Conflicts of Interest in Financial Services: What Should Be Done About Them?

Based on the

Fifth Geneva Report on the World Economy

by

Andrew Crockett (formerly BIS)

Trevor Harris (Columbia University)

Frederic Mishkin (Columbia University)

Eugene White (Rutgers University)

Roma, 31 March 2004

An Information Approach to Conflicts of Interest

• Conflicts of Interest in the Financial Industry are ubiquitous.

• Recent scandals have shown how some of these conflicts have been exploited for enormous profit and to the detriment of the financial markets.

• Our report offers a general framework for analyzing conflicts and identifying remedies

• We employ an approach that focuses on a key attribute of all financial transactions: asymmetric information.

The Problem of Asymmetric Information

• To use financial markets, investors require accurate, reliable, timely information to channel funds to the most productive borrowers. The information may be provided by banks, analysts, auditors, rating agencies and other financial institutions.

• But Asymmetric Information—the fact that the lender knows less about the borrower--is a crucial impediment.

• Asymmetric Information:

• (1) Makes it difficult to screen out and avoid providing credit to poorly managed business

• (2) Makes it difficult, once credit is given, to monitor managers for excessive risk taking.

• (3) Induces investors to shun the financial markets.

The Benefits of Overcoming Asymmetric Information: Economies of

Scale and Scope• If financial institutions can convince customers that

they provide high quality information, they can build a reputation that allows them to grow in size. They will gain Economies of Scale that reduce the cost of services.

• Firms that solve one informational asymmetry may also be efficient at solving others, becoming low cost producers of information for complementary services. They will then gain Economies of Scope or Synergies in the joint provision of these services.

Synergies and Conflicts of Interest: A Package Deal

• Synergies lower costs for customers, but they also create new potential costs from conflicts of interest.

• Conflicts of interest occur when a financial institution or one of its employees has multiple interests that create incentives to misuse information needed for the effective functioning of financial markets

• If individuals or firms can exploit conflicts, they benefit from the synergies and reduce the market’s efficiency.

Five Conflicts of Interest in the U.S. Financial System

I. Underwriting and Research in Investment Banking

II. Commercial and Investment Banking in Universal Banks

III. Auditing and Consulting in Accounting FirmsIV. Credit Assessment and Consulting in Rating

AgenciesV. Diverse Clients in Mutual Funds

Markets and Regulation

• The existence of conflicts does not necessarily imply that they will be exploited, if a firm values and protects its marketplace reputation.

• Public Policy may or may not be required to control potential conflicts. If there is intervention, reduction of conflicts needs to be weighed against reduction of synergies----the central trade-off

Remedies for Conflicts1. Leave it to the market: no loss in market efficiency, but

control conflicts may not be adequately controlled.2. Regulate for Disclosure/Transparency: better information

flow but may disclose proprietary information3. Supervisory Oversight: examination for better

information, timely intervention, industry standards but potential industry capture/forbearance/overbearance

4. Separate by Function: Prevents conflicts, eliminates synergies, very costly

5. Socialize Information: socialization of information production and distribution, but poor incentives for production and setting prices/fees introduces potential distortions

I. Underwriting and Research in Investment Banking: Synergies

• Underwriters and research analysts both help investors overcome the information asymmetry.

• When research analysts identify and monitor companies that are worthy of investment, their information may help underwriters select IPOs.

• Underwriters’ IPO investigations provide information to analysts who may then be able to offer superior buy/sell recommendations and performance forecasts to investors.

• Information synergies from underwriting and research thus provide a rationale for combining these two services.

I. Conflicts between Underwriting and Research

• Issuers benefit from optimistic research while investors seek unbiased research.

• If the incentives for these two activities are not appropriately aligned, employees on one side of the firm may distort information to the advantage of their clients and the profit of their department.

• Setting the appropriate compensation for analysts is difficult because the information they generate benefits more than one department (synergies).

I. How Extensive were the Conflicts?

• Some well documented cases where analysts promoted stocks that they derided in private or manipulated ratings to attract business:

• Blodget at Merrill Lynch• Grubman at Citigroup• Quattrone at Credit Suisse First Boston• BUT, while the market may have missed these cases, in general it was aware

of potential conflicts problem and responded.

