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The Trust Triangle: Laws, Reputation, and Culture in Empirical Finance Research

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Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time. It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence…

– Kenneth Arrow (1972, p. 357)

Abstract

We propose a construct, the Trust Triangle, that highlights three primary mechanisms that provide ex post accountability for opportunistic behavior and motivate ex ante trust in economic relationships. The mechanisms are (i) a society’s legal and regulatory framework, (ii) market-based discipline and reputational capital, and (iii) culture, including individual ethics and social norms. The Trust Triangle provides a framework to conceptualize the relationships between trust, corporate accountability, legal liability, reputation, and culture. We use the Trust Triangle to summarize recent developments in the empirical finance literature that examine how trust is formed and how trust, or its absence, affects financial markets, firm performance, and the incidence of financial fraud. To date, most studies examine only one leg of the Trust Triangle in isolation. The evidence, however, indicates that all three legs of the Trust Triangle have first-order effects on a wide range of financial outcomes and that they are interrelated. Attempts to model trust and trustworthiness that do not incorporate all three aspects of the Trust Triangle will therefore miss essential aspects of the basic economic problem of how counterparties overcome the risks of moral hazard, asymmetric information, and opportunism to engage in mutually beneficial exchange and production activities. We focus especially on culture-related mechanisms, a recently developed area in empirical finance research that has potential to influence the more established research on laws and reputation.

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Notes

  1. The Fraud Triangle states that frauds occur when a person has sufficient (i) perceived gain, (ii) perceived opportunity, and (iii) self-rationalization for the fraudulent behavior. See Albrecht (2014) for a discussion of the historical development of the Fraud Triangle.

  2. Rodgers (2009) uses a throughput model of trust formation. Our Trust Triangle is based on empirical proxies for trust used in the existing literature. There is, however, overlap between Rodgers’s model and ours. For example, his “rule-based” category of trust formation overlaps with third-party enforcement in the Trust Triangle.

  3. Backward induction refers to the logical process that ties the economic outcome – in this case, contracting and exchange behavior – to the sequence of decisions that produce the outcome.

  4. For theoretic formulations of repeated game interactions that emphasize ex post penalties as the source of accountability, see Klein and Leffler (1981), Fudenberg and Maskin (1986), Diamond (1989), and Kreps (1990). Researchers variously use such terms as opportunism, cheating, fraud, and misconduct to denote behavior that deviates from an explicit or implicit agreement. Such terms imply intent to deviate and not perform. Intent plays an important role in most legal definitions of fraud, and whether intent is involved frequently affects the size of ex post legal penalties. In some formulations, however, including models of reputational capital discussed here, what matters is that the behavior deviates from the prior (frequently implicit) agreement, whether or not the deviation is intentional.

  5. Caldwell and Hansen (2010), however, emphasize first-party ethical considerations in the formation of trust and do not consider the roles of third-party and related-party incentives, i.e., the first and second legs of the Trust Triangle as discussed below. They also apply the formation of trust to manager–employee relationships, whereas we emphasize the importance of trust in all contractual relationships.

  6. A reader of a prior version of this paper suggests that we illustrate the importance of trust in most transactions by citing the case in which some Chipotle customers contracted salmonella poisoning. We use the coffee example because it illustrates the importance of trust in even the most mundane transactions, and it highlights how such trust is justified in most cases. Chipotle’s experience, by contrast, illustrates the outlier case in which customers’ trust turns out to be unfounded. As emphasized throughout this paper, the fact that trust is sometimes broken (intentionally or not) highlights how ex ante trust and trustworthiness are not binary outcomes, but rather, reflect probabilistic assessments of the likelihood of satisfactory contractual performance.

  7. This is a central question of firm organization involving specialization in the provision of financial capital and managerial efforts, as discussed by Alchian and Demsetz (1972), Jensen and Meckling (1976), Demsetz (1983), and Fama and Jensen (1983).

  8. For surveys, see Shleifer and Vishny (1997), Denis and McConnell (2003), Malmendier (2009), and Leuz (2010).

  9. See, for examples, LaPorta et al. (1997, 1998, 1999, 2000, 2002, 2006), Demirgüç-Kunt and Maksimovic (1998), Claessens et al. (2000), Beck et al. (2000), Johnson et al. (2000a), Booth et al. (2001), and Beck et al. (2003).

  10. See, for examples, Coffee (2001) and Cools (2005).

  11. Other papers that model how relational contracts and the prospect of future interactions can decrease the threat of opportunism include Fudenberg and Maskin (1986), Bull (1987), Baker et al. (1994), Board (2011), and Halac (2012).

  12. For surveys of this literature, see Karpoff (2012) and Amiram et al. (2018). Parts of this section follow closely from Sect. 4 of the Amiram et al. (2018) paper.

  13. If a firm’s counterparties give favorable terms based on a generally favorable opinion about the firm, as reflected in surveys or CSR rankings, this would be an example of how firm culture can help build trust. That is, it reflects the culture leg of the Trust Triangle, not the reputational capital leg.

  14. See, for examples, Alchian and Demsetz (1972), Stigler and Becker (1977), and Bénabou and Tirole (2006b).

  15. See, for examples, Clouse et al. (2017), Fang and Foucart (2014), Van Hoorn (2014), and the papers surveyed by Cumming, Hou, and Lee (2016).

  16. These findings are consistent with Blau (2017), who finds that a country’s religiosity is negatively related to stock price volatility and conjectures that lower volatility is associated with higher levels of economic output.

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Acknowledgements

We thank Marc Cohen, Douglas Cumming, Chris Parsons, Valentina Zamora, the Editors of this Special Issue, and two anonymous reviewers for helpful comments.

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    Quentin Dupont & Jonathan M. Karpoff

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Dupont, Q., Karpoff, J.M. The Trust Triangle: Laws, Reputation, and Culture in Empirical Finance Research. J Bus Ethics 163, 217–238 (2020). https://doi.org/10.1007/s10551-019-04229-1

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