‘A trust crisis’

1/27/2009 - Trust is a vital element in financial decision-making, whether one is turning a check over to a banker or asking a broker for investment advice.

But the deepening economic crisis has tested that trust, as Paola Sapienza, Kellogg School associate professor of finance and Zell Center faculty fellow, and University of Chicago professor Luigi Zingales explain in their latest research paper, “A Trust Crisis.”

Sapienza and Zingales’ research reveals that investors’ trust in financial institutions has plummeted over the past several months. The professors also suggest that government intervention has further lessened people’s faith in the financial markets.

The business school professors have developed the Chicago Booth-Kellogg School Financial Trust Index to measure the level of trust Americans have in financial institutions, such as banks and the stock market. Sapienza explains the trust index and why trust plays a crucial role in the economy.

Amy Trang: What is the purpose of the Financial Trust Index that you and Professor Zingales have created?

Prof. Sapienza: The objective of the Financial Trust Index is to capture the level of confidence Americans have in the private institutions in which they invest their money. The index, which will be updated quarterly, will measure whether trust in financial institutions has increased or decreased. We will also look at whether increases or decreases of trust are related to how people perceive current events, such as government intervention.

AT: What inspired this research on trust?
 
Prof. Sapienza: In the past, we’ve established in several papers that there is a link between trust and the development of financial markets. When people entrust institutions and people with their money, they do so only if they have sufficient trust that their funds will be invested appropriately. In previous research, we show that trust has an important effect on the decision to invest in stocks and deposit money in a bank, and even on the willingness to pay with checks.

AT: How do you define trust in economic terms?

Prof. Sapienza: Trust is a prior belief that the other person is going to act in a way that is not damaging and is beneficial to your own interests. If you think about the decision to give money to a broker, you are going to estimate the probability that this broker will act in a way that is in your best interests — to execute the order in the best way for you, and, of course, invest your money as requested. It’s hard to put all these details into a contract and sometimes it is hard to enforce contracts.

AT: Why does an individual’s level of trust make a difference in economic decisions?

Prof. Sapienza: The decision to put the money in some kind of investment is fundamentally a trust decision. An investment is nothing but an exchange of money for a promise to return more money in the future. Whether such an exchange can take place depends on the extent of the investor trusting the institution that they are giving the money to. The person making the decision has to trust that the counterpart will act in his or her best interest.

AT: The research suggests that bankers are regarded as less trustworthy than banks and brokers are less trustworthy than the stock market. How is it that you can trust the institution but not the person when these two elements are so intertwined?

Prof. Sapienza: Banks are made of people, but it’s also true that banks are regulated by the government. Some of the behaviors of banks can be driven not by the self-interest of the people working at the banks, but also by some regulatory constraints that banks have to fulfill. In general, institutions are different from the sum of the people. In some instances, an institution can be less or more trusted than the sum of its people.

AT: Are there ways that people can regain trust after it is lost?
 
Prof. Sapienza: What we plan to accomplish with the Financial Trust Index is to measure how trust changes over time, and whether the perception of current events or government policies affects trust in one way or another. That data will allow us to answer that question in detail.

Read more about the Financial Trust Index at www.financialtrustindex.org and more about the research on Kellogg Insight.