Trusting Risk

"How does trust affect the operational risk of agents in financial markets?"

Financial markets typically postulate the orthodox economics of a rational choice theory and optimal individual maximization as most efficient. In this paper I suggest trust provides a wider and deeper motivation for economic action. Operational risk is a subset of the total risks facing economic agents in financial markets. I examine the interaction of trust and operational risk in a number of contexts and arrive at the suggestion trust can affect operational risk in a way not wholly explainable by theories of pure rational choice or individual maximization alone.

The thesis that risk assessment itself is inherently risky is nowhere better borne out than in the area of high-consequence risks. (Giddens, 1991 p122) In an era of global financial markets operating continuously, dealing in monetary amounts orders of magnitude bigger than a decade ago and between loosely bonded agents the probability of contagion from institutional failure is growing. The theoretical interest in risk management is driven by the need to ameliorate just such a crisis. Three major risks face agents in financial markets are market risk, credit risk and operational risk. The Basel Committee on Banking Supervision of the Bank for International Settlements defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems. (DM Review, 2003). Important types of operational risks include fraud and mismanagement such as dealers, lending officers and other staff exceeding their authority or conducting business in an unscrupulous or perilous manner. (DM Review, 2003).

Operational risk within the banking industry is an area of operational risk where the potential losses are high and the actual losses can be difficult to measure. (Walker, 2001 p252) Examples include rogue trading where the potential losses can be extremely high and may not be discovered until it is too late to do anything about them and the situation where the large number of discretionary fees applied to clients allow significant scope for fraud. (Walker, 2001 p253) Banks conduct large numbers of foreign exchange transactions 95% of which are speculative. In this environment, the human factor plays a major role. Banks represent the major proponents of individual maximization and rational choice theory. They are the most in favour of free markets as the most efficient allocaturs of risk and return. They are also the bastion of the econometric approach to managing risk. Basel II is the Accord on capital adequacy due to be introduced by BIS through the BCBS from the end of 2006. This Accord recommends the setting aside of a fixed proportion of capital to cover the cost of operational risk. Are there cheaper alternatives? I will explore some definitions and applications of trust in various contexts and seek to apply these notions to operational risk.

Trust can be described as a particular level of subjective probability with which an agent can assess that another agent will perform a particular action (Gambetta, 1988 in Misztal, 1996 p82). This assumes agents are likely to behave rationally and that trust provides the best strategy for behaving co-operatively. (Misztal, 1996 p85). There is a strong emphasis placed on the incremental nature of the building of trust. (Misztal, 1996 p85). This process needs time and the experience of numerous transactions (Misztal, 1996 p84) This definition accepts trust as a synonym with rational expectations (Ostrom, 1990 in Misztal, 1996 p85) but then goes on to view people as fallible and norm-adapting, and pursuing contingent strategies in complex and uncertain environments. (Ostrom, 1990 in Misztal, 1996 p85) This view expects individuals to make a commitment to rules which describe their mutual rights and obligations which are developed internally in the process of interactions. (Ostrom, 1990 in Misztal, 1996 p85) Trust relationships then monitor and sanction such rules and obligations. This could explain the relationships between the semi-autonomous specialists found on the floor of the NYSE. (Abolafia, 1996 Ch 5). But would not address the informational asymmetries exploited by the hyper-rational bond traders screen trading for large institutions. (Abolafia, 1996 Ch 1).

A distinction needs to be made between the information available to traders within an institution and between institutions. Traders use the institutions sales force, economists and technology to form views on the fundamental value of the bonds they trade. This information is constantly updated and forms the base from which the traders build positions in the market. A certain amount of trust in the judgement and efficiency of the providers of this information is necessary. On the other hand institutional customers are frequently offered incomplete information and their ignorance is often taken advantage of. (Abolafia, 1996 p20). This leads to a culture of mistrust. The customers, such as mutual funds and insurance companies, frequently need to seek information from four or five firms before transacting. (Abolafia, 1996 p20). Furthermore traders not only conceal information, they frequently distort it. (Abolafia, 1996 p20). Showing bids, using the semi-anonymity of screen based trading, to post a higher bid then withdrawing it, the trader hopes others will buy from a third and then attempt to sell in a quick exchange. This sometimes means selling at a loss. (Abolafia, 1996 p21). This is certainly a breach of trust but not illegal. Front running and trading insider information are illegal. Buying a parcel of bonds, marking them up in price and then reselling them to a customer on the certain fore-knowledge the customer is about to purchase is front running. Using information about the economic condition or intentions of a bond issuer not available to the rest of the market is insider trading (Abolafia, 1996 p21). Both are common in financial markets because of the difficulty of detection and add to the culture of distrust.

