Trust and the global financial crisis



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TRUST AND THE GLOBAL FINANCIAL CRISIS
Nicole Gillespie (University of Queensland, Australia)

Robert Hurley (Fordham University, USA)


ABSTRACT

Trust is central to exchange and growth. Nowhere is this more apparent than in the financial arena. In 2008-9, trust in the financial system eroded and financial institutions stopped lending to one another resulting in a credit freeze and a broader global economic slowdown. This paper analyses the financial crisis from a multi-level trust perspective. Our diagnosis reveals that, in many respects, the financial system was untrustworthy as a result of failures by multiple agents at multiple levels in the system (e.g. governments, rating agencies, Boards of Directors, CEOs, management, and agents employed by the financial institutions). Our analysis frames the loss of trust in the system from a theoretical standpoint and draws relevant insights from the literature concerning trust repair and the prospect of restoring trust. We connect our analysis to current debates in the trust literature, including the role of control as a basis for institutional trust building and repair.


Acknowledgements: We would like to thank Graham Dietz and Reinhard Bachmann for their insightful contributions to an earlier co-authored chapter on this topic, and an anonymous reviewer for their thoughtful suggestions.
Trust is central to exchange and growth. Nowhere is this more apparent than in the financial arena. Indeed, the term ‘credit’ is derived from the Latin word ‘credere’ meaning ‘to believe or trust’ (Oxford Dictionary, 2003). In the later part of 2008 into 2009, with the collapse of Bear Sterns and Lehman Brothers, trust was eroded and financial institutions stopped lending to one another. The subsequent lack of credit caused a broader economic slowdown and the lack of trust spread from Wall Street to Main Street and across the globe. The result was a rise in unemployment in many countries and, according to the International Monetary Fund, the destruction of $4.1 trillion worth of wealth on a global scale.

The Global Financial Crisis (GFC) presents a unique setting to examine trust, trust violation and trust repair from a multi-level perspective that crosses the individual (e.g., investors, retirees, employees), organizational (e.g., Lehman Brothers, Citibank, Goldman Sachs), industry (e.g., finance and insurance) and societal (e.g., global economy and governments) levels. In this paper, we analyze the breakdown of trust in the global financial system, revealing that there was a trust failure at multiple levels and by multiple agents. We further examine the foundations of repairing trust in the financial sector post GFC, arguing that the repair process must also be a multi-level and multi-agent phenomenon. In so doing, we draw on sociological theories of impersonal trust. We connect this with an examination of the role of control mechanisms in underpinning and supporting institutional trust and trust repair and the recent debates on the relationship between trust and control.



UNDERSTANDING TRUST AT THE SYSTEMS LEVEL

Trust has been defined as the willingness to be vulnerable to the actions of another party, based upon positive expectations of the intentions or behavior of the other, under conditions of risk and interdependence (Mayer, Davis and Schoorman, 1995; Rousseau et al., 1998). It has also been defined as a judgment of confident reliance on another person, group, organization or system when there is uncertainty and risk (Deutsch, 1973; Hurley, 2012 ; Hurley, 2006). Both of these definitions underscore the criticality of predictability for trust and identify that trust is only relevant when there is an element of risk. The latter definition makes salient that trust exists in different types of relationships and at various levels, and our focus in this paper is on trust in the financial system.

We adopt the definition of trust as confident reliance in recognition that trust at the systems level may involve instances where “willingness” is less relevant because reliance and vulnerability may not be optional due to a lack of practical alternatives. For example, investors must rely on the appointed public accounting firm concerning the accuracy of financial statements - they cannot do their own audit. This is in line with Shapiro’s (1987) argument that in modern society, collectivization, specialization and differentiation results in principals having to rely on agents to perform services they are either unable, or for which it is inefficient, to perform for themselves (e.g. medical diagnoses; tests of the safety of food, drugs, multistory buildings, elevators, automobiles and airplanes; banking, investment and insurance services). But even in situations where reliance is not optional, we still exercise judgment in the level of confidence we hold and choice in the extent of counter-measures that we might employ to mitigate against possible harm. While investors are reliant on audits from accounting firms - depending on their confidence or ‘positive expectations’ - they can do more or less of their own due diligence concerning the financial health of a target firm.

