Chapter 15
Conflicts of
Interest in the
Financial Industry
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
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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
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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.
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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
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Types of Conflicts of Interest
• Underwriting and research in investment
banking
• Auditing and consulting in accounting firms
• Credit assessment and consulting in creditrating agencies
• Universal banking
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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
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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
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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
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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
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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).
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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.
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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
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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
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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.
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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
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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
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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.
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