Trust and finance.

• Author: Sapienza, Paola

In recent years, economists have become increasingly interested in studying how specific institutions and norms affect economic behavior and economic performance. One part of our research, developed with Luigi Guiso, examines the interactions between a small but important subset of norms and institutions: trust and civic capital. This research also explores the effects of these factors on economic outcomes, such as economic growth.

Trust, Social Capital, and Financial Development

Our first contribution in this area introduces the concept of trust into financial economics. One paper investigates how social norms affect financial development. (1) The term "social capital" has been widely used in the social sciences outside of economics and is defined as "features of social life--networks, norms, trust, that enable participants of a given community to act together to pursue shared objectives." (2) As such, a community's level of social capital may affect economic efficiency by enhancing the level of trust among economic agents belonging to the group--here trust is defined as "a particular level of the subjective probability with which an agent assesses that another agent or group of agents will perform a particular action." (3) This concept is foreign in traditional finance, because the prevailing paradigm is based on common knowledge, homogenous beliefs, and, very often, representative agents.

Because financial contracts require trust, differential levels of social capital may have important consequences for the way that financial markets develop. Financing is nothing but an exchange of a sum of money today for a promise to return more money in the future. Whether such an exchange can take place depends not only on the legal enforceability of contracts but also on the extent to which the financier trusts the financee. In relational contracts, what matters is personalized trust--that is, the mutual trust that people develop through repeated interactions. For the development of anonymous markets, though, what matters is generalized trust: the trust that people have in a random member of an identifiable group. Sociological research shows that areas where social capital is greater have higher generalized trust and, thus, are more likely to develop financial relations.

In "The Role of Social Capital in Financial Development" we study this empirical prediction for a variety of households' financial choices: portfolio allocation, use of checks, availability of loans, and reliance on informal lending. Consistent with social capital being important, the results show that in areas characterized by high levels of social capital, households invest a smaller proportion of their financial wealth in cash and a bigger proportion in stock. In areas with a great deal of social capital, households also are more likely to use personal checks and to obtain credit when they seek it. The effect of social capital is stronger when legal enforcement is weaker and is more pronounced among less-educated people, who need to rely more on trust because of their limited understanding of contracting mechanisms. These results have real implications for developing countries where education levels tend to be low and law enforcement is weak. Whether trust is simply an equilibrium outcome of a society in which non-legal mechanisms force people to behave...