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Sunday, 18 October 2015

Bringing trust (back) into finance: a research agenda on trustworthiness in the financial sector

Alexandra Zeitz (Global Economic Governance Programme, University of Oxford)

Presentation: Nicholas Morris and David Vines

Late last month a scandal was splashed across the pages of global newspapers: deliberate deception of consumers and regulators, with culpability running all the way up to senior management. For once, however, the scandal was not in the financial sector, but rather in the auto industry. The financial sector is not alone, clearly, in struggling with trustworthiness. And yet there are reasons that the financial sector should be singled out for concerns about trust: the string of scandals and revelations over the last decade speak to the potentials for abuse in opaque markets selling highly complex products.

In 2014, Nicholas Morris and David Vines published Capital Failure: Rebuilding Trust in Financial Services. The book brought together philosophers, economists, lawyers, historians, and financial practitioners to explain the massive violations of trust that had taken place in the financial industry and explore ways in which trust could be rebuilt. A year on, the next challenge has arisen: how to turn ideas about trustworthiness into plans for action? On October 12, Morris and Vines presented their current agenda for research, how they plan to build an evidence base for rebuilding trustworthiness.
Trustworthiness, in Morris and Vines’ definition, consists of competence, truth-telling and promise-keeping. The sort of strong trust that these behaviours evoke is necessary for the functioning of financial markets. Morris and Vines directly counter what they see as a crude simplification of Adam Smith: the notion that the interactions of selfish individuals can produce socially beneficial outcomes. Instead, bonds of strong trust, those produced by altruism or the desire for esteem and approbation, are required for financial markets to achieve desirable outcomes.

How then to establish trust? Building on the foundations set up in Capital Failure, Morris and Vine propose a research agenda that focuses on three levels: the individual, the firm, and society. At each of these levels, trustworthiness can be cultivated through a four-step process: setting out obligations, identifying those who are responsible, defining mechanisms of trust and accountability, and holding actors to account.

At the level of each individual, trustworthiness in the financial sector could be boosted through professionalization. Lawyers and doctors illustrate how professional identities can help to uphold expectations of ethical behaviour. Morris and Vines cited experimental evidence that revealed when participants were reminded of their identities as bankers they behaved far less ethically than when they were asked to think of their identity as members of their family. A challenge is therefore how to bring the professional identity of those in the financial sector in line with their commitments to their clients.

The idea of bankers as pillars of the community with clear professional obligations to their clients has become an increasingly nostalgic notion as stories of abuse mount and the oft-warranted ‘banker bashing’ follows.

Yet audience members cautioned against nostalgia for closed communities of self-policing professionals. The exclusionary nature of such professional bodies has often served to drive up prices, providing opportunities for collusion. The example of the diamond trade, which Morris and Vines offered as an instance where strong codes of conduct are enforced through professional reputations within a tightly-knit social community, also illustrates the potential for such professional communities to support monopolies. DeBeers’ long running battles with antitrust regulators in the US and EU ended in settlements in both jurisdictions in the last decade. There was also a contrarian viewpoint that suggested that what consumers wanted was not trustworthiness, as such, but reliability.

Future research will draw on psychology and behavioural economics, including experimental work to see whether individuals’ personality types can explain how they respond to incentive structures and normative frames that encourage other-regarding behaviour. This research may reveal that some people would be better suited to assuming positions of trust within the financial sector if they were capable of empathy and consideration for their clients - which the separation of consumers and service providers (including by virtue of income inequality) makes difficult for those in the financial services industry.

People are also a product of their environment. Another stream of research will look at the impact of institutional structures at the level of the firm on trustworthiness of the financial sector. Already, Morris and Vines have clear recommendations for reforms. Agreeing with Colin Mayer and his 2013 book Firm Commitment: Why the corporation is failing us and how to restore trust in it, they argue that the trend in corporate governance towards aligning incentives with short-term shareholder’s interests has been damaging. Instead, they suggest increasing the liability of directors to ensure that short-term profit objectives (and the bonuses that go with them) are not put ahead of the broad corporate purpose of the firm, including providing a service to customers.

The structures of firms can have a direct impact on their behaviour: Morris’ research has shown the damaging consequences of the demutualisation of building societies (a phenomenon the UK is no stranger to). Morris and Vines will be pursuing further research into structures of corporate governance that could encourage trustworthiness, as well as ethics management strategies such as retooling remuneration to reduce incentives to push risky products on client.

Ultimately, trustworthiness rests on social structures. And it’s in analysing what can be done at the level of society to encourage trustworthiness that Morris and Vines may have the most work to do. Government and regulation played a noticeably minor role in Morris and Vines’ account of the drivers of trustworthiness.

In their four-part framework of obligation, responsibilities, mechanisms and holding to account, regulation appears as a mechanism to enforce prohibitions and impose penalties for violations. Skeptics may point out that in an industry such as finance, where the potential personal gains of unethical behavior are so great and this behavior has the capacity to wreak wide-reaching havoc, relying on strong trust at the individual and firm level may be insufficient. Regulations that shore up social norms with the force of law are necessary, including through outright prohibitions of certain financial products, because they allow customers to believe that financial services providers must act broadly in their interest, thereby creating the basis for trust. Comparative work on different legal and regulatory structures may well end up being the most fruitful new area of research that Morris and Vines embark on.

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