The role of trust in financial sector development

Abstract

In any economic environment where decisions are decentralized, agents consider the risk that others might unfairly exploit informational asymmetries to their own disadvantage. Incomplete results, especially, lies at the heart of financial transactions in which agents trade real claims for promises of future real claims. Agents thus need to invest considerable resources to assess the trustworthiness of others with whom they know they can interact only under conditions of limited and asymmetrically distributed information. Thinking of finance as the complex of institutions and instruments needed to reduce the cost of trading promises among anonymous individuals who do not fully trust each other, the author analyzes how incomplete trust shapes the transaction costs in trading assets, and how it affects resource allocation and pricing decisions from rational, forward-looking agents. His analysis leads to core propositions about the role of finance and financial efficiency in economic development. He recommends areas of financial sector reform in emerging economies aimed at improving the financial system's efficiency in dealing with incomplete trust. Among other things, the public sector can improve trust in finance by improving financial infrastructure, including legal systems, financial regulation, and security in payment and trading systems. But fundamental improvements in financial efficiency may best be gained by eliciting good conduct through market forces.Payment Systems&Infrastructure,Economic Theory&Research,Environmental Economics&Policies,International Terrorism&Counterterrorism,Decentralization,Economic Theory&Research,Environmental Economics&Policies,International Terrorism&Counterterrorism,Banks&Banking Reform,Insurance&Risk Mitigation