CONTRIBUTOR / Paola Sapienza
DONALD C. CLARK/HSBC CHAIR IN CONSUMER FINANCE
PROFESSOR OF FINANCE
KELLOGG SCHOOL OF MANAGEMENT / Finance
Italy was the first place where trust was studied by sociology, so when economists wanted to study the relationship between trust and financial transactions, they started in Italy. Research shows that in areas where there is limited social capital and little trust, people tend to use fewer financial contracts, are less likely to invest in the stock market and are less likely to buy insurance products. Research also shows that the level of bilateral trust between citizens of a given country and citizens of another country impacts the amount of trade between the two countries as well as foreign direct investment.
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 The Moral Basis of a Backward Society, 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.