Perceived trustworthiness has been shown to be a strong antecedent to trust (Colquitt, Scott and LePine, 2007; Mayer, Davis and Schoorman, 1995). People, groups and organizations make judgments about the trustworthiness of another party, which in turn lead to postures of trust or suspicion. They do this to protect themselves in vulnerable situations involving trustees (Hurley, 2012; Hurley, 2006). Prior conceptual and empirical work suggests that across situations, levels and national cultures there are three basic elements that are considered when evaluating trustworthiness: Ability, Benevolence and Integrity (ABI, Mayer, Davis and Schoorman, 1995; Schoorman, Mayer and Davis, 2007)1



  • Ability: competence to deliver on commitments and fundamental responsibilities.

  • Benevolence: a positive orientation towards stakeholders, including concern for their interests.

  • Integrity: adherence to commonly accepted moral principles, including fulfilling promises and contracts, honesty and fairness.

In applying these three dimensions of trustworthiness to organizations and systems, it is important to recognize that various stakeholders will have access to different cues ranging from more personal (e.g., relationships, direct interaction) to impersonal forms (e.g., media, websites, and documentation) drawn from multiple elements of the system (Dietz and Gillespie, 2011; Gillespie and Dietz, 2009). For example, investor’s perceptions may be primarily influenced by a bank’s advertising, their exposure to the products, services and individual agents, and third party evaluations of the firm, its leaders and its goods/services. In contrast, bank employees will have an insider view based on interactions with leaders, experience of the organization’s culture, systems and processes, and their work on product or service development and delivery. In each case, stakeholders observe multiple signals from a variety of sources and agents that indicate whether the system, or the particular agents and institutions within that system, can be trusted to serve their interests.

It is recognized that the trustworthiness of socio-technical systems involves personal and impersonal relations across multiple boundaries and subsystems (Katz and Kahn, 1966; Luhmann, 1988). This is certainly true of the financial system. It involves a range of interacting and interdependent actors (e.g., investors, borrowers, bankers, financial advisors, pension funds, accountants, regulators and ratings agencies), operating within organizations and broader systems and subsystems that govern transactions, standards, licensing, and enforcement of laws and regulation.

While certainly there are a myriad of personal trust relations that enable exchange in the financial system, an examination of trust in this large socio-technical system highlights the criticality of impersonal trust. From a sociological perspective, numerous scholars argue that modern socio-economic systems depend on impersonal forms of trust (e.g. Giddens, 1984; Luhmann, 1979; Shapiro, 1987; Zucker, 1986). This perspective is based on the insight that interpersonal relationships are often not efficient or even possible where trust is needed – rather we often need to trust specialized ‘experts’ with whom we have no opportunity to build a personalized relationship (Giddens, 1984; Shapiro, 1987; Zucker, 1986). For example, when we deposit our savings into a bank, we trust the bankers not as individuals, but rather as representatives of complex ‘expert systems’. Indeed, we may deal with a different banker every time we interact with the bank, yet keep the same level of trust in the new representatives. As Shapiro (1987, p.632) states “long-term relationships with trusted bankers, stockbrokers, insurance agents, and others…merely provide a personalized smokescreen for inherently collective forms of actions.”

What makes these ‘experts’ trustworthy is the systems of education and training they have completed, coupled with the standards of expertise, rules and procedures they adhere to, their membership of regulated professional communities, and the legal system which constrains their behavior (Bachmann, 2001; Giddens, 1990; Luhmann, 1988). As Bachmann (2001) notes, when these institutionalized norms, procedures and rules form the basis of our trust in individuals, rather than one-on-one personalized experiences with them, then the relevant form of trust can be called ‘system trust’ (i.e. Luhmann) or ‘institutional-based’ trust (i.e. Zucker).

Niklas Luhmann’s work provides a useful theoretical framework to understand trust and the financial system. Luhmann’s (1988) theory suggests that systems emerge to cope with and contain complexity so that we can function more effectively (Seidl, 2005; see also Shapiro, 1987). Without a set of integrated and reliable systems and structures to enable the transfer of money from savers to borrowers, exchange would occur only in smaller trust networks rather than in the society at large. If the financial system lacked a trustworthy infrastructure, the vast amount of due diligence and decision making required would paralyze all but the experts, leaving the rest of us overwhelmed and, in all likelihood, poorer. This is the experience in parts of the world where economic and legal systems are less developed (e.g., Zimbabwe, Nigeria).

