A short history of banking, at the example of the Iron Bank of Braavos

I am currently writing up some thoughts on money and inflation (here instalments one and two) and as a short intermezzo I’d thought I write about banking, because this will be important, and it will liven things up a bit.

The Iron Brokers of Braavos

As we all know, old Valyria was a high culture, and especially their steel making abilities were second to none (it did help that they could use dragon fire of course). When old Valyria was still young however the art of iron making was just developing, and big producers like Valyria Oriental and Norvos Steel had not even been founded yet. At the beginning the value chain was separated into miners who supplied and refined the ore to produce ingots, and blacksmiths who transformed those ingots into swords and armour (also, sometime ploughs, but the margins in this business were not particularly attractive as local blacksmiths were able to execute this low-skill work equally well, and significantly cheaper).

Both mining and blacksmithing was a highly fragmented market, and blacksmiths did not care too much about the quality of the ingots (they were more or less the same) so they bought where ever it was the cheapest. Initially this meant travelling a lot, but over time the guild of Iron Brokers was established. The Iron Brokers were indeed brokers, not traders, which means they had designed a brokerage platform that allowed to match buyers and sellers: first, both blacksmiths and miners would sign master agreements; then all transaction would be executed over the broker’s raven network, and the miner would send the ingots via Braavos Mail to the blacksmith.

At that time venture capital was virtually unheard of in Braavos, and especially startup blacksmiths often faced serious financing constraints which lead to a growth trajectory significantly below what one would expect given the demand for swords in the Seven Kingdoms. However, Braavos had a very advanced legal system, and suppliers were willing to provide their customers with credit. If debtors would not pay the lenders would repossess the iron; plus debtors were often made to pay the so-called “iron price”, which kept defaults very low.

Now it is important to understand that the societies of Essos and Westeros at that time were a bartering societies: people would simply exchange things or services (“exchangeables”) for other exchangeables; there was no such thing as money.

For credit transactions this lead to an obvious problem, as whilst the spot exchange ratio of ingots into other exchangeables was well known at any given point in time, it was not clear what the exchange ratio of ingots would be in a year or so when the sword was finally finished. The obvious solution was to denominate the whole transaction in ingots: for example, for every 10 ingots received, the blacksmith had to return 11 ingots (or an equivalent amount of exchangeables) after a year.

The Iron Merchant Banks of Braavos

This system worked well, but it had a few shortcomings. From time to time blacksmiths would default, either because they were fraudsters, or — more often — because they were not as skilled in their craft as one had hoped them to be, and they could not sell the swords they produced. Now whilst the legal system was pretty good, this was still quite an inconvenience to the producers who had expected to get their 11 ingots (or equivalent) and who had their own workers to pay, mouths to feed etc.

The Iron Brokers had no skin in the game; they’d just sit there and say: “Read the T&C’s: my job was to bring you in contact with the blacksmith, which I did; everything else is not my problem”. Some of the more enterprising brokers had a side business of thugs that would recover the iron and make the blacksmiths pay the iron price, but their fee was rather steep, so many producers ended up with independent thugs during the recovery process, and the success was mixed. Also, sometimes there were knock-on effects. For example, sometimes multiple blacksmiths defaulted at the same time (typically when there was a short and unexpected period of peace in the Seven Kingdoms) and this could mean that miners had to make hard choices, and often lost their businesses. So overall, the system worked, but it was far from ideal.

In Braavos some enterprising Iron Brokers (whose margins had been squeezed because their value added was quite frankly de minimis; everyone with a few ravens to spare could do the job once the master agreements had been made publicly available) thought up a new business model: what if we’d become Iron Merchant Banks: we’d buy the ingots from the producers, and we’d sell those ingots on to the blacksmiths; however, whilst we’d advance the cows or whatever the miners want for their ingots we’d only get paid once the blacksmiths had sold their swords; in return, we’d be the ones to receive the additional one ingot per ten in ingot interest (the word “interest” comes from the word “ingot” by the way).

This model was significantly more efficient than the previous one, mostly because of better credit analysis and better servicing:

• an Iron Merchant Bank’s underwriting department would visit every (prospective) blacksmith in person, and assess his skill; because it was now their own money on the line it was in their interest to do that well, and they did
• an Iron Merchant Bank’s servicing department would no longer rely on outsourced thugs, but they’d hire their own ones. This kept prices down and — even more importantly — kept the thugs in the servicing department on a tight leash and therefore honest; as independent contractors they had often lied about recoveries, keeping some of the iron for themselves

This business had a number of economies of scale (notably risk diversification and better resource usage in the servicing and underwriting departments) and so the Iron Merchant Banks of Braavos started to merge and consolidate until there was only one which, for historical reasons, was called the Fifth Third Iron Merchant Bank of Braavos.

