Banking Sector Confidence After the 2007–2009 Financial Crisis

Introduction and Background

Although its full effects will not be understood for many years, the 2007–2008 financial crisis is already regarded as one of the most significant financial disasters in history. There is broad consensus that trust and confidence played critical roles in the crisis and are essential to any effective plan for recovery. As with all preceding financial crises, at the root of the problem lies a loss of confidence by investors and the general public in the strength of key financial institutions and markets (Earle, 2009). The reason for this study is that confidence plays a large role in how money is invested, where it is placed, and what markets will do. Everything from bonds to equities to precious metals and even blockchain is affected by confidence. Banks must have some awareness of their confidence levels should another economic crisis arise. If confidence is low, that knowledge can give banks an opportunity to de-leverage and reduce risk in order to better survive an economic crisis.

Statement of the Problem

Two key developments prompted this research study. First, Senior Global Economist Joseph Lupton (2018) at J.P. Morgan pointed out that global sovereign debt has risen by 26 percentage points of gross domestic product (GDP) since 2007. Second, J.P. Morgan Chairman and CEO Jamie Dimon (2017) noted that, given that quantitative easing has never been implemented on this scale and we do not fully understand its myriad effects on asset prices, confidence, capital expenditures, and other factors, we cannot completely anticipate the effects of its reversal. The major issue facing the international banking industry — with debt levels so high and interest rates rising — is therefore whether bankers are any better positioned to withstand a similar or worse crisis than that of 2007–2009.

There is a significant need to address this problem, as the Great Recession remains fresh in the minds of many and the likelihood of another, potentially more severe recession looms (Mauldin, 2018). Understanding the confidence and positioning of international banks can play a key role in determining whether defaults in one region of the world — for instance, the United States, China, or Italy — would affect the banking industry as a whole (Bouvatier & Delatte, 2015) and whether precautions should be taken now. During the 2007–2009 financial crisis, individual banks required bailouts from central banking institutions because they were unprepared for failure, and the collapse of some institutions could have triggered failures across the board (Bruno & Shin, 2015). At present, it is not well established whether international banks are in a better position to endure a similar or even worse financial crisis. Although stress tests are conducted regularly, they do not always reveal the true magnitude to which a crisis could affect the industry.

Purpose of the Study

The purpose of this quantitative study is to assess the confidence levels of members of the international banking community with respect to the sector's ability to weather another global economic crisis like that seen from 2007–2009, following the collapse of sub-prime lending in the U.S. and the wave of defaults across the global banking sector that was only relieved through central banking intervention (Haitsma, Unalmis, & de Haan, 2016; Heller, 2017). The goal of the research is to better understand the extent to which the international banking sector is prepared for another possible global economic crisis. To understand the industry's confidence, it is helpful to address the community directly and hear firsthand how vulnerable real-life bankers felt in 2018, given a trade dispute between the U.S. and China, numerous countries voicing a desire to reduce dependence on the U.S. dollar in response to economic sanctions, and the Federal Reserve's stated intention to initiate quantitative tightening.

The intent of this study is thus to assess the confidence of members of the international banking community regarding whether the sector can safely handle another global economic crisis like that of 2007–2009 and whether geopolitical awareness affects that confidence level.

Need for the Study

Confidence plays a large role in how money is invested, where it is placed, and what markets will do. Everything from bonds to equities to precious metals and even blockchain is affected by confidence. Banks must have some awareness of their confidence levels should another economic crisis arise. If confidence is low, that knowledge can give banks an opportunity to de-leverage and reduce risk in order to better survive a downturn.

Research Questions

The research questions for this study are:

Q1: Is the international banking sector confident that it can handle another global economic crisis like that seen from 2007–2009?

Q2: Does geopolitical awareness impact how confident members of the international banking community feel about whether the sector can handle another global economic crisis like that seen from 2007–2009?

Q3: Does awareness of rising debt levels around the world and changes in central bank monetary policy (i.e., transitioning from quantitative easing to quantitative tightening) impact how confident members of the international banking community feel about whether the sector can handle another global economic crisis like that seen from 2007–2009?

These research questions align with the research problem by focusing on the issues raised by Lupton (2018) and Dimon (2017) regarding rising debt levels, changing monetary policy, and the question of whether banks are prepared for these challenges. The questions align with the purpose statement by focusing on the need to assess the confidence levels of international bankers to ensure they are prepared for what could be an impending recession worse than the last (Mauldin, 2018). Based on survey data to be collected, the constructs of confidence, geopolitical awareness, and awareness of debt and quantitative tightening can be measured.

