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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.
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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.

Information

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

I. Setting the scene: revisiting the specialness of banks

Banks have long been accepted as a substantial part of the development of the economic system due to their critical position in the financial system.Footnote 1 Traditionally intertwined with socioeconomic welfare and macro-stability-related policies, the question of what makes banks different from other financial institutions represents a fundamental theoretical investigation.

Banks can be considered special either because they are subjected to particular regulations or simply because regulators have made them so.Footnote 2 The difference should lie somewhere else because regulation is subordinate to the special nature of banks, not the other way around.

The theories arguing that banks are special in the sense that they serve the public interest due to their importance in the financial system suggest that state intervention in the form of regulations imposed on banks might be justified due to their quasi-public and socioeconomic nature. In contrast to the traditional forms of contract theory in which individuals are free to do business without state intervention, the banking business has developed in such a way that the permission of the state has been necessary.Footnote 3 Their ability to operate in a certain jurisdiction within a predetermined legal framework (eg deposit insurance rules, liquidity and solvency requirements) and to have access to state assistance (ie emergency liquidity support, safety nets) suggests that they operate in a highly regulated environment that brings major constraints on banking behaviour. Therefore, banking firms act in a unique manner compared to other firms. The argument that claims that it is the regulation that makes banks unique is based on the idea that rules of reserve requirements and interest rates make them different and thereby restrict the level playing field.Footnote 4 However, such views leave a question mark over whether this special treatment is justified by the sui generis nature of banks, which makes them irreplaceable to different institutions, or is grounded in their historical evolution that led them to be differentiated at an early stage.

So, what typifies banks in terms of the services they provide to public? Concerning services, a bank very simply can be identified as a financial institution that receives deposits and lends deposits. This definition also does not cover the essential functions of banks in the economy because the same operation can be made through life insurance companies, pension funds or mortgage firms, and depositors may invest their money in debt securities such as corporate or municipal bonds or other investments that pay interest. These practices are not specific to banking.

Fama, writing in 1980, pointed out that the divergence of banks can be seen in their roles as suppliers of transaction and portfolio management services.Footnote 5 In his depiction of banks, economies of scope among deposit taking and lending provide banks with superior “information” power over both other intermediaries and finance firms, as they furnish banks with a borrower’s very detailed deposit history and credit risk.Footnote 6 Goodfriend, on the other hand, underlines the unique role of banks in harmonising information-driven lending and payment services.Footnote 7

From Corrigan’s viewpoint, the economic performance of banks makes them special owing to their standby or backup source of liquidity power in the economy and their pivotal role in the conduction of monetary policy.Footnote 8 However, such characteristics of banks are insufficient to call them special because clearing and settlement services can be substituted by some other financial institutions in today’s world. Moreover, the role of banks in conducting monetary policy is achieved in other ways, such as through security dealers. Such views attempt to show that the historical evolution of banks makes them unique, not their functions. However, today, banking are one of the most heavily regulated sectors, and such detailed regulatory interventions must come from a rational basis, which is difficult to explain simply by considering the historical background of banks.Footnote 9

Since Corrigan’s seminal article on bank specialness in 1982, so much has changed in the financial industry.Footnote 10 Particularly after the recent global turmoil, the shift from the originate-to-hold model to the originate-to-distribute model in share lending, the development of shadow banks and the increased competition through financial innovations or fintech-based financial providers (challenger banks and neo-banks) have been popular discussion topics that have tested the bank specialness hypothesis.Footnote 11 Yet, as this article investigates in the subsequent sections, despite changes in the financial environment, banks are sources of confidence and trust, and for this reason they are still strongly tied to public policy concerns. With this in mind, arguments about the special nature of the banking industry, which partially explain why they are heavily regulated, are generally classified under three groups.

