-1

• 1615: Sir Lionell Cranfield and Mr. Wolstenholme

made the first balance of trade and balance of
payments calculations for England.
• 1661: Bank of Stockholm issued banknotes and
became first chartered bank in Europe to do so.
• 1668: Swedish Parliament established world’s first
central bank: Rikens Ständers Bank (today known
as Svierges Riksbank).
 XVIIth CENTURY-2

• 1682: Sir William Petty published

Quantulumcuque Concerning Money that argues
development of banking is a major stimulus to the
English economy and world trade.

• 1694: Bank of England is established as a quasi-

central bank.
 XVIIIth CENTURY-1

• 1705: John Law published Money and Trade

Reconsidered and advocated the view that the
banknotes issued and managed by a public bank
would remove the brakes on the economy…
• 1729: Benjamin Franklin published Modest
Inquiry into Nature and Necessity of Paper
Currency. Following that publication, he was
awarded the contract for printing Pennsylvania Land
bank’s third issue of notes.
 XVIIIth CENTURY-2
• 1762: Baring Bank was founded (When it went bankrupt
after a scandal in 1995, it was the oldest merchant bank
in Britain)
• 1768: Catherine the Great of Russia established two
state owned banks to finance the war against Ottomans.
The Assignat Bank was entrusted to issue paper money.
• 1776: Adam Smith, in his famous book The Wealth of
Nations defended paper money on the ground that it
stimulated business in Scotland and American colonies.
• 1781 The first American bank, Bank of North America,
was founded.
• 1792: The Dollar is adopted as the money unit in the
United States.
 XIXth CENTURY-1

• 1800: Bank de France established as the central

bank of France.
• 1856: Bank-ı Osmani (Ottoman Bank) established.
• 1857: World wide banking crisis started in the USA
(contagion problem)
• 1863: Bank-ı Osmanii Şahane started to play the
role of a central bank
• 1873: The Great Depression in Britain (Continued
until 1885)
 XIXth CENTURY-2

• 1875: Deutsche Reichsbank is established as

Germany’s central bank.
• 1882: Nippon Ginkō (Bank of Japan) was
established as Japan’s central bank.
• 1886: Ziraat Bankası was established. (Although
the date for the establishment of the Ziraat Bankası
is given as 1863 it is not exactly correct. That date
refers to the establishment of Menafi Sandıkları,
which were rather simple credit institutions for
farmers.)
• 1890: (First) Baring Bank crisis in England,
Uruguay and Argentina.
 FIRST HALF OF XXth CENTURY-1

• 1913: U.S. Federal Reserve System was

established.
• 1923: Inflation in Weimar Germany reached to
3,25x106 %!
• On November 15, 1923 Rentenbank introduced a
new currency, Rentenmark (Security Mark), which
was equal to 1.1 trillion Papiermarks. The
Papiermark was pegged to US Dollar with a parity of
one US$ = 4,2 trillion Papiermarks! (It even climbed
up to 11,7 trillion papiermarks in French occupied
Cologne)]
 FIRST HALF OF XXth CENTURY-2

• 1924: Reichmark became the legal tender in

Germany
• 1924: Türkiye İş Bankası was established.
• 1929: Great Depression
• 1930 Bank of International Settlements (BIS) was
founded
• 1931: On October 3, Türkiye Cumhuriyet Merkez
Bankası became operational.
 POST II.WW DEVELOPMENTS-1

• 1944: Bretton Wood international monetary

agreements.
• 1947: International Monetary Fund became
operational.
• 1971: United States devalues dollar and gold
convertibility for all currencies ends.
• 1973: The US abandons the gold standard
• 1979: European Monetary System created
 POST II.WW DEVELOPMENTS-2

• 1982: Mexican Debt Crisis

• 1985: Savings and Loan Association Crisis
• 1991: BCCI scandal- biggest banking fraud
• 1992: Maastrich Treaty
• 1994: Financial Crisis in Turkey
• 1995: Barings Bank fails for a second time.
• 1997: East Asian Financial Crisis
 LAST DECADE-1

• 1998: Russian Financial Crisis

• 1999: Eleven European countries introduced Euro
as an accounting currency
• 2001: Turkish Financial Crisis
• 2002: Euro banknotes and coins are launched
 LAST DECADE-2

• 2005: China emerged as a major player in the global

financial system
• 2006: Problems in the US Mortgage Market
• 2007: US Mortgage Crisis and Recession
• 2008-?: Global Economic Crisis
 COMPONENTS OF FINANCIAL SYSTEM

1. Money
To pay for purchases and store wealth

2. Financial Instruments
To transfer resources from savers to investors and to transfer risk to those best
equipped to bear it.