Hypotheses

Null Hypotheses:

H01: The international banking sector is not confident that it can handle another global economic crisis like that seen from 2007–2009.

H02: Members of the international banking community with geopolitical awareness do not feel confident that the sector can handle another global economic crisis like that seen from 2007–2009.

H03: Members of the international banking community with awareness of rising debt levels around the world and changes in central bank monetary policy (i.e., transitioning from quantitative easing to quantitative tightening) do not feel confident that the sector can handle another global economic crisis like that seen from 2007–2009.

Alternative Hypotheses:

H11: The international banking sector is confident that it can handle another global economic crisis like that seen from 2007–2009.

H12: Members of the international banking community with geopolitical awareness do feel confident that the sector can handle another global economic crisis like that seen from 2007–2009.

H13: Members of the international banking community with awareness of rising debt levels around the world and changes in central bank monetary policy (i.e., transitioning from quantitative easing to quantitative tightening) do feel confident that the sector can handle another global economic crisis like that seen from 2007–2009.

Definition of Key Terms

Quantitative Easing (QE): An unconventional monetary policy in which a central bank purchases government securities or other types of securities from the market in order to lower interest rates and increase the money supply. QE stimulates an increase in the money supply by flooding financial institutions with capital in an effort to encourage greater lending and liquidity.

Confidence: The belief, founded on experience or evidence such as past performance, that certain future events will occur as expected.

Global Financial Crisis: A financial crisis that affects numerous nations simultaneously. It is a period of severe difficulty and challenge that financial institutions, markets, corporations, and consumers experience at the same time. During a global financial crisis, financial institutions lose confidence and cease lending to one another, and traders stop purchasing financial instruments. Ultimately, most lending ceases and businesses suffer significantly.

Theoretical Framework: Trust, Confidence, and the TCC Model

Trust, Confidence, Regulators, Banks, and the Public

The roles of trust and confidence can be associated with three key groups of actors: regulators, banks, and the general public. In a free society governed by the rights and responsibilities of its citizens, most transactions must be voluntary, which necessarily presupposes trust between those who engage in business transactions. According to Earle (2009), market success requires trust between individuals and institutions, which is made possible through regulation. Market systems depend on regulation to function effectively. They are established through legal, organizational, and contractual mechanisms at varying levels of formality. Reputation, and the trust it cultivates, has always proven to be a fundamental attribute required by competitive markets. When trust is lost, a nation's capacity to conduct transactions is profoundly destabilized. Governments cannot legislate moral sentiment; however, there is a central regulatory role to be played in restoring public confidence in the integrity and effectiveness of institutions whose primary objective is not to enrich individuals but to allocate investment throughout the economy (Tonkiss, 2009).

The issue of trust and confidence in banks arose from the fact that banks became more focused on collateral than on character (Six & Verhoest, 2017). Prior to the financial crisis, interpersonal relationships and individual judgments were replaced by impersonal, mechanized methods of assessing creditworthiness and asset values. As a result, bankers were making decisions without full knowledge of the securities they were acquiring. Investors likely relied on ongoing relationships with bankers and on credit ratings. The general public, as investors, lacks the resources to independently examine such complex financial structures and ultimately depends less on information about structure and fundamentals and more on their relationship with the product seller (Earle, 2009). The third actor in the framework is the general public. As Earle (2009) notes, the general public contributed to the financial crisis by purchasing homes they could not afford, inflating house prices, and participating in the widespread misconception that house prices only ever increase.

The Trust, Confidence, and Cooperation (TCC) Model

Trust is social and interactive, whereas confidence is calculative and grounded in evidence. Trust is defined as the willingness, in anticipation of beneficial outcomes, to make oneself vulnerable to another, based on a judgment of similarity of intentions or values. Confidence, by contrast, is the belief — grounded in experience or evidence — that particular future events will occur as expected (Earle, 2009). The Trust, Confidence, and Cooperation (TCC) model is designed to serve several important purposes. The first is unification: the model provides a framework within which all manifestations of trust and confidence can be interpreted and related to one another. The second is specification: to a greater degree than available alternatives, it identifies the basic psychological processes involved in judgments of trust and confidence. The third is clarification: at the core of the TCC model is an explicit relationship between confidence and trust, which has been a key source of confusion in other approaches. The fourth purpose is the generation of new insights: by uniting and bringing greater specificity and transparency to the understanding of trust and confidence, the TCC model outlines potentially valuable connections with other areas of social psychological and applied research (Earle, Siegrist, & Gutscher, 2010).

