Chapter 16 What Should Be Done About Conflicts of Interest in the Financial Industry?
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Preview We examine recent equity market scandals and the consequences on the investing public. We pose a broad question: what can be done to resolve these problems? Topics include: – What Are Conflicts of Interest and Why Are They Important? – Ethics and Conflicts of Interest – Types of Conflicts of Interest – When Are Conflicts of Interest a Serious Problem? – A Framework for Evaluating Policies to Remedy Conflicts of Interest
Copyright © 2006 Pearson Addison-Wesley. All rights reserved What Are Conflicts of Interest and Why Are They Important? Financial intermediaries engage in a variety of activities to collect, produce, and distribute information. By providing multiple services, they realize economies of scope. However, these services may be competing with one another, and this creates the potential for a conflict of interest.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved What Are Conflicts of Interest and Why Are They Important? The conflicts of interest may arise as the concealment of information for the dissemination of misleading information. We care about these conflicts of interest because a reduction in the quality of information increases the presence of asymmetric information. The problems therein were just discussed in the previous chapter.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Ethics and Conflicts of Interest Conflicts of interest generate incentives to provide false or misleading information. This behavior is considered unethical. One way to limit these conflicts is to make workers aware of the ethics issues at stake, so that they are less likely to engage in unethical behavior.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Types of Conflicts of Interest We will discuss, in turn, four areas of financial service activities that harbor the greatest potential for generating conflicts of interest. These are: – Underwriting and research in investment banking – Auditing and consulting in accounting firms – Credit assessment and consulting in credit-rating agencies – Universal banking
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Underwriting and Research in Investment Banking Some investment banks both underwrite new securities sold the public as well as prove research (buy recommendations) to the investing public When revenues from underwriting exceed brokerage commissions, favorable research will attract more business, at the expense of unbiased recommendations to the investing public.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Underwriting and Research in Investment Banking In initial public offerings of equity, underwriters direct the new shares as they wish, typically to their best clients or potential new clients. Since most IPOs are underpriced, many of these shares are immediately sold for a profit (called spinning). This immediate “profit” may appear as nothing more than payment for future business.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Auditing and Consulting in Accounting Firms The role of auditors in public firms is to provide an unbiased view of the financial reports to reduce asymmetric information between the firm’s management and the investing public. By also providing management advisory services (such as systems support), the auditor has an incentive to fudge the audit if the fees from other services are substantial.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Auditing and Consulting in Accounting Firms Auditors also have a conflict of interest since they are paid by the firm they audit. If the auditor gives an unfavorable audit report, the auditor may lose the auditing business as well. A well known case of the failure of auditors to provide unbiased reports was Arthur Andersen’s audit of Enron.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Credit Assessment and Consulting in Credit-Rating Agencies Bond investors rely on credit-rating agency assessment of firm’s debt (debt ratings). However, ratings are only provided when the firm pays the agency. Agencies, then, have an incentive provide “better” ratings to attract business.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Credit Assessment and Consulting in Credit-Rating Agencies Rating agencies have also started providing firms with other services, and have the same conflicts as auditors in this regard.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Universal Banking Universal banking refers to institutions that provide some combination of commercial banking, investment banking, and insurance services. Glass-Steagall prohibited this in the U.S. as of However, in 1999, Congress repealed this act, allowing for some form of universal banks in the U.S.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Universal Banking Issuers that use the underwriting services of a bank will also benefit from sale of its products to the banks other (retail) customers. Customers should expect unbiased advice, but may not get it. Bank managers may push investing products of its affiliates, even if they aren’t in customer’s best interest.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Universal Banking Lenders with private (bad) information have an incentive to withhold the information during security issuances in order to get paid themselves, at the expenses of the investing public. Lenders may offer favorable terms to secure future underwriting business.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Universal Banking Banks may use strong-arm tactics to sell its affiliate insurance products.