«Abstract There has been substantial public and regulatory attention of late to apparent exploitation of conflicts of interest involving financial ...»
Conflicts of Interest and Market Discipline
Among Financial Services Firms
New York University*
There has been substantial public and regulatory attention of late to apparent exploitation
of conflicts of interest involving financial services firms based on financial market
imperfections and asymmetric information. This paper proposes a workable taxonomy of
conflicts of interest in financial services firms, and links it to the nature and scope of
activities conducted by such firms, including possible compounding of interest-conflicts in multifunctional client relationships. It lays out the conditions that either encourage or constrain exploitation of conflicts of interest, focusing in particular on the role of information asymmetries and market discipline, including the shareholder-impact of litigation and regulatory initiatives. External regulation and market discipline are viewed as both complements and substitutes – market discipline can leverage the impact of external regulatory sanctions, while improving its granularity though detailed management initiatives applied under threat of market discipline. At the same time, market discipline may help obviate the need for some types of external control of conflict of interest exploitation. JEL G21, G24, G28, L14. Keywords: Conflicts of interest.
Financial regulation. Financial services. Banking.
Potential conflicts of interest are a fact of life in financial intermediation. Under perfect competition and in the absence of asymmetric information, exploitation of conflicts of interest cannot rationally take place. Consequently, the necessary and sufficient conditions for agency costs associated with conflict of interest exploitation center on market and information imperfections. Arguably, the bigger and broader the financial intermediaries, the greater the agency problems associated with conflict-ofinterest exploitation. It follows that efforts to address the issue through improved * Paper presented at a Federal Reserve of Chicago - Bank for International Settlements conference on “Market Discipline: Evidence Across Countries and Industries,” October 30 - November 1, 2003. Yakov Amihud, Alexander Ljungqvist, Anthony Saunders, Roy Smith, William Silber, Lawrence White, Clas Wihlborg and David Yermack provided valuable comments on earlier drafts of this paper. Draft of 24 October 2003.
transparency and market discipline are central to creating viable solutions to a problem that repeatedly seems to shake public confidence in financial markets.
In recent years, the role of banks, securities firms, insurance companies and asset managers in alleged conflict-of-interest-exploitation – involving a broad array of abusive retail market practices, in acting simultaneously as principals and intermediaries, in facilitating various corporate abuses, and in misusing private information – suggests that the underlying market imperfections are present even in highly developed financial systems. Certainly the prominence of conflict-of-interest problems so soon after the passage of the US Gramm-Leach-Bliley Act of 1999, which removed some of the key structural barriers to conflict exploitation built into the US regulatory system for some 66 years, seems to have surprised many observers.1 Moreover, recent evidence suggests that the collective decision process in the management of major financial firms impairs pinpointing responsible individuals, and that criminal indictment of entire firms runs the risk of adverse systemic effects.
Monetary penalties and negotiated settlements neither admitting nor denying guilt seem to have emerged as the principal external mechanisms to address conflict of interest exploitation. Market discipline operating through the share price may, under appropriate corporate governance, represent an important additional line of defense.
Part 1 of this paper proposes a taxonomy of conflicts between the interests of the financial firm’s owners and managers and those of its clients, including situations where the firm is confronted by conflicts of interest between individual clients or types of clients. Some of these conflicts have been discussed extensively in the literature,2 while others seem to have surfaced more recently. Mapped onto this taxonomy is the distinction between conflicts of interest that arise in wholesale and retail domains, characterized by very different degrees of information asymmetry and fiduciary obligations, and conflicts that arise on the interface between the two domains. Part 2 of the paper relates this conflict-of-interest taxonomy to the strategic profile of financial services firms, linking potential conflicts of interest exploitation to the size and breadth of financial firms and illustrating how those conflicts can be compounded in large multi-line financial institutions. Part 3 reviews regulatory and market discipline-based constraints on conflictof-interest exploitation, including issues of granularity and immediacy, and considers linkages between the two types of constraints. Part 4 presents the conclusions and some implications for public policy.
1. A Conflict of Interest Taxonomy There are essentially two types of conflicts of interest confronting firms in the financial services industry under market imperfections.
Type 1 - Conflicts between a firm’s own economic interests and the interests of its clients, usually reflected in the extraction of rents or mispriced transfer of risk. In addition to direct firm-client conflicts, indirect conflicts of interest could involve collusion between the firm and a fiduciary acting as agent for the ultimate clients.3 Type 2 - Conflicts of interest between a firm’s clients, or between types of clients, which place the firm in a position of favoring one at the expense of another.4 They may arise either in interprofessional activities carried out in wholesale financial markets or in activities involving retail clients. The distinction between these two market “domains” is important because of the key role of information and transactions costs, which differ dramatically between the two broad types of market participants. Their vulnerability to conflict-exploitation differs accordingly, and measures designed to remedy the problem in one domain may be inappropriate in the other. In addition there are what we shall term “transition” conflicts of interest, which run between the two domains – and whose impact can be particularly troublesome. In the following sections, we enumerate the principal conflicts of interest encountered in financial services firms arranged by type and by domain (see Exhibit 1).
Conflicts of Interest in Wholesale Financial Markets In wholesale financial markets involving professional transaction counterparties, corporations and sophisticated institutional investors, the asymmetric information and competitive conditions necessary for conflicts of interest to be exploited are arguably of relatively limited importance. Caveat emptor and limited fiduciary obligations rule in a game that all parties fully understand. Nevertheless, several types of conflicts of interest seem to arise.
