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Conflicts of interest become a problem for the financial system when they lead to a decrease in the flow of reliable information, either because information is concealed or because misleading information is disseminated. The decline in the flow of reliable information makes it harder for the financial system to solve adverse selection and moral hazard problems, which can slow the flow of credit to parties with productive investment opportunities.

Even though conflicts of interest exist, they do not necessarily reduce the flow of reliable information because the incentives to exploit the conflict of interest may not be very high. When an exploitation of a conflict of interest is visible to the market, it can punish a financial service firm by denying it business. Given the importance of maintaining and enhancing a financial firm's reputation, exploiting any conflicts of interest would decrease the firm's future profitability because it would have greater difficulty selling its services. In this way, the firm has incentives not to exploit a conflict of interest. These incentives limit conflicts of interest in the long run, but they may not be effective in the short run depending on structural factors within the firm, such as a lack of transparency and inappropriate monetary incentives.

One enlightening example of how the market can limit exploitation of conflicts of interest occurs in credit-rating agencies. At first glance, the fact that rating agencies are paid by the firms issuing securities to produce ratings for these securities looks like a serious conflict of interest. Rating agencies would seem to have powerful incentives to gain business by providing security-issuing firms with higher credit ratings than they deserve, making it easier for the firms to sell their securities at higher prices. In reality, little evidence suggests that rating agencies take advantage of this conflict of interest, despite prominent examples such as Enron.2 Much research has shown that a reasonably close correlation exists between ratings and default probabilities. Ratings agencies do not exploit the conflict of interest because giving higher credit ratings to firms that pay for the ratings would lower the credibility of the ratings, making them less valuable to the market. The market is able to assess the quality of biased ratings because it can observe poorer performance by individual securities. Furthermore, credit-rating agencies themselves provide evidence on the relationship between their ratings and subsequent default history. If a rating agency continually gave high ratings to firms that eventually defaulted, investors in the market would no longer trust its ratings, its reputation would become tarnished, and good, nondefaulting firms would go elsewhere for their ratings. For this reason, the rating agency has an incentive not to exploit this conflict of interest and overrate the bonds of its customers.

Commercial banks that underwrote securities prior to the enactment of the Glass-Steagall Act do not appear to have exploited this conflict of interest. When a commercial bank underwrites securities, the bank may have an incentive to market the securities of financially troubled firms to the public because the firms will then be able to pay back the loans they owe to the bank, while at the same time the bank earns fees from the underwriting services. The evidence suggests that in the 1920s, markets found securities underwritten by bond departments within a commercial bank to be less attractive than securities underwritten in separate affiliates where the conflict of interest was more transparent. To maintain the bank's reputation, commercial banks shifted their underwriting to separate affiliates over time, with the result that securities underwritten by banks became valued as highly as those underwritten by independent investment banks. When affiliates were unable to certify the absence of conflicts, they focused on underwriting securities from well-known firms, for which less of an information asymmetry existed and conflicts of interest were less pronounced. Again, the market provided incentives to control potential conflicts of interest. However, it is important to note that the market solution was not immediate, but took some time to develop.

The responsiveness of the market is also evident in the apparent conflict of interest present in investment banks when underwriters who have incentives to favor issuers over investors pressure research analysts to provide more favorable assessments of issuers' securities. Analysts at an investment bank that is underwriting particular IPOs tend to make more "buy" recommendations for these IPOs than do analysts at other investment banks, and the market takes account of this tendency in pricing these securities. Over a two-year period, the performance of other analysts' recommended securities was 50% better than the performance of securities recommended by analysts at the investment banks that underwrote these IPOs. The market appears to recognize the difference in the quality of information when the potential for a conflict of interest exists.

Fewer empirical studies have examined how the market addresses conflicts of interest that arise in accounting firms, but the limited evidence available does suggest that the market adjusts securities' prices to account for potential conflicts of interest. The evidence suggests that clients, who are concerned about the conflicts of interest that arise from the joint provision of auditing and management advisory services, ascribe less value to audit opinions and limit their nonaudit purchases from the accounting firms that have these conflicts of interest.

Although the market can sometimes ameliorate the effects of conflicts of interest in financial service firms, it cannot always constrain the incentives to exploit conflicts of interest. For the market to prevent this type of exploitation, it needs to have enough information to assess whether an exploitation of conflicts of interest is actually occurring. In some cases, parties who want to take advantage of conflicts of interest will try to hide this information from the market. In other cases, alerting the market to potential conflicts of interest would reveal proprietary information that would help a financial firm's competitors, thus reducing the firm's incentives to reveal its true position.

The recent scandals described in this chapter demonstrate that the exploitation of a conflict of interest often leads to large gains for some members of the financial firm even while it reduces the value of the firm as a whole. Inappropriately designed compensation plans (the result of poor management), 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. Indeed, the collapse of Arthur Andersen illustrates how the compensation arrangements for one line of business, such as auditing, can create serious conflicts of interest. In the Arthur Andersen case, the partners in regional offices had incentives to please their largest clients even if their actions were detrimental to the firm as a whole. The conflict of interest problem can become even more hazardous when several lines of business are combined and the returns from one of the activities— such as underwriting or 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 over time.

The extraordinary surge in the stock market created huge temporary rewards, making it possible for well-positioned analysts, underwriters, and audit firm partners to exploit the conflicts before incentives could be realigned. Often, these conflicts of interest were not readily visible to the market, and they may have been invisible even to the top management of a firm. In the most severe cases, opportunistic individuals were able to capture the firm's reputational rents, profits that the firm earns because it is trusted by the marketplace. The exploitation of conflicts of interest clearly damaged the reputation of such investment banks as Merrill Lynch, Salomon Smith Barney of Citigroup, and Credit Suisse First Boston—and perhaps the credibility of analysts in general. Audit firms have lost much of their nonaudit business, while Arthur Andersen was destroyed.

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