metadata: authors: 0: author: Bossone,Biagio
docna: 0: docna: The role of trust in financial sector development
docty: Policy Research Working Paper
subtopic: Legal Institutions of the Market Economy,Capital Markets and Capital Flows,Financial Intermediation,Capital Flows,International Trade and Trade Rules,Financial Sector Policy
teratopic: Finance and Financial Sector Development
abstracts: cdata!: 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.
repnme: repnme: The role of trust in financial sector development
display_title: The role of trust in financial
            sector development
listing_relative_url: /research/1999/10/439957/role-trust-financial-sector-development
topicv3: Trade m1326924 698,Capital Markets m1326967 332,Financial Intermediaries m1326973 2196,Financial Sector Development m1327681 1920,Financial Institutions m1505015 3797
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Financial Sector Vice Presidency
no_of_pages: 40
author_keys: 0: author_key: 167014
model_extractions: POLICY RESEARCH WORKING PAPER 2200

# Summary findings

In any economic environment where decisions are decentralized, agents consider the risk that others might unfairly exploit informational asymmetries to their own disadvantage.

Incomplete trust, especially, lies at the heart of financial transactions in which agents trade current 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, Bossone 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.

- - This paper a product of the Financial Economics Unit, Financial Sector Practice Department is part of a larger effort in the department to study the links between financial sector and economic development and improve financial sector policy reforms. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Elena Mekhova, room MC9-622, telephone 202-458-5984, fax 202-522-2031, Internet address emekhova@worldbank.org. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/ html/dec/Publications/Workpapers/home.html. The author may be contactedatbbossone@worldbank.org. October 1999. (34 pages)

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than folly polished. The papers carry the names of the authors and should be cited accordingly. The findinigs, interpretations, and conclusions expressed in1 this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._ Produced by the Policy Research Dissemination Center
# The role of trust in financial sector development

by Biagio Bossone World Bank I wish to thank J. Caprio, P. Honohan, M. Ghirga, and C. Schioppa for their helpful comments on previous versions of this work. Of course, I remain the only responsible for any errors and the opinions expressed in the text, which do not necessarily reflect those of the World Bank. As usual, and more than usual, I owe profound gratitude to my wife Ornella for her support.
"In a society with growing choices, and one where the depth of information is potentially infinite, the highest value will be given to the source whose information is most dependable"' (T. Rosentiel and B. Kovach).'

# Part **I.** Finance, information, and trust

## **1.1** Asymmetric information and incomplete trust

Although the importance of information imperfections in economic analysis had been early recognized by some scholars (Arrow, 1953; Stigler, 1961; Brunner and Meltzer, 1971; Alchiana and Demsetz, 1972), it was only after research started systematically to look at the implications of the asymmetric distribution of information across the agents, well into the eighties, that information has become central to the study of finance. The essence of the Asymmetric Information (AI) research program in finance is captured by Greenwald and Stiglitz' (1987) emphasis on ". . .the need for a more radical departure from the neoclassical framework, and for a much deeper study of the consequences of imperfections in capital markets, imperfections which can be explained by the costs of information" (p. 123).

Al characterizes a situation where one side of the market has better information than the other on options and incentives, and the less informed side is aware of its informational disadvantage. AI in financial markets creates inefficiencies because the incentives problems due to adverse selection and moral hazard of fund-users diminish the net returns to financial investors. Such incentive problems reduce the opportunity for risk sharing in capital markets and may give rise to fund-rationing as financial investors choose to turn away observationally equivalent borrowers at a fixed rate of interest, or discriminate among borrowers with respect to the terms of the financial agreements.

By challenging the assumption of perfect and costless information, Al theory has derived important implications for understanding rational behavior under risk, also shedding light on the principal-agent problems underpinning a large variety of real-world agent interactions. In particular, AI theory has laid the ground for a micro-economically founded interpretation of the role of financial intermediaries (especially banks) as reducing risks on financial investment through information processing, and has laid out fundamental principles for designing appropriate incentives to limit the inefficiencies from information asymmetries.

2
Yet, the existence of information asymmetries is only part of the more general problem of uncertainty confronting rational choices in a world with time. Post Keynesians radically criticize AI (New Keynesian) theorists for eluding the question of how agents form their decisions in the absence of risk mapping information, by assuming a (typically neoclassical) _ergodic_ world where well-defined and known probability distributions of future contingencies replace Keynesian (fundamental) uncertainty with manageable risk! Moreover, Post Keynesians deny that the implications of AI theory say anything on economic cycles and crises that is not already embodied in Keynes' liquidity-preference theory.

Recognizing that information is intrinsically limited and asymmetric, and that diversification and specialization of activity require agents to rely on the services of others, this study looks at the implications for intertemporal resource allocation and asset prices of that particular form of uncertainty deriving from lack of full trust - or _incomplete trust -_ among agents. Incomplete trust can be defined as _the agents' awareness that others may seek to pursue inappropriate gains either through deliberately reneging on obligations due on earlier commitments, or by hiding information relevant to transactions._ More in general, and considering that agents operate under uncertainty, the concept of trust may involve the _agent 's judgement that her counterparty to a contract would make all reasonable efforts to deliver on the contract._<sup>_3_</sup> Incomplete trust lies at the core of Al. Whereas, in principle, full trustworthy agents can trade at zero (or low) cost, in spite of Al, since each can (risklessly) take everybody else's word at face value, _symmetric_ information is not possible without assuming full trust: full informational symmetry holds only if individuals always reveal their true inner motives, that is, if they are fully trustworthy.