Luhmann (1988) further suggests that trust between agents depends on the establishment of confidence in the system as an antecedent. There are a variety of expert systems in the financial sector designed to generate confidence that exchange can occur safely and efficiently. These confidence inducing system mechanisms (or “guardians of trust”, Shapiro, 1987) include defining standards and training requirements for financial advisors prior to registration and licensing, the auditing of financial statements of public companies, the requirement that companies follow accepted accounting standards, and evaluations by ‘experts’ such as credit rating agencies. We could go on, as there are a myriad of structures, laws, processes and other facilitating mechanisms that underpin the global financial system. Prior to the GFC, these mechanisms produced a high level of confidence in the financial system. But once eroded, the system rapidly ground to a halt – money literally stopped moving.

Luhmann (1988, p.103) states “structural and operational properties of such a system may erode confidence and thereby undermine one of the essential conditions of trust”. Translating this to the financial sector, it may matter little whether investor’s trust the individual broker or advisor, or individual investment firms, such as Lehman Brothers or Goldman Sachs, if they have no confidence in the more macro system of exchanges that governs trading. Rather, a well-functioning financial system requires confidence in both the system and trust in the particular agents on whom stakeholders directly interact and rely.

THE GFC: UNDERSTANDING THE LOSS OF TRUST

Research reveals a host of common reasons why organisations and systems become untrustworthy. An examination of them may lead us to wonder why there are not more failures and to recognize that system trust requires a threshold of assurance rather than absolute trustworthiness. Economists and sociologists suggest that system failures occur because of poorly aligned or conflicting interests of agents and principals, problematic incentive systems that reward the wrong behaviors, lax monitoring and oversight, constrained monitoring due to asymmetries in information or expertise, and overly complex systems that render bureaucratic controls incomplete and inefficient (Milgrom and Roberts, 1988; Shapiro, 1987).

Typically not all of these sources of system failure operate at the same time and weaknesses can be corrected before system-wide failures occur. What is particularly interesting in the case of the GFC is that we see each of these problematic conditions simultaneously – a perfect storm so powerful that credit markets froze.

Table 1 focuses on the US Financial System and identifies key players at multiple levels and summarizes their contributions to the loss of trust in the financial system. We provide a more detailed discussion of the failures below, clustered according to three groups: the financial institutions (including their Boards, senior executives and employees), the rating agencies, and the government and regulatory bodies. For each group, we use the three dimensions of trustworthiness – ability, benevolence and integrity - to isolate the behavior that contributed to the loss of trust. Our intention is not to provide a detailed analysis of all contributing causes but rather to articulate a framework to locate and make sense of key contributing factors. To sharpen focus and clarity, our scope is primarily limited to events within the US.


INSERT TABLE 1 ABOUT HERE
Financial Institutions

Lack of Ability: Two essential responsibilities of banks and financial intermediaries are to manage risk and allocate capital. Joseph Stiglitz, the Nobel award winning economist, concluded that America’s financial system failed in these two crucial responsibilities (Stiglitz, 2008). Over-leveraging and poor underwriting standards were central to the banks failures in risk management. Bank leverage ratios were at historical highs prior to the GFC at nearly one dollar of equity supporting forty dollars of debt. From 2004-07, the top five US investment banks each significantly increased their financial leverage to over $4.1 trillion in debt for fiscal year 2007, about 30% of US nominal GDP. Further, the percentage of subprime mortgages originated to total originations increased from below 10% in 2001-2003 to between 18-20% from 2004–2006. How can we understand this competence failure of financial firms? We identify three underlying factors which contributed: cultural and political shifts towards a high risk trading culture; a failure of integration and learning across organizational departments; and ineffective Board structures.