Firstly, banks are susceptible to runs and panics, which demonstrates their relative systemic importance and their fragile relation with confidence.Footnote 12 Banks are the subject of risk since they provide credit liquidity for the economy via loans, receive deposits from the public and are closely interconnected with each other. A high level of interdependence in the finance and banking industry emanating from the continuous flow of capital among banks can easily disrupt the rest of the industry.Footnote 13

A bank’s ability to function is based on its capacity to attract funds and to maintain them.Footnote 14 This explanation is supported by the fact that banks rely on short-term funding to fund long-term loans. This fragile capital structure of banks as a result of their services might lay them open to illiquidity and credit risks due to the maturity transformation function. As special intermediaries in bridging the trust gap between savers and borrowers, banks could indicate that public confidence constitutes the most critical part of the relationship. If the public loses confidence in the liability side of the banks, this can create a maturity mismatch between short-term liability and medium- or long-term assets. Lack of confidence emanating from a specific bank can result in endangering the liquidity reserves of safe and sound banks in a self-fulfilling prophecy.Footnote 15 Bank instability, within this context, raises public policy concerns, as they are either sources or facilitators of financial instability. This is because they deal with the two-sided problem of information inefficiency: banks face difficulties in assessing the default risks of their borrowers (which causes adverse selection) and depositors find it difficult to assess the financial conditions of their banks. Information asymmetry transforms into financial instability in the form of bank panics or runs. Therefore, temporal mismatch between loans and deposits can create the grounds for illiquidity problems, which is a key component of the first step of a systemic crisis. In normal conditions, liabilities redeemable on demand at par are not a problem for a bank, as it is not usual or expected that all creditors will attempt to withdraw their funds at once. Such en masse withdrawals in a short space of time force banks to liquidate their long-term investments at a loss.Footnote 16

Banks are generally at the centre of financial crises in which financial distress in one bank or the banking industry can contaminate other banks or sectors, and this is explained by the phenomenon of contagion.Footnote 17 In broad terms, contagion in banking can be defined as the risk that financial difficulties or idiosyncratic shocks at one or more banks spill over to a large number of other banks, financial institutions or the financial system as a whole.Footnote 18 Dissemination of bank contagion occurs through information and credit channels in broad strokes. The web of links between banks in the interbank funding market, payment system and over-the-counter derivatives market shows that financial institutions are closely connected where they are overexposed to each other, and cross-exposures allow the sound banks to become vulnerable to a chain of failure if one them fails.Footnote 19 So, while interbank lending, credit exposures, common asset holdings and a disruption on the clearing and settlement system stand as direct sources of contagion, indirect means of contagion generally occur through an information channel such as news, public disclosures, market rumours and noise. Much of this analysis reveals that small shocks can have an enormous impact on the financial system and economy as a whole, and therefore a stable banking system is a crucial pillar of a stable, sound and integrated financial system.Footnote 20

Secondly, banks are said to be unique because of their role in the supply of money, in creating and destroying money and in their custodianship of the payments system. Banks loan withdrawable deposits to borrowers without passing on any cash or third-party liabilities very easily simply by intensifying their liabilities via deposit creation.Footnote 21 Banks, therefore, are seen as capable of crediting the borrower’s account without any reduction in their accounts, which implies that there is no need for pre-reserved funds or savings in order to be able to loan. Proponents of this view assert that modern economies are grounded upon central bank money in the form of cash and the bank account money within their balance sheets and double entry bookkeeping.Footnote 22 The given framework provides that commercial bank money is produced simply on the confidence and incentive of banks, asserting that the size and amount of credit and its expected outcomes in the economy are left to the discretion of banks. This means that the special power of banks to produce money and to enhance it by charging interest enables them to control the resource allocation system of an economy. In a similar vein, this makes them decisive actors in both inflation and production. Money creation by banks thus creates a circular flow and new purchasing power and thereby makes entrepreneurs follow new resources irrespective of the changing form of money today. The neutral position of banks acting as the lubricant of the cogs in the lending mechanism that allows other financial players to save and invest, as undergirded by financial intermediation theory, is, therefore, subject to an ongoing discussion, and the debate requires further attention through the dichotomy of commercial banks versus the traditional concept of money.Footnote 23

Thirdly, the close connection between banks and the central bank is said to prove banks’ “transmission belt” role in monetary policy.Footnote 24 Central banks and relevant bank regulators can remodel the transmission belt by changing interest rates or the amount of money that banks are required to keep in their reserves, and such changes can be reflected through the banks’ lending practices in the way that adjustments in the lending and pricing of loans are made.

