Mistrust (1)

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 bank.

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 creditworthy.

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 would not normally be trusted, because they were not 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. They act as intermediaries to assist savers to lend to people they would not usually trust.