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The role of trust in financial sector development

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  • Bossone, Biagio
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    Abstract

    In any economic environment where decisions are decentralized, agents consider the risk that others might unfairly exploit informational asymmetries to their own disadvantage. Incomplete results, especially, lies at the heart of financial transactions in which agents trade real claims for promises of future real claims. Agents thus need to invest considerable resources to assess the trustworthiness of others with whom they know they can interact only under conditions of limited and asymmetrically distributed information. Thinking of finance as the complex of institutions and instruments needed to reduce the cost of trading promises among anonymous individuals who do not fully trust each other, the author analyzes how incomplete trust shapes the transaction costs in trading assets, and how it affects resource allocation and pricing decisions from rational, forward-looking agents. His analysis leads to core propositions about the role of finance and financial efficiency in economic development. He recommends areas of financial sector reform in emerging economies aimed at improving the financial system's efficiency in dealing with incomplete trust. Among other things, the public sector can improve trust in finance by improving financial infrastructure, including legal systems, financial regulation, and security in payment and trading systems. But fundamental improvements in financial efficiency may best be gained by eliciting good conduct through market forces.

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    Bibliographic Info

    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2200.

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    Date of creation: 31 Oct 1999
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    Handle: RePEc:wbk:wbrwps:2200

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    Keywords: Payment Systems&Infrastructure; Economic Theory&Research; Environmental Economics&Policies; International Terrorism&Counterterrorism; Decentralization; Economic Theory&Research; Environmental Economics&Policies; International Terrorism&Counterterrorism; Banks&Banking Reform; Insurance&Risk Mitigation;

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    1. Paul Resnick & Christopher Avery & Richard Zeckhauser, 1999. "The Market for Evaluations," American Economic Review, American Economic Association, vol. 89(3), pages 564-584, June.
    2. Martinez Peria, Maria Soledad & Schmukler, Sergio L., 1999. "Do depositors punish banks for"bad"behavior? : market discipline in Argentina, Chile, and Mexico," Policy Research Working Paper Series 2058, The World Bank.
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    9. Patrick Honohan, 1997. "Banking system failures in developing and transition countries: Diagnosis and predictions," BIS Working Papers 39, Bank for International Settlements.
    10. Giovannini, Alberto, 1989. "Uncertainty and liquidity," Journal of Monetary Economics, Elsevier, vol. 23(2), pages 239-258, March.
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    12. Klein, Benjamin & Leffler, Keith B, 1981. "The Role of Market Forces in Assuring Contractual Performance," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 615-41, August.
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    14. anonymous, 1998. "Financial intermediation and growth," Economics Update, Federal Reserve Bank of Atlanta, issue Jan, pages 4.
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