The basic idea is that banks borrowing money from the central bank are required to follow the changes in interest rates that are designated by the central bank and reflect those changes to their counterparties due to the increase in their cost of capital. The role of bank reserves in operating as a catalyser in lending and providing security and confidence to the market is important given the link between monetary policy and banks.Footnote 25 The traditional interest rate view is grounded upon the capital requirements whereby any changes in the monetary policy may culminate in changes in the quantity of money held and produced by the bank. The central bank can reduce the supply of money available for investment by raising the amount established as a reserve requirement for banks.Footnote 26 In addition, shifts in the monetary policy have influence over the supply of bank loans such that a decrease in bank loans might disturb economic activity.Footnote 27 This argument is produced based on the premise that bank deposits and loans are special in the sense that these features are difficult to be replaced properly by other institutions, and therefore it emphasises bank funding as a main source of capital as being a driving power in the overall economy.Footnote 28 Overall, the interest rate and credit channels of banks apply central bank orders to the market in their own particular ways.

Another additional aspect is the role of banks in the process of putting savings into beneficial activities, which is significant for growth and welfare. Formal econometric studies show that banks are of prime importance to economic growth.Footnote 29 Economic development and entrepreneurship are strengthened when banks steer the flow of capital through firms that provide the highest probability of social returns and closely observe them in case of default. In terms of income distribution and poverty, the distinction between well and poor functioning is made since states with better banks show reductions in poverty, whilst poorly functioning banks allocate scarce capital to bad projects, mostly to those with the most wealth or power. Ultimately, this has a negative impact on the poor and on economic improvement.Footnote 30

Financial theory has approached the subject of the specialness of banks with caution by examining whether improvements in technology or a large financial liberalisation process can be pursued that may form different financial structures as well as different financial devices to challenge banks.Footnote 31 The rapid rise of shadow banks as competitors to traditional banking exemplifies this position.Footnote 32 It may be true that innovation and rapid change in finance through enhanced competition have the power to reduce the level of superiority of banks and lead to a self-fulfilling transformation over time based on the threat of aggressive shadow banking institutions and the risk of disintermediation.Footnote 33 Yet, the recent Global Financial Crisis (GFC) proved that banks are major players in a state’s financial infrastructure, with effects on real economic activity. The runs on Northern Rock in the UK, Washington Mutual, Wachovia and IndyMac Bank in the USA along with other banks in different countries and concomitant massive government interventions to protect public confidence show that bank runs are not quaint and anachronistic events.

So, banks are still special, but not because of their function in receiving deposits and lending them, and instead because of their role in confidence production and protection and their links with the other parts of the socioeconomic system.

II. The basic machinery of banking: banks produce information

The traditional function of commercial banking consists of the collection of deposits and lending practices based on the private data collected from borrowers and lenders that is subject to continual screening and monitoring activities by banks in order to produce information for running their business. There are several interrelated assertions extracted from the information production role of banks:

  1. (1) Banks are informational intermediaries. Imperfections necessitating the foundation of intermediaries consist of inaccurate severability of financial claims and transaction costs stemming from the acquirement, diversification and transformation of the information.Footnote 34 The basic idea of financial intermediaries highlights that markets are not perfect and complete, so that investors and borrowers cannot achieve risk allocation by themselves.Footnote 35 So, financial intermediaries enable lenders to obtain higher returns while providing lower costs to borrowers compared to direct finance. They facilitate the saving-investment process due to cost efficiency.Footnote 36 The emphasis in the literature on the subject of financial intermediaries has revolved around how intermediaries reduce transaction costs and how information asymmetry is ameliorated via the intermediary channel. In the case of banks, transaction costs consist of both direct and indirect financial costs that emanate from the costs of searching for and gathering the relevant information about agents and the costs of monitoring risk-averse and opportunistic behaviours in order to understand whether they follow the terms and conditions of the contract with the bank; namely, banks act as delegated monitors to limit the moral hazard of borrowers.Footnote 37 However, this delegated monitoring role, while mitigating information asymmetries between borrowers and depositors, leads to another information asymmetry problem between bank and creditors (ie the agency problem).Footnote 38 This type of information asymmetry is dangerous due to the potential for bank runs,Footnote 39 which is closely linked to public confidence. So, a banking relationship occurs when lenders and borrowers share information with the bank that is not available to other parties, which matches the financial needs of investors and savers through banks by mitigating asymmetries.Footnote 40 Within this framework, banks as the unique source of information for helping to distinguish between “good” and “bad” firms by producing information. This first point, therefore, establishes the function of banks in reducing information asymmetries and generating new information. Put simply, there is no banking business in the absence of information.

