How the Middle Ages Handled “Too Big to Fail”

Adrian R. Bell, chair in the history of finance and head of school at ICMA Centre, Henley Business School

It’s the recipe for a financial crisis: A new product exploits a gap in regulations to meet the needs of the marketplace. As this product becomes more popular, hidden risks build up in the financial system. When a disruptive event triggers a market shock, the hidden risks are revealed to be a systemic weakness, crippling major financial institutions that were caught unprepared.

This could be the story of the credit default swaps that played a central role in the 2008 global financial meltdown, but according to Adrian R. Bell, chair in the history of finance and head of school at ICMA Centre, Henley Business School, this is a pattern that has been playing out in markets for at least 700 years.

Bell was one of three researchers involved in a project that identified, transcribed, and translated 228 advance contracts for the sale of wool in the Middle Ages. By testing the pricing methods and structures of the advance contracts for wool, which was a major component of England’s export trade from the late 13th century until the late 15th century, Bell and his colleagues were able to uncover the existence of sophisticated financial products and an efficient market developed around wool futures in England and mainland Europe.

Bell’s work has examined the forces that shaped European financial agreements in the 13th century, when religious restrictions came into conflict with the needs of financial market participants. Because the financial products of Europe’s Middle Ages were designed to avoid Christianity’s religious prohibitions against usury — that is, profiting from excessive interest rates — merchants found new ways to compensate themselves for assuming different types of risk.

In a Bloomberg View article that draws parallels between the 2012 LIBOR scandal and England’s Peasants’ Revolt of 1381, Bell and his co-authors note that “medieval financiers developed various methods of disguising interest within other transactions.” Some of the methods uncovered by Bell and his colleagues include repurchase agreements and detailed foreign exchange transactions.

The Middle Ages in Europe also had its own version of systemically important financial institutions. England’s King Edward I relied on northern Italy’s Ricciardi of Lucca, a merchant society, for credit to fund his military conquests, and the Ricciardi delivered funding through their connections in international credit markets. When short-term funding dried up in 1294 because of various market shocks, including the outbreak of war between England and France, the Ricciardi were unable to meet Edward’s demand for additional funds.

In a discussion on BBC History Magazine’s website, Bell and his colleagues note that “Edward had no intention of bailing out the bankers” when the Ricciardi encountered their difficulties. However, by allowing the Ricciardi to fail in 1294, the English king subjected himself to higher interest rates just a few years later, when he was forced to seek more expensive loans from less well-connected creditors.

Bell’s work leaves observers asking whether the patterns that have played out in the past can offer lessons for avoiding financial catastrophes in the future. At the Fifth Annual CFA Institute Middle East Investment Conference, Bell discussed how practitioners can benefit from hindsight by learning from medieval Europe’s mistakes.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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