To what extant is distrust bred by the mere effort to regulate and is there an irresolvable conflict between regulation and trust? (Cvetkovich & Lofstedt, 1999 p166) The argument implies the less regulation the more likely trusting relationships will be built. Some anecdotal evidence suggests the socialization of traders to the unwritten scripts of trustworthy behaviour in bond markets broke down during the period of deregulation in the 1980’s. (Abolafia, 1996 p21). Every time an example of fraud comes to light institutions and regulators seek to institute new systems to guard against the possibility of re-occurrence. This has resulted in a struggle between the proponents of ‘free’ markets who insist institutions should be allowed to fail and those who see the interconnectedness of these institutions and the consequent risk of contagion too high to be left unregulated. In practice there has developed a dual approach. Some institutions are allowed to go under (Barings after Nick Leeson) and Long Term Capital Management which was re-capitalized. The difference appears to revolve around not just the size of the institution but the way the losses were incurred. If the cause was mismanagement or ‘bad luck’ rather than fraud the institutions are thrown a lifeline.

The Nick Leeson and Barings story is a classic tale of operational risk and the breakdown of trust. After some experience of back office management Leeson was allowed to manage the back office and undertake trading in derivatives in the Singapore office of Barings Bank. From the first he set up and ran a false account to hide his losses and other accounts to declare his gains to head office in London. (Risk Glossary.com 2004). At his trial he defended himself by stating his superiors knew what he was doing. They trusted him on the basis of his previous good conduct. An example of the incremental building of trust discussed above. Almost from his first trade he lost money. (Risk Glossary.com 2004). In a classic example of prospect theory (Tversky and Kahneman, 1981) he began to chase his losses. He doubled his bets in a Martingale until he held half the open interest in the Nikkei 200 futures contract and 85% of the open interest in the Japanese Government Bond futures contracts – a total of GBP 827 million. (Risk Glossary.com 2004). Of course other traders knew somebody was out there accumulating these positions. Derivatives are a zero sum game and all the money he lost was transferred to others. Subsequently every institution trading derivatives made the activities of the back office operationally separate from the traders which introduced a level of intra firm regulation that did not allow for the sort of trust that had cost Barings its economic life. I would argue this example suggests there is an irresolvable conflict between the urge to regulate and trust. I would also suggest the irrationality of Leesons’ trades indicated to risk managers and other traders he had ceased to be committed to the rules of his institution which described their mutual rights and obligations and instead was pursuing a contingent strategy at odds with the rational expectations of his employers.

Social ties, notably kith, kin and co-ethnics, increase trust and trustworthiness, and thus mitigate breach of agreement. (Salter 2002 p279) Landa (1994 p101) suggests this is particularly true in traditional markets as a way of coping with contract uncertainty. She expects the exchange networks based on mutual trust to be replaced by impersonal exchange networks based on contract as an economy develops legal infrastructure. Landa (1994 p113). This implies family firms are limited in scale and lack complexity. This generalization is challenged by Wong who found in many settings large business groups are controlled by one or two families. (Wong, 1985 in Smelser and Swedberg, 1994 p463) Whatever the size of institutions, certain results from the usage of trust are common to all, including the reduction of transaction costs. I include the reduction of the hedging premium or insurance cost associated with operational risk in this definition of transaction costs.

The lower transaction costs associated with searches within ethnic boundaries has two characteristics. Members of the same ethnic community are perceived to be more trustworthy (Landa, 1994 p111). Second it is easier to acquire more information from the network of mutual aid associations within the same community. (Landa, 1994 p111). This trust can be characterised as transitive trust because to trust one business partner is to trust her business partner. (Landa, 1994 p111). This builds an expanding network of initially strong but then progressively weaker ties all bound together by trust. (Granovetter, 1974). If Landa is right and impersonal exchange networks based on contract replace ethnic networks based on trust, then these agents should look forward to an increase in transaction costs, including operational risk, without any increase in efficiency.