  2. (2) Banks provide loans to borrowers of a publicly unknown quality and, in the case of non-tradable loans, the quality of the loans is only available to the bank that produced the information in the first place due the fact that the collection, monitoring and production of information is performed by the bank itself and therefore borrower-tailored agreements lead to an inherent opacity in the banking industry.Footnote 41 Banks take risks that are difficult to verify because the underlying risks supporting the loans are not known due to the opaque nature of the contracting process that means banks internalise information of a soft and granular nature and accomplish their profit-maximisation goal based on the information produced.Footnote 42 Banks privately create debts (bank money such as demand deposits, private bank notes, sale and repurchase agreements and other forms of short-term debt) that trade at par, and the continuum of this production depends on minimising information disclosure in the first place simply because the functionality of this debt as a transaction medium is only possible when the debt is information-insensitive.Footnote 43 Opacity, in this sense, is necessary for banks to maintain their business. This discussion is one side of the debate on bank opacity.

  3. (3) The information production of banks is tied, first, to the willingness of creditors to invest their funds and to keep them in the bank and, second, to the willingness of borrowers to apply to a bank for a loan. It is public confidence that encourages economic agents to meet their liquidity or long-term contract needs at a bank, and therefore the essential job of banks – maturity transformation – would be impossible without it.Footnote 44 The previous two points established that banks produce information that is inherently opaque to outsiders, and this opacity is optimal to the extent that banks continue with their maturity and liquidity transformation roles. The last point mentioned here, namely “public confidence”, is perhaps the essential binding mortar of the banking business that links economic agents with banks, and banks with the rest of the world. Bank prudential regulation and supervision, de facto and de jure deposit insurance systems and lender of last resort and other government support mechanisms exist to maintain and preserve public confidence in banks, such that at the heart of banking regulation there is an attempt to protect public confidence in order to diminish the potential for further meltdown. Deterioration of public confidence does not necessarily derive from a single bank. It might be based on a problem encompassing the whole banking system or the financial system. As public confidence has a psychological dimension, it does not necessarily have to be connected to banks or the financial system. It might be related to uncertainty in the political and economic environment, the legal system or cross-border events. In short, the factors causing changes in the level of confidence might be derived from both endogenous and exogenous sources. Banks, in this scheme, can either be sources or facilitators of a lack of public confidence, and this underlies the need for efficient ex ante regulation and ex post intervention.

Therefore, considering the profound meaning of information in banking, how is bank information related to the terms “trust and confidence”?

III. Trust and confidence: an interdisciplinary concept

The goals of financial regulation are generally grouped under consumer and taxpayer protection and financial and macroeconomic stability.Footnote 45 These overarching objectives of financial regulation also encompass other goals inherent in the way in which an economic ground for regulation is characterised.Footnote 46 State interference, in this respect, is used to establish standards in order to address market failures, facilitate market forces to work through contractual bargaining and constrain those who would manipulate the system due to opportunistic motives. It may take the form of the regulation of markets, taxation or legislatory policy, and it is rationalised on the basis of the promotion of efficiency and equity.Footnote 47

The standard economic canon sets out the philosophical foundations of why there is regulation and what the financial regulation aims to accomplish in intervening in the markets and firms, but it has been quite slow to understand the profound meaning of confidence in financial markets.Footnote 48 So, while rationalising financial regulation in the economic sphere and emphasising the goals and strategies of financial regulation, the place of trust and confidence is often neglected. The literature on the role of trust focuses on its importance in labour markets, product markets or concerning intra- and inter-firm interactions, yet the interdisciplinary concept of trust and its relevance to the broader socioeconomic system is relatively new.Footnote 49

Promotion of trust is one of the objectives of financial regulation, as it standardises behaviours and allows predictability and foreseeability.Footnote 50 Yet, it is mostly taken as a concern directed at behavioural finance and economics or to address bank runs. There is a truism that confidence and trust have psychological and sociological dimensions with strong links to political science and jurisprudence. So, as the fundamental facilitators between agents in society, the meaning of trust and confidence goes beyond the financial services rhetoric.

