Conflicts of Interest: Impacts on Financial Markets and Economy, Slides of Banking and Finance

Download Conflicts of Interest: Impacts on Financial Markets and Economy and more Slides Banking and Finance in PDF only on Docsity! > 10: CONFLICTS OF NTEREST IN THE FINANCIAL INDUSTRY  Conflicts of Interest- a type of moral hazard problem that occurs when a person or institution has multiple objectives (interests) and as a result has conflicts between them.  Conflicts of interest usually take the form of misleading information.  Financial institutions can benefit off of giving out misleading information, hurting the public, while giving the financial institutions greater profits.  Conflicts of interest lead to unethical behavior.  Conflicts of interest occur when an institution or employee serves his interests at the expense of others.  Combinations of services that bring together any group of depository intermediaries, non-depository intermediaries, and brokers, or that allow any of these groups to invest directly in a business, are most likely to lead to conflicts of interest. Docsity.com • Inappropriately designed compensation plans, for example may produce conflicts of interest that not only reduce the flow of reliable information to credit markets but also end up destroying the firm. • The conflict of interest problem can become even more hazardous when several lines of business are combined and the returns from one the activities, such as underwriting and consulting, are very high for only a brief amount of time. Also, a compensation scheme that works reasonably well in the short term might become poorly aligned in the long run. Docsity.com  Threats to truthful reporting in an audit arise from several potential conflicts of interest.  The conflict of interest that has received the most attention in the media occurs when an accounting firm provides its client with auditing services and non-audit consulting services, commonly known as Management Advisory Services, such as advice on taxes, accounting or management information systems, and business strategies Docsity.com  Accounting firms that provide multiple services enjoy economies of scale and scope, but have three potential sources of conflicts of interest  1st: clients may pressure auditors into skewing their judgments and opinions by threatening to take their accounting and management services business to another accounting firm  2nd: if auditors are analyzing information systems or examining tax and financial advice put in place by their non-audit counterparts within the accounting firm, they may be reluctant to criticize the advice or systems  Both types of conflicts might potentially lead to biased audits  With less reliable information available to investors, it becomes more difficult for financial markets to allocate capital efficiently  3rd: arises when an auditor provides an overly favorable audit in an effort to solicit or retain audit business.  The unfortunate collapse of Arthur Andersen suggest this may be the most dangerous conflict of interest Docsity.com •Conflicts of Interest can substantially reduce the quality of information in financial markets, thereby increasing asymmetric information problems. •These asymmetric information problems prevent financial markets from channeling funds into the most productive investment opportunities and causes financial markets and the economy to become less efficient. Docsity.com Analysts in investment banks are persuaded to distort their research to please the underwriting department of their bank and the corporations issuing the securities which undermines the reliability of information investors use for financial decisions and diminishes the efficiency of securities markets. Docsity.com  Spinning occurs when investment banks allocate underpriced shares of newly issued stock to executives of other companies in order to lure them to use that investment bank  When the executives company plans to issue its own securities it uses that investment bank as an underwriter.  This causes a rise in the cost of capital for the firm and hinders the efficiency of the capital market. Docsity.com  Rating agencies are paid for their services  Agencies may give high paying clients a higher rating  Consumers buy bonds and other debt instruments with AAA ratings only to end up losing Example: Fitch Ratings and Standard & Poor’s rated CDO’s issued by Credit Suisse as AAA. Losses on $340 million worth of CDO’s amounted to $125 million Docsity.com  Less accurate ratings led to higher profits  The combined profits of rating agencies doubled from 3 billion in 2002 to over 6 billion in 2007  Moody’s profits quadrupled between 2000 to 2007  In the first quarter of 2008, 98% of rating changes for CDO’s were downgrades Docsity.com Goldman Sachs Group Inc. is under investigation by the Securities & Exchange Commission for fraud in a mortgage securities transaction. Was there a conflict of interest in this transaction? Docsity.com  Goldman Sachs, a premier investment banking firm, may be heavily fined, broken up and/or lose their clients trust, which is Goldman Sachs Group Inc. most valuable asset. Docsity.com  Sarbanes-Oxley Act of 2002  Global Legal Settlement of 2002 Docsity.com Four Major Components of SOX 1. Supervisory oversight to monitor and prevent conflicts of interest  Establishment of Public Company Accounting Oversight Board (PCAOB) 2. Reduced conflict of interest  Unlawful if public accounting firm provide any non-audit service to a client with an impermissible audit 3. Provided incentives for investment banks not to exploit conflicts of interests  Criminal charges for white-collar crime and obstruction of official investigation 4. Improved the quality of information in the financial markets  CEO, CFO, and auditors are required to certify periodic financial statements and disclosures of the firm  Independent members of the audit committee Docsity.com SARBANES-OXLEY ACT OF 2002 GLOBAL LEGAL SETTLEMENT OF 2002  Increased supervisor oversight to monitor and prevent conflicts of interest  Directly reduced conflicts of interest  Produced incentives for investment banks not to exploit conflicts of interest  Instituted measures to improve the quality of information in financial markets  Directly reduced conflicts of interest  Produced incentives for investment banks not to exploit conflicts of interest  Instituted measures to improve the quality of information in financial markets Docsity.com LEAVE IT TO THE MARKET REGULATE FOR TRANSPARENCY  The market may punish the firm exploiting conflicts of interest by causing them to have higher funding costs or decreased demand for services  Open market forces can create means to contain conflicts of interest through information demanded from non conflicted organizations  Mandatory information disclosure decreases information asymmetries  This in turn reveals if conflicts of interest are being exploited  Could be bad because of free-loader effect  If regulated too much can cause loss in information production and profitability for the firm Docsity.com SUPERVISORY OVERSIGHT SEPARATION OF FUNCTIONS  Supervisors can review financial information without revealing it to competitors  This maintains profitability & information production  Supervisors can then take actions to control the exploitation of conflicts of interest and enforce ethical standards  Poor supervisors allow for exploitation to continue  Reduces economies of scope through regulation  Information sharing between departments is regulated  Separates departments and adds firewalls to ensure that the firms agents are not responding to multiple principals  Results in a trade off between information production and reducing conflicts of interest Docsity.com