I. The Market Discounts Information when it is aware of a potential conflict• On average, analysts of lead underwriting firms were

more optimistic. They made 50 percent more buy recommendations for their firms’ new issues than other firms’ analysts.

• But: the market recognized the difference. The market had only half the positive stock price response to their announcements compared to other analysts’ announcements.

• 86 percent of professional money managers said that they discounted the recommendations of analysts when there was a recognized conflict of interest.

I. Policy Remedies?1. Leave it to the market: (a) Firms respond to damaged

reputations—fire analysts and hire more independent ones. Substantial correction before government intervention. (b) Importance of strong independent legal system. Vigorous, quick prosecution of fraud induced firms to reform

2. Regulate for Disclosure/Transparency: Spitzer/Global Settlement (2002) requires stock research to indicate up front if firms do investment banking business with the bank. Quarterly, banks must publish on the web charts showing track records of analysts.

I. Policy Remedies?3. Supervisory Oversight: (a) Spitzer/Global Settlement:

Spinning is Banned. Banks may not allocate IPO shares to corporate executives of client firms. (b) Fines of $1.4 billion against top ten banks, but they are weakly related to damages or investor relief. (c) Congress has increased the SEC budget increased to to provide more supervisory oversight

4. Separate by Function: Spitzer/Global Settlement imposes strict separation within firms of research and underwriting---loss of synergies when market understood and discounted for conflicts. No continuous monitoring from research for underwriting.

I. Policy Remedies?5. Socialize Information: Spitzer/Global Settlement: Firms

must make analysts’ recommendations public. For 5 years each firm must buy research for customers from 3 independent companies. An independent monitor has authority to procure research. Makes research more of a public good, discouraging firms from investing in research. Firms won’t compete on basis of research. Taxing firms to support independent research lowers quality and quantity of information. Consequences: Wall Street Journal (March 5, 2004): “Increasingly, Stock Research Serves Pros, Not the Little Guy” Response to Global Settlement: research budgets are slashed, fewer firms are covered, and reports tailored to institutional investors and big clients.

II. Commercial and Investment Banking: The Glass-Steagall Act Lesson

• In the U.S. in the 1920s, commercial banks moved into underwriting and brokerage.

• Combining different information collected on borrowers by commercial and investment banks improved quality of analysis, creating synergies. Also combination permits larger research staffs, provides an enlarged investor base

• Commercial banks securities affiliates seize over half the market in IPOs.

II. Conflicts of Interest Between Commercial and Investment Banking • Bankers blamed for selling new issues of “unsound and

speculative securities” to benefit the investment side of the bank to the detriment of the commercial side customers who lack inside information.

• Commercial banks were accused of converting bad loans into security issues to be sold to public or bank-managed trusts

• Some egregious cases of managers exploiting conflicts of interest. External stock pools operated for private benefit of officers to speculate in stock—often of parent company

II. How Serious Were these Conflicts?• Commercial banks’ securities affiliates did an equal or

better job than stand-alone investment banks: lower default rates, and lower losses for equivalent securities—evidence for dominance of synergies over conflicts.

• When there was a high potential for conflicts, the market recognized them and penalized banks: their securities sold for higher yields. Banks responded and changed their governance and organization to show the market that they had insulated commercial and investment banking activities.

• Consequently, market rewards their securities with higher prices/lower yields. True in 1920s and 1990s.

II. Policy Remedies?1. Leave it to the Market: Market disciplined

commercial/investment banks in 1920s so that on average their performance was superior to stand-alone investment banks.

2. Regulate for Disclosure/Transparency: 1920s experts advised more disclosure to ensure conflicts are well known and not exploited

3. Supervisory Oversight: (a) Glass-Steagall Act of 1933 banned pool operations (b) 1920s experts advised supervisory examinations of both commercial and investment banking units by one regulator

Policy Remedies?4. Separate by Function: Glass-Steagall Act (1933) imposed a

complete separation of commercial and investment banking. High costs to the financial industry from elimination of synergies and reduced competitiveness of American banks. Gramm-Leach-Bliley Act of 1999 completely repealed the Glass-Steagall Act and placed commercial and investment activities in separate units within the bank, similar to the 1920s. Necessary to avoid problems for the safety net provided by deposit insurance.

