Ch. 15 Notes (BUS G-345; Money, Banking; and Capital Markets; Self)

Ch. 15 Notes (BUS G-345; Money, Banking; and Capital Markets; Self)

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Unformatted text preview: Chapter 15 Conflicts of Interest in the Financial Industry Conflicts of Interest ° Type of moral hazard problem that occurs when a person or institution has multiple objectives and as a result has conflicts between them - Might be responsible for — Previous scandals (Enron) # Subprime financial crisis of 2007-2008 Why are conflicts of interest important? - Economies of scale realized from cost advantages in the collection and use of information ' Economies of scope realized by providing multiple financial services to customers Why are conflicts of interest important? (cont’d) - Focus on conflicts of interest that arise when financial service firms or their employees w interestflvthe expense of another’s, which could be their own interest, rather than their customer’s, or a firm’s interest who wants to sell securities rather than investors’ who are purchasers of the securities. As a result they might misuse information, rovide false information, or conceal information. Why Do We Care? - Conflicts of interest can substantially reducethe quality of information in financial markets incLELEL-ng asymmetric information problems - Asymmetric information prevents financial markets from channeling funds into productive investment opportunities and causes financial markets and economies to be less efficient Types of Conflicts of Interest - Underwriting and research in investment banking - Auditing and consulting in accounting firms I ‘ - Credit assessment and consulting in credit- ' rating agencies - Universal banking Underwriting and Research in Invest _t Banking Issuers benefit from optimistic research Investors desire unbiased research Strong incentive to alter information provided to both types of clients, favoring the issuing firm . . ; Splnnlng InfL ’7TGIC‘?{(€ Gap 6r§£jPKQ£33—fi_ hopes Efvlfiagfynbjw W67 6L0 W’s w/ 7%,,0 {feta-gulf; far 3" 6:13: - .r ‘r 731%»- . , _: x {Jr/‘5 1.542% alga-,9"; fixer?" ( ("Jaguars 1"; {I Z) Auditing and Consultin in Accounting Firms Accounting firms provides its clients with consulting services (taxes, business strategies) Pressure from clients threatening to take business to another firm Reluctance to criticize work done by nonaudit counterparts Provide an Wt in an effort to solicit or retain audit business Cr_edit Assessment and Consulting in Credit-Rating 63919795 - Issuerspay to receive a credit ratin - Investors and regulators depend on well—researched impartial assessments - Credit-rating agencies may also provide consulting services — Auditing their own work —_Favorab|e rating to attract new clients bfl Universal Banking * LJ_nd_grwriti_n,g_d~§partment: aggressive sales vs. unbiased investment advice for customers. Limit losses by selling to customers or to trust accounts Encourage underwriting to push securities from firms with increasing risk Makes loans with overly favorable terms to earn fees for other activities ' Influence or coerce a borrowing or investing customer to buy insurance products Can the Market Limit Exploitation of Conflicts of Interest? - Incentives to exploit conflict of interest may not be very high and therefore this might not be a problem. ' Exploiting conflicts of interest might hurt a financial firm’s reputation - Empirical evidence suggests that — Credit rating firms do not overrate bonds of its customers. — markets adjust when a potential for conflicts of interest arise (securities underwriting by commercial and investment banks). Can the Market Limit Exploitation of Conflicts of interest? (cont’d) - In the shallow, exploitation is possible and can lead to large gains. Motives: — Poorly designed compensation plans. — Temporary rewards ' Individuals might be able to capture reputational rents. Sarbanes-Oxley Act of 2002 increased supervisory oversight to monitor and prevent conflicts of interest, est. the Public Companv Accounting Oversight Board (PCAOB) Directly reduced conflicts of interest Lseparatednon: audit service and audit service by the sam_ef[i;r_ri_) Provided incentives for investment banks to not exploit conflicts of interest Had measures to improve the quality of information in financial markets (CEO, CFO, and auditors have to sign off on the financial statements, off balance sheet activities have to be reported) , _. . . . 2 fl'ifir‘;'l::--ru {'5 ff ’{i’f'f-C'" Global Legal Settlement of 2002 Required investment banks to sever the links between research and securities underwriting Banned spinning Imposed $1.4 billion of fines on accused investment banks. Required investment banks to make public their analyst’s recommendations Required investment banks to contract for a five year period with no fewer than three independent research firms that would provide research to their brokerage customers Framework for Evaluating Policies - The existence of a conflict of interest does not mean that it will have serious adverse consequences —- Does the market have adequate information and incentives to control conflicts of interest? - 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 Approaches to Remedying Conflicts of Interest - Leave it to the market — Penalize the financial service firm — Promote new institutional means - Regulate for transparency — Mandatory information disclosure — Might be too costly for financial service firms Approaches to Remedying Conflicts of Interest (cont’d) ° Supervisory oversight — Appropriate internal controls - Separation of functions — Agents should not be placed in the position to respond to multiple principals ° Socialization of information production — information is likely to be undersupplied if left to private provision. ...
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Ch. 15 Notes (BUS G-345; Money, Banking; and Capital Markets; Self)

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