Hostname: page-component-78c5997874-m6dg7 Total loading time: 0 Render date: 2024-11-13T05:09:46.319Z Has data issue: false hasContentIssue false
  • English
  • Français

The Relevance of “Trust and Confidence” in Financial Markets to the Information Production Role of Banks

Published online by Cambridge University Press:  29 June 2020

Bahriye BASARAN Open the ORCID record for Bahriye BASARAN [Opens in a new window]  and
Mahmood BAGHERI
Bahriye BASARAN
Affiliation:
Lecturer, Department of Commercial Law, School of Law, Ankara Yildirim Beyazit University, Ankara, Turkey; email: bbasaran@ybu.edu.tr.
Mahmood BAGHERI
Affiliation:
Course Director of LLM in International Corporate Governance, Financial Regulation and Economic Law and Associate Research Fellow at the Institute of Advanced Legal Studies, School of Advanced Study, University of London, UK; email: Mahmood.Bagheri@sas.ac.uk.
Get access Rights & Permissions [Opens in a new window]

Abstract

Banks are informational intermediaries whose efficient operation is strongly tied to the maintenance and continuance of the trust and confidence produced by them and by external sources. The literature on trust and confidence with relevance to banking has shown particular interest in their links with panics and bank runs, together with their wider resulting implications on the macro-stability of the financial system. However, on the micro level, an initial outcome emanating from a lack of trust and confidence would be the disruption of the information production that ultimately paves the way for further deterioration, leading to a vicious circle. To investigate this further, this article will shed light on this micro aspect of bank information production and its relationship with public trust and confidence.

Type
Articles
Information
European Journal of Risk Regulation , Volume 11 , Issue 3 , September 2020 , pp. 650 - 666
Copyright
© The Author(s), 2020. Published by Cambridge University Press

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

1 R Levine and S Zervos, “Stock Markets, Banks, and Economic Growth” (1998) 88(3) The American Economic Review 537.

2 J Tobin, “Commercial Banks as Creators of ‘Money’” in D Carson (ed.), Banking and Monetary Studies (Toronto, Irwin 1963) pp 408–19.

3 WW Bratton, “The New Economic Theory of the Firm: Critical Perspectives from the History” (1989) 41 Stanford Law Review 1471.

4 RA Werner, “Can Banks Individually Create Money Out of Nothing? The Theories and the Empirical Evidence” (2014) 36 International Review of Financial Analysis 1, 6.

5 E Fama, “Banking in the Theory of Finance” (1980) 6 Journal of Monetary Economics 39.

6 E Fama, “What’s Different about Banks?” (1985) 15 Journal of Monetary Economics 29.

7 MS Goodfriend, “Money, Credit, Banking, and Payments System Policy” (1991) 77(1) Federal Reserve Bank of Richmond’s Electronic Review <https://fraser.stlouisfed.org/docs/publications/frbrichreview/rev_frbrich199101.pdf#page=5> (last accessed 16 February 2020).

8 See EG Corrigan, “Are Banks Special?” (1982) Federal Reserve Bank of Minneapolis 1982 Annual Report <https://www.minneapolisfed.org/publications/annual-reports/ar/annual-report-1982-complete-text> (last accessed 4 February 2020).

9 Theoretical foundations in regulating banks and the approaches in addressing how financial regulation conceptualises and responds to the pluralistic and diversified interests of different bank stakeholders on different occasions are well-discussed in the literature. See S Arnay and L Scialom, “The Influence of the Economic Approaches to Regulation on Banking Regulations: A Short History of Banking Regulations” (2016) 40 Cambridge Journal of Economics 401; JR Barth, G Caprio Jr and R Levine, Rethinking Bank Regulation (Cambridge, Cambridge University Press 2006) ch 2; S Bhattacharya, AWA Boot and AV Thakor, “The Economics of Bank Regulation” (1998) 30(4) Journal of Money, Credit and Banking 745.

10 Corrigan, supra, note 8.

11 The application of financial intermediation theory to banks traditionally emphasises the superiority of banks in the collection, monitoring and utilisation of private information extracted from borrowers, whereas this comparative advantage of banks has diminished due to: (1) increasing numbers of shadow banks and their ability to rapidly access and process information based on technological innovation; (2) banks’ lack of incentives to gather and process information as the end user of information is not the banks themselves; and (3) the dominance of institutional investors in financial markets. For a discussion, see AN Berger, D Zhang and E Zhao, “Bank Specialness, Credit Lines, and Loan Structure” (30 January 2020) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3276666> (last accessed 30 January 2020).