So, what is “confidence and trust” and what is its relevance to bank information?

1. A perennial discussion: trust and confidence as a basis for economic decision-making

“Trust describes a situation in an economy whereby its individuals and organisations have the confidence to co-operate with one another without needing government assistance”.Footnote 51 This definition sees trust in a mere economic sphere that encompasses confidence as a building block of its description. Yet, there is no straightforward and all-encompassing definition of trust. Trust has been an important subject across economics, sociology and organisational studies for understanding economic behaviour and social interrelations, structures and interactions. One common exploration has been about its “absence”, where uncertainty and a level of risk are strongly tied to the level of trust. Similarly to risk, trust is a socially constructive process with emotive tones, as uncertainty creates anxiety about the future.Footnote 52 This means that trust is contestable and continuously reproduced and reframed under new or changing circumstances. It simply describes a process whereby one’s involvement in certain behaviours is not based on observation, analysis, manipulation or contemplation of facts or realities from a freestanding point of view.Footnote 53 Rather, it is a belief that is grounded on reputation, assessment of present information and assumptions regarding the behaviours of others.

In definitional terms, the interchangeable use of “trust” and “confidence” is beneficial to the extent that both terms stand as common social and psychological norms that link social arrangements with economic outcomes. Their ends are not limited to particular exchanges, entities or persons, and they are general encompassing elements of the social organisation of economic life where shared expectations about economic conduct affect the aggregate behaviour of the public.Footnote 54 Yet, from an analytical perspective, they tend to represent different aspects.Footnote 55

Confidence operates based on objective and reliable information and external and independent rules over conduct and contractual agreements, and therefore the supply of information and necessary regulations that underpin the provision of information lead to rational and informed decisions. As such, confidence here can be seen as a property that is fortified or protected by external sources such as public or private agents of market governance and as instrumental and calculative. It is the belief founded on experience or evidence (ie information) that particular events will take place as expected. So, trust is conceptualised with its irrational meaning in its relation to a situation of risk, uncertainty and vulnerability; confidence resonates with the anticipation of a positive result in a condition of certainty that is shaped by past experiences and simple signals.Footnote 56 By acknowledging the lack of consensus on the differences between these two concepts, for the overarching purposes of this article, trust and confidence will be used interchangeably for the reason that trust and confidence, while highly interrelated with each other, are essential parts of the melting pot of the socioeconomic system that shapes the saving and investment decisions and facilitates the completion of activities.

Trust and confidence designate the rational or sometimes irrational hope about the occurrence or non-occurrence of future events. Optimistic or pessimistic forecasts directed towards the conduct and behaviour of other economic agents or legal, financial and political systems play significant roles in shaping persons’ and organisations’ future decisions. So, trust and confidence might be directed at persons, organisations or the system itself.Footnote 57 Early discussions about trust and confidence make reference to their absence and ensuing negative externalities, yet the last GFC has also proved that overconfidence is inimical to socioeconomic well-being. This means that there is an optimality problem regarding the level of trust and confidence between the constituencies of the socioeconomic system on many levels. Because there is a multitude of participants in the economic system and also multi-layered networks between them, optimality here represents the necessary level of trust and confidence that facilitates intra-firm and inter-firm interactions and protects the general public’s trust in a wider sense. So, trust and confidence should not be solely defined in the economic nexus; rather, they are key factors in the functioning of societies that foster beneficial societal and economic outcomes.Footnote 58 In other words, society itself stands as a representation of trust. The level of trust and confidence identifies the willingness or motivation of participants to interact and cooperate with each other.Footnote 59

