The Investment vs. Commercial Banking Model: a Historical Perspective
The Development of the Monetary and Banking Systems of Britain and Germany in Connection to the Industrial Revolution
David Landes in The Unbound Prometheus examines the role of money and banking during the Industrial Revolution in Britain and Germany, among other nations of the European Continent. While both Britain and Germany succeeded in industrializing, their methods of financing said endeavors differed. Thus both countries developed adequate monetary and banking systems, as industrialization could not have occurred without that prerequisite. In each country, the mobilization of capital through the development of banks allowed the money supply to properly grow and formalize. As a result of their respective starting bases concerning industrialization, Britain steadily developed a commercial banking model whereas Germany’s rapid need to industrialize led to the development of the joint-stock universal investment bank.
Britain, at the outset of the development of its monetary and banking systems, was blessed with an enterprising people and more open society in terms of social structure. Britain had undergone the Glorious Revolution in 1688 and consequently established the Bank of England in 1694. Its establishment was followed by a financial revolution. With regards to Britain’s process of industrialization, it is important to note that it was “not capital by itself that made possible Britain’s swift advance” but rather “an exceptional sensitivity and responsiveness to pecuniary opportunity” for “this was a people fascinated by wealth and commerce”1. Britain’s generally enterprising people can be contrasted to the people of pre mid-nineteenth century Germany, even if they were deterred by a lack of favorable institutions. The aristocracy in England was also more prone to engage in industrial ventures and these joint “business interests promoted a degree of intercourse between people of different stations and walks of life that had no parallel on the Continent”2. Landes even suggests a connection between the openness of society and a prevailing pursuit of business and commerce3. A society that supports the financing of those trying to make their way in the world naturally lends itself to a stable, developed banking system. German capital was prone to remain within the aristocracy and likely within a given family4. This limited business opportunities, innovation and the need for mobile capital creating a large void for banking in pre-industrial Germany. Consequently, “one does not find on the Continent the opportunities that offered themselves in Britain to the small man with more skill and ambition than money”5. Again, Britain started at a much more business friendly, capital hungry base than did Germany. Germany needed time to overcome its stifling social differences. Yet, both nations financed their way to industrialization in their own right and both developments are worthy of study.
Britain’s monetary and banking systems largely developed before its process of heavy industrialization. While pooling capital was certainly important for advancement to occur, lower capital requirements for less complicated machines for textile manufacturing meant these machines “could be built for surprisingly small sums”6. Thus industrialization at its outset in Britain didn’t require massive pooling in capital and banks were needed mainly for small loans. Even still, Landes states that “in no country in Europe in the eighteenth century was the financial structure so advanced and the public so habituated to paper instruments as in Britain”7. So even if the loans were small, the capital was available. The BOE, eventually gaining a monopoly on the issuing of legal tender notes, facilitated the mobilization of savings and the promotion of enterprise as bank notes became a major medium of exchange8. The BOE was established as the government’s banker but “shortly after its formation for intermediating public debt, the BOE began private operations” with numerous other banks beginning operations at that time9. It served as a model for future banks and proved a concept to an enterprising British people. According to North and Weingast, “the rise of banks…brought individual savings into the financial system”10 as British banks acted as intermediaries between borrowers and lenders. Britain’s banks of the 19th century looked more like modern commercial and retail banks generating revenue by loaning out deposits rather than issuing or underwriting securities.
As a result of the accumulation of capital, a “wide range of securities and negotiable instruments emerged in the early eighteenth century and these were used to finance a large range of activities”11. The growth of money and banking in Britain unsurprisingly led to a “growth of private capital markets paralleling that of public capital markets”12. Again, these banks were dealing more in debt than in equities or direct investment into enterprise, which stands in contrast to the financial innovation of the universal investment bank in Germany. Traditionally, British banks lent on shorter term but did extend credit for working capital “as this was more important than fixed capital in the early decades of the Industrial Revolution”13. In short, Britain’s development of its monetary and banking systems was made possible by the institutional changes brought about by the Glorious Revolution including the rise of Parliament and protection of property rights ensuring the “ability to engage in secure contracts across time and space”14. British banks provided financial stability and laid the groundwork for the development of a successful monetary system through efficient allocation of value creating capital.
As the 19th century progressed, Germany saw the pressing need to industrialize. They first tried to finance industry through the government but “state assistance was more often than not an encouragement to laxity and a cover for incompetence”15. Furthermore, “Frederick the Great saw dozens of his creations fold”16 as the government failed to allocate capital for enterprise efficiently or effectively. With this system failing to do the job, it was time for the free market to go to work. The relative dispersion of industry in Germany also necessitated the development of institutions for the dispersion of capital17. Since industry was not as concentrated as in England, entrepreneurs did not have central place to look for capital; thus mobilization was crucial and more formal financial services than existed were necessary for industrial development.
Aspiring bankers could obtain authorization to bank from smaller states but were often refused by Prussia or Frankfurt. As these German states began to realize their fault, they made “legal changes, especially those establishing the charter of modern corporate enterprise [which] contributed substantially to the continental Europe’s new-found ability to compete with Britain”18. Britain had a one hundred year head start developing their banking and resulting monetary system as they industrialized. The Germans needed to catch up. The removal of the blockades to banking and freer flow of capital was a critical first step. As noted previously with Britain, capital accumulation does not ensure industrial development but mobilized savings is a necessary element of industrial undertakings.
