Conflict of Interest

1. Learning Unit #7
Conflicts of Interest

2. Objective of Learning Unit
• Causes and Consequences of Conflicts of
Interest
• Recent Events on Conflicts of Interest
• Types of Conflicts of Interest
• Remedies for Conflicts of Interest

3. Asymmetric Information and
Financial Institutions
• Due to asymmetric information between saver/lenders
and borrower/spenders, saver/lenders face adverse
selection and moral hazard problems.
• Financial institutions in the financial system provide
the information service to saver/lenders to reduce or
eliminate the problems by reducing the degree of
asymmetric information.
– With more and better information about potential
borrower/spenders provided by financial institutions,
saver/lenders can make better decisions to whom to
provide funds and can monitor how their funds are used.

4. Information Service and
Financial Institutions
• Saver/lenders trust financial institutions and their
information. With trust, funds are transferred from
saver/lenders to borrower/spenders efficiently and the
economy prospers.
• Do financial institutions really provide the
information service for the best interest of
saver/lenders?
• Let’s look at recent events in the U.S. financial
system.

5. Recent Scandals
in the U.S. Financial System
There are many recent incidents of unethical and illegal
conducts by business firms and financial institutions in
the U.S. financial system.
• Bankruptcy of Enron and Indictment of Arthur Andersen
• Criminal Investigations of Investment Banks such as Merrill
Lynch, Salmon Smith Barney (Citigroup), Morgan Stanley,
Credit Suisse First Boston
• Fall of Lehman Brothers and Countrywide Financial

6. Enron and Arthur Andersen
• Enron corporation specialized in trading in the energy market,
was valued at $77 billion as the seventh-largest corporation in
the U.S.
• Enron manipulated its financial report by using the special
purpose entities (SPE) to hide its huge loss, and its top
management benefited from falsification.
• When it disclosed a third-quarter loss of $618 million and
revealed accounting irregularities, its stock price fell from $90
to pennies.
• Arthur Andersen was a CPA and consulting firm for Enron,
which advised questionable accounting practices and certified
the manipulated financial report.
• Similar problem was found in MCI WorldCom audited by
Arthur Andersen.

7. Investment Banks
• Late 1990s many Internet and technology firms had initial
public offerings (IPO) and sold their stocks at high prices with
help of top investment banks in the U.S. (i.e. Merrill Lynch,
Salmon Smith Barney, Morgan Stanley, and Credit Suisse
First Boston) even though those firms had never had any
profits.
• To market IPO stocks, investment banks’ research units
provided potential buyers an extremely optimistic outlook of
IPO firms, then continued its hypes to propel stock prices of
Internet and technology firms further up.
• However, from March 2000 to September 2002, the heavily
tech-laden NASDAQ index fell by 50%.

8. Bear Sterns and Countrywide Financial
• Countrywide was the largest mortgage loan company which
specialized to originate mortgage loans to households and sold
them to mortgage securitization firms.
• In mid-2000s during the real estate boom, Countrywide and
many other mortgage lenders provided mortgage loans to less
qualified risky borrowers (subprime loans) and sold them to
private securitization firms (SPE) established by Bear Sterns
and other financial institutions. In many cases, the mortgage
lenders failed to check credit background of borrowers or even
did not ask potential borrowers’ incomes (sometime mortgage
brokers made up or falsified to make borrowers qualified).

9. Bear Sterns and Countrywide Financial
• Bear Sterns and other financial institutions used own hedge
funds to invest investors’ funds in those mortgage-backed
securities.
• When interest rates on the subprime loans reset in 2007, many
mortgage loan borrowers began to default and foreclose their
homes.
• Without payments securitization firms were unable to pay
interest to holders of mortgage-backed bonds.
• Now, Countrywide Financial is acquired by Bank of America,
while Bear Sterns is in process of acquisition by J.P. Morgan
Chase.

10. (Un-)Ethics in Financial System
• These recent financial scandals revealed unethical and
possibly illegal conducts of corporations (borrowers)
and financial institutions.
• These moral hazard problems arose from the
asymmetric information and misuse of trust of
saver/lenders by corporations and financial institutions.
• Two types of moral hazard problems involved in
scandals
– Principal-agent problem created by corporations
– Conflict-of-interest problem created by financial institutions

11. Principal-Agent Problem
• Principal-agent problem: the managers in control (the
agent) act in their own interest rather than in the
interest of the owners (the principal) due to different
sets of the incentives.
• Ex. Top managers of Enron benefited from falsifying
its financial report and manipulating its stock prices.
Before crash, they made millions by selling Enron
stocks, but buyers of stocks (owners of Enron) lost
almost all savings when the Enron stock price fell.