The basis for trust is a judgment of similarity between one individual and another, whereby the trusted person would act as the trusting individual would. Trust is therefore grounded in social relations — more specifically, in shared values. Shared values can be measured in various ways. Empirical studies have shown that trust is reflected in measures of in-group membership, ethics, benevolence, integrity, inferred traits and intentions, fairness, and caring (Earle, Siegrist, & Gutscher, 2010). The foundation for confidence is past performance, or institutions and practices designed to constrain future performance. Past performance and the institutions or practices that govern it can be measured through indicators such as evidence, regulations, contracts, procedures, accounting, competence, social roles, experience, and criteria. Both trust and confidence, in various combinations, can give rise to different forms of cooperation (Earle, Siegrist, & Gutscher, 2010).

This is illustrated in Figure 1 below. Social trust is represented on the upper path, while confidence is represented on the lower path. As shown on the far left of the model, the information perceived by an individual is divided into two types: that which is judged relevant to morality, and that which is judged relevant to performance. In this theoretical framework, morality information consists of actions that reflect the values of an agent. The values of an agent define a relationship of trust, and it is within that relationship that performance information — and the confidence to which it leads — is evaluated (Earle, Siegrist, & Gutscher, 2010).

Figure 1: The Trust, Confidence, and Cooperation (TCC) model (Source: Earle and Siegrist, 2006)

Trust, Confidence, and Key Players in the Financial Crisis

Trust and Confidence: Definitions

The distinction between trust and confidence is important for understanding how to build or restore each, which in turn provides a foundation for constructive action. Earle (2009) defined trust as the willingness, in anticipation of beneficial outcomes, to make oneself vulnerable to another based on a judgment of similarity of intentions or values. Confidence, by contrast, is defined as the belief — grounded in experience or evidence — that particular future events will occur as anticipated. Earle and Siegrist (2006) assert that both trust and confidence support cooperation. However, while confidence operates against a specific criterion of performance, trust operates in the space of freedom afforded to the other: the other is free to act in ways that reflect shared values, regardless of whether specific acts are anticipated. The precursors of trust, as identified across a broad range of empirical studies, include social associations, in-group affiliation, ethics, compassion, honesty, inferred traits and intentions, fairness, and caring (Earle & Siegrist, 2006). These precursors are shaped by morality-relevant information. The foundation for confidence is past performance, or institutions intended to constrain future performance. The precursors of confidence are wide-ranging and include awareness, evidence, regulations, rules and procedures, contracts, accounting, social roles, capability, experience, proficiency, and principles — all specified by performance-relevant information (Earle & Siegrist, 2006). Trust and confidence each play a key role not only in precipitating but also in facilitating recovery from a financial crisis, across the three key groups of actors: regulators, banks, and the public.

Trust and Confidence in Relation to Key Players

With regard to regulators: during the financial crisis, a lack of trust in the accuracy of banks' accounting records and those of other financial institutions — combined with insufficient capital — created profound uncertainty around lending to them. The result was a freezing of credit markets. Laws and regulations can mandate only a minimal proportion of everyday marketplace activity. When trust is lost, a nation's capacity to transact business is profoundly destabilized (Earle, 2009).

With regard to banks: by the time the bubble formed, bankers were making decisions without full knowledge of the structures of the securities they were purchasing. Investors likely relied on ongoing relationships with bankers and on credit ratings. Confidence had been displaced by trust, sustained by the euphoria of the bubble. Although high returns should signal high risk, high levels of trust generated low perceived risk. When the bubble ultimately burst and bank failures began, trust and low perceived risk were rapidly replaced by distrust and panic (Earle, 2009).

With regard to the general public: ordinary citizens contributed to the housing bubble by purchasing homes they could not afford, driving up prices and participating in the widespread illusion that house prices only ever increase. When the bubble burst, the general public quickly shifted its focus from trust to confidence — and to the loss of it. A national public poll demonstrated that public confidence in how the country was being managed was at an all-time low (Earle, 2009).

Tonkiss (2009) argues that the seizure of interbank lending represented not so much a failure of trust as a crisis of confidence. When banks lack reliable information about the value of other banks' assets and liabilities — and therefore about their credit risk — they have no basis on which to make well-reasoned lending decisions. In the absence of dependable information, they lack confidence that a borrower can repay. If banks are also uncertain that their counterparties may be misrepresenting asset values or capital reserves, this constitutes a failure of trust. In the absence of reliable mechanisms of confidence, actors fall back on trust as a means of decision-making and risk management. The financial crisis involved precisely the collapse of these confidence mechanisms: the failure or misrepresentation of information, agreements, and regulation. These are the means through which a stock market crisis escalates into a broader crisis of trust (Tonkiss, 2009).