James McAndrews and William Roberds
Federal Reserve Bank of Atlanta
Working Paper 99-11
August 1999

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The medieval banks of continental Europe facilitated trade by serving as payment intermediaries. Depositors commonly would pay one another by transferring bank balances with the aid of overdraft credit. We model this process in an environment of intermediate good exchange with incomplete contract enforcement. Our model suggests that the early banks were capable of accessing the "netting credit" that exists by virtue of there being a high proportion of offsetting transactions in an economy. Individual traders are unable to net their individual positions because of difficulty in enforcing contracts for future performance with the other traders. Banks, by standing between buyer and seller on a centralized basis, can internalize the offsetting nature of the whole set of trades. This original role of banks is still a vital one.

JEL classification: E58, G21, G28

Key words: payments, intermediation, netting

The authors thank Mark Flannery, Scott Freeman, Ed Green, Joseph Haslag, Bruce Smith, Warren Weber, John Weinberg, and seminar participants at the Bank of Japan, the Clarence Tow Conference at the University of Iowa, the Federal Reserve Banks of New York and Philadelphia, the Swiss National Bank, the Sveriges Riksbank, the University of Texas, and the 1999 Latin American Meeting of the Econometric Society for comments on earlier drafts. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to James McAndrews, Research Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, New York 10045-0001, 212/720-5063, jamie.mcandrews@ny.frb.org; or William Roberds, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8970, william.roberds@atl.frb.org.