Trust, regulation, and contracting institutions

Author:Brandon N. Cline, Claudia R. Williamson
DOI:http://doi.org/10.1111/eufm.12253
Publication Date:01 Sep 2020
Eur Financ Manag. 2020;26:859895. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons Ltd.
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DOI: 10.1111/eufm.12253
ORIGINAL ARTICLE
Trust, regulation, and contracting institutions
Brandon N. Cline
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Claudia R. Williamson
Department of Finance and Economics,
Mississippi State University, Starkville,
Mississippi, USA
Correspondence
Brandon N. Cline, Department of
Finance and Economics, Mississippi State
University, P.O. Box 9580, Starkville,
MS 39762, USA.
Email: brandon.cline@msstate.edu
Abstract
This paper demonstrates that trust directly influences
contracting efficiency. We document that trust reduces
demand for contract regulation and positively relates
to a highquality contracting environment, supporting
a substitution hypothesis. Furthermore, contract regula-
tion no longer leads to poor contracting outcomes. These
findings suggest that lack of trust significantly explains
inefficient contracting institutions. Based on interaction
effects, we note that trust could complement formal
enforcement in countries with weak regulation. As
regulation increases, trust substitutes for contract
regulation. Overall, trust positively promotes efficient
contracting by reducing burdensome regulation and
providing an alternative to formal contract enforcement.
KEYWORDS
contract enforcement, efficiency, trust, regulation
JEL CLASSIFICATION
F2; O17; K2
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INTRODUCTION
Contracting institutions monitor and enforce transactions between private parties, for example,
between a debtor and creditor or a firm and its suppliers. Both sides of a contract might want to
renege on an agreement, and they can do so if there are failures in enforcement. The literature
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We are grateful to an anonymous referee and the editor, John Doukas. We are also grateful for comments by conference
and seminar participants at George Mason University, The University of Alabama, West Virginia University, and
annual meetings of the Financial Management Association, the Southern Finance Association, the Public Choice
Society, and the Southern Economic Association. All errors and omissions are our own.
documents many specific concerns resulting from costly contract enforcement. For example,
Jappelli, Pagano, and Bianco (2005) and Bae and Goyal (2009) illustrate that contract regulation
negatively affects access to credit. Consistent with these findings, other studies document that
more efficient judicial contract enforcement improves overall business climate (La Porta, Lopez
deSilanes, Shleifer, & Vishny, 1998; Lu & Tao, 2009), increases firm size (Giacomelli & Menon,
2016), reduces the informal sector (DablaNorris, Gradstein, & Inchauste, 2008), fosters
innovation (Cooley, Marimon, & Quadrini, 2004; Cumming & Knill, 2012), and promotes
international trade (Nunn, 2007). Consequently, contract enforcement remains an important
predictor of economic growth (Bjørnskov & Méon, 2013; Djankov, McLiesh, & Ramalho, 2006;
North, 1990). Given the importance of understanding the determinants of contracting
institutions, in this paper we focus on the nexus between formal regulation, informal norms,
and the quality of the contracting environment.
To avoid potential opportunism and facilitate exchange, individuals could prefer a third
party contract enforcer, relying on enforcement from government courts. Formal contracting
institutions are comprised of rules and regulations, established by the government, that provide
a legal framework to enforce contracts. A wellfunctioning judiciary requires courts that are
accessible to the public, predictable, and that resolve cases in a reasonable time (World Bank,
2016a). Accordingly, highquality formal contract enforcement can result from a lowregulated,
efficient court system.
Governments, however, range in ability and willingness to provide the necessary legal
framework to enforce contracts, and the rules adopted for settling disputes vary greatly across
countries. In a seminal paper, Djankov, La Porta, LopezdeSilanes, and Shleifer (2003)
illustrate that greater legal complexity to enforce a contract not only increases the costs of
enforcement, but also results in less court consistency, less honesty and fairness in judicial
decisions, and more corruption (see also Djankov et al., 2006). Consequently, more stringent
contract regulations are associated with worse financial outcomes.
