1. Conflicts of Interest in the Financial Industry
Chapter 15
Conflicts of Interest in the Financial Industry

2. What Are Conflicts of Interest and Why Are They Important?
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)
Subprime financial crisis of 2007–2008

3. What Are Conflicts of Interest and Why Are They Important? (cont’d)
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

4. What Are Conflicts of Interest and Why Are They Important? (cont’d)
Focus on conflicts of interest that arise when financial service firms or their employees serve one interest at the expense of another’s, which could be their own interest, rather than their customer’s, or a firm’s interest who wants to sell securities rather than investors’ who are purchasers of the securities. As a result they might misuse information, provide false information, or conceal information.

5. Why Do We Care About Conflicts of Interest?
Conflicts of interest can substantially reduce the quality of information in financial markets increasing asymmetric information problems
Asymmetric information prevents financial markets from channeling funds into productive investment opportunities and causes financial markets and economies to be less efficient

6. 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

7. Underwriting and Research in Investment Banking
Issuers benefit from optimistic research
Investors desire unbiased research
Strong incentive to alter information provided to both types of clients, favoring the issuing firm
Spinning

8. Auditing and Consulting in Accounting Firms
Accounting firms provides its clients with consulting services (taxes, business strategies)
Pressure from clients threatening to take business to another firm
Reluctance to criticize work done by nonaudit counterparts
Provide an overly favorable audit in an effort to solicit or retain audit business

9. Credit Assessment and Consulting in Credit-Rating Agencies
Issuers pay to receive a credit rating
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

10. 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

11. Can the Market Limit Exploitation of Conflicts of Interest?
Incentives to exploit conflict of interest may not be very high and therefore this might not be a problem.
Exploiting conflicts of interest might hurt a financial firm’s reputation
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).

12. 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.

13. What has Been Done to Remedy Conflicts of Interest?
Sarbanes-Oxley Act of 2002
Increased supervisory oversight to monitor and prevent conflicts of interest
Directly reduced conflicts of interest
Provided incentives for investment banks to not exploit conflicts of interest
Had measures to improve the quality of information in financial markets

14. What has Been Done to Remedy Conflicts of Interest? (cont’d)
Global Legal Settlement of 2002:
Required investment banks to sever the links between research and securities underwriting
Banned spinning
Imposed $1.4 billion of fines on accused investment banks.
Required investment banks to make public their analyst’s recommendations
Required investment banks to contract for a five year period with no fewer than three independent research firms that would provide research to their brokerage customers

15. What has Been Done to Remedy Conflicts of Interest? (cont’d)
Dodd-Frank Bill of 2010:
Created an Office of Credit Ratings at the SEC with its own staff and the authority to fine credit-rating agencies and to deregister an agency if it produces bad ratings..
Forced credit-rating agencies to provide reports to the SEC when their employees go to work for a company that has been rated by them in the last twelve months.
Prohibited compliance officers from being involved in producing or selling credit ratings.
Required the SEC to prevent issuers of asset-backed securities from choosing the credit-rating agencies that will give them the highest rating and supported earlier initiatives by the SEC to limit conflicts of interest.
Authorized investors to bring lawsuits against credit-rating agencies for a reckless failure to get the facts when providing a credit rating.

16. A Framework for Evaluating Policies to Remedy Conflicts of Interest
The existence of a conflict of interest does not mean that it will have serious adverse consequences
Does the market have adequate information and incentives to control conflicts of interest?
Even if incentives to exploit conflicts of interest remain strong, eliminating the economies of scope that create the conflicts of interest may be harmful because it will reduce the flow of reliable information

17. 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

18. Approaches to Remedying Conflicts of Interest (cont’d)
Supervisory oversight
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.