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3. Conflicts of Interest in the Financial Industry


Since the end of the stock market boom in 2000, financial markets have been jolted by one corporate scandal after another. The cycle began in December 2001 with the spectacular bankruptcy of Enron Corporation (once valued as the seventh-largest corporation in the United States) and the indictment of Enron's auditor, Arthur Andersen, one of the "Big Five" accounting firms. Subsequently, revelations of misleading accounting statements at numerous other corporations, including WorldCom, Tyco Industries, and Fannie Mae, have increased investors' doubts about the quality of information coming from the corporate sector. Criminal cases have been filed against all of the top investment banks (Morgan Stanley, J. P Morgan, Merrill Lynch, Lehman Brothers, and Goldman Sachs, among others) that encouraged their stock analysts to hype dubious stocks, which later proved to be disastrous investments.

These scandals have attracted tremendous public attention for several reasons. First, the resulting bankruptcies cost employees of these firms their jobs, their pensions, or both. Second, these activities may have been a factor in the massive stock market decline that occurred from March 2000 to September 2002; during this downturn, the value of the S&P 500 index declined by 50% and NASDAQ's value declined by 75%. Third, the scandals have created doubts about the ethics of those working in the financial service 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, may be responsible for the recent scandals. In each case, people who were supposed to act in the investing public's best interests by providing investors with reliable information had incentives to deceive the public and thereby benefit both themselves and their corporate clients. What are these conflicts of interest, and how serious are they? Where do they occur, and why have they been the source of the recent woes in financial markets ? What should, and can, we do about them?

This chapter provides a framework for answering these questions. It first explains what conflicts of interest are, why we should care about them, and why they raise ethical issues. It then surveys the different types of conflicts of interest in the financial industry and discusses policies to remedy them.

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