For all its mathematical models, finance is not physics. In fact, it runs pretty much on faith (Carlin et al. 2009), and can give rise to highly emotional reactions. This was much in evidence during the latest financial crisis. Trust, another name for faith, was shattered among financial actors when Lehman Brothers collapsed, causing a widespread clampdown on lending and prompting investors to rush for the exit, trying to get rid of their securities as quickly as possible on the way out. In a recent report (Saint-Paul et al. 2010), we argue that this is a key factor behind the sudden collapse in economic activity after October 2008.
What is trust?
Defined as the belief that a person has that a counterpart in a transaction will not take advantage of him, trust is crucial in many transactions and certainly in those involving financial exchanges. The massive drop in trust associated with this crisis will therefore have important implications for the future of financial markets. Data show that in the late 1970s, the percentage of people who reported having full trust in banks, brokers, mutual funds or the stock market was around 40%; it had sunk to around 30% just before the crisis hit, and collapsed to barely 5% afterwards. It is now even lower than the trust people have in other people (randomly selected of course).
Trust was destroyed in large measure by the revelation of opportunistic behaviour that the crisis brought to light, of which the Bernard Madoff case is emblematic. Indeed, the data examined shows that in states where the number of Madoff victims was higher, the level of trust towards bankers, brokers and mutual funds has fallen more than in those states with a lower concentration of Madoff victims.
The death of trust
The dark light this has cast on the whole financial industry will most likely result in:
- A drop in investment in risky assets, as such assets lend themselves more easily to opportunistic behaviour than simple securities. This will bias portfolios markedly towards safer securities and away from stocks.
- A drop in demand for complex financial instruments with uncertain returns. Given that such instruments’ complexity exposes them more easily to fraud, a higher dose of trust is required for investors to hold them. If trust is absent, investors will turn to more familiar securities.
- Turning to more familiar assets will increase the share of domestic assets in portfolios, making them somewhat less diversified. On the other hand, investors will tend to diversify their stable of intermediaries, in order to reduce their exposure to any one in particular. Both effects are costly, as the first entails losing the benefits of diversification and the second involves higher costs from setting and maintaining multiple relations.
- A corollary of the above will be less reliance on and delegation to intermediaries, given that a fundamental ingredient in the intensity of financial delegation is the level of investor’s trust. Since delegation is more necessary the more sophisticated the security, this will also fuel a move towards simpler portfolios.
- Lastly, since an insurance contract is also a financial contract, the fall in trust should also affect the demand for insurance.
In sum, the dearth of trust towards all segments of the financial industry will give rise to a generalised flight from financial trades, in particular from those more exposed to opportunistic behaviour.
The shift to safer assets will push up the equity premium, affecting the type of firms that depend on raising equity for their financing. If this preference also means that longer-maturity instruments will be shunned in favour of short-term ones, it will raise the cost of longer-term financing, hampering projects with longer maturities.
How to revitalise trust
All of the above highlights the importance of rebuilding trust in financial markets and intermediaries. We examine two avenues to re-establish trust levels: enhanced regulation and a reaction by the industry.
The regulatory approach rests on increasing the strength of financial regulation. However, many of the proposals, such as those being discussed by the Financial Stability Board, go beyond the purposes of rebuilding trust and will most likely affect the perceived solvency of the intermediaries. They are likely to have little impact on trust.
Initiatives such as the creation of a consumer protection agency, as proposed by the Obama administration, or the establishment of a Financial Fraud Enforcement task force, both specifically aimed at protecting investors from abuses, may help rebuild trust, but will exert a rather limited impact.
But regulation by itself, without the involvement of the intermediaries, may fail to restore trust. Thus, it would be advisable to reinforce the regulatory approach by making the financial industry itself work towards regaining the trust of its customers. We examine three possible mechanisms:
- A rating system that even the most financially illiterate investors can understand. Offered in an easily grasped metric (such as from 0 to 10), it would rate intermediaries on their ability to offer trustworthy services. The rating would not only allow investors to distinguish intermediaries on the basis of their integrity, but its very existence would spur intermediaries to make efforts to raise their trustworthiness.
- A trust-based compensation scheme. If the compensation of an intermediary is tied to the level of trust an investor has in it, the intermediary will have a strong incentive to behave in a trustworthy manner.
- Promoting investors’ financial education. The government can put financial education in school curricula, while financial education material certified by third parties can be made available to investors, among other such measures.
The above measures endeavour, from different angles, to limit the scope for intermediaries’ opportunistic behaviour. Adhering to such measures, however, can only be left to the discretion of the intermediaries, as there is no automatic mechanism to guarantee that they will adopt them. But combined with a new regulatory thrust, this approach should work well towards rebuilding one of the more precious intangibles in financial transactions: Trust.
Carlin, Bruce I, Florin Dorobantu, S Viswanathan (2009), “Public trust, the law, and financial investment”, Journal of Financial Economics, 92(3):321-341, June
Saint-Paul Gilles, Giancarlo Corsetti, Michael P Devereux, Luigi Guiso, John Hassler, Hans-Werner Sinn, Jan-Egbert Sturm, Xavier Vives (2010), “A trust-driven financial crisis. Implications for the future of financial markets”, Chapter2, 2010 EEAG Report on the European Economy.