The Concept of Trust, Social Preferences and Fairness in Corporate Finance - Free Essay Example

Sample details Pages: 9 Words: 2702 Downloads: 2 Date added: 2017/06/26 Category Finance Essay Type Compare and contrast essay Did you like this example? This essay examines the concept of trust, social preferences and fairness in corporate finance and then explores and discusses their respective importance in the financial markets. Ernest Hemingway famously quoted that à ¢Ã¢â€š ¬Ã…“the best way to find out if you can trust somebody is to trust them.à ¢Ã¢â€š ¬Ã‚  The role of trust has become paramount in financial markets due to their increasing complexity, and especially because of the escalating use of electronic communication within them, which has made exchanges more estranged and depersonalised. The concept of trust has often been credited for providing significant insights into the transactions and conduct that are found in financial markets. Don’t waste time! Our writers will create an original "The Concept of Trust, Social Preferences and Fairness in Corporate Finance" essay for you Create order It is however important to first understand the meaning of the term à ¢Ã¢â€š ¬Ã‹Å"trustà ¢Ã¢â€š ¬Ã¢â€ž ¢, in order to carry out a meaningful analysis of its salience in these markets. The dictionary definition of the word is à ¢Ã¢â€š ¬Ã‹Å"a firm belief in the reliability, truth, or ability of someone or somethingà ¢Ã¢â€š ¬Ã¢â€ž ¢ or à ¢Ã¢â€š ¬Ã‹Å"a reasonable belief that people will tell the truth, and keep their promisesà ¢Ã¢â€š ¬Ã¢â€ž ¢. A particularly relevant definition of trust is à ¢Ã¢â€š ¬Ã‹Å"faith or confidence in the loyalty, strength and veracity of a person or thing, without examinationà ¢Ã¢â€š ¬Ã¢â€ž ¢. This definition demonstrates the connection between trust and confidence and is therefore significant, since more often than not; collapses in confidence in financial markets are largely attributed to breakdowns in trust (Tomasic and Akinbami, 2011). Another relevant concept of trust that is pertinent is the definition which was later examined experimentally in the trust game experiment, by Bacharach and Gambetta (2001) and Ermish and Gambetta (2006). The financial system being a series of interlocking markets requires trust within them and between firms and consumers to operate effectively and efficiently. Trust instils a feeling of belief that the relationship with the corporation will be predictable, reliable, and consistent in meeting the necessary needs and requirements (CoveyLink Worldwide, 2006). It is crucial to the health of the economy and the financial landscape because it provides investors with a fairly easy and inexpensive way to make decisions. Banking and finance scholars, such as Gray and Hamilton have asserted that emotions such as trust and confidence have significant influences on decision making, because evaluating the vast array of information and risks associated with complex and uncertain financial services products is difficult for consumers. Thereby, in reality, investors and consumers use trust as some sort of a heuristic, relying on it to fill information gaps. It is therefore imperative that due attention be paid upon it to help investors to continue investing in financial products and services, and securities. Guiso and Sapienza et al. (2008) explicitly addressed everyday investment activity in terms of trust in the stock market by saying à ¢Ã¢â€š ¬Ã…“The decision to invest in stocks requires not only an assessment of the risk-return trade off given the existing data, but also an act of faith (trust) that the data in our possession is reliable and the overall system is fair.à ¢Ã¢â€š ¬Ã‚  Trust therefore is important not only in commercial relationships, but is relevant in both retail financial and wholesale markets. Quigley (2007) emphasized the critical role of trust, stating, à ¢Ã¢â€š ¬Ã…“Without trust and confidence, markets do not function and value is destroyedà ¢Ã¢â€š ¬Ã‚ . It has been observed in the past that key components of financial markets such as transparency, investor confidence, liquidity and uncertainty, are largely based and dependent on trust and when financial institutions engage in trust abuse, these very components are severely eroded. This was particularly highlighted during the global financial crisis wherein when confidence (trust) declined, the abovementioned important foundations receded, thereby eventually weakening the financial market. The collapse of Northern Rock in 2007 serves as a stark illustration of why trust is instrumental and how its disappearance can have a detrimental effect on financial markets. Furthermore, breakdowns of trust between the members of a firm, and between a firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s relationships with other firms through self-dealing and abuse can have a damaging impact as strongly illustrated by the