Until then, ethnic networks based on trust provide a good example of the definitions outlined above. These individuals make a commitment to rules which describe their mutual rights and obligations which are developed internally in the process of incremental interactions. The relationships are then monitored and sanctioned. In the complex and uncertain environments of minorities doing business within larger economic systems these rational agents build deeper and wider behaviours that mitigate operational risks and the costs involved.

McKean conjectures it would be extremely expensive to contractualize every aspect of an agreement. (McKean, 1975 p31). In fact the financial markets should not be included in this generalization. The over-the-counter market for financial instruments is much larger than the exchange traded markets with notional values of derivatives alone being US$128 trillion at the end of 2002. (Beyer, 2003) In these markets the International Swaps and Derivatives Association has developed and distributes to its members a standardised contract. Trades are executed over the phone with the voice recording being the evidence of the offer and acceptance of the contract. Consideration passes at the settlement which is typically by 10 am the following day. Exchange traded markets use a clearing house which forms a novated contract between the parties. There has not been a clearing house fail in the more than 100 years of futures and options trading (Beyer, 2003). These contractual systems are relatively simple, historically robust and have relatively low transaction costs. In the financial markets the transaction cost savings are more to be found within the institution than between institutions.

The Leeson story is an example. According to Hechter (in Misztal, 1996 p86) what is necessary for cooperation in large groups is formal control. However Molm, Takahashi and Peterson (2000 p1398) suggest negotiated terms and strictly binding agreements have the unintended consequence of reducing trust in relationships. For them the risk of incurring a net loss provides the opportunity for exchange partners to demonstrate their trustworthiness. (Molm, Takahashi and Peterson, 2000 p1401) Raise the level of uncertainty and the partners level of trust will increase in a reciprocal exchange. This difference is attributed to the expectation of future interaction. (Molm, Takahashi and Peterson, 2000 p1404) So inside an institution the development of reciprocal exchange should increase trust. By this logic if Leeson had not been a one man band, Barings would still be alive today. But how did the sales force in the Abolafia study feel about the bond traders who systematically communicated incomplete and misleading information? (Abolafia, 1996 p20) I would suggest they would grow increasingly distrustful no matter how many reciprocal exchanges were expected. The traders would have to develop some other form of opportunity to compensate the sales-force for this loss of utility. And here opens the potential for an increase in operational risk. The temptation to engage in collusive fraud, should the opportunity arise, would increase. This leads us back to the need for the introduction of formal controls.

Formal controls have been increasingly implemented in institutions. Chinese walls have been built between analysts and traders to mitigate conflicts of interest. Risk managers have more econometric tools to measure and manage risk. The psychometric testing of traders has increased. These institutions demand their employees make a commitment to rules which describe their mutual rights and obligations but which are enshrined in contracts. This assumes agents are likely to behave rationally and that trust provides the best strategy for behaving co-operatively. But if they behave irrationally, in situations where trust has broken down, then these institutions have a hedge. The cost of implementing these insurance policies is high. But the cost of not having them is higher.

Conclusion
In this paper I have explored theories of trust and asked how they affect operational risk. Without eliminating the use of rational choice theory or individual utility maximization it becomes clear utilizing notions of trust deepens and widens understanding of efficient market behaviour. Informational asymmetries within and between institutions were compared to illustrate the effects on trust and operational risk. Aspects of the debate over regulation and its affect on trust and operational risk were examined. I have argued trust plays an important role in reducing a number of costs associated with operational risk for the small ethnic entrepreneur in traditional markets and the largest and most complex institutions in financial markets, Drawing on stories from bond traders in the 1980’s and the failure of Barings in the 1990’s I have demonstrated how mistrust within institutions can grow and compared that with aspects of the development of trust based on expectations of reciprocity. Contractual arrangements within and between institutions were compared. Leading to the conclusion trust affects operational risk in a number of ways.

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