A common saying is that the financial system is based on trust. Many
economists suggest that trust disappeared at the end of 2007 and the
system ground to a halt. For example, depositors queued outside Northern
Rock to withdraw their deposits, because they no longer trusted the
The view that the finance system is based on trust is wrong. A sound
financial system should be based on mistrust. We know that some people
are dishonest, some are greedy and anyone can be tempted if the right
opportunity arises. We also not that people can get into financial
difficulty, despite there best intentions. These factors mean that
lending money to another person can be very risky.
Originally people would only lend to people they trusted because they
knew them really well. That is the original meaning of the word credit.
A person would be given credit, because their character was known to be
Limiting lending to family and friends can be quite restricting for
the development of an economy, so investors started looking for ways to
expand the scope of lending. The banking system emerged as a way of
reducing or managing the risks of lending to people who are not fully
trusted, because they were no well known. A whole range of practices
were introduced to prevent borrowers from defaulting or absconding
without repaying their loans: letters of credit, documentation, credit
checks, sets of accounts, guarantees, collected, liens, mortgages and
repayment insurance. These institutions have two purposes. They identify
people who should not be trusted and so lenders do not make loans to
them. They also ensure that if a borrower defaults on a loan, the lender
has sufficient security to get back most of what they lent.
This system works well when banks do their job. The bank’s role is
to identify potential borrowers who can afford to repay their loans and
who will be willing to repay when any loan when its term is complete.
The bank will also endeavour to hold sufficient security to ensure that
that they can recover the loan, if the borrower defaults. The bank’s
role is based on the principle that borrowers cannot always be trusted,
so processes are put in place to ensure that borrowers are unable to
abscond without repaying their loans. The act as intermediaries to
assist savers to lend to people they would not usually trust.
During the last decade these practices broke down and were replaced
by blind trust. Many financial innovations widened the gap between
lenders and borrowers to the extent the final lender knew nothing about
the trustworthiness of the borrower. They had no reason for not
mistrusting them, but they chose to trust.
- Mortgage brokers stopped scrutinising potential borrows and
started trusting anyone who asked for a housing loan.
- Credit ratings agencies stopped scrutinising financial
institutions and starting taking payments for helping them to cook up
their crazy financial concoctions.
- Banks lent money without knowing whether the borrower was
creditable and with no certainty about the collateral.
- Hedge funds and pension funds purchased securitised mortgages
without any idea whether they would be repaid or not. The just trusted
the investment banks that issued the securities.
- Many of these securities have proved to be unworthy of trust,
which is just what you expect.
The credit crisis emerged because mistrust disappeared to be replaced
with blind trust.
Increased regulation is not the answer. Regulation cannot make
dishonest people honest and greedy people generous. Regulators cannot
eliminate temptation and they cannot eliminate the risk of default.
Regulations make the situation worse, because they encourage people to
trust regulated activities, when it would be better for them to mistrust
Solution is Mistrust
The only solution is to go back to mistrust. Lenders must recognise
that some borrowers will be unwilling or unable to repay their loans.
Banks need to get back to doing all the things that they did in the past
when dealing with borrowers that are not completely trusted. Credit
checks, guarantees, collateral mortgages allow savers to lend to people
they mistrust, by managing the risk of default.
When savers go back to mistrusting banks, they will start monitoring
their activities and looking for banks that are running less risk.
Savers should follow the example of the people who queued outside
Northern Rock, because they had heard that the managers of the bank had
been engaging in risky practices. We need more of this behaviour.
If I have tend gold coins, who would I trust to look after them. I
would trust my wife, my adult children, a few of my friends, some of the
members of my church, but that is about. Gold coins can be melted, so
proving ownership is very difficult. If I am going to give them to
anyone else to look after, I would be wise to approach them with an
attitude of mistrust. Only a fool would lend would blindly pass their
coins on to anyone else to look after without putting in place a process
to ensure that they will get them back. We should approach banks in the
People who mistrust banks will look for banks which will look after
their money without shifting it onto the banks balance sheet and
treating the depositors money as if it was their own. More mistrust is
the key to a more stable financial system.
The powerful governments of the world are talking about starting a
“bad bank”. Their idea is that other banks would sell all their
toxic assets to the bad bank, where they could be isolated. The other
banks could then get on with being normal banks.
This is a very expensive solution as the government will become
responsible for all the losses on the toxic assets.
We do not need another bad bank. There are already plenty of them.
What we really need is a good bank. I hope that a private business will
take the opportunity presented by the current uncertain situation to
establish a good bank.
We need a bank that does not claim money entrusted to it belong to
it; that does not record deposits as assets of the bank.
We need a bank that does not take money that belongs to one person
and loan it to another without permission.
We a bank that does not rely on mathematical models or commission
agents to make decisions about lending, but trusts relationship with
borrowers and knowledge of their character.
We need a bank that does not chase profits from shonky speculations
or random risk taking.
I have described how a good bank would function in Bank Deposits and
If a good bank started, depositors would move their money to it.
Other good banks would start when they saw how well the good bank was
doing. Good banks would spring up everywhere, as depositors look for a
safe haven. The world would see a dramatic shift of money from the
existing banks to the good banks.
The true nature of our existing banks would be revealed. They would
be left holding their toxic assets and depending on funding by
government bailouts. Everyone would see that they really are bad banks,
and avoid them like the plague.