The Price of Trust

Investment bankers usually start speaking about trust when they begin to sense that investors are losing trust in them. During good economic times, they talk about new financial instruments for lowering overall risk. In bad times, though, they warn that if their firm goes bankrupt, the entire financial system will collapse. Then the taxpayers are asked to bail them out simply because the bankers miscalculated their financial risk. Since there is some truth to the rule that a financial giant's bankruptcy can trigger a chain reaction with serious, broad repercussions for the economy, the government often agrees to step in and help. The authorities use public funds to avert a financial collapse and then introduce legislation to expand the market regulators' influence.

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What happened in the United States over the weekend illustrates this principle. Bear Stearns, which was once the fifth-largest investment bank in the United States, had too many mortgage-related securities in its portfolio. Confidence in its liquidity eroded, and by the end of last week it fell victim to a classic run on the bank. Although it might well have been clear to investors that the bank's underlying financial foundation was strong, they nonetheless panicked and rushed to withdraw their money, fearing the bank might not be able to meet all of its obligations if everyone tried to withdraw at the same time. Historically, these panics have affected retail banks rather than investment banks, but the same economic principles apply to both. By Friday, the U.S. Federal Reserve had effectively offered a government guarantee to cover Bear Stearns' bad debts. The deal was structured as a credit line from JPMorgan Chase, the nation's third-largest bank by assets, which received funds from the Federal Reserve, using the bad debts of Bear Stearns as collateral. The Federal Reserve has resorted to such extraordinary measures only twice before over the last century -- during the 1930s and 1960s. By Monday, it was announced that JPMorgan Chase would buy Bear Stearns at $2 per share, a huge drop from its $84 per share book value at the end of fiscal 2007.

Of course, a similar financial crisis could not happen in Russia because the country's investment banks do not carry the same kinds of complex portfolios as those held by U.S. financial firms. But this does not mean that there won't be a crisis of trust in the Russian market. Investment banks holding shares in Russian companies could suffer if they find themselves in a situation where they have in reality far less control over their holdings than would otherwise be assumed from their market valuation. Even though Russian financial regulators do not now allow management as much leeway in diluting company shares as they used to do in the 1990s, this does not mean that the protection of property rights has improved dramatically. Investor trust in Russian equities is based more on the perceived security of the current Kremlin leadership than on the faith that financial institutions will somehow protect shareholders' rights. The big question is: Will the government act decisively, if necessary, to avert the collapse of the financial system by protecting private investors against stock dilutions or other manipulations by major companies, many of which are owned in part by the state? The political pressure from the "titans of Russian industry" will be enormous. The issue of trust will become critically important once one company is allowed to ignore its obligations and if others follow suit.

Is this a far-fetched scenario? It would seem that investment banks' holdings of shares in Russian firms are protected from dilution, but, then again, it also seemed that, seven months ago, Bear Stearns would have had another year of profits -- what would have been its 85th profitable year in a row.

Konstantin Sonin, a professor at the New Economic School/CEFIR, is a columnist for Vedomosti.