3. Financial Markets
Buy and sell financial instruments

4. Financial Institutions.
Provide access to financial markets, collect information & provide services

5. Central Banks
Monitor financial Institutions and stabilize the economy
 FINANCIAL MARKETS

• Markets in which funds are transferred from

people who have an excess of available funds to
people who have a shortage of funds.
FUNCTIONS OF FINANCIAL MARKETS

• Perform the essential function of channeling

funds from economic players that have
saved surplus funds to those that have a
shortage of funds
• Promotes economic efficiency by producing
an efficient allocation of capital, which
increases production
• Directly improve the well-being of consumers
by allowing them to time purchases better
 STRUCTURE OF FINANCIAL MARKETS

• Debt and Equity Markets

• Primary and Secondary Markets
– Investment Banks underwrite securities in primary markets
– Brokers and dealers work in secondary markets

• Centralized vs. and Over-the-Counter (OTC) Markets

• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital markets deal in longer-term debt and
equity instruments
THE BOND MARKET AND THE INTEREST
RATE
• A security (financial instrument) is a claim on
the issuer’s future income or assets
• A bond is a debt security that promises to make
payments periodically for a specified period of
time
• Interest rate is the cost of borrowing or the price
paid for the rental of funds
 THE STOCK MARKET

• Common stock represents a share of ownership

in a corporation
• A share of stock is a claim on the earnings and
assets of the corporation
INTERNATIONALIZATION OF FINANCIAL
MARKETS

• Foreign Bonds—sold in a foreign country and

denominated in that country’s currency
• Eurobond—bond denominated in a currency
other than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited
in banks outside the home country
– Eurodollars—U.S. dollars deposited in foreign
banks outside the U.S. or in foreign branches of
U.S. banks
• World Stock Markets
 THE FOREIGN EXCHANGE MARKET

• The foreign exchange rate is the

price of one currency in terms of
another currency
• The foreign exchange market is where funds are
converted from one currency into another and
the foreign exchange rate is determined.
 BANKING AND FINANCIAL
INSTITUTIONS

• Financial Intermediaries—institutions that

borrow funds from people who have saved
and make loans to other people
• Banks—institutions that accept deposits and
make loans
• Other Financial Institutions—insurance
companies, finance companies, pension
funds, mutual funds and investment banks
• Financial Innovation—in particular, the advent
of the information age and e-finance
 FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT FINANCE
• Lower transaction costs
– Economies of scale
– Liquidity services

• Reduce Risk
– Risk Sharing (Asset Transformation)
– Diversification

• Asymmetric Information
– Adverse Selection (before the transaction)—more likely to select
risky borrower
– Moral Hazard (after the transaction)—less likely borrower will
repay loan
 WELL KNOWN (!) “CORE PRINCIPLES”
FROM MICROECONOMICS
1. Time has value
2. Risk requires compensation
3. Information is the basis for decisions
4. Markets determine prices and allocation
of resources
5. Stability improves welfare
 TIME HAS VALUE

– Time affects the value of financial instruments

– Interest payments exist because of time
properties of financial instruments
 RISK REQUIRES COMPENSATION

– In a world of uncertainty, individuals will

accept risk only if they are compensated in
some form.
 INFORMATION IS THE BASIS FOR
DECISIONS

– The collection and processing of information

is the basis of foundation of the financial
system.
– Information Theory and Economics:
 John Maynard Keynes/Frank Knight
 KennethJ. Arrow
 Joseph E. Stiglitz/Michael Spence/Geoge Akerlof
 Claude Elwood Shannon/Christopeher Sims
MARKETS DETERMINE PRICES AND
ALLOCATE RESOURCES

 Markets are “places” where buyers & sellers

“meet”.
 In a market based system prices (as well as
quantities) are determined by markets.
Therefore markets allocate resources.
 STABILITY IMPROVES WELFARE

 A stable economy is believed to reduce risk.