As the risk of unfair exploitation of asymmetries grows real, what becomes important to the agents is to be able to benefit from asymmetric information while managing their mutual trust gaps. More information is searched by the agents not so much to reduce information asymmetries, as to see whether and how they can trust each other, some agents specialize in bridging these gaps, and institutions evolve to reduce the effects of distrust by improving incentives to honest or fully informative behavior and contractual performance. Resources invested in activities aimed to reduce the inefficiency costs from incomplete trust affect transactions and the price of commodities and assets exchanged among the assets The problem of incomplete trust is particularly crucial in financial transactions, where anonymous agents trade current real resource claims in exchange _for promises_ to receive back real resource claims at some given point in future. Traders of promises need to ascertain whether their counterparties do their best to keep to their promises, and whether they are able to use information efficiently to this end.

3
In small communities of societies in early stages of economic development, with strong ties among members, financial transactions even with long-term obligations can take place at reasonable costs.<sup>4</sup> In contrast, in larger and more complex communities, where interpersonal bonds are weakened by agent anonymity and information asymmetries are embedded in largely decentralized-decisions contexts, financial transactions can be undertaken only if institutions specialize in activities to limit the costs of incomplete trust and if they are supported by appropriate infrastructure.

Specializing means investing in information to select trustworthy and efficient fund-users, monitoring their behavior, adopting incentives to elicit honest behavior, thus creating a reputation of their own for being good _bridges of trust_ between anonymous agents.<sup>5</sup> Anonymous financial-service users, on their part, invest more to identify reliable and efficient bridges of trust with other agents, so as to reduce the costs from AI separating them.

The role of specialized institutions is complemented by infrastructural components (e.g., legal system, regulation and supervision, trading technologies, incentives and enforcement mechanisms) aimed to strengthen commitment compliance from individual agents.

This study analyzes how incomplete trust shapes transaction costs and - hence - asset allocation, and how the financial system and public policy respond to the problem of incormplete trust. The study is structured in two parts. In part I, section 1.2 discusses the role of money and financial assets under incomplete trust, develops a model to determine the impact of financial efficiency on intertemporal resource allocation, asset prices and capital accumulation, and draws implications for the relationship between finance and economic development. Part II focuses on policy issues: sections 11. I and 11.2 discuss how financial intermediaries can enhance trust by accumulating reputational capital, and section 11.3 identifies policies to improve the efficiency of the financial system in dealing with incomplete trust.

# **1.2 Information and trust in intertemporal resource allocation and pricing**

In a world where transactions were carried out simultaneously, money would be redundant. Money becomes necessary as a store of value and a transaction device only when time is introduced in the exchange process and the simultaneity assumption is dropped.

The link between time and money rests on a twofold argument. The first - following the Keynesian-Hicksian tradition - relates to uncertainty and market incompleteness: to the extent that transactions are effected sequentially, the future is uncertain, and markets do not exist for all possible contingencies, the agents hold reserves of purchasing power stored in instruments that can easily be exchanged for real commodities as needs arise.

4
The generally accepted analytical implication of the uncertainty argument is that under the assumption of complete markets (as in a typical Arrow-Debreu setting), and notwithstanding the existence of time, money becomes as irrelevant as in timeless models. Gale (1978) has proved this argument flawed by showing that, even with complete markets, money serves as a store of value if the agents do not trust each other in their commitment to fulfill their contract terms<sup>7</sup> Incomplete trust is thus the second reason for tying money to time.<sup>8</sup> Even if all agents had perfect forecast capability of future contingencies, their anticipation that others might renege on obligations, or cheat on the quality of whatever they supply, would by itself create the need to adopt some means that can store value over time and be equally acceptable to all agents in the exchange process. Such means must be easily _recognizable_ by all participants, so that its information content is visible to all at a low cost.9 This requirement would not be necessary in a world of fully trustworthy individuals, even if information were distributed symmetrically among them, as each would be taken at her own word as to the value of whatever she supplies in the exchange process. Of course, individuals' uncertainty of the future would still make them hold stores of value for precautionary reasons, or give them incentives to hold assets for speculative purposes.

Under incomplete trust, information is necessary for the agents to assess their mutual trustworthiness as well as the _quality_ of the assets submitted to trade.1<sup>0</sup> In such a case, assets differ from one another as to their power to convey information on their quality and the trustworthiness of their suppliers: some assets are relatively more costly than others for use in the exchange and payment process, since their acceptability requires more information and involves longer search activity than others. In a competitive equilibrium setting, the asset return structure should thus reflect the transaction costs underlying each asset's trading, ultimately associated with the quality of the assets and the trustworthiness of those for whom they represent a liability." On their side, asset holders should hold more of an asset up to where its return equals its marginal utility net of what is lost due to the (asset-specific) transaction costs. In fact, one way to look at the financial system in a decentralized-decisions context is to consider its role to reduce the transaction costs associated with incomplete trust.

# **1.2.1 A model of incomplete trust in asset trading**

The model used in this study is an integrated version of Bossone's (1997). As in the former version, the core of the model consists of deriving a general form of optimal demand functions for assets trading in a multi-sector economy, under incomplete trust and uncertainty. In the following, the first step will be to define the rationale for, and the mechanism of, asset price discounting in an incomplete trust context. As a second step, the utility content of money and 5
financial assets will be formalized. An optimal intertemporal decision framework under general equilibrium will then be used to study the effects of financial system innovations and output variability on resource allocation and pricing.

# **Asset price discounting**

Assume an asset Q - say, a financial security - earning a nominal interest rate _r Q.12_ With incomplete trust, asset Q may be purchased (sold) at market price _pQ_ (= 1 / _rQ)_ plus (minus) a unit premium (discount) specific to the asset, _d Q._ To formalize the discount factor _d Q,_ define first the asset trading context under incomplete trust.

An holder of Q who wishes to realize the asset advertises its sale on the market and submits an ask-price for it."<sup>3</sup> If the holder is fully trusted by _all_ other agents, no prior assessment is necessary from potential buyers and the transaction costs involved are smaller than under incomplete trust since Q is equally acceptable to all agents and against all other assets. With incomplete trust, on the other hand, sellers need to undertake longer and costlier processes for achieving _best price_ sales as: i) different agents submit different bid-prices for the same asset due to their different perceptions of asset quality, and ii) not all agents stand ready to buy assets on sale due to the assets' limited acceptability in trade. Also, _iii)_ higher costs are incurred by the agents to assess their mutual trustworthiness as well as the quality of the asset traded. Lastly, iv) assets with different characteristics bear different information costs.