12 DW Diamond and PH Dybvig, “Bank Runs, Deposit Insurance and Liquidity” (1983) 91(3) The Journal of Political Economy 401.

13 A Busch, Banking Regulation and Globalization (Oxford, Oxford University Press 2009) pp 23–28.

14 V Di Lorenzo, “Public Confidence and the Banking System: The Policy Basis for Continued Separation of Commercial and Investment Banking” (1986) 35 The American University Law Review 647, 648.

15 P Krishnamurthy, “Regulating Capital” (2014) 4(1) Harvard Business Law Review 1, 14.

16 Bank capital, in this respect, serves as a cushion to maintain confidence in the bank by providing liquidity to the bank in order to cover the risk of loan defaults and to meet withdrawals. Yet, a fractional reserve system does not help when an exceptional situation that disturbs confidence occurs. Creditors’ behaviours can be best explained by the “first come, first served” logic, which puts banks in a more difficult situation than forced liquidation because fire sales initiated or expedited by creditor behaviour lead to the rapid deterioration of bank assets.

17 GG Kaufman, “Bank Contagion: A Review of the Theory and Evidence” (1994) 8(2) Journal of Financial Services Research 123.

18 D Schoenmaker, Contagion Risk in Banking (London, LSE Financial Markets Group 1996) p 88.

19 Liu, Z, Quiet, S and Roth, B, “Banking Sector Interconnectedness” (2015) Q2 Bank of England Quarterly Bulletin 130 Google Scholar.

20 A Ittner, “Banking System and Financial Stability” in A Dombret and O Lucius (eds), Stability of the Financial System (Cheltenham, Edward Elgar 2013) ch 7.

21 J Hicks, A Market Theory of Money (Oxford, Clarendon Press 1989) p 58.

22 See J Huber, “Modern Money Theory and New Currency Theory: A Comparative Discussion, Including an Assessment of Their Relevance to Monetary Reform” (2014) 66 Real-World Economics Review 38.

23 For discussions regarding banks’ money creation role, see Z Jakab and M Kumhof, “Banks Are Not Intermediaries of Loanable Funds – and Why This Matters”, Bank of England Working Paper no. 529 (May 2015) <https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2015/banks-are-not-intermediaries-of-loanable-funds-and-why-this-matters.pdf?la=en&hash=D6ACD5F0AC55064A95F295C5C290DA58AF4B03B5> (last accessed 4 January 2020); RA Werner, “How Do Banks Create Money, and Why Can Other Firms Not Do the Same? An Explanation for the Coexistence of Lending and Deposit-Taking” (2014) 36 International Review of Financial Analysis 71; Tobin, supra, note 2; Huber, supra, note 22.

24 Corrigan, supra, note 8.

25 C Borio and P Disyatat, “Unconventional Monetary Policies: An Appraisal” (2009) BIS Working Paper No: 292 at 16 <http://www.bis.org/publ/work292.pdf> (last accessed 18 February 2020).

26 EF Gerding, Law, Bubbles, and Financial Regulation (Abingdon, Routledge 2014) p 369.

27 J Peek and ES Rosengren, “The Role of Banks in the Transmission of Monetary Policy” (2013) Federal Reserve Bank of Boston Public Policy Discussion Papers No: 13-5 <https://www.bostonfed.org/publications/public-policy-discussion-paper/2013/the-role-of-banks-in-the-transmission-of-monetary-policy.aspx> (last accessed 24 February 2020).

28 This is particularly relevant to countries with bank-based financial systems. See European Central Bank, “The Role of Banks in the Monetary Policy Transmission Mechanism” (2008) European Central Bank Monthly Bulletin <https://www.ecb.europa.eu/pub/pdf/mobu/mb200808en.pdf> (last accessed 20 February 2020).

29 See R Levine, “Financial Development and Economic Growth: Views and Agenda” (1997) XXXV Journal of Economic Literature 688; C James, “Some Evidence on the Uniqueness of Bank Loans” (1987) 19(2) Journal of Financial Economy 217.

30 See T Beck, A Demirguc-Kunt, L Laeven and R Levine, “Finance, Firm Size and Growth” (2004) National Bureau of Economic Research Working Paper No: 10983 <http://www.nber.org/papers/w10983> (last accessed 1 January 2020).

