Tuesday 19 July 2011

Structured finance in the twelfth century

Wordle: stuctured finance in 12 cent

From about the twelfth century the Catholic Church began to examine closely the concept of usury, elevating it, without scriptural justification, to a sin equivalent to one of the seven deadly sins [MacCulloch2009, p 369]. 

Usury is sometimes equated with the charging of interest, but by the thirteenth century it was recognised that the two ideas were different. Usury derives from the Latin usura, meaning ‘use’, and referred to the charging of a fee for the use of money. Interest comes from the Latin intereo, meaning ‘to be lost’, and originated, in the Roman legal codes as the compensation someone was paid if they suffered a loss as a result of a contract being broken[Homer and Sylla1996, p 73]. So a lender could charge interest to compensate for a loss, but they could not make a gain by lending [Kaye1998, p 83]. 

It is easier to understand this with a simple example. A farmer lends a cow to their cousin for a year. In the normal course of events, the cow would give birth to a calf and the cousin would gain the benefit of the cow’s milk. At the end of the loan, the farmer could expect the cow and the calf to be returned. The interest rate is 100%, but it is an interest since the farmer, if they had not lent the cow to their cousin, would have expected to end the year with a cow and a calf. Similarly, if the farmer lent out grain, they could expect to get the loan plus a premium on the basis that their cousin planted the grain, he would reap a harvest far greater than the sum lent. 

Another aspect, which was important in the Jewish tradition, but is, in fact, deeply rooted in all societies [Homer and Sylla1996, Chapter 1], [Mauss1924 (2001], was that loans should be made to support members of the community who were in distress, and not for the benefit of the lender [Homer and Sylla1996, p 71]. This approach was taken to maintain the cohesiveness of the community, a distinguishing feature of Judaism, and so the Talmud prohibited the charging of interest within the Jewish community, but allowed a Jew to charge interest to an outsider [Poitras2000, p 77]. 

By the start of the twelfth century different streams of thought, Greek, Roman, Biblical and feudal, came together at a time of great economic growth and the question of where the dividing line between usury and interest lay became one of the most important questions of the age. At the extreme where the ‘manifest usurers’ who were quite content with flouting Christian doctrine. The most well known example of these usurers were the Jews, who were immune from the Church’s sanction of excommunication and were able to take usury outside of their community. 

Pawnbrokers were another class offer manifest usurers. Pawnshops were widely tolerated, and frequently defended by local magnates in retrain for a license fee [Poitras2000, p 43], [Homer and Sylla1996, p 72]. The last group of recognised usurers were the Lombards. Originally from modern day Hungary, they dominated Italy during the Dark Ages and centred around the port of Amalfi, the Lombards produced communities of “remarkably creative and energetic” merchants [Swan1999, p 100], who, for a reason not well understood, “showed a strange insensitivity to ecclesiastical and social censure” [Poitras2000, p 43, quoting de Roover, 1948] and quite happily engaged in usury. Over time, the term ‘lombard’ was used to describe any Christian usurer and today many European cities have a Lombard Street at the heart of the financial district. 

These manifest usurers were beyond the influence of the scholastics, who focused on establishing the legitimacy of various types of related contracts; poena, census, prestiti, societas and, most widely used, the Bill of Exchange

In Roman mythology, Poena was the goddess of punishment who accompanied Invidia (the Latin version of Nemesis), who dealt out retribution for excessive pride, undeserved happiness or good fortune, and the absence of moderation. The word poena became synonymous with a penalty for late payment under the terms of a contract. In the medieval world, this Roman principle evolved into the practice of entering into ‘legitimate’ loan contracts that included the implicit understanding that the borrower would delay payment, by and agreed period, incurring the poena, which could be justified to the clerics as a licit interest payment [Poitras2000, p 87]. 

A census originated in the feudal societies as an “obligation to pay an annual return from fruitful property”[Homer and Sylla1996, p 75, quoting Noonan], [Poitras2000, p 91]. What this means is that the buyer of the census would pay a landowner, for example, for the future production from the land, such as wheat or wine, over a period of time. As economic life in western Europe became based on money transactions rather than barter transactions, censii lost the link to specific produce, cartloads of wheat or barrels of wine. The buyer of the census would accept regular cash payment instead of the actual produce, and this was legitimate in the eyes of the canon lawyers as long as the lump-sum paid buy the buyer ‘equated’ with the value of the ‘fruitful property’ being produced by the seller. 

Anyone who could became involved in censii. A labourer might sell a census based on the future revenue from their labour, states sold them based on the future revenue from taxes and monopolies, and the Church invested bequests by buying censii [Homer and Sylla1996, pp 75–76], [Poitras2000, pp 31–33]. Censii issued by governments, usually linked to specific tax revenues, became known as rentes [Poitras2006, p 82]. Censii could be ‘temporary’, lasting a few years, or ‘permanent’, until one of the parties died. In today’s terms, temporary censii resemble modern mortgages, permanent censii resemble the ‘annuities’ pensioners live off today. They could be ‘redeemable’, by one or both parties, meaning that the contract could be cancelled. 

The complexity of these innovative contracts meant that they did not have a clear price. For example, a census to supply three cows, every November, for five years had a price that was fairly explicit. But what about a permanent cash census based on someone’s labour? How much was the labour worth each year, and how long would the seller live? 

