Trust and Economic Prosperity: A Finance Perspective

It takes a lot of trust for people to depart with their money in exchange for a promise.

Foundations

Contributor / Paola Sapienza

Donald C. Clark/HSBC Chair in Consumer Finance
Professor of Finance
Kellogg School of Management / Finance

A fundamental aspect of finance is credit, and credit comes from the Latin word ‘credere’, which means to trust. Virtually every commercial transaction has in itself an element of trust, and research shows a remarkable correlation between communities that tend to exhibit anonymous trust and economic growth, which suggests that the link between trust and economics could be finance.

Transcript

In 1972, Ken Arrow, Nobel Prize–winning economist, said that virtually every commercial transaction has within itself an element of trust. Indeed, he actually went on saying that it can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.

Since then, economists have correlated generalized trust, the concept that whether people tend to trust each other in an anonymous way with economic growth, and they found the remarkable correlation between these two variables.

It was actually, though, quite puzzling why there was such a strong correlation between the way people tend to interact in certain communities and economic prosperities.

So, economists start wondering, what is the missing link between these two variables?

One of the hypotheses postulated is that the missing link could be finance. Why? Well, in finance, a fundamental element is credit. And indeed, the word “credit” comes from ‘credere’ in Latin, which means to trust. Why is that so?

It takes a lot of trust for people to depart with their money in exchange for a promise. And this is fundamentally the way finance works.

We delegate a broker, an insurance company, a bank, we put our money in their in their hands in exchange of a future promise. And for a long time, we’re not going to see the money that we gave to them.

Now, finance is very, very important for economic prosperity. We know from years of research that without finance, allocation of resources doesn’t happen properly and economic prosperity doesn’t happen.

BUMPER: Exploring Trust through the Stock Market

Given the hypothesis postulated by economists that finance is the missing link between trust and economic prosperity, economists start investigating empirically whether indeed trust facilitated development of financial contracts in various economies.

They started studying the willingness people have to invest in the stock market.

Investment in the stock market has been one of the puzzling features in financial economics, because we know by observation that many people deliberately stay away from the stock market even when they would benefit from investing in it.

Therefore, it was reasonable to think whether, besides all the other variables that economists generally considered as determinant of investing in the stock market—such as risk aversion—trust was a big player in this decision.

Economists studied whether people that have lower generalized trust are less likely to invest their money in risky investment, such as putting their money in the stock market or even opening a checking account.

And they found a remarkable correlation between the level of generalized trust that individuals have with their willingness to invest their own money.

They also found a remarkable correlation between areas where there is a generalized low level of trust and the development of financial markets in general, suggesting that indeed this link between trust and economics could be indeed going through finance.

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In the absence of trust, people are willing to engage in transactions, especially in financial transactions. But where is trust coming from, and how is it spread across countries?

We know there are remarkable differences across countries, with northern European countries being very high on the trust scale and some Latin American countries being at the bottom of the distribution.

In fact, what we know, and it’s very interesting, is that immigrants from countries with high trust, when they move to countries with lower trust, they tend to hold onto their original trust level. And this suggests that our upbringing has something to do with how much we trust.

So, if I think about banks, insurance companies, trust is a fundamental ingredient to convince customers to depart themselves with their money and indeed trust the financial institution that they would do the right thing.

BUMPER: Winning Customer Trust: Dealing with Culture and Bias

It’s also important to understand that when dealing with different ethnic groups, different social background, where is the level of trust or mistrust coming from and indeed understand how this could be ameliorated at some level.

For example, we have evidence that shows that people tend to trust more people that look much more like them. So, diversity in facing customers could be an important mechanism to generate trust.

If we have that financial institutions are too homogeneous and they don’t reflect the demographic of their potential customers, it’s hard somehow to have customers relate to the specific experience.

But generally speaking, evidence shows that lack of trust indeed makes it really, really hard for some customers to walk into financial institutions.

And so, dealing with this reality and understanding the different reasons why people may or may not trust is a very important aspect of every customer interaction in the financial service.

We need to make sure that we unbias our customer force to make sure that they don’t bias themselves to favor some specific people.

But we also know that our customers, they have biases, and they tend to trust less people that look very different.

For example, a big debate among executives nowadays has been to the extent to which, given the fact that women are one of the largest buyers in the US nowadays of insurance products, why our customer force doesn’t mimic that, given the fact that they’re going to be the recipient of effort to convince them to buy some of this product.

Given the fact that women are among majority buyers of insurance, the question is whether a customer force that is more balanced and reflects this demographic should really be a conscious decision on the side of executives.

Similarly, think about the ethnic changing demographic of the customer base—to what extent corporate America should reflect that in order to, A, be able to understand better the needs of this group, and B, in order to really inspire a level of trust and confidence in the financial institution that we know is fundamental for a good relationship to start.
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Paola Sapienza Finance Measurement,Generalized Trust,Economic Exchange,Distrust,Institutions and Context When economists wanted to study the relationship between trust and the existence of financial transaction and the importance of trust for financial markets, they faced an important challenge: it’s really hard to measure causal relationships in environments that are very different along many other dimensions.

So, economists decided to go to Italy. Why Italy? Well, Italy was the first place where trust was studied by sociologists.

Back in 1950, Banfield wrote a very famous book, which is called <i>The Moral Basis of a Backward Society</i>, where he identified the characteristic values, cultural values of societies where there is a very limited level of trust.

More than 40 years later, his student Robert Putnam, in 1993, wrote a very famous book called ‘Making Democracy Work’ in which he argued that social capital and trust are a necessary ingredient for democracy to work and went to Italy to study that.

