Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 15 Conflicts of Interest in the Financial Industry

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Conflicts of Interest Type of moral hazard problem that occurs when a person or institution has multiple objectives and as a result has conflicts between them Might be responsible for –Previous scandals (Enron) Enron: The Smartest Guy in the Room –Subprime financial crisis of –Li Xuli (Rat Trading, Caijing.com.cn)Li Xuli (Rat Trading, Caijing.com.cn)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Conflicts of interests a conflict of interest –as a situation in which a party to a transaction can potentially gain by taking actions that adversely affect its counterparty. (Mehran and Stulz, 2002, Journal of Financial Economics, The Economics of Conflicts of Interest in Financial Institutions)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Conflicts of interest conflicts of interest –used to describe the situation in which a public official or fiduciary who, contrary to the obligation and absolute duty to act for the benefit of the public or a designated individual, exploits the relationship for personal benefit, typically pecuniary.(Encyclopedia of American Law)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Conflicts of interest in financial industry Possible causes: –Information and cost advantage of financial intermediaries Economies of scale realized from cost advantages in the collection and use of information Economies of scope realized by providing multiple financial services to customers

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Conflicts of interest in financial industry Undesired consequences –Possible adverse effect on customers might misuse information, provide false information, or conceal information. –Less efficient financial markets Misuse of information Reduced quality of information Outright fraud Conflicts of interest increase financing cost

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Types of Conflicts of Interest Underwriting and research in investment banking Auditing and consulting in accounting firms Credit assessment and consulting in credit- rating agencies Universal banking

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Underwriting and Research in Investment Banking Issuers and investment banks benefit from optimistic research –Investors desire unbiased research Investment banks have strong incentive to alter information, favoring the issuing firm –Morgan Stanley internal memo –Blood on the Street, by Gasparino, 2005 The booming 1990s, research analysts, traders, kickbacks Spinning

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Morgan Stanley internal memo an internal Morgan Stanley memo excerpted in the Wall Street Journal on July 14, 1992, stated: “Our objective... is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice.”

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Frank Quattrone Nearly 200 IPOs in 1990s $120m annual pay Upenn, Stanford Morgan Stanley, Deutsche Bank, Credit Suisse First Boston 2003, legal charges –See FINRA new releaseSee FINRA new release 2008, founded Qatalyst Group –70% premium for clients vs. typical 37% (Reuters article, 2011 Sep 14(Reuters article, 2011 Sep 14) Smith Interview About Frank Quattrone (Bloomberg video)Smith Interview About Frank Quattrone (Bloomberg video)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Auditing and Consulting in Accounting Firms Auditing: –Primary functions (validate information) –Other consulting services (taxes, business strategies) Pressure from clients threatening to take business to another firm Reluctant to criticize work done by nonaudit counterparts Provide an overly favorable audit in an effort to solicit or retain audit business

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The case of Arthur Anderson Anderson’s Auditing and Consulting businesses, and their bitter dispute Enron’s accounting practices –Offshore entities –Mark-to-market –Enron as a large regional customer

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Credit Assessment and Consulting in Credit-Rating Agencies Credit rating – default probability Conflicts of interest –Issuer-pay business model –Investors and regulators depend on well-researched impartial assessments –Credit-rating agencies may also provide consulting services Auditing their own work Favorable rating to attract new clients

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Credit rating agencies and the subprime crisis Three major credit rating agencies: –Moddy’s, S&P, Fitch Issuer pays 90-95% revenue from rating services Rating derivatives more profitable than rating corporate bonds (3 times) Massive downgrade during the crisis –S&P – 16,381 out of 31,935 tranches –Consequences: capital loss, forced sale of assets, further devaluation

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Testimony by former executive at Moody’s [A] large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pay business model and on rating shopping by issuers of structured securities. A drive to maintain or expand market share made the rating agencies willing participants in this shopping spree...Originators of structured securities typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality. - Testimony to Congress, U.S. House of Representatives, Committee on Oversight and Government Reform, Hearing: Credit Rating Agencies and the Financial Crisis, 10/23/2008

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Universal Banking Underwriting department: aggressive sales vs. unbiased investment advice for customers. Limit losses by selling to customers or to trust accounts Encourage underwriting to push securities from firms with increasing risk Makes loans with overly favorable terms to earn fees for other activities Influence or coerce a borrowing or investing customer to buy insurance products

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Inside Job 2010 Academy Award for Best Documentary Feature financial crisis –Iceland crisis –Subprime crisis in U.S –Regulation vs. deregulation –Banking system –Rating agencies –Even in academics (82:00) mlhttp://v.youku.com/v_show/id_XMzA0MTY1MTg0.ht ml

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Can the Market Limit Exploitation of Conflicts of Interest? Conflicts of interest –adverse selection, moral hazard Factors may limit exploitation –Not very high incentives –Reputation consideration –Long run profitability Empirical evidence suggests that –Credit rating firms do not overrate bonds of its customers. –markets adjust when a potential for conflicts of interest arise (securities underwriting by commercial and investment banks). –See Mehran and Stulz, 2007, JFE paper

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Can the Market Limit Exploitation of Conflicts of Interest? (cont’d) In the short run, exploitation is possible and can lead to large gains. Motives: –Poorly designed compensation plans. –Temporary rewards Individuals might be able to capture reputational rents.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Sarbanes-Oxley Act of 2002 Also known as “Public Company Accounting Reform and Investor Protection Act” Primary objectives: –Increased supervisory oversight to monitor and prevent conflicts of interest establishes the Public Company Accounting Oversight Board –Directly reduced conflicts of interest restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Sarbanes-Oxley Act of 2002 Primary objectives (continued): –Provided incentives for investment banks to not exploit conflicts of interest specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations –Had measures to improve the quality of information in financial markets enhanced reporting requirements for financial transactions establishes standards for external auditor independence

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Global Legal Settlement of 2002 An enforcement agreement between the SEC, NASD, NYSE, and ten of the United States's largest investment firms to address issues of conflict of interest within their businesses Primary actions –sever the links between research and securities underwriting –Banned spinning –$1.4 billion of fines on accused investment banks. –make public their analyst’s recommendations –to contract for a five year period with no fewer than three independent research firms that would provide research to their brokerage customers

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Framework for Evaluating Policies a conflict of interest  serious adverse consequences (necessarily) –Does the market have adequate information and incentives to control conflicts of interest? Eliminating the economies of scope may reduce the flow of reliable information

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Approaches to Remedying Conflicts of Interest Leave it to the market –Penalize the financial service firm –Promote new institutional means Regulate for transparency –Mandatory information disclosure –Might be too costly for financial service firms

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Approaches to Remedying Conflicts of Interest(cont’d) Supervisory oversight –Overseeing appropriate internal controls Separation of functions –Agents should not be placed in the position to respond to multiple principals Socialization of information production –Information is likely to be undersupplied if left to private provision.