infamous collapse of Lehman Brothers in 2008 and in Goldman Sachsà ¢Ã¢â€š ¬Ã¢â€ž ¢ role in the ABACUS scandal in 2007. Stakeholders such as shareholders, creditors and employees trust the senior m anagement of the firm to run it in their best long term interest; the drawback however of strong relations of trust is the high dependency of one party on another that it entails. The use of creative accounting represents an impact of the abuse of this trust, most noticeably demonstrated by the managers of Enron that ultimately contributed to its downfall. Such esoteric accounting treatments conceal short-comings in corporate performance and could be used to fundamentally mislead the market, and raise doubts about the reliability of financial report. Moreover, the so called à ¢Ã¢â€š ¬Ã‹Å"Agency problemà ¢Ã¢â€š ¬Ã¢â€ž ¢ highlights the need and importance of trust between the internal members of a firm, as exhibited in the case of Lehman Brothers wherein the management failed the trust placed on them by their shareholders, thereby leading to its inevitable collapse. For financial markets to operate smoothly, trust between consumers and their agents, between consumers and intermed iaries, and between consumers and the market are undoubtedly required (Social market foundation, 2011). Trust, through the assumption that others will behave similarly according to common norms of economic conduct, instils a belief in a person that their counterpart in a transaction will not take advantage of them and this is an important aspect in the wider social context in which financial organisations operate. It is thus a necessity amongst the diverse professionals and organisations that constitute the market, and promotes economic efficiency in instrumental terms and reduces the transaction costs of economic exchange. Although trust is normally ignored in standard economic models, the existence of trust amongst those who operate within financial markets and the financial markets as a whole, is of prime importance. It is presumably ignored in the standard models due to the supposition that external law and order parties can effectively protect the interests of contracting parti es from fraud and abuses of trust. Companies that inculcate values such as integrity, trust and transparency outperform other firms by a wide margin in terms of growth in stock price and profitability (Kouzes and Posner, 2002). Moreover, à ¢Ã¢â€š ¬Ã‹Å"transparency paysà ¢Ã¢â€š ¬Ã¢â€ž ¢, as declared by Robert Eccles (2001). Divulging essential information has proven invaluable to companies as it lowers the cost of capital and poses less risk for investors. They are perceived by the public to be more honest as providing accurate information helps the investors in making informed decisions. Deliberately withholding information that is a requisite to making these decisions can create a sense of mistrust and thereby seriously damage a corporations potential to improve business performance within the financial markets. High profile debacles of financial shenanigans, such as Enron and Tyco demonstrated the negative effects of complex business structures and dispensing fallacious finan cial information. The integrity of markets therefore largely depends on market participants being honest and open with each other. According to Tonkiss (2009), à ¢Ã¢â€š ¬Ã…“Trust leads a double life as both a social value and an economic resource; as such, it is a critical concept for linking social arrangements with economic outcomes.à ¢Ã¢â€š ¬Ã‚  The conservative view of contractarianism states that corporations are a à ¢Ã¢â€š ¬Ã‹Å"web of implicit and explicit contracts,à ¢Ã¢â€š ¬Ã¢â€ž ¢ with established rights and obligations amongst the firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s many stakeholders which includes investors, creditors and the management. Participants upholding this view generally disregard values such as trust, ethics and fiduciary duties. On the other hand, progressive scholars state that trust is predominantly important within firms and the stakeholders do not necessarily behave in a strictly individualistic and selfish manner, as is often implied by other economic models . Additionally, they believe that economic relationships are also social relationships that look beyond just the pursuit of self-interest and in fact, require a certain degree of trust to flourish in the first place. This arguably applies to the associations between different entities in the financial markets and raises doubts as to whether financial markets are merely contract-based markets or if they have a social character, and whether some financial market participants should have à ¢Ã¢â€š ¬Ã‹Å"other-regardingà ¢Ã¢â€š ¬Ã¢â€ž ¢ duties such as fiduciary duties imposed upon them. The traditional description of à ¢Ã¢â€š ¬Ã‹Å"homo economicusà ¢Ã¢â€š ¬Ã¢â€ž ¢, as the perpetual pursuit of self-interest may not