Topic 10: Conflicts of Interest in the Financial Industry

Conflicts of Interest- a type of moral hazard problem that occurs when a
person or institution has multiple objectives (interests) and as a result has
conflicts between them.
Conflicts of interest usually take the form of misleading information.
Financial institutions can benefit off of giving out misleading information, hurting
the public, while giving the financial institutions greater profits.
Conflicts of interest lead to unethical behavior.
Conflicts of interest occur when an institution or employee serves his interests
at the expense of others.
Combinations of services that bring together any group of depository
intermediaries, non-depository intermediaries, and brokers, or that allow any of
these groups to invest directly in a business, are most likely to lead to conflicts
of interest.
Conflicts of interest can substantially reduce the quality of
information in financial markets, thereby increasing asymmetric
information problems.
In turn, asymmetric information prevents financial markets from
channeling funds into the most productive investment
opportunities and causes financial markets and the economy to
become less efficient.
The growing economies of scope have led to financial institutions
to offer many services under one roof, increasing conflicts of
interest and in turn increasing unethical behavior.
of interest become a problem for the financial
system when they lead to a decrease in the flow of
reliable information, either because information is
concealed or because misleading information is spread.
decline in the flow of reliable information makes it
harder for the financial system to solve adverse
selection and moral hazard problems, which can slow
the flow of credit to parties with productive investment
Inappropriately designed compensation plans, for
example may produce conflicts of interest that not only
reduce the flow of reliable information to credit markets
but also end up destroying the firm.
The conflict of interest problem can become even more
hazardous when several lines of business are
combined and the returns from one the activities, such
as underwriting and consulting, are very high for only a
brief amount of time. Also, a compensation scheme
that works reasonably well in the short term might
become poorly aligned in the long run.
Threats to truthful reporting in an audit arise
from several potential conflicts of interest.
The conflict of interest that has received the
most attention in the media occurs when an
accounting firm provides its client with auditing
services and non-audit consulting services,
commonly known as Management Advisory
Services, such as advice on taxes, accounting
or management information systems, and
business strategies
Accounting firms that provide multiple services enjoy economies of scale
and scope, but have three potential sources of conflicts of interest
 1st: clients may pressure auditors into skewing their judgments and
opinions by threatening to take their accounting and management
services business to another accounting firm
 2nd: if auditors are analyzing information systems or examining tax
and financial advice put in place by their non-audit counterparts within
the accounting firm, they may be reluctant to criticize the advice or
 Both types of conflicts might potentially lead to biased audits
 With less reliable information available to investors, it becomes more difficult for
financial markets to allocate capital efficiently
3rd: arises when an auditor provides an overly favorable audit in an
effort to solicit or retain audit business.
 The unfortunate collapse of Arthur Andersen suggest this may be
the most dangerous conflict of interest
In the Arthur Andersen case the partners in regional offices had
incentives to please their largest clients even if their actions
were detrimental to the firm as a whole
Young accountant who founded his own firm
Until the early 80’s auditing was the most important source of
profits for this firm
By late 80’s the consulting part of the business began to
experience high revenue growth with high profit margins, even
as the audit profits slumped in a more competitive market
Consulting partners began to assume more power within the
firm, and the resulting conflicts split the firm in two
Arthur Andersen and Andersen Consulting were established as
a separate company in 2000
During the period of increasing conflict before the split,
Andersen’s audit partners had faced increasing pressure to
focus on boosting revenue and profits from audit services
Largest clients in Regional area included: Enron, WorldCom, Qwest,
and Global Crossing
The combination of intense pressure to generate revenue and profits
from auditing and the fact that some clients dominate the business of
regional offices translated into big incentives for regional managers to
provide favorable audit stances for these large clients
So losing a client such as Enron or WorldCom would be devastating
Arthur Andersen ignored many problems in the infamous Enron
reporting and became indicted in March 2002 and convicted in June
2002 for obstruction of justice for impeding the SEC’s investigation of
the Enron collapse.
Its conviction, the first ever against a major accounting firm, barred
Arthur Andersen from conducting audits of publicly traded firms and
so effectively put it out of business
The collapse of Arthur Andersen illustrates how the compensation
arrangements for one line of business, such as auditing, can create
serious conflicts of interest.
of Interest can substantially reduce the quality of
information in financial markets, thereby increasing
asymmetric information problems.
asymmetric information problems prevent financial
markets from channeling funds into the most productive
investment opportunities and causes financial markets and the
economy to become less efficient.
Analysts in investment banks are persuaded to
distort their research to please the underwriting
department of their bank and the corporations
issuing the securities which undermines the
reliability of information investors use for
financial decisions and diminishes the
efficiency of securities markets.