With the elimination of the Glass-Steagal Act in 1999, for which the financial industry groups heavily lobbied, there was a shift in the culture and power brokers within the banks. This Act removed the long-standing separation between the risk-averse conservative commercial (depository) banks and the high risk, high growth investment banks. Cultural forces promoting growth and profit trumped those concerned with risk management (Lanchester, 2010; McDonald and Robinson, 2009; Tett, 2009). This shift in the underlying culture and values of the commercial banks facilitated and legitimized high-risk strategies and the creation of incentive structures to match. Traders - the group that was making the most money - moved into positions of power leaving more traditional bankers (who were more versed in risk and underwriting) with a weaker voice in strategic decision-making. Traders by their nature are aggressive risk-takers (Turbeville, 2010).

There was also a failure of integration and learning within many of the financial institutions that led to a fatally delayed response to the emerging crisis. As firms like Lehman Brothers and Merrill Lynch created new securities to grow, they failed to upgrade their capability to manage these new profit pools. For example, at Lehman Brothers, the distressed debt department tried to get senior management to reduce its exposure to subprime instruments, while the real estate department was loading Lehman’s books with these instruments. There was no clear process for sorting through the data and taking a reasoned firm-wide approach to managing risk (McDonald and Robinson, 2009).

Another key contributor was the failure of Boards to fulfill their essential responsibilities – to hold management accountable and manage institutional risks prudently (Zingales, 2009). A well-functioning, competent and committed Board is an essential foundation to the trustworthiness of any organization. Yet we see evidence indicating that this foundation was often misplaced. For example, at Lehman Brothers, CEO Fuld had nine members of the ten-person board who were retired and four were seventy-five years of age or older. Few had expertise in financial services.

Board Directors are agents who are supposed to invest time, seek information and use expertise to ensure that shareholder interests are served (Shapiro, 1987). To warrant trust, Boards of Directors and shareholders interests must be aligned. In practice, this is often not the case. Despite some use of Board nominating committees, in the US most candidates are proposed by senior management of the company and corporate directors generally run for election unopposed and are not required to get a majority vote of shareholders to be elected (Bebchuk & Fried, 2004). It is clear that if someone were interested in becoming or remaining a Director, the constituency whose interests they would appeal to would be management not shareholders. For most public Boards, the invitation to join is influenced greatly by the CEO and he or she also influences which directors remain on the Board. For example Arthur Levitt, former Chairman of the SEC, was invited to join the Board of Apple but after some of his views concerning increasing shareholder influence were discovered, he was promptly uninvited from the Board by Steve Jobs (Levitt & Dwyer, 2002).

Zingales (2009) argues that Boards serving management at the expense of shareholders and not holding management accountable is the single biggest problem with trust in the financial system, enabling management fraud and mistakes to continue unfettered. The primary alignment of Board members with management explains a great many decisions, which make little sense for investors but great sense for senior managers. For example, the Board of the New York Stock Exchange approved a $140 million dollar severance payment to its departing CEO Dick Grasso. Board members who are not aligned with shareholders’ interests or do not have the capacity or expertise to fulfill their responsibilities are misleading symbols of trust. Some have suggested the need for “professional” Board members who are truly independent and have the necessary time and expertise to adequately represent shareholders (Bebchuk & Weisback, 2010).



Lack of Benevolence: In the lead up to the GFC, there was a general lack of concern for stakeholders and many rules of fairness were violated. Within financial firms, decision-making was often driven by a single minded focus on short-term stock price increase and its link to executive bonuses. This culture of pursuing stock price appreciation led executives to engage in risky earnings growth that betrayed the interests of employees, long-term investors and broader communities (Cohan, 2009; Lewis, 2010; McDonald and Robinson, 2009; Paulson Jr., 2010; Sorkin, 2010). Leaders gained millions in bonuses for generating earnings that would later turn into write-offs, while shareholders and employees suffered loss of wealth, jobs or both. For example, CEOs Stan O’Neal of Merrill Lynch, Dick Fuld of Lehman Bros and Jimmy Cayne of Bear Stearns, received well over $500 million in bonuses in total prior to the demise of their firms. These bonuses were based on earnings growth that would largely vanish due to subsequent write-downs of risky assets. The incentive structures approved by the Boards of these companies benefited executives who received a portion of their compensation in cash but hurt long term investors whose stocks turned out to be worth much less when the poor quality of the assets were uncovered. A lack of claw back provisions in executive compensation, except in the case of fraud, left many investors with no recourse.