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved When Are Conflicts of Interest a Serious Problem? Conflicts of interest are a problem when they lead to a decreased flow of reliable information (increased asymmetric information). However, even with potential conflicts, the incentives (financial gain) may not be present to actually act on them.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved When Are Conflicts of Interest a Serious Problem? Empirical evidence suggests that rating agency debt ratings are unbiased, despite being paid by the firms. Underwriting and commercial banking also appeared to be free from exploitations. Many banks in then 1920s spun-off their investment banking activities to separate the functions.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved When Are Conflicts of Interest a Serious Problem? Empirical evidence also suggests that the investing public “discounts” recommendations made by the underwriter’s analysts. However, when temporary rewards to high (such as the late 1990s), “trusted” firms may extract reputational rents from the investing public by seeking short-term gains at the expense of their future reputation.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved What Has Been Done to Remedy Conflicts of Interest? Two major policies were implemented following the scandals of the late 1990s and early 2000s. These are: – Sarbanes-Oxley Act of 2002 – Global Legal Settlement of 2002
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Sarbanes-Oxley Act of 2002 Passed following the public outcry over corporate scandals. The act, in summary, has the following six major components: 1.Established the Public Company Accounting Oversight Board to supervise accounting firms. 2.Prohibited public accounting firms from engaging in nonaudit services to a client it is also auditing. 3.Members of the board’s audit committee must be independent.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Sarbanes-Oxley Act of 2002 Passed following the public outcry over corporate scandals. The act, in summary, has the following six major components: 4.Required the reporting of off-balance sheet activities. 5.Appropriated additional funding for the SEC. 6.Increased the charges for white-collar crimes and obstruction.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Global Legal Settlement of 2002 The was a settlement reached between the New York Attorney General and several of the largest U.S. investment banks. The key terms of the agreement included: 1.Firms must severe the link between underwriting and research activities. 2.Spinning is banned. 3.Firms must make public analyst recommendations and target prices.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Global Legal Settlement of 2002 The was a settlement reached between the New York Attorney General and several of the largest U.S. investment banks. The key terms of the agreement included: 4.Brokerage firms required to obtain third-party, independent research for their clients. 5.$1.4 billion in fines.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved A Framework for Evaluating Policies to Remedy Conflicts of Interest A trade-off between potential conflicts of interest and economies of scale exists. Simply eliminating any potential conflict may not be the best solution: 1.The existence of a conflict of interest does not mean that the conflict will have severe consequences. 2.Even if incentives to exploit conflicts are high, eliminating the conflict may be worse if it reduces the flow of reliable information.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Approaches to Remedying Conflicts of Interest Leave It to the Market: an appealing approach that relies on market forces, but has the problem that the market has a “short” memory for past problems. Regulate for Transparency: regulate mandatory disclosure, even if it is more costly than the information provided.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Approaches to Remedying Conflicts of Interest Supervisory Oversight: force firms to provide private information to a supervisor, who can act on it as deemed necessary. Separation of Functions: separate those functions that create conflicts, either within firms or (in extreme cases) by not allowing those functions within the same firm.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Approaches to Remedying Conflicts of Interest Socialization of Information Production: look to public funding for information providers, such as credit agencies.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Summary What Are Conflicts on Interest and Why Are They Important? We discussed the role of information flow that may be affected by conflicts of interest Ethics and Conflicts on Interest: we discussed how conflicts of interest may lead to unethical behavior and agued for awareness of the potential conflicts
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Summary (cont.) Types of Conflicts of Interest: we reviewed potential conflicts in underwriting, research, auditing, credit assessment, and universal banking When Are Conflicts on Interest a Serious Problem? We reviewed empirical evidence suggesting that markets do take into account known conflicts of interest
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter Summary (cont.) What Has Been Done to Remedy Conflicts of Interest? The implications of the Sarbanes-Oxley Act and the Global Legal Settlement were reviewed A Framework for Evaluating Policies to Remedy Conflicts of Interest: potential remedies were suggested to address the trade-off between the cost of conflicts and the benefits of economies of scope