Fukuyama’s approach to trust attempts to identify its importance on the macro level. Fukuyama argues that trust is a social medium and a foundational ingredient in which institutions and societal links are established, and the level of trust inherent in a culture affects economic development through reducing transaction costs and therefore enhancing market efficiency and increasing welfare.Footnote 60 So, trust and confidence have intrinsic socioeconomic value, and it is not possible to see them as soft issues that are independent from tangible concepts such as laws, money or legal structures.Footnote 61 Following this line of thought, trust and confidence have major roles in the complex balance between persons, organisations and the state, and a calculative and measurable determination and conceptualisation that covers all of the links between these actors is not possible.

Yet, this conceptualisation can be seen in the micro context of an interlinked network of relationships where the existence or absence of trust and confidence as intangible forces within these networks and creates tangible consequences. The financial services industry, as one of the sub-systems within the socioeconomic system that transforms and channels information and liquidity, exemplifies how the power exerted by trust and confidence has feedback effects on the real economy. Liquidity created and circulated by the trust industries is a form of trust, such that the protection and enhancement of trust and confidence, as objectives of financial regulation, are closely tied to liquidity concerns. Even if there is no liquidity problem, lack of trust and confidence can freeze credit–debt relations and cause a drying up of the money that circulates in markets. In these cases, injections of optimism in the form of, for example, enhanced deposit insurance schemes and lender-of-last-resort or other supportive and preventative mechanisms come into play to forestall further meltdown. This is a perennial discussion in the literature.Footnote 62

Having discussed the significance and the nature of trust and confidence, particular attention will be given to banks, as they are perfect examples of trust industries due to the fact that the very nature of their business is based on generating and preserving trust.

2. Banks are trust-driven industries

Bank runs, financial panics and crises and evaporation of trust and confidence have historically been associated with each other. Following Fukuyama’s approach, economic agents do not cooperate unless there is “a system of formal rules and regulations, which have to be negotiated, agreed to, litigated and enforced, sometimes by coercive means”,Footnote 63 and in this sense, bank regulation and supervision are substitutes for trust.Footnote 64

a. Exogenous and indigenous confidence and trust

External sources generating exogenous trust and confidence are surely beneficial as they institutionalise and formalise certain rules and conduct mechanisms, promote good behaviour and punish abuses, and therefore bank stakeholders will have positive expectations that contractual obligations will be met without disruption.

Indigenous confidence and trust, in this context, means that banks themselves produce trust as long as they offer their services without intervention or disruption. The sources of this endogenous trust can be found in their role in reducing information asymmetries. The very existence of banks is explained, as discussed in Section I, by the situations in which trust and confidence matter. Contractual mechanisms utilised by banks to bridge surplus funds to those who need funding means that the information asymmetries inherent in imperfect markets exist because intermediation itself is a product of a lack of trust. Agents do not have the necessary information nor the necessary incentives and funds to search for the most optimal deals that enable them to trust and proceed with financial transactions. This dimension of banking is simply characterised as “banks are the protector of the trust”, where every fund deposited to banks and every credit provided to borrowers by a bank is a means of “trust” bestowed to banks. The loss of public confidence and trust, with its systemic, relational, cognitive or emotional dimensions, therefore has gained considerable attention in the literature. Together with the aggregate trust and confidence created collectively by the banking system itself, exogenous trust and confidence produced by external sources (particularly bank regulation and supervision or all of those rules and measures ensuring economic and financial stability and the prevention of systemic risk) are complementary to the trust and confidence produced by the individual bank.