Consider in more detail the lack of benevolence to shareholders inherent in the compensation scheme at Lehman Brothers prior to its demise. The rule of thumb for Lehman traders was that if they made $20 million for the firm they could expect about a $1 million bonus. This could be paid roughly half in restricted stock and half in cash with no claw back provision. The CEO Richard Fuld, who many blame for the disastrous management decisions that caused Lehman’s bankruptcy, was awarded a $40 million dollar bonus the year before the company ceased to exist. While Fuld and the traders lost millions of dollars of stock compensation, they earned significant cash compensation whereas stock investors and bondholders lost most of their principal invested.

In another demonstration of a lack of benevolence to clients and investors, mortgage brokers used ‘no documentation’ and ‘predatory lending’ techniques to sell loans to people who they knew would default, and then sold off those loans to clients knowing they would not collect (Hutton, 2009). These were known in the industry as NINJA (no income no job or assets) loans. Commission schedules were put in place that provided extra incentives to brokers to sell these higher rate, riskier mortgages. One does not have to be a mortgage specialist or banker to know that lending significant amounts of money to people with no income, jobs or assets is unwise at best, and lacks any sense of due concern for the people taking out the loans, or the clients to whom the ‘collateralized debt obligations’ (CDOs) and mortgage-backed securities (MBSs) were sold2.

Lack of Integrity: There are many clear cases of deception and fraud in the accounting practices used by the financial firms in the lead up to the GFC. For example, Citibank and others were using off-balance sheet financing as Enron had done, and this made it hard for analysts to determine their true leverage ratios. They were also engaging in complex transactions to move risk and disguise the sliding value of assets (Stiglitz, 2008). Bear Sterns has been described as a ‘house of cards’ (Cohan, 2009). Bear Stearns, Merrill Lynch, and Lehman Brothers all made representations to employees and analysts that their firms were in excellent shape just prior to their demise (Paulson 2010; McDonald and Robinson 2009; Sorkin 2010).

Misleading sales and marketing techniques which lacked full disclosure appeared to be widespread. For example, Goldman Sachs paid one of the largest fines in SEC (the US Securities and Exchange Commission) history because they failed to disclose to investors purchasing the Abacus instruments that they were working with a hedge fund manager on the other side of the deal, who was selecting debt instruments that had obtained high safety ratings but that would most likely default; they were creating an instrument designed to fail. Some firms had less than transparent, and in some cases misleading, communication with their Boards (Lehman with risk management and Merrill with payment of bonuses). Merrill Lynch and Bank of America were charged with fraud by the SEC because they failed to disclose to shareholders that they paid millions of dollars in bonuses to executives after the firm had received a multi-billion dollar bailout from taxpayers.



Rating Agencies

Market perceptions of the risk of investing in CDOs, MBSs and associated products, were heavily influenced by the credit worthiness scores provided by rating agencies such as Moodys, Standard and Poor’s, and Fitches. Yet these agencies themselves were riven with incompetence and conflicts of interest.



Lack of ability, benevolence and integrity: Ratings agencies lacked people with the necessary skill and ability to evaluate some of the more exotic instruments being developed by the banks. The CDO products became so complex that many such credit ratings were little more than ‘guess-timates’ of the risk. Demonstrating a lack of integrity, the ratings agencies continued to rate these instruments and products without disclosing their lack of understanding. In email exchanges, rating agency staff described giving misleading AAA ratings to financial products that they admitted to not fully understanding. The ratings agencies figured that they could boost their income by providing favorable ratings and earning fees from the financial institutions whose instruments they were rating. Ratings agencies were paid for rating products by the institutions requesting them and earned consulting fees for advising these companies. Clearly they had a strong incentive to offer favorable ratings. In some cases people working at rating agencies took higher paid positions at companies for whom they were previously providing ratings. These incentive structures hurt investors. Self-interest, rather than a responsibility to provide accurate ratings and a concern for investors, appeared to be the guiding consideration. These rating agencies were unregulated by the government and not accountable to any other body.

