VIEWS: 32 PAGES: 16 POSTED ON: 10/15/2011
Chapter 16: Conflicts of interest FINC 412 Professor Cicero Benefits of Financial Institutions Expertise in collecting and interpreting information Limiting adverse selection and moral hazard Economies of Scale Benefit by re-using information or systems Economies of Scope By spreading information they gather across many services for clients, financial institutions can lower the cost of information production Example: credit analysis for lending underwriting a bond issue Efficiency gains lead institutions to provide many services under one roof Conflicts of Interest Definition: a moral hazard problem that occurs when a person or institution has multiple competing objectives (or conflicting interests) As a result, if one interest is more PROFITABLE, the person or institution may sacrifice their integrity with respect to the less profitable interest to the benefit of the more profitable one Specifically, conflicts of interest can arise when financial institutions or their employees have opportunity to serve their own interests, instead of the interests of their customers by Misusing information Providing false information Concealing information Why do we care? Those who are privy to information do not accurately and fully reflect it to the marketplace This reduces the overall quality of information available, and leads to GREATER INFORMATION ASSYMETRY Society therefore is less efficient at allocating capital to its “highest use” Also, firms must pay higher “costs of capital” since it is more difficult to know their quality Underwriting and Research Analysts Investment banks perform two key tasks: Underwriting securities (i.e., bringing securities to market) Providing research reports on companies to clients Is there a conflict of interest between these two services??? Companies choosing UW want the bank to provide “support” for the price of their securities by issuing favorable research At time of issuance To support trading in secondary market Clients who purchase research want accurate research What gets compromised and why??? How do you get research analysts to be “biased”? Example: Morgan Stanley Memo: “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” (July 14, 1992) Read about King, Queen and Jack of the internet (Henry Blodgett, Mary Meeker and Jack Grubman) Underwriting and Research Analysts “Spinning” Banks allocating “hot” IPO shares to executives of companies for whom they hope to provide underwriting services in the future! Problems? Some clients only get “cold” IPO shares! Executives may later pick an underwriter based on this “kickback” as opposed to which firm can raise capital at the best price! Frank Quattrone and the “Friends of Frank List” Auditing and Consulting in Accounting Firms Auditor’s traditional role: reduce information asymmetry!!! Conflicting objective: “management advisory services” Advice on taxes, accounting, MIS and business strategies Economies of scale and scope Once you do the audit, you are well prepared to provide advice, and you already have a relationship with the managers What problems do the conflict lead to? May give rosier audit to keep advisory business (often more profitable!) Advisors may be reluctant to criticize their partners in audit Result positively biased audits!!! Remember Arthur Andersen and Enron??? Credit Ratings Agencies What do investors and regulators want in a credit rating? Accurate ratings What do rated companies want? Good ratings Who pays for the rating? Companies who are rated! What might this arrangement lead to? Upwardly biased ratings since the agency wants to get the deal done, and also wants to be chosen for future ratings business Also, remember that only 3 ratings agencies do most of the work Moody’s, S&P, and Fitch What does this lead to? Additional conflict: companies often ask agencies for advice on structuring their securities to get a favorable rating. What are the potential problems? Gaming the system; not wanting to lose this business Universal Banking 1933: Glass-Steagall Act prohibits one company from providing commercial banking, investment banking and insurance contracts 1999: Gramm-leach-Bliley Financial Services Modernization Act repealed Glass- Steagall Many potential conflicts: Aggressive marketing of IPO securities to commercial bank clients or managed trust accounts (the inevitable back end of Spinning) Recommending inappropriate insurance products in effort to “cross-sell” If a bank has a loan out to a company that is getting into financial distress, it might try to help the company sell new debt or equity to raise capital to pay off the loan Bank might make a loan on favorable terms to attract future underwriting business get private information for trading in its own accounts or accounts it manages, or To generate more accurate analyst reports (My research shows this!!!) Bank might issue favorable research reports to attract new borrowers and all the benefits of the private information that comes along with lending (My research shows this!!!) Others??? Can the market be expected to solve conflicts of interest problems? Not all conflicts are a problem – the incentive to exploit it must be HIGH (profitable) The opportunity to exploit it must be GOOD (information asymmetry) Reputation Risk!!! Can the market be expected to solve conflicts of interest problems? (how has it done?) Credit ratings agencies: older evidence was consistent with reputation concerns leading to UNBIASED ratings Investment Banking / Commercial Banking: In the 1920s, investors discounted the value of bonds issued by banks that made loans Banks tended to set up subsidiaries to separate the underwriting and commercial lending businesses Banks that made loans also tended to underwrite securities only for well- known reputable companies Investment Banking / Research: Evidence shows that the market only partially discounted the recommendations of underwriter-affiliated analyst biases! Auditing / Consulting: Some evidence that audit clients will at times refrain from using affiliated consulting services to avoid the potential for the appearance of a biased audit Lending / Research: market adjusts for bias!!! Can the market be expected to solve conflicts of interest problems? (what are the issues?) A problem with market solutions: there is always INNOVATION in conflict exploitation, and as the markets become more complex, there is more asymmetric information to take advantage of! The role of internally generated incentives Compensation schemes may give incentive to exploit conflicts Arthur Andersen: employees in Houston had incentive to fudge Enron numbers because that one client had such a large effect on the Houston partners’ compensation. Research analysts were often compensated based on the level of underwriting business These incentive schemes are not readily observable to the market!!! The role of “Reputational Rents” There is a time-inconsistency problem between the long-term owners or managers of a firm and the lower level employees Long-term employees or owners have incentive to maintain reputation, since future profitability is derived from it Short-term employees may exploit the market’s trust to make short-term profits if they do not believe they will be able to cash in on the longer term profits Governmental policy responses to conflicts of interest – How should they be evaluated? Remember, there are economies of scope from combining activities The overall information available to the market may increase! Efficency gains may be passed on to customers in form of lower costs Conflicts are only a problem if The incentive to exploit them is HIGH The market cannot identify conflicts and impose restrictions Reputation loss if misleading information is given out Discounting the information Devising business structures that mitigate the conflicts If market cannot control conflicts, then will a restrictive policy do more good than harm? Different approaches for controlling conflicts of interest Leave it to the market! Economic penalties (higher cost of capital / less demand for services) Pro: Can avoid risk of over-reaction! Con: market may not identify conflicts Require greater transparency Pro: make it easier for market to identify conflicts Why: Individuals may not have the incentive to gather information on their own because (1) information would be a “public good” and (2) individuals can diversify Con: Must balance the need to know about conflicts against: Revelation of proprietary or strategic information Examples: revealing forecasts (research departments) or investment strategies (hedge funds) may eliminate competitive advantage Purely transactional cost of disclosure Approaches for controlling conflicts of interest Governmental supervisory oversight Pro: can be good if Information is proprietary or strategic Disclosure is bad or confusing (consider complexity of banks!) What is Con? Not clear government authorities are best at identifying risks Bernie Madoff??? Separation of functions in marketplace Pro: you can eliminate conflict all together Examples: In-house firewalls (limit direct communications) Require separate affiliates (non-aggregation of information) Total prohibition What is Con? May lose economies of scope Approaches for controlling conflicts of interest “Socialization” of information production function For example, macroeconomic data is gathered by the federal reserve b/c it would be difficult for the market to aggregate the information. Could auditing / rating securities be done by government? Potential Cons? Best and brightest? New conflicts??? Governmental workers might have incentive to say good things Bribes? Risk aversion b/c of low incentives?
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