12. Conflicts of Interest
• Conflicts of Interest: Moral hazard problem that
occurs when a person or institution has multiple
objectives (interests) and has conflicts between them.
• Ex. Arthur Andersen was supposed to provide
accurate financial information to holders of Enron
stocks (owners of Enron), but instead it helped top
managers of Enron in expense of stockholders.

13. Conflicts of Interest in Financial Service Firms
– Financial service firms or their employees serve to
investors as well as corporate clients (two
objectives).
– They are supposed to act in the investing public’s
best interests by providing investors with reliable
information.
– They have incentives to deceive the public and
benefit both themselves and their corporate clients.

14. Causes of Conflicts of Interest
• The exploitation of a conflict of interest becomes
more likely at financial institutions when
− more lines of business are combined.
They have different clients with different interests.
− the extraordinary surge in the stock market creates
huge temporary rewards.
They have more incentive to gain personally and for
one client at cost of other clients.

15. Multiple Financial Services
• Financial institutions combine various financial services to
many different clients.
• When financial institutions have many different clients, there
are potential conflicts of interest among clients.
−Ex. Arthur Andersen provides auditing (for stockholders
who want accurate information) and consulting (for managers
who do not want to reveal information) services.
−Ex. Merrill Lynch provides investment banking (for
corporations who want to sell stocks at high prices) and
security dealer (for savers who want to purchase stocks at
reasonable prices) services.

16. Benefits of Multiple Financial Services
• Financial institutions provide many different, but
related financial services for more customers and
more profits.
• Economies of Scope: Lower the costs of information
production for each service by applying one
information resource to many different services.
• With economies of scope and economies of scale,
financial service firms can provide services to many
clients at lower costs.

17. Effects of Conflicts of Interest
• For saver/lender/owners: Conflicts of interest often cost
saver/lender/owners financially (one client’s gain is other
client’s loss).
• For the economy: Conflicts of interest reduce the quality of
information and increase asymmetric information problems.
– Less funds flow into the financial system due to high uncertainty and
risk, and funds are not allocated efficiently.
– The economy becomes less productive: low economic growth.
• For financial service firms: The exploitation of a conflict of
interest results in
− Large gains for some members of the financial firm who exploit the
conflicts of interest.
− Reduction in the value of the financial service firm as a whole due to
loss of clients.

18. Types of Conflicts of Interest
Conflicts of interest can occur in many different
types of financial institutions.
– Brokerage firms: underwriting and research
– Accounting firms: auditing and consulting
– Credit-rating agencies: credit assessment and
consulting
– Universal banking

19. Brokerage Firms and Conflicts of Interest
Brokerage firms serve
• Corporation clients as an investment bank for
underwriting
• Savers as a security broker for providing information
about borrowers (corporations) through its research.
• Conflict of interest between corporate clients and
savers
– Corporate clients want to raise funds at a low cost (sell
securities at a high price) even if it is risky.
– Savers prefer low risk securities at a reasonable price.

20. Consequence of Conflicts of Interest of
Brokerage Firms
• Because corporate clients pay large fees for
underwriting and issuing new securities, brokerage
firms may favor corporate clients (in order to get
underwriting business) over savers.
– Even if issuing corporations are risky, brokerage firms may
provide a favorable research and recommend them to its
clients (savers).
Ex. Jack Grubman at Salomon Smith Barney
Frank Quattrone at Credit Suisse First Boston

21. Accounting Firms and Corporation
• Accounting (CPA) firms audit corporations and
report to stockholders and SEC.
• Because accounting firms know very well the
financial condition of corporation through auditing,
they can also provide advices to improve its financial
condition (consulting).

22. Accounting Firms and Conflicts of Interest
Accounting (CPA) firms serve
• Stockholders for providing information of
corporations through auditing
• Managers of corporations for consulting
• Conflict of interest between stockholders and
corporate managers (principal-agent problem)
− Corporation managers want to provide good financial
reports to stockholders (so they may get bonus and keep
their jobs) even if it is not so good.
− Stockholders want accurate financial information about the
corporation (so they can decide who to manage the
corporation)

23. Consequence of Conflicts of Interest of
Accounting Firms
• Because corporate managers choose an accounting
firm and pay for auditing and consulting, accounting
firms may favor corporate managers (in order to get
accounting and consulting business) over
stockholders.
− Even if the financial condition is not so good, accounting
firms may suggest how to make it look good through
consulting and to hide any potential financial problems
from stockholders.
Ex. Arthur Andersen and Enron

24. Credit-Rating Agencies
• Credit-rating agencies: financial service firms that rate the
quality of corporate and municipal securities in terms of risk.
– Ex. Standard and Poor’s, Moody’s
• To make securities marketable, securities are assessed in terms
of its risk when they are issued and thereafter. Without credit
assessment, savers are less likely to purchase those securities
due to lack of information.
• Like accounting firms , credit-rating agencies know very well
the financial condition of corporation through credit
assessment, they can also provide advices to improve its
financial condition (consulting) to get a higher rating.