Under incomplete trust, one may assume that the shorter the time available to the holder for realizing the asset, and the lower the asset's acceptability in trade, the larger is the cost that the holder must be willing to bear in order to raise the needed liquidity. Such a cost takes the form of a discount on the asset market price that the seller offers to potential buyers. The rationale for price discounting rests on two factors: a) risk-averse agents are reluctant to trade assets whose _true_ value they know with certainty against assets with uncertain or unknown value to them; b) even if some agents possess sure knowledge of the true value of the asset, they consider that others might not share the same knowledge thereby introducing frictions in the indirect exchange of the asset.

The time factor plays here a crucial role: with incomplete trust and a given financial structure (as characterized by institutional and legal arrangements, range and quality of intermediaries, and transaction technologies), each asset is characterized by its own _optimal transaction time._ This is the minimum time required of the asset-holder to maximize the net proceeds from the asset sale, including as such the time it takes the buyer to assess the 6
trustworthiness of the seller, the quality of the asset, the asset's acceptability in indirect exchange, as well as the time necessary to complete the transaction.<sup>14</sup> Operationally, the optimal transaction time can be defined as the interval necessary for the seller to realize the asset at its current market value. The proceeds from optimal asset sale equal such a price net of the minimum asset-specific (unit) transaction cost _d Q*,_ involved in completing the sale in the given trading context. Thus, _suboptimal_ sales that take place at discounts on the asset market price greater than the minimum transaction cost, and occur when the asset must be realized within a time span shorter than its optimal transaction time. Discount factor dQ 2 _dQ*_ can thus be formalized as a function of:

1. the optimal transaction time interval, At*: the longer the latter, the larger the discount at which Q must trade to shorten the sale time; and

2. the time interval, At , available to Q's holder to realize the asset: for At" < At;, the shorter the former vis-a-vis the latter, the larger the discount at which Q sells.

Expectations of higher output variability affect the price discount factor by shortening AtQ .

Thus,

- (1) _dQ = dQ (1- AtP(_ I _wt) / iAt ())_

where (, I _wI) =,E[,_<sup>_8_</sup> _Jatwj I_ w reflects the agent's expected (time weighted) average variability of consumption from date _t_ onward, conditional on signalw,. The conditional relation of **_(o_** on w is such that the forner increases as w approaches one. Signalw e (0,1) varies directly with the uncertainty perceived by the agents in the economy (see Appendix IV).TN e R + indicates the level of _efficiency_ of the underlying financial system, defined in this context to reflect the financial system's capacity to reduce transaction costs related to incomplete trust through institutions and infrastructure (e.g., markets, technologies, regulations, and enforcement mechanisms) for the intermediation of financial resources. For our purposes, function (1) can be simplified as The effect of the financial efficiency indicator is such that, other conditions being equal, price discount factors for the same assets are larger in less efficient financial systems, that is, assets' optimal transaction times are longer under lesser financial efficiency. As a result, all extra discounts with respect to d Q on suboptimal sales would be larger. Note that for each Q, the 7
variable and state-contingent price discount would be determined according to the following conditions: Also, it is assumed that _d=d_ = 0 if At* 0, that is, perfectly liquid assets trade at zero discount. In the extreme, where no financial system existed andT approached zero, trading most assets would present no economic convenience. On the other hand, financial technological and institutional development (i.e., a higher T ) increases safety and speed of asset trading - and hence the degree of trust that agents place in asset trading - and reduces asset optimal transaction times. Note, thus, that the concept _offinancial efficiency_ as here defined involves that of _safe_ trading as well.

# Asset **_utility_**

In this model, money and financial assets are vehicles used for transferring consumption decisions across time, to the point where future (contingent) consumption yields the highest expected marginal utility. They transfer such decision at different speed, or transaction costs. The structure of such costs is, as discussed above, asset specific, while their scale is determined by the overall efficiency of the financial system.

Assets produce _utility_ in terms of their power to make consumption accessible to their holders when and as needed. Utility varies positively with the consumption accessible though the asset, and negatively with the cost of liquidating the asset. If an agent holds an asset for a period during which she might incur income shocks, she could use that asset as an option to be exercised at any point of the period to avert (or limit) consumption losses. To estimate the option's current value, the agent needs to conjecture the probability of having to exercise the option (i.e., realize the asset) at each future date of the holding period and at a given cost. Such probability depends on the agent's knowledge of the distribution of future possible shocks, and on her use of current information to anticipate future shocks.

The probability is defined as follows. Consider a discrete and infinite time horizon [0,oo), and call _sr e S_ c R, c R + the date-event whereby at any instant prior to r the agent expects a consumption shock to be received at -r and mobilizes her resource endowments (that could otherwise be invested) to support consumption. Let _s-C_ be the complement of _s'_ in S, and let 8
Wt E (0,1), Vt < r, be an appropriate transformation of current information w', E Q, (see Appendix IV) where Q, is the information set available to the agent at t. Finally, consider space _={~pr(sc =s'w,>w,),O < pr() <_ 1 and _pr(sc =s'>tw, ) + pr(sc =sI w,)=1},_ wherein at every date t each agent attaches a probability of occurrence to future date-events s' 1 's, conditional on signal _w, ._ The signal is such that the probability of occurrence of date-event s' increases as w, approaches one, that is, _lim[pr(sc_ = _SC I w)_ = 1] = 1. As clarified in Appendix W, -- *1 IV, w, approaches one as uncertainty in the economy is perceived to increase.

