Networking Reference
In-Depth Information
measures. To address this problem, many specialized institutions have emerged over
time to provide information about the past transactions and the financial health of
the debtor. Examples of such institutions are the Mercantile Agency in the 1880s,
Standard and Poor's, and the Securities and Exchange Commission. These public
and private institutions have developed different mechanisms for reporting and
evaluating financial information. In particular, various regulations have led to the
standardization of the reporting of various financial information, such as income
tax. Privately-created information such as credit ratings have also become important
indicators of the financial health of debtors. As a result, financial transactions rely
on the accuracy and availability of this type of information. Hence, the trustors, i.e.,
lenders, trust the institutions to provide correct and timely information needed to
assess the risks associated with the transactions.
Some legal institutions enable the trustors to perform actions that reduce their
vulnerability. For example, negotiability allows creditors to exit the debt relationship
before the loan has come to maturity, and security gives the creditors claim over
debtors' assets [ 4 ]. To the degree that the legal system as a whole can be trusted,
these mechanisms make it possible for the lender to reduce her losses by moving
the debt to a third party or by seizing a valuable asset. In essence, the trust for the
credit rating depends on the legal system's ability to enforce the specific contract
between the debtor and the creditor. We will discuss trust for the legal system in the
next section.
Other financial institutions help to manage risk by grouping and evaluating
multiple debts concurrently. For example, early banker's handbooks urged lenders
to reduce their overall risk by making sure that the debtors come from different
industries or geographic regions. This diversification of debt is meant to ensure that
risks are uncorrelated and hence the amount of risk the lender is exposed to from
one debtor is offset by the lower risk from another. On the other hand, securitization
refers to the process of grouping loans into large pools, which can then be divided
into smaller portfolios of similar risk and sold to other lenders. This process spreads
the ownership of risk, makes it easier to sell the loans and create revenue for the
lenders and other intermediaries. In essence, it allows risks to be defined more
accurately for the securitized assets within the larger group. These mechanisms
are different methods to manage risk, sometimes at the individual lender level and
sometimes in the context of a large group of investments.
One of the institutions that underlies all financial transactions is the monetary
system, which ensures that money exchanged in the transactions has value and this
value is stable [ 4 ]. Lenders rely on the institutions that regulate the value of money
and trust that the government behind a specific currency will not issue money at a
rate that exceeds the rate of growth in the production of goods and services in the
corresponding economy [ 8 ]. Finance in general involves a set of actors including
bankers, brokers, traders, banks, insurance companies, hedge funds. These actors
are involved in many different actions that go well beyond simple credit. An actor
may serve one role (e.g., trustor) in one action, and another role (e.g., trustee)
in another action, creating complex nested relationships. These actions are taken
within the context of rules and regulations that describe which actions are possible
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