25. Credit-Rating Agencies and Conflicts of
Interest
Credit-rating agencies serve
• Savers for providing information about securities
(credit assessment).
• Corporations for consulting
• Conflict of interest between savers and corporations
− Corporations want to get a high rating from credit-rating
agencies to lower the cost of borrowing even if it is
actually risky.
− Savers want an accurate credit assessment on securities.

26. Consequence of Conflicts of Interests of
Credit-Rating Agencies
• Because corporations pay for credit assessment,
credit-rating agencies may favor corporations (in
order to get paid on credit assessment) over savers.
− Even if the security is risky, credit-rating agencies may rate
it as not so risky to make its corporate client happy.
Ex. Moody’s and Standard and Poor’s on (subprime)
mortgage-backed securities

27. Universal Banking
• Universal banking: provides all types of
financial services (commercial banking,
insurance, securities, and real estate).
Ex. Citigroup provides commercial banking service
under Citibank, insurance under CitiInsurance, and
security dealer/broker/investment bank service
under Salmon Smith Barney.

28. Universal Banking and Conflicts of Interest
Universal banking serves
• Savers who want
− Banking services (Deposits)
− Securities
− Insurance
• Borrowers who want
− Loans (personal, mortgage, credit-card, education,
automobile, business)
− Underwriting services
Because of its diverse clients, there will be potential
conflicts of interest among its clients.

29. Consequence of Conflicts of Interests of
Universal Banking
Stock market crash of 1929 resulted in many banks to
fail and many savers to lose their savings.
• Some universal banks sold risky securities to bank customers.
• Some universal banks securitized risky loans and sold them to
their trust division.
Ex. Banksters during the stock market crash of 1929

30. Solutions for Conflicts of Interest
Potential conflicts-of-interest problems of financial
institutions may be reduced or eliminated by
– Market-based solutions: Clients penalize firms
engaged in conflicts of interest.
• Each financial institution establishes own rules (corporate
governance) to reduce or eliminate conflicts of interest.
– Government regulations: Government tells what
financial institutions cannot do and penalizes firms if
they engage in conflicts of interest.

31. How to Reduce Conflicts of Interest
Conflicts of interest can be reduced by
– Transparency/disclosure: Because the problem arises from
asymmetric information, it can reduce by making sure
accurate information available.
– Supervisory oversight: regulating agencies examine
conducts and ensure transparency.
– Separation of functions: Because the conflicts of interest
arise from serving multiple clients, separating services
internally or eternally can eliminate multiple interests.
– Socialization of information production: Because an
incentive to exploit conflicts of interest arises from fees paid
by clients to produce information, the government may either
produce information or fund financial institutions to produce
information.

32. Market-based Solutions
The existence of a conflict of interest does not necessarily mean
that it will have serious adverse consequences.
• The incentives to exploit the conflict of interest may not be
very high.
Financial institutions adjust their compensation plans for
employees.
• Exploiting the conflict of interest would decrease the firm’s
future profitability.
Deceived investors will do business with other financial
service firms in a competitive financial service market.

33. Government Regulations
Since scandals of Enron and Arthur Andersen and Internet IPOs,
government agencies investigated activities of financial
institutions and Congress enacted laws to prevent the conflicts of
interest in financial institutions.
• Sarbanes-Oxley Act of 2002
̶ Regulate accounting firms, separation of auditing and
consulting, & establishment of independent audit
committee
̶ Improve financial information disclosure and make CEO
and CFO accountable for accuracy of financial reports.
• Global Legal Settlement of 2002
̶ Regulate investment banks, separation between research
and underwriting, & use of independent research firms

34. Government Regulations
Responding to the financial crisis of 2008, the Congress
enacted law and established a new agency to prevent
the conflicts of interest in financial institutions.
• Dodd-Frank “Wall Street Reform and Consumer
Protection Act” of 2010
̶ Grant the SEC a supervise power over the credit-rating
agencies.
̶ Consolidate regulatory power spread over many regulatory
agencies and establish “the Financial Stability Oversight
Council” and “the Bureau of Consumer Financial
Protection.”
̶ Regulation over shadow banking system (e.g. hedge funds)
and over-the-counter derivatives (e.g. CDS) to improve
transparency and accountability of financial institutions.

35. Trade-off of regulations
Policy, that eliminates the economies of scope
that create the conflicts of interest, may increase
the problem of asymmetric information instead
of reducing it.
– Prohibiting an accounting firm to engage in
consulting, a brokerage firm to provide research, or a
commercial bank to underwrite will increase cost of
information and reduce quantity and quality of
information produced by financial institutions.

36. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University