Lowering risk may lead to an improvement in
everyone's welfare.
 Is the competitive market mechanism stable?
Kenneth J. Arrow, Leonid Hurwicz, Frank Hahn
et. al.’s contributions: What they really show?
Stability of the competitive equilibrium or its
general instability?)
MONEY
 MONEY AND THE PAYMENTS SYSTEM

1. What is money?
2. How do we use money?
3. How do we measure money?
 DEFINITION OF MONEY

Money is an asset that is generally accepted as

payment for goods and services or repayment of
debt.
 MONEY: CHARACTERISTICS

1. Means of payment: Used in exchange for

goods & services
2. Unit of account: Used to quote prices
3. Store of value: Used to move purchasing
power into the future
 HOW WE PAY FOR THINGS-1

• Commodity Money: Objects with intrinsic value

• Fiat Money: Value comes from government

decree (or fiat)

• Checks: Instructions to the bank to shifts funds

from your account to that of the person or firm
whose name is written in the “Pay to the Order
of” line.
 HOW WE PAY FOR THINGS-1

• Credit Cards
• Debit Cards
• Electronic Funds transfers:
• Stored Value Cards
• E-Money
 CREDIT AND DEBIT CARDS

• Credit cards:
– Deferred payment
– Issuer makes payment for you
– You have to pay it back
• Debit cards:
– Like a check
– Electronic message to your bank to transfer
funds immediately
 THE FUTURE OF MONEY

Question: Which function of money will be with

us for a long time?
Answer:
– Means of payment: disappearing
– Unit of account: likely to remain
– Store of value: disappearing
 TECHNOLOGICAL ADVANCES AND
PAYMENT METHODS
• Technological advances create new methods of
payment.
• Cell phones and other types of hand-held mobile
devices are providing access to the payments
system.
• What will be next?
 MEASURING MONEY

• Changes in the quantity of money are

related to
– Interest Rates
– Economic Growth
– Inflation
• How do we measure money?
 DEFINITION OF LIQUIDITY

Liquidity a measure of the ease an asset

can be turned into a means of payment
(Money).
 MONEY AND BUSINESS CYCLES

• Evidence suggests that money plays an

important role in generating
business cycles
• Recessions (unemployment) and booms
(inflation) affect all of us
• Monetary theory ties changes in the money
supply to changes in aggregate economic
activity and the price level
 INFLATION

• Inflation: The rate at which the general price

level is increasing over time
• Inflation rate: The measure of the inflation
process
 MONEY AND INFLATION

• The general (aggregate) price level is the

average price of goods and services in an
economy
• Question: Asset prices?
• A continual rise in the price level (inflation)
affects all economic players
• Data shows a connection between the money
supply and the price level
 CONSUMER PRICE INDEX (CPI)

• The CPI answers the question:

"How much more would it cost for people to
purchase today the same basket of goods and
services that they actually bought at some fixed
time in the past?“
 MONEY AND INTEREST RATES

• Interest rate is the price of money

• In the USA prior to 1980, the rate of money
growth and the interest rate on long-term
Treasury bonds were closely tied
• Since then, the relationship is less clear but still
an important determinant of interest rates
 MONETARY AND FISCAL POLICY

• Monetary policy is the management of the

money supply and interest rates
– Conducted by the TCMB in Turkey [by the Federal
Reserve Bank (Fed) in the USA]
• Fiscal policy is government spending
and taxation
– Budget deficit is the excess of expenditures over
revenues for a particular year
– Budget surplus is the excess of revenues over
expenditures for a particular year
– Any deficit must be financed by borrowing
 BANK CONCEPT IN A NUTSHELL

A Bank is an institution whose current

operations consist in granting loans and
receiving deposits from the public.
 ANALYSIS OF THE DEFINITION

i) “Current”: “Temporary Landing is not counted”

ii) “and”: Mutual Funds only collect “deposits”, they

do not extend loans, instead they hold portfolios,
“finance companies” only lend by issuing equity or
debt instruments.

iii) “public”: Service is given to “general public” and

not to specialists.
 BANKING FUNCTIONS

I. Liquidty and Payment Services

i) Money Changing
ii) Payment Services
II. Asset Transformation
i) Convenience of Denomination (unit size)
ii) Quality Transformation (better risk return characteristic)
iii) Maturity Transformation
III. Managing Risk
i) Estimating Risk on Bank Loans
ii) Managing Interest Rate and Liquidity Risk
iii) Off-Balance Sheet Operations
IV. Monitoring and Information Processing