31 B Bosone, “What Makes Bank Special? A Study of Banking, Finance and Economic Development” (2000) The World Bank Policy Research Working Paper 2408, at 4 <http://documents.worldbank.org/curated/en/348281468739569626/What-makes-banks-special-a-study-of-banking-finance-and-economic-development> (last accessed 1 January 2020).

32 LA Gornicka, “Banks and Shadow Banks: Competitors or Complements?” (2016) 27 Journal of Financial Intermediation 118.

33 L Rethel and TJ Sinclair, The Problem with Banks (London, Zed Books 2012) p 69.

34 JJ Pringle, “Bank Capital and the Performance of Banks as Financial Intermediaries: Comment” (1974) 7(4) Journal of Money, Credit and Banking 545, 546.

35 J Santos, “Bank Capital Regulation in Contemporary Banking Theory: A Review of the Literature” (2001) 10 Financial Markets, Institutions & Instruments 41.

36 Pringle, supra, note 34.

37 D Diamond, “Financial Intermediation and Delegated Monitoring” (1984) 51 Review of Economic Studies 728.

38 Bank reporting/disclosure requirements aim to mitigate these agency problems. See A Beatty and S Liao, “Financial Accounting in the Banking Industry: A Review of the Empirical Literature” (2014) 58 Journal of Accounting and Economics 339, 342–43.

39 Bank runs are frequent withdrawals of funds from the bank within a very short period of time.

40 AMH Slager, Banking across Borders (Rotterdam, ERIM 2004) p 40.

41 DP Morgan, “Judging the Risk of Banks: What Makes Banks Opaque?” (1997) FRBNY Report No: 9805 <https://www.newyorkfed.org/medialibrary/media/research/staff_reports/research_papers/9805.pdf> (last accessed 11 January 2020).

42 Alan Greenspan’s speech delivered at Financial Markets Conference of the Federal Reserve Bank of Atlanta on 23 February 1996 <https://fraser.stlouisfed.org/scribd/?item_id=8561&filepath=/files/docs/historical/greenspan/Greenspan_19960223.pdf&start_page=1> (last accessed 21 January 2020).

43 G Gorton, “The Development of Opacity in the U.S. Banking” (2014) 31(3) Yale Journal of Regulation 825.

44 For the role of confidence in financial regulation, see F Partnoy, “Financial Systems, Crises, and Regulation” in N Moloney, E Ferran and J Payne (eds), The Oxford Handbook of Financial Regulation (Oxford, Oxford University Press 2015) pp 80–83.

45 AS Blinder, “It’s Broke, Let’s Fix It: Rethinking Financial Regulation” (2010) International Journal of Central Banking 277, 279.

46 Goals such as the prevention of financial crime, the encouragement of innovation and the promotion of competition and capital formation are some of them. See J Armour et al, The Principles of Financial Regulation (Oxford, Oxford University Press 2016) pp 61–71.

47 The theory of regulation and state interference has been a hot topic in economic analysis of law. See GJ Stigler, “The Theory of Economic Regulation” (1971) 2(1) The Bell Journal Economics and Management Science 3; R Posner, “Taxation by Regulation” (1971) 2(1) Bell Journal of Economics 22; GS Becker, “Theory of Competition among Pressure Groups for Political Influence” (1983) 98(3) The Quarterly Journal of Economics 371; S Peltzman, “The Economic Theory of Regulation after a Decade of Deregulation” (1989) Brookings Papers on Economic Activity 1.

48 Adam Smith provided an early mention of confidence in the economic sphere, noting confidence as a calculative value linked to the merchant’s reputation. R Swedberg, “The Role of Confidence in Finance” in KK Cetina and A Preda (eds), The Oxford Handbook of the Sociology of Finance (Oxford, Oxford University Press 2012) pp 532–33. Development of the discussion today is notably attributed to studies of Keynes, who was the first economist to extensively contribute to the discussion by focusing on how the functioning of the economy is related to confidence, which lessens uncertainty, facilitates future investments and therefore establishes production and economic growth. In his setting, “animal spirits” – short, irrational impulses – drive human relations and rational calculations regardomg probabilities and do not necessarily comply with the reality of markets. JM Keynes, The General Theory of Employment, Interest and Money (London, Macmillan 1936). Akerlof and Schiller, by referencing animal spirits, take Keynes’ observations one step further and establish that personal and business psychology is driven by the sense of trust that economic agents have in each other, the sense of fairness in economic interactions and the sense of the degree of exploitation and bad faith. GA Akerlof and RJ Schiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton, NJ, Princeton University Press 2009). So, from the economic standpoint, trust and confidence are dynamic concepts that infuse through social, public and economic life and diffuse through national and global boundaries.