Principal transactions. A financial intermediary may be involved as a principal with a stake in a transaction in which it is also serving as adviser, lender or underwriter, creating an incentive to put its own interest ahead of those of its clients or trading counterparties. Or the firm may engage in misrepresentation beyond the ability of even highly capable clients to uncover.5 Tying. A financial intermediary may use its lending power to influence a client to use its securities or advisory services as well – or the reverse, denying credit to clients that refuse to use other (more profitable) services.6 Costs are imposed on the client in the form of higher-priced or lower-quality services in an exercise of market power. This differs from cross-subsidization, in which a bank (possibly pressured by clients) engages in lending on concessionary terms in order to be considered for securities or advisory services. There may be good economic reasons for such cross-selling initiatives, whose costs are borne by the bank’s own shareholders. The line between tying and cross-selling is often blurred,7 and its effectiveness is debatable. In 2003 the Federal Reserve helped to clarify the concept of tying, imposing a fine of $3 million on WestLB for violating antitying regulations.8 Misuse of fiduciary role. Mutual fund managers who are also competing for pension fund mandates from corporations may be hesitant to vote fiduciary shares against the management of those companies, to the possible detriment of their own shareholders.
Or the asset management unit of a financial institution may be pressured by a corporate banking client into voting shares in that company for management’s position in a contested corporate action such as a proxy battle.9 The potential gain (or avoidance of loss) in banking business comes at the potential cost of inferior investment performance for the firm’s fiduciary clients, and violates its duty of loyalty.10 Board interlocks. The presence of bankers on boards of directors of nonfinancial companies may cause various bank functions such as underwriting or equity research to differ from arms-length practice.11 This displacement may impose costs on the bank’s shareholders12 or on clients. Although constrained by legal liability issues, director interlocks can compound other potential sources of conflict, such as simultaneous lending, advisory and fiduciary relationships.13 Spinning. Securities firms involved in initial public offerings may allocate shares to officers or directors of client firms on the understanding of obtaining future business, creating a transfer of wealth to those individuals at the expense of other investors.14 Investor loans. In order to ensure that an underwriting goes well, a bank may make below-market loans to third-party investors on condition that the proceeds are used to purchase securities underwritten by its securities unit.
Self-dealing. A multifunctional financial firm may act as trading counterparty for its own fiduciary clients, as when the firm’s asset management unit sells or buys securities for a fiduciary client while its affiliated broker-dealer is on the other side of the trade.15 Front-running. Financial firms may exploit institutional, corporate or other wholesale clients by executing proprietary trades in advance of client trades that may move the market.16 All of the foregoing represent exploitation of Type 1 conflicts, which set the firm’s own interest against those of its clients in wholesale, interprofessional transactions.
Type 2 conflicts dealing with differences in the interests of multiple wholesale clients
seems to center predominantly on two issues:
Misuse of private information. As a lender, a bank may obtain certain private information about a client. Such proprietary information may be used in ways that harm the interests of the client. For instance, it may be used by the bank’s investment banking unit in pricing and distributing securities for another client, or in advising another client in a contested acquisition.17 Client interest incompatibility. A financial firm may have a relationship with two or more clients who are themselves in conflict. For example, a firm may be asked to represent the bondholders of a distressed company and subsequently be offered a mandate to represent a prospective acquirer of that corporation. Or two rival corporate clients may seek to use their leverage to impede each other’s competitive strategies. Or firms may underprice IPOs to the detriment of a corporate client in order to create gains for institutional investor clients from whom they hope to obtain future trading business.18 Conflicts of Interest in Retail Financial Services Asymmetric information is intuitively a much more important driver of conflictof-interest exploitation in retail financial services than in interprofessional wholesale financial markets. Retail issues all appear to involve Type 1 conflicts, setting the interests of the financial firm against those of its clients.
Biased client advice. When financial firms have the power to sell affiliates’ products, managers may fail to dispense "dispassionate" advice to clients based on a financial stake in promoting high-margin “house” products. Sales incentives may also encourage promotion of high-margin third-party products, to the ultimate disadvantage of the customer. The incentive structures that underlie such practices are rarely transparent to the retail client.19 Even when the firm purports to follow a so-called “open architecture” approach to best-in-class product selection, such arrangements normally will be confined to suppliers of financial services with whom it has distribution agreements.
Involuntary cross-selling. Retail clients may be pressured to acquire additional financial services on unfavorable terms in order to access a particular product, such as the purchase of credit insurance tied to consumer or mortgage loans. Or financial firms with discretionary authority over client accounts may substitute more profitable services such as low-interest deposit accounts for less profitable services such as higher-interest money market accounts, without explicit instructions from the client.
Churning. A financial firm that is managing assets for retail or private clients may exploit its agency relationship by engaging in excessive trading, which creates higher costs and may lead to portfolio suboptimization. Commission-based compensation is the usual cause of churning, which can also arise in institutional portfolios – average US equity mutual fund turnover rose from 17% annually in the 1950s to almost 110% in the early 2000s.20 Inappropriate margin lending. Clients may be encouraged to leverage their investment positions through margin loans from the firm, exposing them to potentially unsuitable levels of market risk and high credit costs. Broker incentives tied to stock margining usually underlie exploitation of this conflict of interest.