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What does this look like


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									   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

   This reduces the overall quality of information available, and leads to


   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
                       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,
        Read about King, Queen and Jack of the internet (Henry Blodgett, Mary Meeker and Jack
                   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-

   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

   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

     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
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
           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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