Spinning occurs when investment banks
allocate underpriced shares of newly issued
stock to executives of other companies in order
to lure them to use that investment bank
When the executives company plans to issue
its own securities it uses that investment bank
as an underwriter.
This causes a rise in the cost of capital for the
firm and hinders the efficiency of the capital
A bank may make loans to a firm on overly
favorable terms to obtain fees from it for
performing activities such as underwriting the firms
A bank with an outstanding loan to a firm whose
credit or bankruptcy risk has increased has private
knowledge that may encourage the bank to use its
under-writing department to sell bonds to the
unsuspecting public, thereby paying off the loan
and earning a fee.
These conflicts of interest decrease the amount of
accurate information and hinders the banks ability
to promote efficient credit allocation
Standard & Poor’s
Fitch Ratings
Moody’s Corp.
Goldman Sachs
Rating agencies are paid for their services
Agencies may give high paying clients a higher rating
Consumers buy bonds and other debt instruments with
AAA ratings only to end up losing
Fitch Ratings and Standard & Poor’s rated CDO’s issued
by Credit Suisse as AAA. Losses on $340 million worth
of CDO’s amounted to $125 million
Less accurate ratings led to higher profits
The combined profits of rating agencies doubled from 3
billion in 2002 to over 6 billion in 2007
Moody’s profits quadrupled between 2000 to 2007
In the first quarter of 2008, 98% of rating changes for
CDO’s were downgrades
Goldman Sachs Group Inc. is under investigation
by the Securities & Exchange Commission for fraud
in a mortgage securities transaction.
Was there a conflict of interest in this transaction?
Goldman Sachs purchased many mortgages
from the US housing market.
They then converted them into mortgage
backed securities.
They advised clients to buy these mortgages.
At the same time they sold these mortgage
securities short as either a hedge against their
portfolio to reduce risk or as a major position
anticipating a drop in value in the US housing
Goldman Sachs has an obligation to offer investments
that it believe are in the clients best interest.
They are also legally obligated to know their client, as
well as what is a suitable investment for their client.
In this case the clients of Goldman Sachs were
knowledgeable investors (i.e. International banks and
hedge funds)
Did Goldman Sachs disclose, to the clients purchasing
these mortgage products, that they were also shorting
these same securities?
If they did not, Goldman Sachs was acting in their own
best interest as opposed to that of their clients. This is
a conflict of interest.
Goldman Sachs, a premier investment banking
firm, may be heavily fined, broken up and/or
lose their clients trust, which is Goldman Sachs
Group Inc. most valuable asset.
Sarbanes-Oxley Act of 2002
Global Legal Settlement of 2002
Four Major Components of SOX
1. Supervisory oversight to monitor and prevent conflicts of interest
Establishment of Public Company Accounting Oversight Board (PCAOB)
2. Reduced conflict of interest
Unlawful if public accounting firm provide any non-audit service to a client with an
impermissible audit
3. Provided incentives for investment banks not to exploit conflicts of
Criminal charges for white-collar crime and obstruction of official investigation
4. Improved the quality of information in the financial markets
CEO, CFO, and auditors are required to certify periodic financial statements and
disclosures of the firm
Independent members of the audit committee
Key elements on the agreement
1. Reduced conflict of interest
required to sever the links between research and securities
banned spinning
2. Provided incentives for investment banks not to exploit conflict of
imposed $1.4 billion of fines on the accused investment banks
3. Had measures to improve the quality of information in financial
Required investment banks to make public their analysts’
The existence of a conflict of interest does not mean that it
will have serious adverse consequence.
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.
Increased supervisor
oversight to monitor and
prevent conflicts of interest
Directly reduced conflicts of
Produced incentives for
investment banks not to
exploit conflicts of interest
Instituted measures to
improve the quality of
information in financial
Directly reduced
conflicts of interest
Produced incentives for
investment banks not to
exploit conflicts of
Instituted measures to
improve the quality of
information in financial
The market may punish
the firm exploiting conflicts
of interest by causing
them to have higher
funding costs or
decreased demand for
Open market forces can
create means to contain
conflicts of interest
through information
demanded from non
conflicted organizations
Mandatory information
disclosure decreases
information asymmetries
This in turn reveals if
conflicts of interest are
being exploited
 Could be bad because of
free-loader effect
 If regulated too much can
cause loss in information
production and profitability
for the firm
Supervisors can review
financial information
without revealing it to
This maintains profitability
& information production
Supervisors can then take
actions to control the
exploitation of conflicts of
interest and enforce
ethical standards
Poor supervisors allow for
exploitation to continue
Reduces economies of scope
through regulation
 Information sharing
between departments is
Separates departments and
adds firewalls to ensure that
the firms agents are not
responding to multiple
 Results in a trade off
between information
production and reducing
conflicts of interest
Thank You

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