September 2nd, 2021
The presence and development of financial institutions have always been indicators of economic stability and growth prospects. Generally, the more evolved that the financial systems are in an economy, the more likely it is that efficient markets are present (Temin). In such economies, barring capital controls and other excessive government interference; entrepreneurs have access to capital that is needed to fund the innovative ideas that progress society. For this reason, examining the evolution of financial intermediation is critical for understanding the current landscape of financial markets and the institutions that amass and distribute capital.
Financial intermediaries are institutions that facilitate indirect finance - the transfer of capital from entities with excess funds to entities that desire additional funds (Cetorelli). By doing so, intermediation promotes market efficiency.
Intermediaries provide other important benefits to both borrowers and depositors. The pooling of capital from numerous sources allows for substantial investments into entities that require large amounts of capital. Furthermore, an intermediary’s pool of capital can be deployed into diverse investments, which in effect, decreases risk for lenders.
Lowering costs is another major advantage associated with intermediation. This is accomplished by intermediaries eliminating many of the transactional costs that individual investors are subject to, as well as taking advantage of economies of scale in order to collect financial data in a cost-efficient manner (Temin).
While the web of financial intermediaries can be organized in a variety of ways, the following groupings are meant to be easily comprehensible.
The simplest categorization can be made between primary and secondary intermediaries.
More complex classification of financial intermediaries can vary across countries and over time. That is because the organizational structure of intermediation largely depends on the established legal framework and customary roles of financial institutions, which can be unique to a given time and place (Goldsmith).
In the United States, one grouping of financial intermediaries is characterized by institutions that primarily function as depositories of short-term funds. Within this grouping, a distinction can be made between entities that can create money and those that cannot due to restrictions on their lending and investment activities. The depositories that can create money are broadly referred to as the banking system, and include Federal Reserve Banks, commercial banks, and savings banks (Goldsmith).
Commercial banks are where consumers primarily do their banking and are generally the most familiar intermediary. Individuals make deposits to checking accounts or other basic financial products, and in return, banks pay a small amount of interest. Bank deposits are attractive because of their liquidity, as well as the insurance policy of the FDIC (Kagan). In order to profit, commercial banks earn interest income on loans that they offer. The difference between the income banks earn on issued loans and the amount paid on deposits is known as net interest income (Kagan).
Another grouping can be made for intermediaries who collect payments in return for insurance protection against specified risks. These intermediaries are commonly known as insurance organizations. Due to the fact that the liquidation of claims by policyholders is relatively uncommon, the liabilities of insurance companies have a low turnover rate and thus are generally long-term in nature. Examples of insurance organizations include life insurance organizations, private and government pension funds, and property insurance companies (Goldsmith).
Other types of financial intermediaries are investment companies, land banks, government lending institutions, as well as secondary intermediaries such as mortgage companies, finance companies, and security brokers and dealers. Investment companies, financed primarily by issuing equity securities, are particularly pertinent to the funding of early-stage companies and larger corporations (Goldsmith).
The need for financial intermediation emerged as the prevalence of purely agrarian societies waned. In agricultural societies, the mismatch between savers, those with surplus, and investors, those who need capital to fund ventures, was not as pronounced. Wealthy landowners generally embodied the role of both savers and investors, rendering financial intermediation unnecessary (Temin).
Banking, the earliest form of financial intermediation, is widely acknowledged to have roots in ancient temples. When empires began the practice of taxation in order to fund their numerous capital expenditures, currencies emerged. Temples were considered a safe place for individuals to store their currency. Demand for large loans necessitated temples, with their pool of money, to act as lenders. Thus, the first banks were born.
Temple banks were widespread in the Roman Empire, and especially in minor cities. During wars, temples were often destroyed, largely because of their economic importance to the pillaged community. In addition to functioning as commercial banks, some temples had religious endowments, from which they offered aggressive loans to businessmen in order to fund endowment-sponsored activities (Temin).
In addition to temples, private banks were prevalent in Ancient Rome. Roman argentarii were the modern equivalent of bankers, receiving deposits and offering loans. Preserved records from the burial of Pompeii reveal the financial transactions of a supposed argentarii; tablets show receipts of holding goods for consignment, accepting deposits, and making loans to purchasers. Other tablets describe the financial activity of the Sulpicii, businessmen who facilitated trade in a port city by collecting deposits from the households of the Emperor and senators and extending commercial loans.
Evidence also suggests the presence of global interbank activity. The presence of these financial institutions were of great importance to the Roman Empire’s economic vitality (Temin).
In pre-industrial Europe, the societies with financial intermediation systems saw far greater economic development than the societies who did not. In these economies, those who sought capital had access to it, which in turn facilitated financial transactions and promoted market efficiency.
