1. Chapter 15 Conflicts of Interest in the Financial Industry

2. © 2016 Pearson Education, Inc. All rights reserved.15-2 Preview This chapter explains what conflicts of interest are, why we should care about them, and why they raise ethical issues. It then surveys the different types of conflicts of interest that occur in the financial industry and presents policies to remedy them.

3. © 2016 Pearson Education, Inc. All rights reserved.15-3 Learning Objectives Explain the relationship between economies of scope and conflicts of interest in the financial industry. Identify the ways in which conflicts of interest can create ethical dilemmas in financial services firms. Identify the four areas of financial services most prone to conflicts of interest and explain why they are so susceptible.

4. © 2016 Pearson Education, Inc. All rights reserved.15-4 Learning Objectives Summarize how and why markets may self- regulate and limit conflicts of self-interest. Summarize the key features of the three policies enacted to limit conflicts of interest in financial markets. List and summarize the five approaches used to remedy conflicts of interest in financial markets.

5. © 2016 Pearson Education, Inc. All rights reserved.15-5 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

6. © 2016 Pearson Education, Inc. All rights reserved.15-6 What Are Conflicts of Interest and Why Are They Important? 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

7. © 2016 Pearson Education, Inc. All rights reserved.15-7 What Are Conflicts of Interest and Why Are They Important? 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.

8. © 2016 Pearson Education, Inc. All rights reserved.15-8 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.

9. © 2016 Pearson Education, Inc. All rights reserved.15-9 Ethics and Conflicts of Interest Conflicts of interest raise ethical dilemmas for those engaged in the financial service business by generating incentives for financial service firms and their employees to conceal information or provide misleading information, thereby hurting the customers for whom they work.

10. © 2016 Pearson Education, Inc. All rights reserved.15-10 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

11. © 2016 Pearson Education, Inc. All rights reserved.15-11 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

12. © 2016 Pearson Education, Inc. All rights reserved.15-12 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 non- audit counterparts Provide an overly favorable audit in an effort to solicit or retain audit business –Arthur Anderson

13. © 2016 Pearson Education, Inc. All rights reserved.15-13 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

14. © 2016 Pearson Education, Inc. All rights reserved.15-14 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

15. © 2016 Pearson Education, Inc. All rights reserved.15-15 FYI: Banksters The Pecora hearings which followed on the heels of the Great Crash of 1929 revealed numerous cases of severe exploitation of conflicts of interest in the banking industry. An affiliate of National City Bank (the pre- cursor to Citibank) was accused, for example, of selling “unsound and speculative securities.” Bankers came to be referred to as ‘banksters’, a reference to gangsters.

16. © 2016 Pearson Education, Inc. All rights reserved.15-16 FYI: Banksters The resulting scandals led to passage of the Glass-Steagall Act in 1933, which eliminated the possibility of these conflicts of interest by mandating complete separation of commercial banking from investment banking activities. It was not until 1999 that this act was repealed by Congress to enable banks to become more competitive.

17. © 2016 Pearson Education, Inc. All rights reserved.15-17 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).

18. © 2016 Pearson Education, Inc. All rights reserved.15-18 Can the Market Limit Exploitation of Conflicts of Interest? 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.

19. © 2016 Pearson Education, Inc. All rights reserved.15-19 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

20. © 2016 Pearson Education, Inc. All rights reserved.15-20 What has Been Done to Remedy Conflicts of Interest? 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

21. © 2016 Pearson Education, Inc. All rights reserved.15-21 What has Been Done to Remedy Conflicts of Interest? 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.

22. © 2016 Pearson Education, Inc. All rights reserved.15-22 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

23. © 2016 Pearson Education, Inc. All rights reserved.15-23 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

24. © 2016 Pearson Education, Inc. All rights reserved.15-24 Approaches to Remedying Conflicts of Interest 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.