The marginal utility of _Q_ at t, conditional upon current information, can thus be constructed as the present value of the marginal utility from the stream of future contingent consumption accessible through the asset, net of the marginal utility lost to price discounts from asset liquidation: where: the time subscript S = r - t is used for the compound interest factor _PQQ, /I pc_ is the consumption attainable atr with Q-holdings valued at their t-dated price (note that expected future changes in the price of _Q_ are incorporated in Q's return); _p c_ is the price of (composite) consumption commodity C _R =_ I _+ rQ_ - zT is the gross real rate of return on asset Q and **_;f_** is inflation.

Note that _d Q_ = 0 for perfectly liquid assets, and that for given values of _Q, r Q, pc,_ and ,B, different combinations of _d Q and pr_ () yield different values of _u'(Q)_ (see Appendix III). Operationally, relation (2) could be said to represent the expectation of the liquidity services provided by the asset to its holder during its holding period and contingent upon future states of nature. Note also that innovations in financial efficiency increase the marginal utility of _Q_ by reducing its discount factor. Finally, an increase in w reduces Q's marginal utility by increasing both the probability and the size of suboptimal sales (which increases Q's discount factor).

9
# **1.2.2 Asset allocation and prices under incomplete trust**

To determine the individual resource allocation choices when (trust-related) transaction costs are incorporated into the agents' decision-making process, assume an economy with three sectors - households, government and firms -, one composite commodity C for consumption expressed in real terms, and three assets expressed in nominal terms: monetary asset _L,_ government bond B, and corporate financial security A.

Firms are owned by the households. Firms use capital K to produce nominal output y° **,16** Firms sell output at pricepC and turn their income to households _(yh)._ Households also receive government income transfer g and pay out lump-sum taxes t to the government. The government finances income transfers via taxation and bond issues to the households.

Households have well-behaved utility functions with regular shape throughout their domain, i.e., with u'( )>O and _u"(_ * )<O yielding positive risk aversion, and with _u"'(_ )>O ensuring that changes in the variance of consumption affect the agent's expected marginal utility.

Asset _L_ is a non-interest bearing instrument issued by the government and accepted by all the agents as a means of exchange in force of a government legal restriction; thus, it trades at zero transaction costs. In every period, the households enter the goods market with a predetermined amount of _L._ Bond B is a default-free (govenmment-guaranteed) debt instrument, earning nominal interest _rB_ and issued by the government. Its supply Bo = g - t + _rB_<sup>_0_</sup> + _B°_<sup>_0_</sup> is determined as the state sector borrowing needed to finance the current fiscal deficit and the interest expenditure on outstanding bonds. Bond B trades at market pricepB and may be used by the households either as for storing value or in indirect exchange at a discount since, unlike _L,_ it is not covered by a legal restriction on circulation as a means payment. 1<sup>7</sup> In light of the government guarantee, however, such discount is small and supposed to be constant over time and across states of nature.

Asset A is a (risky) corporate bond issued by firms to finance capital acquisition. Its supply _A_<sup>_0_</sup> is placed with the households and is determined at the point where the marginal efficiency of technology equals the marginal cost of funds. Asset A is exchanged in the financial market at price _pA_ and earns nominal interest **_rA(= I /IpA)_** It is used as a store of value and it can (in principle) be used also as a medium of exchange, although its indirect trade takes place at a discount much larger than B's due to the absence of guarantees on its quality and of legal restrictions on its use.

In the exchange process, at each date, the infinitely-lived h-th household (h=l,...,B) uses its earnings to finance current consumption and/or to add to its wealth stock. The household derives 10
utility _directly_ from current consumption and _indirectly_ from asset holdings. With money and financial assets defined as future consumption options conditioned by transaction costs, the household maximizes at each date of its time horizon a composite utility function based on the utility delivered by current consumption, and the utility produced by asset holdings.

The household thus orders its preferences across consumption commodities and (money and financial) assets according to a strictly quasi-concave, time-separable utility function _U:_ R **+4-** R + defined as _U=U(C,L,B,A)._ The household's plan at date t is thus to maximize: subject to the intertemporal constraint reported in Appendix I.:

**_+_** _EQ [dt_ max(0 P, _I~Qf, -- PI 2Qh_2)-dF ma-_ (, **_pQQQ_ -** pQ **_Qh_** )]

_(5) C,L,B,A>0_ (6) limL, = limB, =limA, = 0 **r-* T-.** _r_ with _d Q >_ 0 if At; = - (T - 1) = 1 > At (suboptimal sale) and where: _YN=_ **_+ g_** -t is disposable income; E **_rFI_** _P,Q Qt7-I_ is the interest income received from last period's Q-holdings; Q _PoQ_ is the purchase price of Q; and the two terms in _d_ Q max(-) represent, respectively, the eventual gain/loss from buying/ selling asset Q _(=B,A)_ at a discount.

The solution to the household plan (see Appendix I) requires that at date t, for given current and expected values of _a, ,8, )r, rB_ and r **_A,_** the household selects for each date r 2 t an allocation _(CH*, L$', BH", A)_ that satisfies the optimal intra-date rule _(7)_ **_U,_** _(C?*)(PC)I_ = _u (LI*)_ = _u (B,*)(PB)l_ = _uW(Ar* ,P_ I _w)(PA)'_ = A 11
Rule (7) requires each household to equate at every instant the _weighted_ marginal utilities derived from allocating the marginal resource unit to the available consumption commodities and assets (weighted with the inverse of their own current market price). For given expectations of future shocks to consumption, rule (7) ensures that the costs of mobilizing resources to absorb those shocks are minimized since the underlying optimization model incorporates the probability of incurring such costs (relation (2)). At each date, prices in each market must be such that rule (7) holds across all households under the following market clearing conditions:

- (El) _E Ch = yo_ = E _yh_

(E3) _EhBh =Bo_

- (E4) _E Ah = AO_

From rule (7) it is immediately evident that a lowerT implies at the margin a lower utility of the illiquid asset. Equilibrium allocation would then involve relatively smaller shares of asset _A_ in portfolios. Thus, rule (7) implies that:

**Proposition 1.** Ceteris paribus, _in an economy with relatively lowerfinancial efficiency (i.e., a lower T ) equilibrium current consumption and the equilibrium stocks of liquid assets in individual portfolios are larger than in an economy with a more efficient financial system._

Call T -efficient (resp., T -inefficient) the economy with high (low) financial efficiency. The two economies are hypothetically equal in all other respects. As asset _A_ represents a financial claim on the economy's productive capital and its supply is interest-elastic (with positive but finite elasticity), rule (7) and conditions E(l)-E(4) imply that:

**Proposition 2.** _The T -inefficient economy has a smaller equilibrium capital endowment than T -efficient economy.'_

In terms of relative price structure, rule (7) and conditions E(l)-E(4) also imply that: 12
**Proposition 3.** _In the ' -inefficient economy capital trades at a discount as compared to the T -efficient economy. The same equilibrium stock of capital is held in the two economies only if,_ ceteris paribus, _the return on capital in the T -inefficient economy is enough to compensate holders for the relativefinancial inefficiency._

## Note however, that:

**Proposition 4.** _The increase in the rate of return required to induce holders of capital in the T -inefficient economy to catch up with the capital endowment of the T -efficient economy is not feasible under the existing technology._

The extent of the unfeasible region - defined by the demands for capital in the two economies and the marginal efficiency of capital - represents the cost of the relative financial inefficiency of the 'P -inefficient economy (see Appendix II). The above propositions have clear implications for economic development policy, as they emphasize the importance of reforms to enhance financial efficiency as a way to support productive capital accumulation in emerging economies.

# **1.2.3 Impact of uncertainty**

Uncertainty is here assumed to affect the probability distribution functions used by the agents to predict future supply innovations in the economy: a higher degree of uncertainty implies a more spread out probability density function of future supply shocks and, therefore, a larger output volatility (Appendix IV). This section takes the case of real output uncertainty, but the methodology could as well apply to monetary uncertainty (Bossone, 1997). By way of a simple analysis of the model's f.o.c.'s under the given assumptions, it is possible to assess the impact on equilibrium allocation and prices of an increase in agents' perceived uncertainty over future output shocks in an economy with incomplete trust. With utility functions featuring the properties described earlier and assuming that the agents anticipate real supply shocks to affect their consumption, one has that 13
where the difference of the LHS increases with the expected variability of future consumption. To take into account the _riskpremium_ associated with increasing consumption variability, function OC can be introduced whereby (9) _, E[u' (C1 )]_ = _0(,E(C 1), (o,_ I w _)),_ 0c <0, **_4bi'J_** > 0 Relation (2) can thus be rewritten as (2b) _u' (Qth I_ w,) with derivatives (10) _q'Q< 0 ,q'p> 0',, R?,qY R>,0,>0_ where _pr =[tEp% c=_ and _RrQ =[_ E _l(Ri ,)]'11_ are the vectors of the expected values (as of date _e+i_ _t)_ of, respectively, commodity prices and compound gross real interest rates on assets. As discussed earlier, the sign of O', depends on the behavior of both _d Q_ and pr(.) and thus, ultimately, on the liquidity of the asset. Note, however, that O',r _(L), si' (B) >_ 0 while O', _(A)_ < 0. Finally, an increase in financial efficiency increases Q's marginal utility. It is assumed that this effect is relatively stronger for private claims, such as equity, while it is negligible for government securities which already trade at a low discount due to government guarantee (see above).

Using (2b) and positing w, = wo, rule (7) under (El)-(E4) can be written as 14
Note that current consumption is conditional on w° when r > t. From (7a), (2b) and (10), and recalling that both(a, I _w1)_ and _pr(sc = s' I_ w,) increase as w approaches one, it follows that an increase in _w1_ to w' > w° affects equilibrium prices since Recalling the invariance of B's discount factor, the inequality in (I1) is due to the differential impact of A's discount factor on A's marginal utility following the change in signal w. Note that, in response to the signal, the other marginal utilities in (11) all increase by an equal amount due to the expected increase in consumption variability. Clearly, at prices _pC , p B*_ and **_pA*_** , and with a given current inflation rate, the new aggregate demands for consumption and assets are At date t, re-attaining equilibrium (E1)-(E4) from (DI)-(D4) requires instantaneous prices and inflation to adjust to the new levelspc > **_pC* pB*_** _> p B, pA <pjA_ and _t' >_ **_Z7._** The new equilibrium prices reflect agents' revised expectations over future prices and interest rates, based on new information. Note that instantaneous inflation needs to increase if the marginal utility of the unremunerated L-holdings is to adjust consistently with rule (7a). Note also that, in light of the inverse price/interest rate relationship, the new equilibrium asset prices imply that: _RtB* <RB*_ and R **_A**_** _> RA*_ . This shows: _15_
**Proposition** _5. An expected increase in output variability drives risk-averse agents to substitute future with present consumption, and to shift their portfolio composition towards more liquid assets enabling them to absorb negative consumption shocks with minimum suboptimal asset sales. For equilibrium to be re-established in all markets, the price of current consumption and the required (equilibrium) real rates on less liquid assets have to rise, while the required (equilibrium) real rates on liquid assets have to adjust downward._

Basically, the way uncertainty works its effects through the economy in this model is via its expected impact on the timing of asset trading and its related transaction costs. In times of higher perceived uncertainty, agents expect discounts on less liquid assets to increase when they suddenly want to make their portfolio more liquid.

In fact, there is no guarantee that the new equilibrium prices will be attained or sustainable, if attained. Risk perceptions might be such as to lead the agents to deny their money to new supply of less liquid liabilities at whatever price they are offered. Such a disequilibrium outcome is consistent with financial market rationing phenomena typical of AI models of credit and capital markets.