Joint-stock companies, which grew rapidly in the 17th century, were an early example of pooling funds and offering equity. Shares of joint-stock companies were used to secure bank loans, a form of credit intermediation, before government bonds became credible collateral. This practice began with the Dutch East India Company in Holland (Temin).
By the 17th century, the Dutch financial system was the most progressive in Europe. However, although private and public loans were often issued, the practice of pooling funds for intermediation was not commonplace.
England during the 18th century began to develop a more complex form of intermediation. Because international trade involved significant time between when a good was sold and when the good was received by the buyer, bills of exchange were developed. These bills represented the ownership of exchanged goods, and could be sold as an accepted form of currency. Bills were purchased and sold by merchants, which promoted intermediation by indirectly connecting those who needed funds with those who had excess funds.
Private banking also became more popular in 18th century England, especially in western London (Temin).
Financial intermediation in the United States in the early 1800s was still in a nascent stage, especially when compared to the financial systems of the 21st century. Total assets of financial intermediation accounted for about (Goldsmith), and were primarily limited to commercial banks located in New York, Philadelphia, and Boston. Over the next 50 years, the scope of commercial banking expanded, although other forms of intermediation remained immaterial. While the number of commercial banks grew nearly twenty-fold, their operations remained mostly limited to short-term financing options (Goldsmith).
The subsequent century, however, would have a dramatic effect on the landscape of financial intermediation. During the second half of the 19th century, commercial banks continued to grow in breadth, but were joined by the emergence of new forms of intermediation: life insurance companies, mutual savings banks, savings and loan associations, and personal trust departments. From 1900 to 1950, these new intermediaries, as well as commercial banks, continued to grow in size and influence.
Significant world events during this time period prompted the appearance of yet more forms of intermediation. Sales finance companies, investment companies, and land banks became increasingly important during the 1920s. The economic downturn spurred by the Great Depression necessitated the development of government intermediation in the 1930s.
Of the 23 types of intermediaries present by 1950, 13 gained relevance in the first 30 years of the 20th century, making this period arguably the most transformative era of intermediation. Financial intermediaries’ assets per person, which equaled around $250 per head in 1800, totaled over $3,500 per person in 1952 (Goldsmith).
Despite the absolute size and asset base of commercial banks continuing to increase, their share of total financial institution assets decreased from 50 percent in 1900 to around 33 percent by 1952. From 1900 to 1950, intermediaries falling under the umbrella of insurance companies and government lending institutions increased their assets by over 60 times, a far greater acceleration rate than the banking system experienced.
A striking difference manifested in the growth rates of public and private intermediaries: from 1929 to 1952, assets of private intermediaries grew by almost three times, paltry compared to the 18-fold increase in the assets of public intermediaries. The assets of public intermediaries (led by government lending institutions and the Federal Reserve Banks) comprised less than 5 percent of total national assets in 1929 but totaled almost 25 percent of all assets by 1952 (Goldsmith).
By the 21st century, the system of financial intermediation remained a bank-centered system, but the role of both banks and non-banks had evolved dramatically. Intermediation had become a decentralized process, with a more complex web of institutions replacing the traditional lending done by banks. This credit intermediation chain allows for non-bank institutions to perform specialized roles in the larger process to connect the supply and demand of capital. This decreased the importance of the traditional role of commercial banking which forced banks to adapt (Cetorelli).
The income mix of bank holding companies underwent a transformation starting in the 1990s. Banks’ traditional forms of income - interest income from loans and service fees - were joined by income earned from new financial services. One source that gained prominence over this time period was the securitization of assets, pooling loans to create an asset-backed securities, which in turn, could be marketed to investors.
Also notable was the banking industry’s increasing reliance on fee-based income. For most banks in 1994, the ratio of noninterest income to operating revenue fell below 0.4. By 2006, the ratios of the top bank holding companies were more evenly distributed between high and low (Cetorelli).
The Gramm-Leach-Bliley Act (1999), which repealed the Glass Steagall Act (1933), allowed banks to provide services other than commercial banking, opening up a plethora of potential income sources (Kagan)(Heakal). Banks began to offer new financial services, which can be categorized as nontraditional, including income from trading assets, trading revenues, venture capital revenues, investment banking, and insurance income.
While smaller banks largely remained homogeneous in their reliance on traditional sources of income, larger banks developed a newfound heterogeneous distribution of income mixes. The increasing importance of noncommercial banking within the financial industry also disproportionately affected larger banks. Larger banks, which counted almost entirely on commercial bank subsidiaries for non-interest income in the 1990s, relied on noncommercial subsidiaries for 40 percent of non-interest income by 2009 (Cetorelli).
The continued development of financial intermediation fostered an environment in which individuals and entities were connected to others through financial institutions. Thanks to this increased level of financial interconnectedness, entities with excess capital were exposed to more profitable investment opportunities. Eventually, to satiate the appetites of aggressive and risk-seeking investors, the idea of risk capital gained relevance.
