Trust and confidence in financial markets following the 2008 crisis

Prospectus Paper on Financial Markets

Background
The performance of the financial market is constrained by a number of influences including the health of the economy, the perception of investors and the government system. Debate on the distinct triggers of the 2008 global financial crises centers on factors such as relaxed monetary policy, or excessive financial regulation, or excessive powers but the banks. In-depth analysis of the financial crisis by IMF identifies factors such as the excessive debt burdens, unsustainable asset price increase, marginal loans build up, systematic risk and regulatory failure as a proximate cause for the 2008 financial crisis (Fleck & Lude, 2015). Financial markets failed in their twin tasks of managing and distributing risk, and effectively allocating capital for investment. While regulatory authority failed in their financial activities monitory responsibility, the financial markets failed in their dual responsibility of effective investment capital allocation and risk distribution (Tonkiss, 2009).
Nonetheless, the financial crisis brought to light the unsurmountable role of trust and confidence in the financial system. Post financial crisis surveys indicated declining levels of trust and confidence in the banking system (Butzbach, 2014). According to Knell & Stix (2010), post crisis surveys in the US demonstrates a declining trust and confidence in the banking system by US citizens. Essentially, the financial sector is a guardian of trust while confidence essential for the implementation of transaction. Trust ought to proliferate among the multiple stakeholders in the financial for strategic interaction to persist. The 2008 Global Financial recession was characterized by intense fraud and opportunistic behavior which subsequently yielded decline unprecedented levels of trust and confidence in the financial system. Exploring the paradox of the financial bubble, Earle (2009) argues that erosion of trust played a catalyzing role in the 2008 global financial crisis. Fleck & Lude (2015) posits that financial confidence and trust are an essential dimension of the system of finance that was eroded and demands institutional adjustments to restore.
Statement of the Problem
The September declaration of the bankruptcy by Lehman Brothers triggered unprecedented market volatility. Creditors of investment banks had lost confidence resulting liquidity trap due to suppression of loaning to the market for repurchase agreement. The financial markets could no longer allocate capital efficiently. Subsequently, the financial market reported a drastic decline in loans, amplified uncertainty in asset valuation, rapidly increase in fire sales, and declining collateral valuation (Malliaris, Shaw, & Shefrin, 2016). The declining investor confidence resulted in depressed stock market activity and falling stock prices.
Preserving consumer confidence is key for a healthy financial system. A synthesis of the studies undertaken on investor confidence and trust during the global financial crisis demonstrates that high vulnerability of the investors to distrust. Extant literature hypothesizes the link between economic prosperity and social trust and findings demonstrate that trust mediates the risk in economic uncertainty. By exploring the 2008 global financial crisis these study seeks to demonstrates how deep the consequences of distrust and lost confidence in the system leads to market failure
Purpose of the Study
Extant literature focuses on the general link between trust and economic performance with lesser research explicitly exploring institutional trust, confidence in the financial sector (Knell & Stix, 2010). Additionally, erosion of confidence and trust inherit from the 2008 global financial crisis has fundamental implications for future financial markets. Lack of confidence in the financial system due to the revelation of pervasive cheating is likely to increase the cost of risk capital due to a decline in investor’s willingness to bear the risk. Hence, as financial markets complexities evolve understanding the role of trust in addressing systematic risk is essential. Following the financial crisis, multiple approaches have been instituted to ensure stability in financial structure in an effort to restore trust and confidence. Fleck & Lude (2015) highlights regulations such as the US Dodd-Frank Act represents approaches that sought to reinstate confidence in the US financial system. The current study explores the perceived effectiveness of structures instituted to reinstate confidence and trust in the financial sector.
Research Objectives
The study seeks to explore post 2008 financial crisis trends of trust and loyalty by investors/customers to the financial system. The central objectives that this study seeks to pursue include: Explore the impact of financial crisis on customers trust and confidence patterns on the financial systems Explore the perceived effectiveness of structures instituted to restore confidence and trust in the financial system after a financial crisis Literature review
Following the financial crisis, research on trust and confidence in the financial sector is drawing increasing attention. Several theoretical frameworks have been analyzed to explore the dynamics of the financial crisis. This section discusses the agency theory as a founding theory for the financial sector, disaggregates trust and confidence and explores the structures instituted to restore confidence in the financial sector.
Agency Theory
The primary role of financial markets of settling financial needs constituted by credit contracts. The model entails trusting of lenders that the borrowers would pay. Therefore, the contractual relationship epitomizes the financial sector with the relation between investors and financial institution conceivable as an agency relationship (Butzbach, 2014). The financial sector operates through the lenses of agent-principal relationship whereby the banks (agent) operates on behalf of the investor (principal). Information asymmetry between the agent and principal results to moral hazards Kleing (2009). The agents possess significant information relative to the principal resulting in opportunistic behavior by the agents. On the contract, the principals possess limited access to information and its analysis, resulting in agency engagement. Since there exists uncertainty about the future, the principal trust the agent to act on the best interest of the principal.
But the principal- agency relationship is in permanence susceptible to be shaken due to unstable trust. As Kleing (2009) observes, the interest of the investment professionals (agents) and the shareholders (principal) were not aligned in the 2008 financial crisis. The short term strategies adopted by the investment professionals prior to the financial crisis resulted in an unprecedented decline in stock value resulting in losses to the principals (shareholders). The decline in trust has ripple effects. The ensuing reduction in stock prices due to actions of the investment professionals caused variance in investors’ confidence. The aftermath of the 2008 financial crisis demystifies that trust that had been a foundation of addressing the agent-principal information asymmetry is eroded resulting in the commission of moral hazards (Kleing (2009).
