The Death of Trust Across the Finance Industry

Courtesy of Peter Limbach, P. Raghavendra Rau, and Henrik Schürmann

The financial sector plays a crucial role in a country’s economic development. For example, better developed financial systems are associated with faster economic growth, increased levels of technological innovation, and reduced poverty. A well-functioning financial system depends on the reliability of contracts and contractors. This reliability can be achieved through explicit mechanisms, particularly formal regulation by the government, and by implicit incentives, such as social norms prevailing in a society or a class. Understanding the evolution of trust among finance professionals is therefore relevant not only for financial institutions and their clients, but also for regulators and policymakers.

Despite the erosion of trust in American society in general,  little is known about the evolution of trust across finance professionals. In our study, we show how implicit incentives have gradually evolved in the finance industry. Using data from a representative U.S. survey spanning over four decades, we examine the time trend in generalized trust, i.e., trust in anonymous others, that exists across finance professionals.

We uncover three novel empirical findings on the evolution of the trust trend. First, we show that generalized trust of professionals working in the finance industry has declined substantially over the last four decades. Notably, the level of trust of finance professionals has not only declined in absolute terms, but also relative to the general U.S. population. Simply put, while generalized trust has declined in U.S. society as whole, it has declined significantly more across finance professionals. This relative decline in trust is unique to finance. Second, we find that the relative decline in trust is particularly strong in the investment sector and among professionals with higher seniority, i.e., those who set the tone. Third, we find evidence for several channels, particularly changes in economic conditions, professional environments, and the level of socialization, that are related to and may potentially explain the significant decline of trust across finance professionals.

Why does the level of generalized trust in the finance industry matter?

Generalized trust, which is the trust that people have toward a random member of an identifiable group, is vital in any economic activity. Virtually every commercial transaction has within itself an element of trust. Trust is also crucial for interactions between unfamiliar people, which are common in financial markets. Economists have argued that generalized trust and other forms of social capital facilitate economic activities because they discourage opportunistic behavior and increase people’s willingness to cooperate. Importantly, people who trust more also tend to act more trustworthily.  The level of generalized trust is essential in the finance industry because financial products are complex, and conflicts of interest are common. While the finance industry provides services that most people need, only a few understand the services resulting in a level of information asymmetry between finance professionals and clients that is higher than in most other industries. Consequently, in the finance industry, clients are more dependent on the knowledge and expertise of finance professionals and trust.

Furthermore, the U.S. financial sector has experienced almost half a century of deregulation, which makes the role of trust even more significant. Both theoretical and empirical studies suggest that when formal regulation and governance are less established or efficient, generalized trust is more valuable, providing a substitute for formal regulation by discouraging opportunistic behavior. It is thus plausible that a simultaneous decline of generalized trust and regulation may lead to adverse outcomes for both consumers and society.

Generalized trust is an implicit mechanism that guides the behavior of finance professionals, mitigates clients’ risk of being expropriated, and serves as a protection against financial fraud. It is thus fundamental to explore how trust and other forms of ethical behavior form in the finance industry.

Methods and findings

In this study, we investigate the time trends in generalized trust of individuals working in the finance industry relative to the general U.S. population using data from the General Social Survey (GSS). We use survey responses from 25 cross-sectional waves spanning 39 years (covering about 1,500 respondents each year from 1978 through 1993 and around 2,800 respondents every second year from 1994 through 2016) to the question: “Generally speaking, would you say that most people can be trusted or that you can’t be too careful in dealing with people?” This measure of generalized trust is a valid predictor for individuals’ actual level of trust.

We demonstrate that the level of generalized trust of professionals working in the finance industry has declined substantially over the last almost four decades, both in absolute and relative terms to the general U.S. population. Across all industries covered by the GSS, the relative decline in trust is unparalleled and is unique to finance. Other industries that are also heavily dependent on trust,  such as healthcare, legal services, or the tech industry, do not experience such a decline in generalized trust. This decline in trust is even stronger in the investment sector and for finance professionals working in top hierarchy levels who generally strive to “set the tone” of an ethical work culture.

We examine three non-mutually exclusive explanations for the relative decline in generalized trust – changes in general economic conditions, selection, and socialization. The first hypothesis argues that disparities in economic conditions have differential effects on finance professionals. The selection hypothesis argues that the type of individuals entering the finance industry has changed over time and that the change in workforce composition affects individuals’ levels of trust. The socialization hypothesis argues that changes in the style of working in the finance industry over time have led to fewer opportunities for human interactions, which, in turn, made the formation of generalized trust more difficult.

We find support for all three hypotheses. Supporting the first hypothesis, proxies for economic conditions in the U.S. are disproportionally strongly correlated with trust among finance professionals than for the average American. Supporting the second, the share of highly educated finance professionals has grown disproportionally, while the share of female workers has declined disproportionally relative to trends in the general U.S. population. We show that a larger fraction of highly educated workers, a more ethnically diverse workforce, larger income inequality in the finance industry, and a lower share of females in finance are all correlated with lower levels of trust. Consistent with the third hypothesis, the generation of social capital through social activities has become rarer for finance professionals than for the U.S. population. Individuals in finance work more hours and are less likely to participate in social groups than they used to.

Our work contributes to the ongoing debate on ethics and misbehavior in the finance industry. Our study supports the view of Luigi Zingales who argues that without proper rules, finance can easily degenerate into a rent-seeking activity. Specifically, the evidence we provide suggests that trust, i.e., implicit contracts, among people, has significantly declined, which can make proper explicit rules necessary. One potential consequence of this decline in trust is the evolution of disruptive technologies such as blockchains that eliminate the need for trust in finance.

Our study also has implications for the effectiveness of bailout programs that governments around the world tend to enact during crises, including the recent coronavirus bailouts. A lack of generalized trust across finance professionals can complicate government efforts to implement credit programs and other measures to combat crises. Participants in the financial system, like banks, need to trust the actions taken by central banks or governments in order for them to react appropriately by extending credit to the rest of the economy. This is also relevant for the coronavirus bailouts as governments are typically providing aid with few mandatory requirements, which raises the need for implicit regulatory mechanisms like trust. If banks do not react to government stimulus by relaxing credit constraints appropriately, a lack of trust can have direct consequences on the real economy. The public response to the Paycheck Protection Program is a case in point. Designed to get needed funds to struggling small businesses, who do not have to pay it back provided they keep employees on the payroll, the program became mired in controversy over perceptions that banks were favoring their largest customers. Thus, the program has become another data point in the slow decline in f