Risk capital can be thought of as funds that are deployed into high-risk, high-reward investments. Generally, the returns on risk capital investments are speculative in nature. High risk tolerance is necessary due to the minimal likelihood of a profitable outcome, or even that the investor will recoup the amount of their contribution. For this reason, risk capital is often limited to a small percentage of a given portfolio. For example, pension funds managers can dedicate only 10 percent of funds to invest in risk capital (Shabecoff).
An important aspect of risk capital is the long-tail distribution of return on investments (Siegel). The success rates of startups, which can generally be viewed as risk capital ventures, have a dramatic skew. Almost 80 percent of current startups fail to exist past the seed round of fundraising. However, a minuscule percentage of startups reap dramatically lucrative returns.
The potential to hit on one of these “home runs” makes up for the high likelihood of failure and is what incentivizes investors to invest in risk capital ventures. For an investor to increase their chances of success, scale and diversification within their portfolio are crucial.
Just like other aspects of high society, risk capital investing was primarily limited to wealthy white individuals who possesed outsized wealth and influence. For much of history, risk capital investing, and its potential to reap dramatic returns, was only available to the accounts of wealthy families, monarchs, and governments. Entrepreneurship was a viable career path only for business founders who were rich themselves or had connections to rich people (Siegel).
Limiting entrepreneurship to a small demographic inherently limits the development of new technologies. Now that the importance of free markets to progressing society forward is better understood, it is clear that systematic exclusion of large swaths of society from risk capital investing not only oppressed other ethnic groups but also stifled innovation.
Financing for innovative ideas often required substantial investments and involved considerable risk. However, risk capital ventures remained attractive to investors because of their potential to solve a societal problem or bring about increased efficiency to a given process, which would ultimately translate into substantial returns for investors. Examples of risk capital are interesting to examine for their similarities and differences to current financial practices.
Some consider the funding of Christopher Columbus’ 1492 expedition to be the earliest example of high-profile risk capital investing. Queen Isabella agreed to fund the expensive sea voyage because of the potential riches that lay on the other side of a successful journey (Kupor).
300 years later, the sea was still a hotspot for risk capital. The whaling industry of colonial America represented a classic model for risk capital and had striking similarities to modern venture capital. Whaling expeditions were notoriously dangerous, with a high chance of failure, and even death for those involved. Despite this enormous risk, the upside of a successful voyage was so lucrative that investors competed to finance whaling ships.
New Bedford, Massachusetts (circa 1800-1940) was to the whaling industry what Silicon Valley is to modern day startups. Whaling agents acted as intermediaries, pooling funds from wealthy investors, and investing those funds into whaling ventures. These voyages required substantial upfront capital, and many voyages were unsuccessful; it is estimated that 50 percent of sea voyages resulted in death for crew members. The high risk, high-reward nature of these voyages embodied the long-tail return aspect of risk capital (Hathaway).
Inspired by the Gilded Age of American history, it became increasingly common for wealthy families in the U.S. during the early 1900s to become interested in investing in risk capital projects (Gompers). Railroad, oil, steel, and banking innovations during this period were bankrolled by families like the Rockefellers, Whitneys, Morgans, and Vanderbilts (the “robber barons”). By the 1930s, some of these families were hiring investment managers to search for investment opportunities with early-stage companies. Investment vehicles began to emerge in order to manage portfolios of risk capital ventures, which were considered long-term assets (Nicholas).
Early-stage companies require funding to get off the ground. And some companies, especially those developing innovative technologies, require substantial funding. However, these companies are largely unproven, and thus present as high-risk investments.
Entrepreneurs are generally incapable of directly funding entities themselves. For most early-stage businesses, cash-strapped and possibly years away from profitability, banks are unlikely to offer loans of the requisite size. Yet, the risky nature of these companies makes them suitable for long-tail investing.
Venture capital firms are equipped to meet the needs of high-risk ventures. With the ability to pool large sums of capital, venture capital firms can offer startup companies sufficient capital. Venture capitalists, responsible for managing the firm’s funds and day-to-day operations, serve as active investors.
Within portfolio companies, venture capitalists can serve on the board of directors, lead fundraising rounds, and provide guidance. For investors in venture capital firms (who hold equity stakes in portfolio companies), the advantage of venture capital comes from the firm’s ability to invest in a diverse range of risk capital ventures, pooling risk and increasing the chance of participating in the rewards of a “home run.” (Gompers)
Precursors of modern venture capital can be found throughout post-Industrial Revolution history. The advent of innovative - but costly - technologies ushered in investment by wealthy investors into risk capital ventures. Examples, such as the whaling industry and the investment offices of wealthy families like the Whitneys and Rockefellers, demonstrated the increasing prevalence of this unique form of investing.