Trust and Confidence Differentiated
Reflecting on the 2008 financial crisis, declining trust by the private households resulted in a bank run yielding an extensive demand for 500 euro bills. In addition, interbank trust declined with banks demanding securities for interbank lending. The two forms of trust meltdown accelerated liquidity demand bringing a virtual standstill in the financial market. Consequently, the declining trust in financial institutions resulted in a decline in consumer spending, persistent bankruptcies and depressed employment (Fleck & Lude, 2015).
Economic sociologist institutional economist and political economist argue that confidence and trust are the backbones of economic functioning. Although there exists stark difference, confidence and trust are discussed in idiosyncratic ways in the literature of financial crisis. Earle (2009) links confidence and trust to three institutional players: banks, regulators and the general public. Earle (2009) further observes that regulations intermediate trust and confidence between the general public and banks to ensure stability. Hence, the efficacy of institutions is essential for trust and confidence to prevail.
While confidence is rational, calculative and based on past performance, trusts are relational, irrational, social and based on shared values (Tonkiss, 2009). Confidence is enhanced by contracts, indicators of proof, procedures, regulations, competence social roles and accounting. The precursors for confidence include evidence, rules, regulations, social roles, experience, principles, capabilities, proficiency, and contracts while the antecedents of trust include compassion, social associations, ethics, inferred individualities and honesty (Earle, 2009). Combination of confidence and risk yields multiple benefits such as unification, specification, and clarification (Earle, 2009).
Confidence and trust have emerged as powerful tools of risk management. (Knell & Stix, 2010) the analytical review identifies a positive link between trust and stock market capitalization, access to credit, lower interest rate margins and efficiency in the financial market operations. In addition to playing a fundamental role in a financial crisis, bot trust and confidence are instrumental in recovery from a financial crisis. Tonkiss (2009) observes prior to the financial crisis trust had overtaken confidence with investors relying on incomplete information and lesser on structures, but rather on trust. Arguably, trust is related to lower perceived risk. However, the financial bubble, the perceived risk rose, and investors switched their decisions to confidence. An empirical analysis after the financial crisis indicated an erosion in people’s confidence and declining trust in the federal government. A majority of the respondent indicated that the government bailout would hardly benefit them, hence the government intervention would hardly improve the economy (Earle, 2009).
Restoring Trust and Confidence in the Financial Sector
Trust takes two forms; personal and systems trust. While persona trust is anchored on individual attributes, system trust is anchored on institutional constellations. System trust is fundamental for effectively performing financial systems. Consequently, institutional constellations inform of rules and regulations that monitor deviant market behavior is essential in reducing risk associated with eroded systematic trust and confidence. The USA the Dodd-Frank Act, European Union Single Rulebook represents some of the institutional constellations aftermaths of the 2008 global financial crisis to increase surveillance and increase confidence in the financial sector in the US and the insurance sector in the EU respectively (Fleck & Lude, 2015). However, the success of the new institutional measures in restoring trust and confidence remains it remains unclear (Fleck & Lude, 2015), creating a research need that the current study seeks to explore.
Research Method
Butzbach (2014) highlights that studies exploring the concept of trust and confidence employ perceptions and public options as measures collected from sources such as Eurobarometer Surveys, national banks reports, financial trust index among other sources. The study seeks to undertake a qualitative study by collecting primary data of bank customers to evaluate the levels of trust and confidence in the banking sector. Given that the variable is perception data, a qualitative approach would be appropriate to develop a theoretical framework Earle (2009) links confidence and trust to three institutional; banks, regulators and the general public who will form the study population for this study. The exploratory variables are based on extant literature that is subjective and captures individuals perceptions (Knell & Stix, 2010). To measure customer perceptions, several sociodemographic variables such as race, age, religion, ethnicity and gender that affect general trust will be considered.
Validity and reliability tests are essential to ensure data and interpretation can be generalized across other population’s data. Test measures will be undertaken to establish the validity and reliability of the data and interpretation of results. The credibility of the research will be verified through investigator triangulation that establishing consensus and conclusions based on confirmation from data sources collected (Ary, Cheser & Sorensen, 2010). To establish the transferability of the findings cross-case findings will be undertaken. Back and forth coding coupled with triangulation will ensure the dependability of the study findings. Lastly, audit trials will be undertaken to guarantee the confirmability of the study findings and interpretation (Ary, Cheser & Sorensen, 2010).
References
Ary, D., Cheser, L., & Sorensen, C. (2010). Introduction to Research in Education 8 the Edition. Belmont: Wadsworth Cengage Learning.
Butzbach, O. (2014). Trust in banks: a tentative conceptual framework, 36.
Earle, T. C. (2009). Trust, Confidence, and the 2008 Global Financial Crisis. Risk Analysis, 29(6), 785–792. https://doi.org/10.1111/j.1539-6924.2009.01230.x
Fleck, J., & Lude, R. (2015). Union, Restoring Trust and Confidence at the Institutional Level by Higher Order Control The Case of the Formation of the European Banking. Behemoth, 851- 854.
Knell, M., & Stix, H. (2010). Trust in Banks - Evidence from normal times and from times of crises. Retrieved from https://core.ac.uk/reader/39358306
Malliaris, A. G., Shaw, L., & Shefrin, H. (2016). The Global Financial Crisis and Its Aftermath: Hidden Factors in the Meltdown. Oxford University Press.