Even in countries with higherquality formal contracting institutions, it is impossible to
create formal rules that sustain all complex financial exchangessimilar to the difficulty of
writing complete contracts (Algan & Cahuc, 2013). Informal institutionsand, in particular,
generalized trustcan fill these missing gaps, contributing to more efficient contracting
(Dixit, 2004; Knack & Keefer, 1997). Fukuyama (1995) describes trust as a set of reciprocal
moral habits and obligations that are internalized, thereby reducing expectations of being
cheated. When individuals do not expect to be cheated, they do not desire costly government
oversight and are simultaneously incentivized to engage in exchanges that would otherwise not
take place.
We therefore focus on the role that generalized trust plays in facilitating contractintensive
financial exchanges. We hypothesize that trust affects contracting through two channels: first,
trust decreases demand for regulation over the courts that formally enforce a contract; and
second, trust directly influences contracting efficiency by substituting for costly formal
regulation.
To understand how trust, formal contract enforcement, and efficient contracting institutions
are linked, we first conceptualize how generalized trust generates preferences for less control
over the government courts where contracts are enforced. Based on the prior works of Aghion,
Algan, Cahuc, and Shleifer (2010) and Pinotti (2012), who document a negative association
between new business entry regulation and trust, we hypothesize that, when a society embodies
more trust, there will be less demand for regulation over the courts to enforce a contract.
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CLINE AND WILLIAMSON
Given this inverse association, our second main contention is that trust and formal contract
enforcement can directly influence contracting outcomes by acting as substitutes. Trust not only
influences the amount of contract regulation but can also promote market exchange by acting
as a substitute when formal contract enforcement is too costly.
A variation of this hypothesis is that, depending on the level of contract regulation in a
country, trust can be both a substitute for and a complement to contract regulation. Carlin,
Dorobantu, and Viswanathan (2009) show that regulation and trust act as complements if
formal rules enable trust. Thus, at low levels of regulation, trust complements formal rules,
further enabling complex transactions. However, when formal contract enforcement is
excessively costly, trust substitutes for formal contract regulation.
In addition, we hypothesize that, once trust is considered, the negative effects of contract
regulation documented in the literature are mitigated or disappear. Based on our first
hypothesis, that distrust is driving the demand for more government regulation over the courts,
the level of trust can also explain badeconomic outcomes previously attributed to contract
regulation. If so, lack of trust rather than regulation explains contracting inefficiency.
Trust enters our framework in two ways. First, it influences the demand for regulation of the
courts. Second, it promotes efficient contracting by substituting for formal regulation. If trust
substitutes for regulation, we expect a negative association between trust and contract
regulation but a positive direct link between trust and contracting outcomes. To test each claim,
we distinguish contract regulation from contracting outcomes, which capture efficient contract
enforcement.
To maximize sample size, we create an unbalanced panel from 2000 to 2015 for up to 86
countries. To proxy for formal contract enforcement, we collect countrylevel contract
enforcement regulation data from the World Bank (2016a) project. This includes the number
of procedures and the number of days to enforce a contract through a local court. We create an
overall contract regulation index by extracting common variations in time and among
procedures to enforce. A higher score reflects greater court regulation to enforce a commercial
contract and, thus, lowerquality formal contract enforcement. We also collect data measuring
the level of trust within a country from the World Values Survey (WVS). The most common
proxy of trust, generalized trust, is measured by the percentage of respondents who answered
yesto the question, Do you think most people can be trusted?
Our analysis reveals that societies with more generalized trust adopt fewer regulations to
enforce commercial contracts, including fewer procedural steps and less time. For example, a
one standard deviation increase in trust, the difference between New Zealand and Belarus,
lowers the contract regulation index by 0.27 standard deviations, the difference between the
United States and China.
Next, we test the substitution hypothesis by examining the direct link between trust and
contracting outcomes while controlling for the level of contract regulation. Due to inability to
directly observe contract formation and enforcement, we rely on several measures of de facto
contracting outcomes of efficient contracting that could result from informal or formal
enforcement: the size of the shadow economy, the rule of law, auditing quality, the ease of
venture capital acquisition, and research and development (R&D) expenditures.
We find that trust significantly relates to all five contracting outcomes. As expected, stricter
contract regulation deters efficient contracting when trust is excluded. However, the
simultaneous inclusion of trust and contract regulation shows that the coefficients on contract
regulation are attenuated. This result suggests that prior interpretation of the effects of contract
regulation could be confounded when the variation in trust across countries is not considered.
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