strictly apply in financial markets because the trustees could anticipate additional and institutional benefits from behaving a certain way or making a particular business decision. By expecting the other party to act correspondingly and by upholding the interests of others, they may derive benefit from their seemingly altruistic behaviour. This brings us to the importance of social preferences or à ¢Ã¢â€š ¬Ã‹Å"other-regardingà ¢Ã¢â€š ¬Ã¢â€ž ¢ duties in financial markets. Social preferences or à ¢Ã¢â€š ¬Ã‹Å"other-regardingà ¢Ã¢â€š ¬Ã¢â€ž ¢ duties are a type of preference including trust, fairness, reciprocity and empathy, and are studied in behavioural and experimental economics and social psychology, through economics experiments. Folk wisdom in behavioural economics depicts that in competitive markets, social preferences are of no importance. The standard neoclassical model is built on the assumption that all economic agents are only interested in their own material well-being. Many experiments, starting with Smith (1962, 1964) and later confirmed by Fehr and Schmidt (1999) and Dufwenberg et al. (2008) have shown that the standard neoclassical model holds true and that due to the presence of competition, all market participants behave as if the y are purely self-interested. These authors maintain that even though the standard model is unfair and distributes almost the entire surplus to one side of the market, the classic model predicts market outcomes quite well. Dufwenberg et al. (2008) through a general equilibrium model that allowed for a large class of social preferences identified necessary and sufficient conditions on preferences, which they termed à ¢Ã¢â€š ¬Ã…“separabilityà ¢Ã¢â€š ¬Ã‚ , which further strengthened their belief in the à ¢Ã¢â€š ¬Ã…“classicalà ¢Ã¢â€š ¬Ã‚  theory; participants with social preferences behave as if they were purely self-interested. However, in contrast, there is also a large body of mounting experimental and field evidence showing that many people are not purely self-interested and that their behaviour is affected by caring about the well-being of others (Ledyard 1995, Fehr and GÃÆ' ¤chter 2000, Karlan 2005, Egas and Riedl 2008, Falk and Heckman 2009). Such social (aka othe r-regarding) preferences constitute a profound deviation from the standard neoclassical homo economicus assumption and also show that people are heterogeneous; some care a lot about other peopleà ¢Ã¢â€š ¬Ã¢â€ž ¢s payoffs while others care very little. The findings by these authors imply that people have been found to promote fairness and care about the welfare of other people by willing to sacrifice their own resources. This behaviour has been termed à ¢Ã¢â€š ¬Ã…“social preferencesà ¢Ã¢â€š ¬Ã‚  or à ¢Ã¢â€š ¬Ã…“other-regarding preferencesà ¢Ã¢â€š ¬Ã‚  in the behavioural literature. It has through experiments shown that many people do not only care about their own material well-being, but are also concerned about the payoffs of other people they interact with. Despite the cited evidence, the standard neoclassical assumption is still prevalent in the finance literature. Guth el al. (1982) introduced the first and probably most famous experiment on social preferences, term ed as the ultimatum game. Many other experiments ensued in which observed behaviours were inconsistent with the self-interest assumption. For example, in public good games many people deviate from the dominant strategy of free-riding and voluntary contribute to the public good (Ledyard 1995). Furthermore, if given the opportunity, they are willing to punish non-contributors even if this is costly to themselves (Fehr and GÃÆ' ¤chter, 2000). In gift exchange games subjects in the role of workers provide higher effort than contractually enforceable if their employers offer generous wages (Fehr et al. 1993). Thus, experimental evidence does suggest that many subjects are willing to give up some resources to help others. While many subjects in such experiments are willing to spend resources to achieve a fair allocation or to reciprocate kind or unkind behaviour, there are also many subjects who behave very selfishly. To understand the outcomes of these experiments it is necessary to a cknowledge the heterogeneity of social preferences and to study the interaction of fair-minded and self-interested subjects (Fehr and Schmidt 1999, Fehr, Klein and Schmidt 2007). Furthermore, experimental studies such as Brown et al. (2004,2008) showed that the role of social preferences is magnified when parties interact repeatedly and form relational contracts or if they interact once but can acquire a reputation for fair or trustworthy behaviour (Bartling et al. 2009). These findings cannot be explained by the standard neoclassical model but they are consistent with the models of social preferences discussed above. Social preferences are important because they can be used as an