Finally, relations (11), (DI)-(D4) and the propositions above imply that:

**Proposition** 6. _Improving the efficiency of the financial system helps the economy's relative prices better absorb exogenous shocks_ and

**Proposition** 7. Ceteris paribus, _higher financial efficiency lowers the equilibrium relative price of capital and the required premium on "catch-up " investment_ (see Proposition 4).

The last proposition suggests that, especially in the context of emerging economies, there is a complementarity between financial and real sector development that can be exploited through appropriate policies, a point which today is supported by considerable empirical evidence"<sup>9</sup> 16
# **Part II. A policy** view

## **11.1 Enhancing trust**

Information limitation and asymmetries are a fact of life and agents may have strong incentives to exploit them unethically. Also, information and its use are costly and not all agents can afford them. Moreover, specialization of human activities is such that a world with _symmetric_ information is not attainable, nor would it be economically efficient (which is not to deny, however, that at least in principle more information is always better than less). Indeed, a market economy is essentially based on the need of each individual in society to rely on the specialized knowledge of others as an efficient way to increase her welfare.

What matters, then, is that agents be able to rely on each other, and to have means to select counterparties they can trust with using private information efficiently and fairly. As shown in part I, the trust issue is crucial in financial transactions whereby anonymous agents trade promises. Finance can thus be seen as the complex of institutions, instruments, norms and infrastructure aimed to reduce transaction costs associated with trading promises between agents who do not trust each other fully. In this respect, financial intermediaries act as bridges of trust between agents, and their efficiency can be measured by their ability to reduce the costs involved in bridging trust gaps (consistently with the definition of financial efficiency offered in part 1).

The public sector can enhance trust in finance by improving the enforcement technologies embodied in financial infrastructure (e.g., legal system, financial regulation, security in payment and trading systems). But although strengthening enforcement technologies is necessary, it cannot be the only solution since enforcing obligations becomes extremely costly if obligations run contrary to private incentives. Fundamental improvements in financial efficiency can thus be gained by eliciting good conduct as much as possible through market forces"<sup>0</sup>

## **11.2 Trust and reputational capital**

As noted, in a world with incomplete trust, agents can earn positive quasi-rents by specializing in financial intermediation between anonymous traders unwilling to trade promises directly. In terms of part I model, intermediation by good bridges of trust reduces transaction costs on the trading of promises and attracts demand for promises that would otherwise be prohibitively expensive. In a competitive environment where agents seek to discriminate between 17
_good_ and _bad_ bridges of trust, it pays intermediaries to earn a good reputation and to signal such reputation to the market. Where agents reward trust for honest and prudent behavior and punish untrustworthy behavior, reputation links the intermediaries' stream of future profits to their past business conduct. Good intermediaries thus accumulate _reputational capital_ which conveys to the market the value of their commitment not to breach their (implicit or explicit) contracts with clients and counterparties.Y Operationally, the reputational capital of a financial intermediary consists of a complex of variables that _signal_ the intermediary's commitment and capacity to fulfil its obligations. The most relevant variables are: the intermediary's long-term mission, its market presence and past performance, financial strength and profitability, organizational and governance structure, capacity to manage financial and operational risks, track record of compliance with legal and financial obligations, quality of service and advice delivered, quality of projects financed, quality and ethics of management and personnel, and transparency of operations, resources invested to stay in business. Other variables, external to the individual intermediaries, bear on their reputational capital and include the quality of financial regulation and supervision and the strength of law enforcement to which they are subject.

Klein and Leffler (1996) study the conditions under which the franchise of firms supplying high quality of products exceeds their one-time wealth increase from distrustful behavior (i.e., selling to customers a quality less than contracted for). They show, _inter alia,_ three important results: First, they determine the price premium (above the competitive price) at which the value of satisfied customers exceeds the return to the firm from cheating, thus motivating competitive firms to honor high quality promises. This quality-assuring premium provides the supplying firm with a perpetual stream of quasi-rents whose present value is greater than the profit from cheating, that is: the _net_ franchise value of the firm is positive, this being the value at loss if misbehavior puts the intermediary out of business net of the one-time gain obtainable from misbehaving.<sup>22</sup> Second, firms accumulate non-salvageable (productive and/or nonproductive) capital assets through which they signal to customers their commitment not to cheat. Such assets are part of the firms' reputational capital and represents the collateral that firms stand to lose if they supply less than the anticipated quality (bank capital and reserves are an example). As the reputational capital saves on the costs to evaluate trustworthiness, it gives the agents an incentive to pay a premium to the firms for receiving the desired quality. In the case where the supplying firm is a financial intermediary, such a premium reflects the value to the agents from minimizing the cost of trading promises under incomplete trust:<sup>23</sup> investors accept to pay a trust-assuring premium for being able to entrust the intermediary agents with managing informational asymmetries vis-a-vis fund18
takers. 24 In fact, the intermediaries may extract extra-rents from fund-takers, too, in the form of higher than competitive prices, as they enable them to economize on their reputational investment in non-salvageable assets. This is consistent with the evidence reported by Rajan and Zingales (1999) indicating that firms operating in more developed financial sectors undertake less fixed capital formation.<sup>25</sup> Third, as prices below the quality-assuring level decrease the demand for high quality output, Klein and Leffler show that, under free market entry, firms compete on non-price terms and seek to win customers by signaling a higher reputational capital. Under their model, it can be shown that reputational capital accumulates (and new entries occur) within the industry to the point where the business _net_ franchise value is competed away.

Abstracting from ethical considerations (which, of course, influence the incentive structure of individual intermediaries), what precedes suggests that investing in reputational capital is meaningful only in repeated-game contexts with long business time horizons<sup>6</sup> Repeated and extended dealings must take place over a period long enough to ensure that the net franchise value is positive.27 Designing incentives to promote investment in reputational capital in the financial sector requires to consider these features.