Prestiti were a development from the rentes created by states. Around the twelfth century the Italian city-states of Venice, Genoa and Florence began to forcefully sell temporary rentes to their rich citizens. By the mid-thirteenth century the different issues of rentes were consolidated into a mons (mountain) and everyone who had been made to buy a rente was given a share, proportionate to their contribution, in the mons. 

Venice created its mons, the monte vecchio, in 1262 and the shares, known as prestiti, entitled the holder to be paid 5%, a year, of the sum they lent, which was written on the prestiti and known as the ‘face value’. While there was no obligation for the states to pay the coupon, the annual payment, there was an expectation that they would if it could be afforded and the mountain itself was paid back as and when funds allowed [Poitras2000, pp35–36]. 

Quickly a market for Prestiti emerged, where holders who needed ready cash would trade them with people who had a surplus of cash and wanted to save. During times of peace and prosperity they had a high price, but during war and uncertainty, they traded at a low price. 

For example, Venetian prestiti traded for their face value around 1340 when the Republic paid off a lot of the mons, but in 1465, during a disastrous war with the Ottoman Turks, they fell to 22% of face. The Florentine prestiti actually had a built in facility where a holder could go to the state and sell them for 28% of their face value, however their market price was never so low as to make this profitable. 

The legitimacy of the prestati was debated by the canon lawyers. On the one hand the coupons, the regular cash payments can be seen as compensation for the forced nature of the original loan. The lender had no choice and so does suffer a loss. However, if a prestiti with a face of 100 ducats was sold for 22 ducats, the buyer would be receiving interest at a rate of 522 = 23%; in what way had this buyer of the prestiti been forced to enter into the contract? An interest payment of 23% in these circumstances seemed to be “asking for more than what was given”. 

Prestiti are important in that are one of the earliest representations of an actively traded financial instrument. The prestiti does not represent bushels of wheat or barrels of oil, it is a contract where by a state promises to pay a specified amount of money. Whether or not the state does pay out on the contract, is unknown and uncertain, hence the value of the contract is also unknown and uncertain. 

The Franciscans, in the fifteenth century, developed the state run mons into the Montes Pietatius (‘mount of piety’). This mons was created by bequests from the wealthy and then the friars would make low interest loans to those not able to borrow money elsewhere. The Montes Pietatius can be seen as a medieval version of micro-finace schemes, now spreading throughout the developing world. 

A Societas was a partnership contract. Originally each partner would put a sum of money into an enterprise and at the end of the activity, the enterprise was capitalised, all its assets sold off and converted into cash, which was divided between the partners in the same proportion as their original investments. For example a group Venetian merchants might form a societas to trade with Caffa, the the trading post on the northern shore of the Black Sea. Pooling their money, they would buy a shipment of manufactured goods and hire a ship to transport the goods, where they, or their agents, would trade the manufactured goods for furs and amber, which they would ship back to Venice and sold. The proceeds from these sales would be shared amongst the partnership. 

A societas was obviously legitimate, and this type of contract still represents the cornerstone of Islamic finance. The agreement was usually created by a close knit group1 meaning that an outsider, a foreigner or a poor entrepreneur, without the right connections would find it difficult to participate in a societas. To get around this barrier, the ‘triple contract’ was created. 

At the heart of the triple contract was a societas between the entrepreneur and an investor, this was the first contract. The second contract would be an insurance contract taken out by the entrepreneur to insure against the loss the investor’s capital. The third contract was another ‘insurance’ contract given to the investor by the entrepreneur, where by the investor surrendered their rights to a share of the profit in exchanged for a fixed payment from the entrepreneur, this payment was guaranteed by the second contract. In effect, the triple contract was a ‘usurious’ loan to the entrepreneur, wrapped up in a complex financial structure to hide its nature from the prying eyes of the Church. [Poitras2000, p38] What is most striking is the similarity between a ‘triple contract’ and the Credit Default Swap. 

All in all, at the start of the thirteenth century western Europe was going through a financial revolution (See also [Usher1934]). The creation and management of the poena, censii, prestiti, societas and Bill of Exchange required complex negotiation and calculation. The merchant would be looking to ensure they did not lose money on a transaction, for the sake of their family, while the Church tried to ensure the contracts were not usurious, for the sake of their souls. 

1If the partners did not know each other, it was an anonymous partnership, and today limited companies are known as S.A., or “anonymous societies” across continental Europe.


   S. Homer and R. Sylla. A History of Interest Rates. Rutgers University Press, 3rd edition, 1996. 

   J. Kaye. Economy and Nature in the Fourteenth Century. Cambridge University Press, 1998. 

   D. MacCulloch. A History of Christianity. Allen Lane, 2009. 

   M. Mauss. The Gift: Form and Reason for Exchange in Archaic Societies. (Routledge), 1924 (2001). 

   G. Poitras. The Early History of Financial Economics, 1478–1776. Edward Elgar, 2000. 

   G. Poitras. Life annuity valuation. In G. Poitras, editor, Pioneers of Financial Economics: contributions prior to Irving Fisher, pages 79–99. Edward Elgar, 2006. 

   E. J. Swan. Building the Global Market: A 4000 year history of derivatives. Kluwer Law, 1999. 

   A. P. Usher. The origins of banking: The primitive bank of deposit, 1200–1600. The Economic History Review, 4(4):399–428, 1934. URL http://www.jstor.org/stable/2245435.

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