1. Business ethics In the last several years, the financial system has been jolted by many scandals. The scandals have created doubts about the ethics of those working in the financial service industry. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-1

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-2 Chapter Preview We examine recent scandals and the consequences on the investing public. We pose a broad question: what can be done to resolve these problems? Topics include: – What Are Conflicts of Interest and Why Are They Important? – Can the Market Limit Exploitation of Conflicts of Interest? – What has been done to Remedy Conflicts of Interest?

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-3 What Are Conflicts of Interest and Why Are They Important? Financial intermediaries engage in a variety of activities to collect, produce, and distribute information. By providing multiple services, they realize economies of scope. However, these services may be competing with one another, and this creates the potential for a conflict of interest.

4. What Are Conflicts of Interest and Why Are They Important? Conflicts of interest: a situation where multiple interest have to be served, often the investing public and corporate clients. Conflicts of interest generate incentives to provide false or misleading information. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-4

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-5 Types of Conflicts of Interest We will discuss, in turn, four areas of financial service activities that harbor the greatest potential for generating conflicts of interest. These are: – Underwriting and research in investment banking – Auditing and consulting in accounting firms – Credit assessment and consulting in credit-rating agencies – Universal banking

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-6 Underwriting and Research in Investment Banking Some investment banks both underwrite new securities by selling them to the public, and provide research (buy/sell recommendations) to the investing public When revenues from underwriting exceed brokerage commissions, favorable research will attract more business, at the expense of unbiased recommendations to the investing public.

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-7 Underwriting and Research in Investment Banking In initial public offerings of equity, underwriters direct the new shares as they wish, typically to their best clients or potential new clients. Since most IPOs are underpriced, many of these shares are immediately sold for a profit (called spinning). This immediate “profit” may appear as nothing more than payment for future business.

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-8 Underwriting and Research in Investment Banking Several recent cases highlight the conflicts that IPOs can create. Criminal charges have been filed against all of the top investment banks: J.P. Morgan, Morgan Stanley, Merrill Lynch, Lehman Brothers and Goldman Sachs

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-9 Auditing and Consulting in Accounting Firms To return to our discussion of Types of Conflicts, we now look at the role of auditors in public firms. They provide an unbiased view of the financial reports to reduce asymmetric information between the firm’s management and the investing public. By also providing management advisory services (such as systems support), the auditor has an incentive to fudge the audit if the fees from other services are substantial.

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-10 Auditing and Consulting in Accounting Firms Auditors also have a conflict of interest since they are paid by the firm they audit. If the auditor gives an unfavorable audit report, the auditor may lose the auditing business as well. A well known case of the failure of auditors to provide unbiased reports was Arthur Andersen’s audit of Enron.

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-11 Credit Assessment and Consulting in Credit-Rating Agencies Bond investors rely on credit-rating agency assessment of firm’s debt (debt ratings). However, ratings are only provided when the firm pays the agency. Agencies, then, have an incentive provide “better” ratings to attract business.

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-12 Credit Assessment and Consulting in Credit-Rating Agencies Rating agencies have also started providing firms with other services, and have the same conflicts as auditors in this regard.

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-13 Mini-case: Why get rated? In the 1970s, rating agencies earned revenue by providing information about securities (ratings). However, this changed to where the agencies now charge the issuer to have its debt rated. Why the switch?

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-14 Mini-case: Why get rated? “Free-riders” explains this. Few actually paid for the research. One would pay, and then make copies for everyone else. The agencies started losing revenue. It’s unfortunate that the solution (charging issuers) created a conflict…

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-15 Universal Banking Universal banking refers to institutions that provide some combination of commercial banking, investment banking, and insurance services. Bank managers may push investing products of its affiliates, even if they aren’t in customer’s best interest. Banks may use strong-arm tactics to sell its affiliate insurance products.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-16 Can the Market Limit Exploitation of Conflicts of Interest? Conflicts of interest are a problem when they lead to a decreased flow of reliable information (increased asymmetric information)…The Banksters However, even with potential conflicts, the incentives (financial gain) may not be present to actually act on them… future reputation.

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-17 A Framework for Evaluating Policies to Remedy Conflicts of Interest A trade-off between potential conflicts of interest and economies of scale exists. Simply eliminating any potential conflict may not be the best solution: 1.The existence of a conflict of interest does not mean that the conflict will have severe consequences. 2.Even if incentives to exploit conflicts are high, eliminating the conflict may be worse if it reduces the flow of reliable information.

18. Approaches to Remedying Conflicts of Interest Potential remedies for addressing the trade-off between the cost of conflicts and the benefits of economies of scope: – Leave it to the market – Regulate for transparency – Supervisory oversight – Separation of functions – Socialization of information production Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-18

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-19 Approaches to Remedying Conflicts of Interest Leave It to the Market Market forces can penalize the financial service firm if it exploits a conflict of interest (lower demand for the firm’s services) An appealing approach that relies on market forces, but has the problem that the market has a “short” memory for past problems.

20. Approaches to Remedying Conflicts of Interest Regulate for Transparency If a financial institution is required to provide information about potential conflicts of interest, the user of the institution’s information services may be able to judge how much weight to place on the information this institution supplies. Monitoring and constraining Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-20

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-21 Approaches to Remedying Conflicts of Interest Supervisory Oversight Force firms to provide private information to a supervisor, who can act on it as deemed necessary. Supervisory oversight is very common in the banking industry, but… …supervisors have not always done their job well…

22. Approaches to Remedying Conflicts of Interest Separation of Functions Separate those functions that create conflicts, either within firms (different in- house departments with firewalls between them) or (in extreme cases) by not allowing those functions within the same firm. It reduces synergies of information collection Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-22

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-23 Approaches to Remedying Conflicts of Interest Socialization of Information Production Look to public funding for information providers, such as credit agencies. A government agency or pubblicly funded entity may not have the same strong incentives as private financial institutions to produce high-quality information…