The Iron Bank of Braavos

The other important resource at the time was silk, and there was actually a very similar development with the Silk Brokers of Braavos and then the Silk Merchant Banks of Braavos. Now the economics in the silk space are slightly different: notably, the exchange ratio for the raw silk into other items (eg ingots, wine, ships) is very volatile, mostly because of supply volatility: in some years favorable weather leads to bumper crops, in others the crops get decimated by weather, plagues, or dragons. This means that lending silk is a risky business: if exchange ratios move against you you get less than it was worth initially, and if it moves the other way your customers might not be able to pay.

This does not necessarily mean that this is a bad business, but it means that it is subject to a much higher volatility than the iron lending business. One year it happened that the (only remaining) Silk Merchant Bank was in severe economic trouble because of customer defaults. Additionally, both its CEO and its owner died shortly after each other (involvement of the Faceless Men was rumoured, but could never be proven) and to cut a long story short, the Fifth Third Iron Merchant Bank of Braavos acquired the Silk Merchant Bank of Braavos at a very favorable price.

Whilst the owners were initially running those two businesses as separate divisions under their original brands, a project by the Braavos Consulting Group identified significant synergies between those divisions. More importantly, BCG helped them realise that their key business was not so much in traditional iron and silk banking, but that they should be establishing a universal banking business. This was the invention of money as we know it: the Fifth Third Iron Merchant Bank of Braavos (which renamed itself to the name it still has today, Iron Bank of Braavos) issued small tokens, called “coins”, that were fully iron-backed: the most valuable coin was called the “pound” (which was short for pound iron because it could initially be exchanged against a standard ingot of iron weighing one Braavos pound; later it was merely backed by silver). There were also smaller coins, notably the shilling (which was 20 to the pound), the penny (12 to the shilling, 240 to the pound) and the farthing (4 to the penny, 48 to the shilling, 960 to the pound). It should be noted that regulation was not very strict at the time, and so noone really knew whether or not the Iron Bank had enough ingots in their vaults backing all the coins they had issued.

The entire credit business was moved over to the new “monetary” standard, ie all loans were now denominated in pounds and shilling instead of ingots of iron, or bundles of silk. For the iron lending business that was not an issue because of the definition of the pound. However, the silk lending suddenly depended on the exchange ratio iron vs silk at contract maturity, which because of the silk volatility was dangerous for the borrowers. However, BCG came up with another invention: the Iron Bank Markets business that would offer commodity forwards that would allow to lock in the silk/iron exchange ratio (and therefore the silk price) at the end of the loan period. I leave it as an exercise to the reader to show that as far as silk borrowers were concerned this was equivalent; however, the Iron Bank could now interact with a number of counterparties on the liability side, and there was no longer a strict requirement to match borrowing and lending amounts for each of their business lines (iron, silk; later also other commodities): they could either ride out those risks themselves, or they could lay them off with the local managed futures and hedge fund community.

We know that this system proved extremely successful and stable, so much so that we know from historical records that during to the entire First Targaryan Empire (and in the brief Baratheon interregnum that followed) the Iron Bank of Braavos was the only bank operating both in Essos and Westeros.

Ahem. What are you trying to tell us here?

Alright. So I find those stories rather interesting, and they are of genuine historical value. However, this is actually part of a series on money, inflation, and negative rates, so I probably have a little explaining to do as to how this is relevant.

To cut a long story short — the thesis at which I want to arrive at the end is that money supply is nowadays a rather irrelevant concept in the world of mainstream finance, dealing with major currencies. There used to be a time when it mattered, which was when money supply mostly meant physical supply of coins, and when absence of coins (eg because of hoarding) had all kind of funny effects in the real world that relied on those to keep the economy going (and we might see a similar effect to this in crypto currencies, unless they get proper banking system at one point). However, nowadays banks create money (almost) at will, the constraints to money creation being mostly solvency and liquidity requirements imposed by the regulators.

Many commentators focus on this money creation aspect of banks, and act as if it was their raison d’etre — it is not! A bank’s function in the economy is to provide resources from those who have them to those who need them, so that those who need the resources can employ them profitably, and that they share some of those profits with those who have provided the resources in the first place. Or, to look at it from the other side: their function is to allow those who have excess resources that they can not usefully employ to lend them to others who can, and share the profits.

Now it is not only banks operating in this space: the above description works equally well for any kind of individual or collective investment schemes, investing in all kind of assets along the debt / equity spectrum. Banks happen to be those where the investors (ie savers / lenders) want to be reasonably certain about the wealth they’ll get back at the end of the period (which is more difficult to define in practice than one might naively think). We can again look at this from the other side: borrowers tend to be those who want leverage, ie they want to keep the upside of the project for themselves, and are prepared to not draw any money for their efforts before all lenders are repaid.