# **11.3 Incentives**

The discussion in this section centers on incentives to _induce_ trustworthy behavior in the financial sector by soliciting agents' self-interest in ways that generate self-sustaining enforcement mechanisms of good behavior. Areas of public policy to strengthen financial infrastructure are not dealt with here, although - as noted - their omission should not be understood as neglecting their importance.

## **11.3.1 Investing in reputational capital: the role of regulation**

Increasing the franchise of financial institutions is a necessary first step of financial sector reform. Only a positive net franchise value from intermediation may attract investment in reputational capital from financial institutions. Use of mild regulatory _restraints_ on market competition might increase the franchise value of domestic institutions, especially in least developed countries and in those emerging from long periods of financial repression, or in deep financial crisis and restructuring their financial sector (see Hellmann and Murdock 1995, and Hellmann, Murdock and Stiglitz 1994, 1995, 1996).

In the banking sector, restraints such as (market-based) deposit rate ceilings and restrictions on market entry may have large rent creation effects that would allow banks to raise 19
profits during the initial phase of reform. Hellmann _et al.,_ cit., show that the degree of restraints necessary to produce significant rents is such that would not generate large financial market price distortions. Also, to the extent that banks respond positively to restraints by investing rents in reputational capital, price distortions would be partly eliminated by lower risk. In terms of Klein and Leffler's framework, restraints correspond to determining the trust-assuring price premium exogenously while preventing free market entry. As a result, accumulation of reputational capital is not induced by competition and must therefore be forced by regulation (see below).

Restraints should be accompanied, and eventually replaced, by restrictions on market entry/exit based on reputational capital criteria. With exogenous reputational capital and competitive or contestable markets, trust-assuring price premiums become endogenous and restraints are no longer desirable. Reputational capital criteria could include minimum requirements on financial capital, organizational, operational, and governance structures, riskmanagement capacity, and conditions for _fit and proper_ owners and managers. Licensing should imply serious initial commitments from owners and managers wishing to enter the market, showing their strong commitment to forsake one-time rent options from cheating or from behaving imprudently. Issue of subordinated uninsured debt (see 11.3.5) and publicly observable discretionary guarantees (Boot _et al.,_ 1993) could also be required by regulation as signaling devices for reputational capital and its dynamics.

Where restraints apply, reputational capital criteria could be used by regulators to make markets contestable: licenses could be granted (transferred) to owners and managers on the basis of their plans for a strong reputational capital. Transparent reputational capital criteria could be used by regulators to decide on approval of changes in ownership and management resulting from market takeovers, mergers, and reorganizations.

# **11.3.3** Investing **in reputational capital: the role of economic capital**

Economic capital is a core component of the reputational capital of financial intermediaries. The capital adequacy ratios of the Basle Accord are a first essential step to induce banks to accumulate capital vis-a-vis risks. As is well known, however, the static approach embodied in the Accord may cause inefficiencies in resource allocation (Nickerson, 1995), and result in either inadequate economic capital or undue costs on banks. Moreover, if capital ratios are perceived exclusively as regulatory requirements, compliance with them could induce to selfcomplacency from the intermediaries and to misleading signals to investors.

As the financial system develops in emerging economies, banks in these countries should be advised to replace static capital ratios with more dynamic (and tailor-made) methods that correlate financial capital more closely to risks. This would render the effects of risk 20
diversification more visible and measurable, and strengthen the incentives to portfolio diversification. More in general, it would make clearer to banks the trade-off between the cost of raising extra capital funds and the marginal reputational gain associated with additional financial capital and would thus induce banks to internalize decisions on capital ratios.

As more dynamic risk-management systems are introduced, regulation should: 1) require banks to disclose their market and credit risk position; 2) require banks to raise capital if this is less than the reported risks; 3) prevent banks from underestimating their potential losses by requiring them to put up extra capital if actual losses exceed the _ex-ante_ estimations (i.e., restore their capital or maintain higher ratios as a penalty) S Ultimately, regulators would be less concerned with determining capital ratios and specialize in assessing the methodologies used by banks to determine their own ratios.

# **11.3.3 Investing in reputational capital: the role of self-regulation**

To the extent that the franchise of intermediaries interacting in financial markets can be very sensitive to their mutual behavior, they have an incentive to undertake _self-policing_ activities through which they can monitor each other, elicit voluntary good conduct, and sanction misbehavior.<sup>29</sup> Increases in franchise value and incentives to build reputational capital may result from the interest that private-sector agents take in establishing long-term mutual bonds to enforce honest and prudent behavior through self-policing.

Self-policing arrangements may develop within financial communities (Goodhart, 1988)3° In some cases, they evolve into fully fledged self-regulatory organizations (SROs) with internal statutory rules (regarding admission and sanctions), financial resources, and formal structures involving shareholders, managers and employees, codes of conduct, and oversight procedures involving rules of conduct and information disclosure (Glaessner, 1993). Many countries today adopt SROs in payments and securities markets. SROs may range from interbank deposit markets, to wholesale and retail payment systems, securities trading and stock exchanges, securities lending and settlement clearinghouse services, deposit insurance, and credit information sharing systems.

Incentives in financial SROs - especially in interbank payment and settlement systems - can be strengthened by members agreeing to pre-committing resources - in the form of mutual lending obligations or collateral pooling -that would be mobilized if one or more members run into illiquidity or insolvency problems. Pre-commitments to liquidity- and loss-sharing arrangements generate incentives for each member to monitor the others, agree on and enforce rules, and sanction misbehavior. Liquidity and loss-sharing arrangements protect market participants from the systemic consequences of failures of one or more financial institutions.

21
They thus afford supervisors some higher degrees of freedom in deciding whether to let insolvent institutions fail, and enhance the certainty of government exit policies. To the extent that greater certainty lessens agent expectations of government bailouts or forbearance, investors are faced with stronger incentives to good conduct and careful monitoring.