The concept of modern venture capital is formally recognized to have originated with the formation of the American Research and Development Corporation (ARD) in 1946. Since ARD, the venture capital industry has certainly evolved, but some key attributes that ARD introduced remain crucial to the underpinnings of venture capital.
Georges Doriot, president of ARD, was instrumental in developing the vision for venture capital. Doriot, later dubbed “the father of venture capital,” was inspired by the rapid development of new technologies during the World War II war effort and was passionate about the importance of supporting entrepreneurship.
Believing innovation to be a necessary component of an economy, ARD focused its investments on early-stage scientific companies. Per Doriot’s vision, ARD supported its portfolio companies not only with capital, but with guidance and resources, and realized that long-term returns required ARD to not pressure its companies into premature profitability (Pazzanese).
Before ARD, private companies were primarily financed by the wealthy families of the day. One defining factor of ARD, which differentiated the firm and became an important quality of venture capital, was the firm’s practice of granting private equity from non-family funds (ARD). More than the funds of wealthy families and their networks, ARD was successful at pooling investment capital from a wider, and more comprehensive, net of institutional investors. This relatively larger pool of capital was important; at the time, the demand for capital to fund the creation of new technologies far outweighed the supply (Hathaway).
While Doriot’s vision and ARD’s revolutionary structure were notable, the major reason why ARD’s legacy is still pertinent today is because of its success at realizing massive returns. Digital Equipment Corporation (DEC), ARD’s flagship investment, returned over 5,000 times ARD’s initial investment (DEC). The capital earned from DEC’s wild success transformed ARD from market-underperforming to overperforming, thus proving the long-tail model of venture capital investing to be immensely lucrative. Even though deployments of risk capital more often results in failure rather than success, hitting a home run like DEC makes the risk worthwhile.
Despite its historic innovations, one aspect of ARD’s structure did not prove lasting and eventually pushed the firm into irrelevance. ARD operated as a closed-end fund, meaning that it raised capital by issuing a limited number of public shares (Nicholas). This organizational structure proved disadvantageous for a number of reasons. In addition to regulatory obstacles, ARD’s structure excluded the firm’s investment managers from enjoying high rewards and subjected investors to unfavorable tax treatment.
Enter limited partnerships. Limited partnerships offered more flexible regulatory requirements (i.e., reporting) and allowed investment managers (general partners) to hold equity in portfolio companies, allowing them to reap the rewards of a successful exit. The pass-through tax aspect and limited liability nature of limited partnerships were also key factors that led to widespread adoption (Tarver). The limited partnership structure was adopted by the U.S. venture capital industry first with Draper, Gaither and Anderson (1959), and later was popularized by the success of Greylock Partners and Venrock (Hathaway).
Public policy also played a role in the development of American venture capital.
The passage of the Small Business Act in 1958 allocated public funds for small business investment companies (SBIC). SBICs effectively acted as venture capital firms, pooling investment funds to deploy into risk capital ventures. At an important time when high-tech science companies were being rapidly developed, SBICs provided opportunities to savvy investors, increasing competition and bringing new blood into the evolving venture capital industry (Hayes).
However, SBICs were subject to strict government oversight, which deterred many investors. The issue of scale also served to stifle SBIC returns: an undersupply of capital prohibited SBICs from building a sufficiently diverse portfolio to pool risk. Due to interest obligations periodically owed to the government, SBICs needed to finance portfolio companies with debt rather than the equity financing that would come to define venture capital. This limited the ability of SBICs to pursue investments in high-risk ventures.
During economic contractions, like the 1973-1974 recession, SBICs and their portfolio companies, both highly leveraged, had trouble meeting interest requirements (Gompers). Thus, after the number of SBICs peaked in 1964, the presence and scope of SBICs would decrease in subsequent years (Hathaway).
A 1979 amendment to the Employee Retirement Income Safety Act (ERISA) opened the floodgates for the venture capital industry (Shabecoff). Under the authority of ERISA’s “prudent man” rule, managers of pension funds had been effectively prohibited from allocating funds for risk capital investments.
With the 1979 amendment, managers were free to allocate 10 percent of funds for high-risk assets. Pension funds poured into venture capital, contributing over $3 billion by 1988 to become the largest source of capital (Gompers). This allowed for more venture capital firms to be properly capitalized and diversify their portfolios, increasing their propensity to oversee lucrative exits.
Venture capital continues to evolve to this day, but the general premise remains - a form of intermediation responsible for pooling investment funds to be deployed into high risk ventures, with generally long-tailed returns.
The next section will continue to elaborate on important historical information relevant to the venture capital industry, and begin to explore the evolution of entrepreneurial hubs. Additionally, the structures and strategies of investors will be examined.
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