This means that there are two layers in characterising the general outline of trust and confidence in the banking. The first one is the exogenous one, which is produced by the system and is collectively formed by individual banks. The second one is the indigenous one, whereby banks engender trust by protecting their reputations, establishing efficient risk management and corporate governance policies or effective compliance systems and continuing in their everyday businesses by functioning as an intermediary. So, the issue of trust and confidence has many faces.

b. Cognitive and affective trust

Referring to the last GFC as a crisis of confidence is a product of severe and continuing discussion about the systemic risk, contagion channels and vulnerabilities emanating from interbank and market discipline. Most of the debate regarding interbank and market discipline is associated with the revealing of adverse information and its ensuing outcomes on the safety and soundness of an individual bank. Translation of uncertainty or certainty about the poor financial standing of a bank is not necessarily based on cognitive trust, where persons apply a calculative and cost–benefit analysis before making a decision, as there is also affective trust that is grounded on emotions, past experiences and assumptions about the future.Footnote 65 So, while the latter is grounded on relationships and affective bonds developed through interaction and empathy with others, the former captures rational and instrumental judgments.Footnote 66

Building on a recent investigation that conceptualises trust along its affective and cognitive dimensions, the role of disclosure in the banking industry here is a double-edged sword: if the market knows that a bank or some banks have liquidity problems, market participants (including peer banks) might change their behaviour in a self-protective way, but not in a way that protects the system. This behaviour might be individually rational, but not socially optimal. If the market does not know which banks have liquidity problems, then this will reflect a lack of confidence and uncertainty in a way that is, once again, self-protective. So, here, disclosure play a key role in maintaining trust and confidence, but also in losing them as well.

Disclosure of information is cardinal for keeping the market and bank stakeholders informed in order to prevent them showing sudden withdrawal or hoarding behaviour, and therefore it maintains their trust and confidence to the bank and the system it operates in. Yet, affective trust as being particularly applicable to bank depositors can be a driving force during financial turbulence; for example, information-based bank runs occur along socio-psychological lines due to self-interest.Footnote 67 Liquidity hoarding in the interbank market, en masse withdrawals over a short period of time, the inability to raise funds in capital markets or the unwillingness of bank counterparties to roll over their contracts with the bank are typical results of a lack of confidence and trust in which both cognitive and affective forms of trust come into play.

c. Bank runs under the influence of a lack of trust and confidence

The very nature of banks, shaped by the opaque character of investments and their credit and their maturity and liquidity transformation roles, reflects the fragility of their operations, which makes them vulnerable to potential runs. So, any doubts or uncertainty about a bank’s ability to continue its operations destroy the level of trust produced. Banks invest in reputational capital, and the level of confidence about their solvency and liquidity position is closely tied to the well-being of the socioeconomic system. As opposed to traditional contractarians who see firms as a product of explicit and implicit contracts and therefore as a legal fiction that is mostly isolated from abstract factors such as ethics, trust and confidence, cultural values or morality,Footnote 68 the mere existence of bank runs proves that banks are not simply profit-seeking firms that are isolated from the economic, political or social environment.

Bank runs show that there is an imbalance between the level of trust and confidence produced and destroyed because, while the trust produced by banks supports the smooth functioning of the financial system, its absence does not put the level of trust and confidence at zero, but rather it places the level of trust and confidence at somewhere that is below zero. This means that the underpinning of trust and confidence in banking becomes more critical during times of crisis or turbulence, as this suboptimal level of trust has effects on the financial system with real economic consequences. This means that there is an extreme difference between the existence of trust and confidence and their absence, reminiscent of one of Warren Buffet’s memorable quotes: “Trust is like the air we breathe … When it is present, nobody really notices. But when it is absent, everybody notices”.Footnote 69

The imbalance between the effects of the existence or the lack of trust and confidence, therefore, reiterates the importance of keeping the banking system safe and sound in order to avoid destabilisation with systemic footprints. Strategic interactions between bank creditors in responding to potential future economic conditions or in making sheer assumptions about a bank’s liquidity and solvency position, reliability, links with defaulted counterparties and the quality and nature of disclosed information represent a continuing subject of discussion regarding how the perception of risk grounded upon personal and impersonal judgments and expectations can actually cause a dynamic collective response. The runs on Northern Rock in the UK or Washington Mutual in the USA during the GFC are clear examples that bank runs are not simply historical events. As rollover decisions of creditors are highly based on her/his beliefs about the decisions of other creditorsFootnote 70, the collective action problem arises as a result of the evaporation of trust and confidence. This reflexivity of trust and confidence, whether in the form of bank runs or other forms that are not necessarily as extreme as bank runs (eg decreases in the number of depositors or other persons having a relationship with the bank, such as borrowers, trading entities, etc., falls in market shares, the inability to find funding from the money or capital markets), has a self-fulfilling dimension in the way that personal distrust can be translated into systemic distrust, which is now addressed through the overarching goal of financial stability.