Government and Regulatory Bodies

Lack of Ability: The financial regulatory system in place today in the United States was largely designed in the 1930s in response to the financial crisis that led to the Great Depression. After the 1930s market crash there were congressional hearings and reports of bank abuses, insider trading, corrupt business networks and favoritism. People had lost trust in the system and it imploded. A part of the system also exploded as a bomb went off at the offices of JP Morgan Bank killing 30 people. In response, the SEC was created in 1934 to regulate the US financial sector. The problem is that this basic regulatory structure has not been fundamentally changed since it was created (Levitt testimony 2009). The 2009 Financial Reform report by the Group of Thirty pointed out that our modern economy contains a myriad of entities that did not exist in the 1930’s that now affect the financial markets (Reform, 2009). For example, the unregulated market for credit default swaps grew in the past 10 years from 0 to 44 trillion dollars, more than twice the size of the U.S. stock market (Zingales, 2009). In testimony before Congress in 2009, Levitt suggested that the regulatory structure at the time of the GFC was under-resourced and over-matched in its capability to competently perform its function.

There are many agents whose behavior was largely unregulated leading up to the GFC, such as ratings agencies, mortgage brokers, hedge funds, sovereign wealth funds, private equity funds, and commodities brokers. What makes this problematic for citizens and, therefore the government, is that major trust violations can materially affect the standard of living of millions of citizens. In the 1920’s one in eight US households owned stock, today it is one in two. More importantly, there has been a significant move from retirements based on defined benefit plans to retired contribution plans (70% today). Retirement funds are a large portion of the US economy (60% of GDP). The fact that the reliability/performance of markets is directly linked to the retirement nest egg of millions of people with votes creates a strong force for politicization of the economy which some have argued created the bubble and subsequent recession in 2009 (O’Brien 2007).

Starting in the 1990’s until 2007, there was a strong trend toward de-regulation. Under the Clinton and Bush administrations, a number of rule changes were passed that reduced constraints and relaxed regulation of financial institutions, in favor of self-regulation. For example, as previously discussed, the government eliminated the Glass-Steagall Act in 1999, removing the long-standing separation between commercial banks and high risk investment banks. The 2004 SEC decision to allow US investment banks to issue substantially more debt was seized upon to purchase more mortgage-backed securities. The expansion of less regulated markets was a deliberate move by industry groups and the government to create a two-tier system where there would be a “somewhat regulated public market” and an “unregulated private market” for more sophisticated investors. This addressed the fear that the costs imposed on companies by Sarbanes-Oxley or other regulations would lead to a flight of capital away from the United States. There was also a thought that the degree of regulation should be reduced if certain investors had the knowledge and resources to protect themselves rather than having regulators do so.

This unregulated private market led to a rapid growth in Hedge Funds, Private Equity (5 billion raised in 1980 versus 250 billion in 2006) and an increase in capital raised through offerings to more sophisticated investors (more than 50% of capital raised in the U.S. in 2006; Zingales, 2009). The assumption behind the laissez-faire, hands-off approach was that “reputational damage” would constrain fraud and deter improper behavior and that trust in the financial system could be maintained by active self-management of conflicts and the natural corrective mechanism of the free market (Greenspan, 2008). Arthur Levitt, the former Chairman of the SEC decried the fact that influential bankers and professional groups, who felt that the SEC was an annoyance, lobbied Congress to reduce regulation. Regulation became unpopular and deregulation became the order of the day. This lack of constraint and oversight directly contributed to the scale and scope of the financial crisis.

Failures among regulatory agencies included lax enforcement and a passive role on the part of the SEC in the US and the Financial Services Authority (FSA) in the UK. The essential watchdog, SEC, took a passive role. In 2005, Chris Cox was offered the job of SEC Chairman by Vice President Dick Cheney replacing William Donaldson. Donaldson stepped down after he frustrated fellow Republican commissioners by subjecting companies to multimillion-dollar fines and trying to impose new regulations on mutual funds and hedge funds. He also angered business groups, who complained to President Bush’s administration after Donaldson tried to give shareholders more power to pick corporate directors. Under Cox, an ‘anti-regulation’ mentality was taken, enforcement penalties declined, as did agency morale based on reports of former staffers.