Some problems may complicate the setting up of financial SROs in developing countries. Scarcity of institutional resources may constrain the quality of oversight, and the lack of reasonably homogenous institutions could impede the formation of internally balanced structures. Also, SROs might transform themselves into cartels and jeopardize competition. Even so, because of their specialized knowledge and self-interest, SROs are better placed than government bureaucracies to design rules consistent with the features of their business, to keep their operational institutional process apace with progress, and to improve their business standards. Also, as inforrnation is vital to each SRO member, the SRO setting is better positioned than government agencies to achieve enforcement of disclosure rules through peer monitoring.

Government has a key role to play in supporting the formation of financial community ties along sound self-regulatory principles. It could delegate to domestic financial institutions the task to form industry groups for governing and running specialized markets. Government should monitor SRO operations and intervene if their action deviates from purposes. Government should also ensure that SRO rules and practices are compatible with fair market competition.

Finally, the efficiency of dispute resolutions and adjudication processes is crucial for the success of SROs.<sup>3</sup> ' Government should not preclude (indeed, it should encourage) private judicial mechanisms and institutions that serve to enforce good conduct. In a number of cases, out-ofcourt procedures have been successfully employed to govern corporate restructuring processes (Claessens, 1998).

# **11.3.4 Signaling reputational capital: the role of information**

In a competitive environment, good-quality information on financial intermediaries can stimulate investment in reputational capital as it increases the franchise of intermnediaries who achieve higher reputational standards. In the trust-related context developed above, information is the vehicle that conveys to the market knowledge about the reputational capital of individual intermediaries. A critical component of financial sector reform is thus the improvement of the information generation and dissemination process. The government can help a private market for information to develop.

Provided that financial institutions invest in reputational capital and investors optimize their risk/return combinations, there are incentives for information to be searched and supplied by specialized agents.<sup>32</sup> On the demand side, sensitivity to capital losses motivates investors to use 22
information to select well-reputed financial intermediaries. Govermnent should exploit this sensitivity to design market devices for raising information demand (see section 11.3.4). For example, where there is a subordinated debt requirement for banks, healthy banks have an incentive to reveal their true reputational capital status so that subordinated-debt holders facing aggregate shocks, and otherwise unable to discriminate good from bad banks, do not indiscriminately sell their holdings.

Market demand for information, in turn, prompts intermediaries seeking to enhance their reputation to provide reliable information. Increasing extended dealings may strengthen this incentive, as intermediaries with large reputational capital seeks to exploit extended dealings by disclosing more information to their clientele (Hellmann _et'al.,_ 1995). One way of doing this is by allowing intermediaries to operate across a broad range of market and maturity segments, since reputational capital in one segment affects their franchise in the others. This increases the franchise of well-reputed intermediaries and give them an incentive to act prudently and honestly in the new segments.

The demand and supply factors for information induce agents to specialize in information provision. Examples are credit bureaus, rating agencies, and securities underwriters. Credit bureaus, for instance, improves the signal from borrowers' reputational capital and increases lending volumes to safe borrowers that would otherwise be priced out of the market due to adverse selection (Jappelli and Pagano, 1991). Matching or referral services - such as the wellknown accreditation schemes in the US health sector - could be provided by private agents to inform clients about quality, terms, and conditions of services from individual intermediaries. Financial referral services could rely on information disseminated by agencies or on information made available by the intermediaries themselves, as well as on clients' evaluations, opinions and satisfaction rating reports. Referral services would supply a channel for intermediaries to advertise their reputational capital to potential clients on the basis of tested and verifiable information." Providers of customized information might operate for a profit and sell specialized reports. If information is proprietary, its production can be profitable. Providers of uniform information might otherwise organize themselves as _consumer unions_ or _producer cooperatives_ and be remunerated by their respective communities (Klein, 1997). In the case of credit bureaus, increasing returns associated with additional participating banks tend to make the systems operate as natural monopolies (Jappelli and Pagano, cit.); in this case, they might organize themselves as SROs.

Government can support information provision in direct ways. It could subsidize one or a few private enterprises until a market takes off. Through SROs, government could induce private23
sector financial intermediaries to set up information services for their mutual benefit and for clients. Government could initially provide information services directly, as in the case of the Central de Deudores in Argentina, and later let the private sector take over (Calomiris, 1997; World Bank, 1998). Government could also provide infrastructure that would ease the flow of private information. It could disseminate information on bank credit risk collected in its banking supervisory capacity and establish a centralized registry for collateral.34

# **11.3.5 Signaling reputational capital: the role of private risk-takers**

As noted, sensitivity to capital losses motivates investors to use information to select wellreputed financial intermediaries. In the banking sector, deposit insurance schemes could be designed so as to induce much closer attention from (both large and small) depositors on the true status of their banks.<sup>35</sup> This would be achieved, for instance, if insurance premiums were correlated with bank risks and made known to depositors, since a higher premium would indicate a lower reputational capital. Such an incentive would be further strengthened if the insurance was provided by competing private insurers, as these would seek to correlate premiums with risks as closely as possible and thus generate a strong demand for good-quality information from banks. Similarly, limited insurance coverage would likely induce depositors to assess more carefully their banks. Another strong incentive would hold if depositors were asked to co-pay insurance premniums correlated with bank risks, and if premiums were to vary with the extent of insurance coverage purchased.

Another market-based signaling device for reputational capital would be provided by requiring intermediaries to finance a small portion of their non-reserve assets with subordinated debt (uninsured certificates of deposits) bearing an interest rate not greater than the riskless rate plus a given spread and held by _well-informed_ market agents (Keehn, 1989; Wall, 1989; Calomiris, 1997). Subordinate-debt holders would have an incentive to monitor debtors' compliance with the risk-cap requirement and to sell at discount the debt of under-performing institutions. This device would supply the market with reliable signals on the intermediaries' reputational capital, provided there was a liquid secondary market for the subordinated debt and that the debt-issue requirement was credible and effective in the first place3<sup>6</sup> 24