5. Socialize Information/Pricing: Not relevant.Consequences: Glass-Steagall Act (1933) imposed decades of high costs on the industry. Since gradual repeal began in 1987 and was completed in 1999, there have been no problems from conflicts of interest. Instead competition and access of small firms to the market has increased.

III. Conflicts of Interest and Synergies between Auditing and Consulting in

Accounting Firms• Accounting firms found synergies in the joint

provision of auditing and other services including tax advice, management information systems and strategy because of the broad information they collected

• Conflicts of Interest are potential problems (a) if there is pressure on auditors to bias their opinions to limit loss of fees from other services (b) if they audit their own consultant’s work

III. Were Conflicts of Interest a Problem?

• No systematic evidence that conflicts of interest were exploited.

• Non-audit fees were not associated with reduced auditor independence

• Audit clients were aware of potential problem and often limited non-audit purchases from incumbent auditors

III. What were the Problems?• Dominance of a regional audit office by one firm:

Enron, Worldcom, Qwest and Global Crossing for Arthur Andersen. Enron prize client of Houston office, loss would devastate local office.

• Lack of auditor independence. Auditors selected by management not audit committee. Some Enron executives were ex-auditors from Andersen

• Litigation Risk----high cost class action suits---audit profession and corporations seek and rely on increased codification of GAAP as legal defense. Rather opine on “true” financial condition, audits attest to whether firms comply with GAAP.

III. Policy Remedies?

1. Leave it to the Market: (a) Arthur Andersen fails—ultimate discipline of the market (b) Vigorous prosecution of fraud emphasizes the importance of legal system in disciplining individual firms. (c) Although the market generally exerted control over conflicts of interest, new legislation gives it scant attention. (d) Study ordered by Sarbanes-Oxley Act of 2002 to examine whether accounting firms should focus on GAAP, but no solution in near future to problem of litigation risk.

III. Policy Remedies?2. Regulate for Disclosure/Transparency/Improved

Governance: Sarbanes-Oxley Act of 2002: (a) For corporations’ audit committees, each member must be a member of board of directors or otherwise independent. This act removed management from the selection of auditors, ensuring that a more independent committee is responsible for the appointment, compensation, and oversight of work of auditors. Corrects important flaw that allowed managers to interfere with auditor independence. (b) Study ordered for mandatory rotation of audit firms.

III. Policy Remedies?3. Supervisory Oversight: Sarbanes-Oxley Act of

2002 reduced industry self-regulation and established the Public Company Accounting Oversight Board (PCAOB) to (1) register public accounting firms, (2) establish rules for auditing, quality control, ethics, independence and other standards, (3) conduct inspections of accounting firms (4) conduct investigations, disciplinary proceedings and impose appropriate sanctions.

III. Policy Remedies?4. Separate by Function:Sarbanes-Oxley Act of 2002

strictly separated auditors and consulting. Unlawful for a public accounting firm to provide any non-audit service contemporaneously with the audit. (Including: bookkeeping, financial information systems design, appraisals, actuarial services, internal audit outsourcing, management functions, broker, investment advisor, investment banker, and any other service that the Board determines is impermissible. As the combination of services was not a key problem in the scandals, this separation imposes a high unnecessary cost on the industry given the synergies.

5. Socialize Information/Setting Prices: Not relevant.

IV. Conflicts of Interest and Synergies in Rating Agencies

• Rating Agencies gain access to information and rate the quality of borrowers for investors, helping to bridge the information asymmetry.

• Synergies arise from the joint provision of rating with consulting services for financial structuring, including packaging to certify credit quality and ratings.

• Conflicts of Interest can arise if the agencies are in the position of rating their own consulting work, equivalent of auditing their own work

IV Problems in the Ratings Industry

• Increased regulatory dependence on ratings drives up demand for financial structuring

• Barriers to entry reduce competition: in 1975 SEC designated “National Recognized Statistical Rating Organization” (NRSRO) to limit “ratings shopping” as regulatory use of ratings grows.

• More public information: need to identify any relationship of agency to any issuer

• Currently, only potential not significant problems.

