Social Trust, Bank Liquidity Creation, and Financial System Architecture

Abstract

Social trust – belief that potential trading partners will act honestly – has powerful economic and financial impacts, but effects for banks are controversial. Banks expertly screen/monitor borrowers to mitigate dishonest adverse selection/moral hazard behavior and protect depositors. Existing research is mixed whether banks behave honestly. We formulate and test questions of whether more social trust increases versus decreases bank output and raises or lowers bank prominence in financial system architectures. We employ large international datasets, measure bank output using the comprehensive liquidity creation concept, and gauge financial system architecture prominence with market liquidity provision. We find social trust reduces bank liquidity creation and lowers bank prominence, especially for poorer nations/bank-based systems where liquidity is likely most needed, and offer future directions to address such issues.

Keywords: Bank Liquidity Creation, Social Trust, Financial System Architecture

JEL Classification: F3, G21, G28