While the re-establishment of public confidence at the macro level is attributed to policy and regulatory reforms through macro-prudential regulation, on a day-to-day level, issues regarding trust and confidence might be addressed through compliance with regulation and corporate, ethical and cultural strategies which provide a sense of security to the public. So, when grouping trust and confidence within the context of banking either as exogenous or indigenous, systemic or personal, cognitive or affective, there are two points that have to be made in relation to bank information production. Firstly, there is information about the bank itself that has effects on financial stability, and this dimension of bank information is that which is impacted by the effects of negative information lessening the level of public trust and confidence and causing changes in bank creditor behaviour. Secondly, the bank information mentioned in the first point is only possible through banks functioning as informational intermediaries. This means that bank information has two layers: the initial base consists of the gathering, screening and processing of information from other economic agents and then putting a meaning to this soft and private information (which is inherently opaque and unknown to third parties) and turning it into hard information and analysis that can be reflected on bank balance sheets, information disclosed as a result of reporting obligations or other information channels. So, the following layer represents the filtered assessment of the information created in the first place. This could be information regarding liquidity deficits, counterparty defaults, loan losses or leverage ratios, narrative explanations and analyses about the management, cash flows, earnings, future operations and other information providing feedback about the financial and managerial position of the bank, and of course this represents information about the bank itself.

Based on the bank information layers mentioned above, lack of trust and confidence causes unintended changes – from the very first disruption in banks’ information production at the start to the end effects at a societal level. Leaving aside reasons such as exogenous shocks hitting the monetary and financial system, sudden declines in asset values in another market, political movements within the state or other triggering elements that interfere with the smooth functioning of the banking system, ensuing damage on public confidence and trust might show itself in the form of outflows of deposits, reductions in the number of borrowers and lenders and the unwillingness of bank counterparties, which ultimately undermines the machinery underpinning the everyday business of banking. Under these circumstances, there would be a decrease in the credit produced that is primarily based on the information banks created in the first place. Furtherance of this position means that a problem in a single bank can be transmitted through different channels. According to Lastra, at least four (perhaps overlapping) categories describe these channels: (1) inter-bank, inter-institution and inter-instrument channels; (2) payment system channels; (3) information channels; and (4) psychological channels.Footnote 71 The latter are complementary to the information channels. Here, an interruption that hits a single bank and damages its daily operations can be translated into collective destruction of the trust and confidence produced by other banks or the banking system. So, this type of information is that which is attributed to bank runs, banking crises or other resulting negative externalities emanating from the disruption in a single unit.Footnote 72

Information spill-over is more obvious when financial market investors, including peer banks, interpret a problem in a bank as a negative signal about other banks, provoking a loss of confidence in these other banks. As such, an information channel includes psychological connotations in terms of affecting public perceptions and triggering panics, which are directly related to market confidence. Hence, the chain mentioned here starts from a contraction in a single bank whose information and credit production roles are interrupted to the point that the information about the bank itself becomes a powerful intangible force on other banks and the banking system. So, two layers of bank information are both affected.

IV. Conclusion

Trust and confidence have behavioural, cognitive and social aspects, and they are portrayals of shared expectations and interpretations regarding future events. This means that the very nature of banking is strongly tied to the trust and confidence produced, as theories explaining bank runs see these elements as pillars of a well-functioning financial system. Banks’ role in extending credit, and therefore in providing liquidity to the market with real economic consequences for overall economic activity, is a product of the trust and confidence generated by indigenous and exogenous factors. Following this line of thought, this article approaches bank information both as an indispensable part of running a bank’s business (first layer: collection, monitoring and production of information to make and extend loans) and as a value- providing continuance for banks in terms of producing confidence (second layer: information about a bank’s overall financial standing), and finally it establishes that trust and confidence, as an interdisciplinary concept that has socioeconomic value in one’s everyday life, are indispensable element of a bank’s information production and protection of micro- and macro-stability.

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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.

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