The central role that excessive deregulation played in facilitating the GFC is underscored by analysis suggesting that strong regulation played a primary role in the four big Australian retail banks retaining their AA credit ratings in the immediate aftermath of the GFC (four of only eight retail banks globally). Similarly, Canadian government regulation played a central role in keeping their banks in the AA list.



Lack of Benevolence: The politicization of the economy also resulted in misdirected benevolence in the form of over-promotion of home ownership in the US. After the September 11 terrorist attacks, the US government lowered interest rates, fuelling a tremendous rise in household debt. The government pressured Fannie Mae and Freddie Mac to increase mortgages, as well as buy risky mortgages, in effect creating an incentive for self-interested mortgage brokers to originate more bad loans.

Escaping most peoples’ attention concerning reform and regulation of the financial system is the conflict of interests among those governing the regulators, namely Congress. Congress has an oversight role with respect to the SEC, Fannie Mae, Freddie Mac, and the Federal Reserve. As an example of the problem, Senator Chris Dodd chaired the Senate Banking Committee, which took as one of its mandates to clean up the financial regulatory system. In the 2008 election year cycle, Senator Dodd received almost 5 million dollars in campaign contributions from the securities industry (see opensecrets.org). To be fair, the Banking committee as a whole obtained approximately 13 million dollars from the securities industry and this problem is endemic in Washington (Hamilton, 2004). While these lobbying practices are legal in the US, the same practices would be considered bribery and unethical conduct in other western democracies, such as the UK or Australia.

As Levitt (Levitt and Dwyer, 2002) argues individual investors and voters have much less influence over policy and regulation than the business special interests groups (e.g. the Securities Industry Association, the American Institute of Certified Public Accountants, U.S. Chamber of Commerce etc.). The Securities industry alone gave $39 million dollars of soft money in the 2000 election cycle, making it the third largest contributor across all industries. Edelman (1985) explains that the tangible resources and intense commitment of special interest groups often outweigh the public quiescence and passivity, such that the public is satisfied with empty symbolic reassurances whereas the special interest groups command real benefits. So a Congressman maximizes their chance of getting re-elected by helping well-financed special interest groups while maintaining a posture that he or she is protecting the interests of citizens. This explains a good deal of congressional behavior, why more stringent safeguards for individual investors have not been made into law and why Congress has failed to end the cycle of legal corruption via campaign financing.

Summary

In sum, trust failed in the 2008 financial crisis because the foundation of the financial system was extremely fragile. The system was based on an intricate network of trust relationships: Home buyers trusted the knowledge and expertise of their mortgage brokers; banks trusted the mortgage brokers and the credit rating agencies on the viability of the loans and securities; investors, lenders and hedge funds trusted the banks and credit rating agencies on the predicted profitability and assessed risk levels of their products; bank shareholders trusted their leaders and their Board to monitor institutional risks prudently; ordinary citizens with a pension trusted the pension fund managers as well as government regulators. Everyone trusted the market. The system relied upon reputational effects and indicators of trustworthiness that, in the final analysis, proved to be largely unwarranted.

As our analysis shows, all three dimensions of trustworthiness were comprehensively violated by multiple parties and at multiple levels. Significant conflicts of interest in the financial system undermined the system’s trustworthiness. An examination of these conflicts leads to an inescapable conclusion that they exist because they benefit those with the most power and influence. Most often this is not the investor or the shareholder but another agent in the system, such as the government, industry groups, senior management, Board members or rating agencies. This perfect storm of violations led to a massive erosion of confidence in the financial system and loss of trust in firms and leaders. The 2011 Edelman Trust Barometer showed a 46 and 30 percentage point decline in trust in banks in the US and UK respectively from 2008 to 2011.

These significant flaws and conflicts of interest in the system should have led knowledgeable market participants to choose suspicion over trust. However, as behavioural finance experts have indicated, the nature of financial markets involves not only assessing risk and return, but also the psychology of crowds which sometimes leads to market manias followed by panics and crashes. This brings us back to Luhmann (1988) and the interconnection between familiarity, trust and confidence. Market participants seemed not to calculate trustworthiness but rather adopted a familiar posture of assumed confidence, perhaps even unquestioned faith. This unwarranted confidence forced the entire system into a massive trust repair experiment.

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