49 See M Quddus, M Goldsby and M Farooque, “The Social Virtues and the Creation of Prosperity – A Review Article” (2000) 26(1) Eastern Economic Journal 87; F Tonkiss, “Trust, Confidence and Economic Crisis” (2009) 44(4) Intereconomics 196; R Tomasic and F Akinbami, “The Role of Trust in Maintaining the Resilience of Financial Markets” (2011) 11(2) Journal of Corporate Law Studies 369; PO Mulbert and A Sajnovitz, “The Element of Trust in Financial Markets Law” (2017) 18(1) German Law Journal 1.

50 Partnoy, supra, note 44, p 81.

51 M Coleman, “Trust: The Basis of Capitalism” (1997) 86(342) Studies: An Irish Quarterly Review 156.

52 LG Zucker, “Production of Trust: Institutional Sources of Economic Structure” (1986) 8 Research in Organizational Behavior 53, 59.

53 AT Peperzak, Trust: Who or What Might Support Us? (New York, Fordham University Press 2013) ch 1.

54 Tonkiss, supra, note 49, p 198.

55 For more details, see Swedberg, supra, note 48, pp 529–46.

56 See N Luhmann, “Familiarity, Confidence, Trust: Problems and Alternatives” in D Gambetta (ed.), Trust: Making and Breaking Cooperative Relations (Hoboken, NJ, Basil Blackwell 1988) pp 94–107; RC Mayer, JH Davis, FD Schoorman, “An Integrative Model of Organizational Trust” (1995) 20(3) Academy of Management Review 709; D Padua, John Maynard Keynes and the Economy of Trust (London, Palgrave Macmillan 2014) p 49.

57 Mulbert and Sajnovits, supra, note 49, pp 7–11.

58 A van Hoorn, “Trust Radius versus Trust Level: Radius of Trust as a Distinct Trust Construct” (2014) 79(6) American Sociological Review 1256.

59 JS Coleman, Foundations of Social Theory (Cambridge, MA, Harvard University Press 1990).

60 F Fukuyama, Trust (New York, Free Press Paperbacks 1996).

61 See M Reuter, F Wijkstrom and B Uggla, Trust and Organisations: Confidence across Borders (London, Palgrave Macmillan 2013) p 2.

62 For example, see H Thornton, An Inquiry into the Nature and Effects of the Paper Credit of Great Britain (London, J Hatchhard 1802); W Bagehot, Lombard Street: A Description of the Money Market (London, Armstrong & Co 1873); RH Brescia, “Trust in the Shadows: Law, Behaviour and Financial Re-Regulation” (2009) 57 Buffalo Law Review 1361; D Murphy, “Maintaining Confidence” (2012) LSE Financial Markets Group Paper Series Special Paper 216 <http://www.lse.ac.uk/fmg/assets/documents/papers/special-papers/SP216.pdf> (last accessed 26 January 2020).

63 Fukuyama, supra, note 62, p 27.

64 For the relationship between trust and regulation, see LM Van Swol, “The Effects of Regulation on Trust” (2003) 25(3) Basic and Applied Psychology 221.

65 RJ Colombo, “The Role of Trust in Financial Regulation” (2010) 55(3) Villanova Law Review 577, 601.

66 See A Newman et al, “Examining the Cognitive and Affective Trust-Based Mechanisms Underlying the Relationship between Ethical Leadership and Organisational Citizenship: A Case of the Head Leading the Heart?” (2014) 1 Journal of Business Ethics 123; JL Morrow, MH Hansen and AW Pearson, “The Cognitive and Affective Antecedents of General Trust Within Cooperative Organizations” (2004) 16(1) Journal of Managerial Issues 48.

67 For details on information-based bank runs, see CJ Jacklin and S Battacharya, “Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications” (1988) 96(3) Journal of Political Economy 568.

68 SM Bainbridge, “Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship” (1997) 82(4) Cornell Law Review 856.

69 Cited in C Sandlund, “Trust Is a Must” (2002) 3 Entrepreneur 70.

70 G Ordonez, “Confidence Banking and Strategic Default” (2018) at 5 <https://www.sas.upenn.edu/~ordonez/pdfs/Confidence.pdf> (last accessed 30 January 2020).

71 RM Lastra, “Systemic Risk, SIFIs and Financial Stability” (2011) 6(2) Capital Markets Law Journal 197, 202.

72 See Liu et al, supra, note 19.