alternative to performance based incentive schemes and in fact, they are consistent with many of the frequently observed anomalies in financial markets. They give rise to externalities that will not be internalized if each agent chooses a consumption bundle that maximizes their internal utility. A fe w papers have also shown that socially responsible investments may sometimes perform financially better or not worse than conventional investments (Derwall et al. 2005; Kempf and Osthoff, 2007; Edmans, 2011). Social preferences might be important in many other strategic situations as well and therefore the results of such experiments have broad implications for economists and non-economists alike. They may give rise to herding, multiple equilibria and to booms and busts on asset markets. Herding is an optimal strategy if investors have social preferences and gives rise to multiple asset market equilibria. Even if all market participants behave optimally and have rational expectations, these effects can be used to elucidate time varying risk premia, stock market bubbles and crashes Gebhardt (2002, 2004). Despite these advances and the topicà ¢Ã¢â€š ¬Ã¢â€ž ¢s importance, it is fair to say that little is known about whether, and to what extent, social preferences influence economic ou tcomes in financial markets. A standard argument against the importance of social preferences in finance and economics is that they are driven out in the market place (Levitt and List 2007, List 2009). The regulation of financial markets is however is shaped not only by considerations such as beyond trust, efficiency or self-interest; they also include concern for ethics and fairness (Shefrin and Statman, 1993). The view that fairness concerns and adequate punishment of unfair behaviour are an expression of preferences has been proved to be consistent by Neuro-scientific studies. Fairness is an equally important consideration in financial markets, particularly signified by the Dodd-Frank Wall Street Reform and Consumer Protection Act in which the words à ¢Ã¢â€š ¬Ã‹Å"fairà ¢Ã¢â€š ¬Ã¢â€ž ¢, à ¢Ã¢â€š ¬Ã‹Å"unfairà ¢Ã¢â€š ¬Ã¢â€ž ¢ or à ¢Ã¢â€š ¬Ã‹Å"fairnessà ¢Ã¢â€š ¬Ã¢â€ž ¢ were mentioned a hundred and thirty times. The dictionary meaning of fairness is à ¢Ã¢â€š ¬Ã‹Å"the stat e, condition, or quality of being fair, or free form bias or injustice. Although the words à ¢Ã¢â€š ¬Ã…“fairà ¢Ã¢â€š ¬Ã‚  and à ¢Ã¢â€š ¬Ã…“fairnessà ¢Ã¢â€š ¬Ã‚  can mean a variety of different things in different contexts, there are two common themes in most discussions of fairness. The first being procedural fairness i.e. equal rules apply to all participants while the second one is distributive fairness; it examines the outputs rather than the inputs and is concerned with the equality of outcomes. The à ¢Ã¢â€š ¬Ã‹Å"inequality of endowmentsà ¢Ã¢â€š ¬Ã¢â€ž ¢ has always been an integral problem in financial markets since some investors start with more resources and investments than others, and therefore generate a competitive advantage from the very beginning. Procedural fairness thus can be viewed from the perspective of equal opportunities for all, wherein all market participants are treated alike. Important analysis however has shown that distributive fairness has a la rger influence on consumersà ¢Ã¢â€š ¬Ã¢â€ž ¢ evaluations of overall fairness, being over four times as important as any other element of fairness (The Financial Services Research Forum, 2012). Shefrin and Statman (1999) identified seven dimensions of fairness in financial markets and viewed fairness as a à ¢Ã¢â€š ¬Ã…“claim to entitlementsà ¢Ã¢â€š ¬Ã‚ . The various dimensions namely being: Freedom from coercion. Freedom from misrepresentation. Equal information. Equal processing power Freedom from impulse. Efficient prices Equal bargaining power References: Adler, P. S. 2001. Market, hierarchy, and trust: the knowledge economy and the future of capitalism.Organization science, 12 (2), pp. 215234. Corsetti, G., Devereux, M. P., Guiso, L., Hassler, J., Saint-Paul, G., Sinn, H., Sturm, J. and Vives, X. 2010. A trust-driven financial crisis.EEAG Report on the European Economy, pp. 5370. Duggar, J. W. 2009. The role of integrity in individual and effective corporate leadership.Journal of Academic Business Ethics, 3. Mayer, C. 2008. Trust in financial markets.European Financial Management, 14 (4), pp. 617632. Mcclure, B. 2014.The Importance Of Corporate Transparency. [online] Available at: https://www.investopedia.com/articles/fundamental/03/121703.asp [Accessed: 6 Mar 2014]. Shefrin, H. and Statman, M. 1993. Ethics, fairness and efficiency in financial markets.Financial Analysts Journal, pp. 2129. Tomasic, R. and Akinbami, F. 2011. The role of trust in maintaining the resilience of financial markets.Journal of Corporate Law Studies, 11 (2). Tonkiss, F. 2009. Trust, confidence and economic crisis.Intereconomics, 44 (4), pp. 196202.