IV. Policy Remedies for the Ratings Industry1. Leave it to the Market: Reliance on market discipline (a)

Importance of limiting conflicts to maintain reputational capital. (b) Need to ensure that appropriate incentives are maintain for agents within rating agencies that provide both assessment and consulting (c) Need to increase competition and reduce barriers to entry (d) Lessen government dependence on ratings.

2. Regulate for Disclosure/Transparency—identify any relationship of the rating agency to any issuer

3. Supervisory Oversight: none

4. Segregate by Function: Firms not government should ensure internal firewalls are in place.

5. Socialize Information/Setting Prices: Not appropriate

V. Conflicts of Interest and Synergiesin the Mutual Fund Industry

• Customers benefit from selection among a family of mutual funds and other investment opportunities. Multi-product financial intermediaries gain synergies.

• Conflicts arose because mutual funds are sponsored by large multi-product financial intermediaries or have investment advisors involved in multiple activities.

• The information asymmetry between the manager and the shareholders allowed the former to exploit the special liquidity characteristics of mutual funds, engaging in Market Timing and Late Trading

V. How Conflicts of Interest were Exploited

• The board of directors is responsible to the shareholders for overseeing the investment advisor who manages the fund. But, information and independence of directors may have been limited, consequently they did not adequately monitor conflicted managers

• Insufficient disclosure of conflicted relationships and actions

• NAV prices sometimes deviated from market prices. Combined with liquidity rules that were are easy to exploit, there are huge arbitrage opportunities

• Opaque structure of fees and costs

V. Extent of Late Trading and Market Timing

• Hedge Funds exploit Mutual Funds in High Profile Cases: Stern/Canary Capital/Bank of America, Strong Capital Management, MFS, PBHG with Late Trading (select investors can trade after 4 p.m. deadline) and Market Timing (select investors can arbitrage across time zones and in thin markets)

• Problem of Market Timing appears to be very widespread---estimates vary but funds may have lost ½ to 1 ½ percent of their value (over $5 Billion) annually to this activity

V. Policy Remedies for Mutual Funds1. Leave it to the Market (What are the

Incentives?): (a) most managers compensated by fee that is a percentage of fund assets not by maximizing return—incentive to allow market timing (b) Harden 4 p.m. deadline for orders to eliminate Late Trading (c) Higher redemption fees to halt Market Timing. Fees reduce but do not eliminate it, and impose costs on other investors (d) Using Fair Value Pricing when Net Asset Values (NAVs) deviate from market prices. Optimal solution but problem of approximating market prices.

V. Policy Remedies

2. Regulate for Disclosure/Transparency/ and Governance: (a) Board are weakly independent, meet few times a year oversee many funds—weak monitoring of managers. Fraction of outside directors raised from 40% to 50% in 2001, now (2004) 75% with independent chairman. Evidence shows in past more independent boards, fewer problems, lower costs. (b) Poor disclosure of fees—SEC promises increased improved disclosure

V. Policy Remedies

3. Supervisory Oversight: Little prior oversight by the SEC. New larger budget, more examination and supervision.

4. Separate by Function: not appropriate and has not been discussed as a remedy

5. Socialize Information/Set Prices: (a) NY Attorney General attacks poorly disclosed fees with fines and directly forces companies to set lower fees. Ad hoc solution, uneven playing field for firms.

The Big Picture• Potential Conflicts of Interest in the Financial Industry

are very common

• While they cannot be eliminated easily, their exploitation can be controlled

• The market exerts control over conflicts because reputation is important to firms---conflicts are usually exploited when short-term gains are taken by some agents at the longer-term expense of the firm

• The most important contribution of regulation is to strengthen the flow of information to promote disclosure, transparency and good governance structures, supported by appropriate regulatory oversight.

Quis Custodiet Ipsos Custodes?• Central to the operation of the financial system are the

“cani di guarda” the watchdogs

• Research analysts, Auditors, Rating agencies----and also Regulators and Prosecutors

• They provide overlapping but different types of corporate monitoring, none can be replaced

• They play an essential role---we want them to be vicious watchdogs---feared by companies. They should be lean and hungry, driven by competition. The danger is that they may not be able to do their job if they are excessively regulated. Goal should be to strengthen market forces and ensure more disclosure of vital information