Iron Brokers. The idea behind the Iron Brokers story is that you can have banks in a world that is being built on barter and where money does not exist. The specific mechanism described here is supplier finance, ie the upstream producer gives his output to the downstream producer without any immediate payment, with the understanding that accounts will be settled when the downstream producer has delivered his wares to the end customer. Now bartering is complex — this is why we invented money — and therefore barter lending is complex as well. I sort of simplified this by assuming that the commodity producer is happy to receive his commodity back, just more of it. This should be a reasonable assumption in a world where there are downstream customers who are willing to barter immediately and there is not too much volatility. Otherwise a producer might want to lock in what he receives back in terms of what he wants, say 5 cows and 3 cubic metres of wood. This of course puts the downstream producer in a difficult position, and the coordination along the value chain can be quite complex for a system based on barter credit. It is however not impossible, especially not if we can lock in the items “paid” by the ultimate downstream customer, and he has something that everyone along the value chain wants (eg food).

Iron Merchant Bank. In the Iron Brokers example the upstream producers provide credit to downstream producers. In the case of the Iron Merchant Bank we actually have a bank, ie a professional provider of credit who can build a competitive advantage in underwriting and servicing. However in this world we still do not have money, which makes this business rather specialised: there is the Iron Merchant Bank, and the Silk Merchant Bank etc, and all have to individually manage their supply chains. In particular their credit business is limited by their deposit business: in order for an iron merchant bank to be able to provide a blacksmith with iron it must have first got it from a miner (or, in a later cycle, as part of an interest payment).

There is quite an interesting variation in possible business models in the merchant banking space, the merchant-led model, or the bank-led model. In a merchant-led model the miners want immediate payment (in cows, say) and the merchant’s balance sheet is therefore is limited by his own funds, so the liability side is 100% equity. In a bank-led model on the other hand the miner makes iron deposits, and is being paid iron interest on his deposited iron. He can then withdraw the cow equivalent of iron principal plus iron interest at a later stage. Assuming the cow/iron exchange ratio remained constant he will have been rewarded with more cows than he’d have got had he asked being paid immediately. Alternatively we can assume that there is no longer any merchant aspect, and that miners simply withdraw their iron plus iron interest to sell it elsewhere against cows, but then our iron merchant bank would no longer be a merchant at all.

Iron Bank. The Iron Bank finally is the only bank in this line-up that is a bank in the sense that we use it nowadays (actually, it is more of an old-style bank issuing “bank-notes” that represent claims on assets supposedly held in their vaults; nowadays currency is generally issued by a central bank or, like in Scotland, under the authority of a central bank). The main reason why this bank exists is still is to provide resources from people who have them to people who need them, with some compensation being paid to everyone participating in this value chain.

The Iron Bank however can create money. Before we go into this a quick aside: if we assume that the coins can be exchanged into iron on demand then their value is floored by the corresponding value of the iron (otherwise people sell iron, buy coins with the proceeds, exchange them into iron and make an arbitrage profit). Provided the bank is smart the iron value is also a ceiling, otherwise they’ll just issue more and buy iron with it; that’s not an immediate arbitrage profit but close enough so that it should bring the price down. Therefore this ‘you can exchange your coins at will’ backing is kind of boring: similar to an ETF, the coins are very tightly coupled to the underlying iron, but the bank can’t do much with it but holding the entire iron amount in their vaults at all time to avoid runs. So for the Iron Bank to function as a bank the linkage must be a little more loose, along the lines of “we promise that — once we collected all that is owed to us — we have enough iron to redeem all the coins we issued”.

So what happens upon issuance of money? Well, provided everything is transparent this depends really on what happens with the issuance: if they are exchanged to buy commensurate of iron this should be value neutral. Similarly if they are given away against the promise of receiving iron in the future this should be value neutral as well, provided that — on a portfolio basis — the expected iron receipts are commensurate (note that there is no upside to the valuation of the coins from excess expected future iron receipts over and beyond par, because the coin holders will see none of the excess amount).

However, if the newly created money supply is given away for free, or stolen, or simply used to make bad iron loans that, on a portfolio basis, will not repay sufficient amounts of iron, then the value of all coins is diluted, and they will be worth less than par (which is why it is important that there is no right to redeem them at par, because otherwise we’d have a bank run even after relatively moderate losses — in theory any epsilon below par, however small, would cause a run).

Conclusion

They key conclusion here is that banks are first and foremost to be understood as intermediating credit, ie matching clients who have resources now and want to consume them later with those who need resources now, either to produce more resources later, or because they expect to receive resources later.

Bartering is difficult enough on spot markets with immediate execution, and once borrowing and lending is involved the difficulties become even bigger. This does not mean that it is not possible to design a banking system based on barter, but given that we have invented money a while ago we might as well use it in the banking system because it really really simplifies things there.

Once we build a banking system on money, we’ll find that any reasonable definition of money supply must include certain bank liabilities, and will in fact be dominated by those liabilities, so the overall money supply is the aggregation of those bank liabilities plus some smaller items like physical currency and central bank money.

I will argue in a forthcoming post that whilst money supply in a world without banking (which includes hypothetical economies based on crypto currencies like bitcoin) is highly relevant from a macro-economic point of view, it becomes less relevant in a world where banks can create money ex nihilo.