Italy is a very interesting country because it’s been unified for a relatively short time—150 years. Legally, regulatory, the views are the same, so it’s the perfect setting to study trust because trust has been very different across regions.

Financial economists borrowed from the sociologists and political scientists this incredible laboratory, Italy, and decided to study the effect of different levels of generalized trust on financial contracts.

Generalized trust defines how much people trust other people they don’t know. It’s generally measured as the answer to the following question: Generally speaking, do you think you can trust other people, or you can never be too careful about it?

The answer to this question has been linked to several economic outcomes. More specifically, financial economists wondered whether there is a connection between generalized trust and finance.

BUMPER: The Relationship between Generalized Trust and Financial Contracts

In the paper, “The Role of Social Capital in Financial Contracts,” we studied the different levels of generalized trust on the availability and use of financial contracts in different regions.

We found that in areas where there is very limited social capital and very limited trust, people tend to use less of those financial contracts that we consider basic, such as writing a check, opening a bank account, investing in stock, borrowing money.

Why is that the case? Because trust is very important in these financial transactions, as it is required for people to depart with their money.

And in fact, the results show a remarkable correlation between the extensive level of generalized trust in a given area and the availability and use of those contracts in certain areas.

So, in the paper, “Trusting the Stock Market,” the link is actually closer. We look at a sample of Dutch households all living in the same countries with the same legal views but with different level of trust. It’s a representative sample of household investors.

And we ask the question whether generally speaking, they trust other people and linked the answer to this question to their financial investment.

We find that individuals that have low levels of trust are less likely to invest in the stock market. They’re also less likely to buy insurance products.

And this is a very important result in the financial literature because of the puzzle, a generalized puzzle on why some people stay away altogether from the stock market even when they would benefit from it.

The concept that is developed in this paper is very much related to an important idea in economics that if we don’t trust the rule of the game or we don’t trust the players playing the game with us, we may stay out of it altogether.

By staying out of it altogether, we’re never going to learn that indeed it’s beneficial for us to participate, and this lack of participation therefore is indeed pervasive but also persistent over time.

BUMPER: The Role of Culture in Generalized Trust

Having established that the level of generalized trust in a given area affects the use and availability of financial contracts, that the individual level of generalized trust toward others affect his willingness to invest in the stock market, a follow-up question was whether bilateral trust—so, this is a little bit more special trust.

It’s still general in the sense that it’s a trust that is applied to different groups, and it’s generally measured as how much do you trust people from France? Or how much do you trust people from this other country? Or how much do you trust people from your own country?

So, the question is still a generalized trust question but is applied to different groups. And the question the paper “Cultural Biases in Economic Exchange” tried to answer was whether this bilateral level of generalized trust affected the willingness people have to enter in specific transactions.

The results are remarkable. We find that absorbing every other bilateral characteristics like language, specificity, legal contracts, and so on, controlling for all those characteristics, the level of bilateral trust between citizens of a given country and citizens of another country affect the composition of the portfolio, the amount of trade between the two countries, and foreign direct investment.

So, we looked at whether the extent to which citizens of a given country trust citizens of another country affects the willingness to invest in stocks of that specific country, the willingness to trade with the country, and the willingness to do foreign direct investment.

We find that bilateral trust is correlated with the composition of the portfolio of mutual fund managers in the following way: The higher the level of trust between Country I and Country J, the bigger the weight of Country J’s stocks in the portfolios of Country I.
Although credit reports adequately quantify trust, they are not necessarily the best thing to base relational trust on.

Jacked Up Ratings: Problems with Quantifying Trust

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One of the things that happens is, as we rely on quantitative measure of underlying features, like a quantitative measure or score that measures somebody’s creditworthiness or how trustworthy they are.

As these scores become consequential, as people start to take them seriously, and as they are used in actual important decision-making, there’s an incentive for people to corrupt them, to game them, to stop paying attention to what it is they’re measuring and instead focus on the measure.

And there are a couple of really clear examples of this becoming a big problem.

And one was, in 2008, people realized that the bond rating scores that had been attached by Moody’s and S&P and Fitch and whatnot, and that were attached to asset-backed securities based on subprime mortgages.

That the investment bankers and the rating agencies worked together to try to jack up the ratings as high as possible so that whenever outside investors looked at a security, they saw, “Oh, it’s AAA. Well, that’s great.”

Had they been savvy (and now they’re very savvy because they know what the problem is), they might have realized that, in fact, that AAA rating was a score that was kind of jacked up.

And so, I think in a world in which the quantitative information becomes increasingly important, what you have to do is be a sophisticated consumer of numbers and always be mindful of their limits and vulnerabilities. And you simply cannot take them too seriously.

BUMPER: Re-Engineering Trust with Peer-to-Peer Lending

Peer-to-peer lending is a very interesting experiment that, again, takes advantage of the IT revolution.

It used to be that if you were going to do peer-to-peer lending, it was going to happen in your small hometown. Those were your peers.

Those were the people who could trust you, who knew about your business, who might be willing to lend to you or whose business you knew about and to whom you might be willing to lend.

And what we’ve done is, we’ve sort of disconnected what used to be the high correlation between social knowledge and geographic concentration.

And so, peer-to-peer and similar models are re-engineering some of the differences between relational lending and relational trust and generalized trust in very interesting ways.

It’s a re-articulation of the connection between personal and impersonal. It’s a way of saying, “We can personalize what would otherwise be a default impersonal situation. We can create peers out of people that aren’t even in the same country.

Other pages in Videos:

Pages in The Trust Project at Northwestern University