Germany at this period was a fragmented collection of states but began to become more interconnected as Prussia pursued its imperial desires. In 1871, the Second Reich was established and unification allowed capital intermediated by Germany’s developing banking system to be more easily collected for use both domestically and internationally.
The Deutsche Bank was established in 1870 demonstrating Germany’s early push into international investment and rapid success of their joint stock model signaling opportunity far and wide. The unification of Germany was important in the development of its banking and monetary systems, because it stabilized the country encouraging enterprise and the saving of capital which could then be poured into the new, unified economy. Furthermore the “simplification of the confusion of currencies”19 around this time increased circulation of money in Germany by nearly 800%20. A unified Germany allowed money to become more fungible and increase in supply. This increased circulation was backed with adequate capital thus holding down inflation and promoting freer flow of savings into investment. As in Britain, the banking system developed in tandem to a reliable monetary system.
The lack of mobile capital and Germany’s greater geographical dispersion of industry led to the financial innovation of the joint-stock investment bank. These universal investment banks “were generally mixed in function, that is, they received deposits and performed the traditional commercial services at the same time at they promoted companies, floated securities and lent at long term”21. German bankers were much more active financial intermediaries than their English counterparts. The “combination of deposit and investment functions [served as] a source of tremendous strength for it multiplied many times the ability of these institutions to accumulate resources and this in turn meant greater support for the banks’ industrial and commercial protégés”22. These banks were multifaceted players in the market and actively expanded by “absorbing competitors and sowing the land with branches and subsidiaries”23. Besides growing their own market clout, they also promoted the cartelization of the industries in which they were invested. Germany’s industrialization process and its rapid expansion of output of iron and steel required great amounts of capital. Investment banks mobilized their own capital as they actively pursued business opportunities rather than waiting for capital hungry industrialist to come to them.
German investment banks played a large role in heavy industry as “almost three quarters of the share of capital invested in Prussian joint-stock companies from 1850 to 1870 went to railway firms”24. Germany’s investment banks developed to fund heavy industry while the banks in Britain were introduced to finance a war and began privatizing by making smaller loans. Whereas British banks developed over the 17th and 18th centuries, German banks had less time to mobilize and allocate capital. Thus “German bankers and investors, often seconded or anticipated by French and Belgian capital, hastened to create a rash of joint-stock mining and metallurgical corporations”25 demonstrating a bias toward action similar to British entrepreneurs finding opportunity and engaging in commercial activities. German bankers found the joint stock investment bank model the quickest way to close the industrial gap. In contrast to British bankers, German financers had more skin in the game and followed businesses from the cradle to the grave. To a degree, the bankers were the industrialists in Germany; they just needed to find entrepreneurs to perform technical tasks like metallurgy.
While the banking systems developed differently in these two countries their role in economic development is similar. According to Landes, “it would be impossible to do justice in a few paragraphs the contribution of the investment bank to the economic development of these decades”26. German investment banks channeled wealth into industry, expanded the capital market and specialized in critical industrial credit27. Likewise, the pooling of capital was the enabling factor for the development of advanced capital markets and subsequent financing of industrialization in Britain. “Britain achieved maturity by the middle of the century; Germany, not until the 1890s and even then not to the same degree”28 but Germany would continue to develop as its heavy industry continued expanding with help from investment banks. The British systems evolved differently and were less forced because of a higher relative starting base and less pressing need to encourage industrialization with a pile of capital.
By the mid nineteenth century interest rates fell in both places and volume of credit expanded29. Thus, the money supply increased but inflation rose at a controllable pace. Both countries were able to engineer efficient methods for matching available capital with people willing to put it to work. Certainly, “a good portion of the increase in economic life in Germany is attributable to this interest of the banks and bankers in productive, economic activities.”30 German bankers pushed industry but the bankers of both nations provided a wholly necessary service for the forward progress of their countries. Thus, their impact on history is not minor. By serving as middleman and investors in Germany’s case, they ensured their respective nations would allocate capital as efficiently as possible.
Notes
1. Landes, David S. The Unbound Prometheus: Technical Change and Industrial Development in Western Europe from 1750 to the Present. 2nd ed. Cambridge: Cambridge University Press, 2008. 66. ; 2. Ibid., 70; 3. Ibid., 66; 4. Ibid., 130; 5. Ibid., 130; 6. Ibid., 65; 7. Ibid., 74; 8. North, Douglass, and Barry Weingast. “In Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England.” The Journal of Economic History 49, no. 4 (1989): 827.; 9. Ibid., 825; 10. Ibid., 825; 11. Ibid., 828; 12. Ibid., 828; 13. Landes, 75; 14. North and Weingast, 831; 15. Landes, 136; 16. Ibid., 136; 17. Ibid., 159; 18. Ibid., 197; 19. Ibid., 200; 20. Ibid., 204; 21. Ibid., 209; 22. Ibid., 209; 23. Ibid., 209; 24. Ibid., 201; 25. Ibid., 227; 26. Ibid., 207; 27. Ibid., 208; 28. Ibid., 229; 29. Ibid., 204; 30. Class Notes
