Trust is notoriously difficult to define but the erosion of trust is one of the few diagnoses of the crisis that few dispute. Somehow, the idea has grown that we can “rebuild trust”; unfortunately, this is a fallacy.
Trust oils the wheels of commerce and finance; it is an efficient solution to a wide range of problems. Simply put, in a world where trust is prevalent, more gets done; much of it collaboratively and co-operatively. The reality of our world is one in which both formal contracts and informal trust-based arrangements can co-exist to support the exchanges of business. Formal contracts introduce the state as arbiter of performance; while informal contracts rely upon trust and are enforced informally. Soft concerns, such as reputation and reciprocity, encourage performance and perhaps, penalise breach.
Trust requires the presence of a risk or hazard to be necessary. When we place our trust in another, we are committed and exposed to this hazard. We are vulnerable. Trust and commitment are synonyms. We are also exposed to the possibility of exploitation. If we are prudent men, we place our trust only in those we deem trustworthy. This is a matter of judgement. The role of experience and repeated interactions as both evidence for this judgement and in building trust cannot be overemphasised; just look at the bonds that can form among soldiers who have seen action together.
There may be nothing that we can do to “rebuild trust”, but there is much that we can do to enhance our own trustworthiness. The aspects of trustworthiness most relevant in the financial services sector are[1]:
The challenge is to prove our trustworthiness. Most of us can certainly improve our competence and reliability. Of course, we can practice, demonstrate and signal all of these, which should increase the willingness of others to place their trust in us. Evidence, its transparency and disclosure are key. Information exchange between the parties allows them to surmount jointly the problems of interpretation of ambiguities, but this does add structure to the informal contract as this information exchange is usually a formal term of the contract . In a fund management setting, the client relations officer as conduit is central.
In our exchanges and collaborations, we often use mixtures of contract form – formal for the foreseeable and informal for the unforeseen. There are also questions as to the degree to which these different forms are complements to or substitutes for each other. Substitutes are rivalrous.
Some have proposed the use of guarantees and collateral security as mechanisms to enhance trust, but this will not work. Reducing the hazard or consequence does not improve the degree of commitment or trust; rather it reduces it. These techniques may increase the number of transactions, but they increase their cost. These arrangements are substitutes for trust-based agreements and co-operations, and can be expected to crowd them out.
Perhaps more subtle is the situation where formal and informal contract are intertwined. Fund management is a case in point: these services are sold on trust, but are evidenced by a formal contractual agreement. In dispute, they are only-too-often resolved solely on the formal contract and the legal system, leaving investors feeling that fairness and reciprocity have been thrown to the winds.
This is a particular illustration of the problems of institutional corruption. To quote Malcolm Salter[2]: "Institutional corruption ... refers to institutionally supported behaviour that, while not necessarily unlawful, erodes public trust and undermines a company’s legitimate processes, core values, and capacity to achieve espoused goals. Institutional corruption in business typically entails gaming society’s laws and regulations, tolerating conflicts of interest, and persistently violating accepted norms of fairness, among other things. ...” There may be a very fine line here when dealing with innovation and arbitrage. The sale made based on trust which reverts to the fine print of the formal contract when troubled, is perhaps the classic illustration of institutional corruption.
Though the ability to extract information from the parties in order to verify performance are central to its ability to form judgements and set remedies, it should be realised that a court’s ability to impose sanctions to extract information must be limited. If it were not, it could become unaffordably expensive and undermine the original rationale for writing a formal contract in the first place. Standards have a role here as benchmarks and as devices to minimise enforcement costs. Open standards bring the additional advantage that they also benefit informal contracts.
Enforcement in an informal situation can take a number of forms. The cessation of business or a tit-for-tat strategy are perhaps the best known and can even work in a multilateral setting. Others are concerned with morality; on these grounds, many do not exploit vulnerabilities even when they have clear gains available and no threat of retribution. Social ostracism can also serve to encourage performance and offer remedy of informal arrangements, as indeed it did widely in the clubby world of the old City of London. It is often superior to use informal enforcement practices even when the formal court processes are available as it is usually cheaper and does not require further expenditure.
One of the major problems for informal contracts lies with high levels of noise and uncertainty where the true signals and information may become unobservable, and even be misinterpreted. Here, rigid tit-for-tat strategies must be replaced by more generous versions that forgive some apparent transgressions.
When trust is honoured, it is self-reinforcing and develops naturally into fruitful long-term relations. It is a key element in any transition to a world where the short and long-term are well balanced and generosity can be justified by the (asymmetric) gains to be had from its development.
When trust is abused, relationships should end. This is the world of ‘lemons’ and agency problems[3]; it is the world of contract and negotiation – with all that costs, and entails. We should also be cautious in proposing formal sanctions and requirements. These can overwhelm the informal process and the best-known example of this was the introduction of a fine for parents who were late collecting their children from school, which had the counterproductive effect that more parents now felt free to collect their children later. There is little doubt that this form of behaviour may occur in financial services – many have argued that the advent of explicit financial services regulation led directly to self-interested income maximising behaviour. We should also be aware that the more formal a rulebook the more it suppresses informal arrangements.
This is not to propose that regulation be entirely principles-based for there is a paradox of trust here also. To quote Julia Black[4]: “Principles-based regulation is based upon trust that it alone cannot create, though it can facilitate its development. ... Without trust, Principles Based Regulation will never be operationalised; it will exist only in the text of the rule books, not in the way they are implemented.”
The role of formal contracts in these mixed contracting situations is to create a governance framework that supports the informal arrangements. Statutory obligations do not have to crowd out trust and can reinforce it by supplying an independent arbiter of the performance of soft and informal arrangements. This is not the absolute regulation of the reorganisation of the LIBOR pricing mechanism, which is clearly a substitution. Rather it is the extension of fiduciary responsibility to the entire chain of investment advisors and fund managers supporting and providing services to the trustees of pension schemes. Here, the incentives to perform well are then well-aligned, and there are implicit covenants.
Much of the governance literature is concerned with the concept of engagement, for example between management and shareholders. When shareholders are trusting and committed, management should engage. If they don’t, they are abusing trust and it is time to remove them.
There are some signals of a lack of trustworthiness – a prime example is an asymmetry of disclosures. Investment consultant demands for details of changes in fund manager personnel and clientele must be matched by their own equivalent disclosures. The suppression of details of settlements made with disgruntled clients is another. The use of share buy-backs rather than special dividends to return capital to investors, which of course benefits managers where they have earnings per share related compensation, is yet another.
Men of integrity will be trusted, but they must also be distinguishable from the crowd. Trust must be earned, which begs the question: is it worth the effort? Well, a world where trust and commitment are predominant is not just a better economic world; it is a better social world.