Former Bank of Canada governor, David Doge, said trust “is more than a simple belief in something or someone without supporting evidence. Trust is what develops when a group of people share an understanding that the rules for behaviour governing their system or society work well and make things better for everyone.”
Unfortunately, this shared understanding of rules and behaviour is seemingly missing in financial services. According to the Edelman trust barometer (2012), a yearly survey monitoring public trust in institutions, only 40% of people trust banks. Trust in the more general “financial institutions” sits only slightly higher at 45%.
Trust is not a unitary concept, however. There are many forms of trust, and the various forms are malleable. All follow the basic premis that an agent will act in a consumers best interest. But, problems of performance based executive compensation, commission fees and a focus on short-terminism means this is rarely the case.
A loss of trust in financial services is problematic for several reasons. Trust helps the functioning of the financial system, which positively impacts the real economy. With trust, less effort is expended on “keeping tabs, so systems can run more efficiently,” and transaction costs are reduced. There is less of a chance of bank runs and capital is allocated more efficiently.
While all three forms of trust can and have been broken in recent history, the most common breach of trust occurs in an agency relationship. An agency relationship is a contract where “one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent.” Unfortunately, “there is a good reason to believe the agent will not always act in the best interest of the principle,” if both parties are utility maximizers.1
Agents in financial firms are particularly well placed to maximize their own utility because of asymmetric information, moral hazard and complexity inherent in the financial system. In fact, financial firms exist, in part, because of asymmetric information. Financial agents, be it investment advisors, fund managers or bankers, are employed to utilize this superior information on behalf of the consumer. Agency relationships are fraught with moral hazard, as the agent is not typically responsible for the costs associated with risk taking. The complexity of the financial system is, in part, is what makes agents able to maximize in this way. Together, these three issues create a severe principal-agent problem.
How can regulators help bring trust back into financial services? You can’t, really. Trust develops slowly but surely over time. But, here are some recommendations to develop and maintain trust into the future.
- Increase transparency
- Principles over rules based regulation
- Increase competition in the financial sector while reducing switching costs (consider portability of account numbers)
- Only allow certain products that meet risk requirements
- Criminalise breeches of trust
- Increase financial literacy
Some of these are already occuring, or at least there are movements in this direction. After LIBOR, for instance, criminal charges are being levied against perpetrators. Think tanks and educational instituitions are attempting to encourage literacy. But, its not enough.