In the intricate web of global financial institutions, diverse services, ranging from investment banking to equities trading, are offered across different divisions and business segments. As the spectrum of responsibilities widens within financial institutions, the specter of conflicts of interest looms larger.

Investment banks are champions of economies of scale and scope, offering a myriad of services that address informational disparities in primary and secondary capital markets. Their multifaceted activities encompass launching new and seasoned securities, guiding mergers and acquisitions, acting as brokers or dealers, providing research, and making markets.

The crux of the matter is that economies of scope in information production can inadvertently give rise to conflicts of interest. These conflicts, in turn, result from financial institutions juggling multiple objectives, often leading to the concealment or dissemination of misleading information.

In the context of the relationship between financial institutions and clients, conflicts of interest are tantamount to breaching fiduciary duties. A fiduciary relationship is a unique legal connection where one party commits to act solely in the best interests of the other, sidelining their own interests. Financial institutions, as intermediaries linking borrowers and lenders (depositors), simultaneously function as principals and agents. This dual role places them in competing and potentially compromising situations.

Why should we be concerned about conflicts of interest? Beyond moral hazards and ethical quandaries, conflicts of interest can significantly diminish the quality of information in financial markets, aggravating problems related to asymmetric information. Consequently, financial markets struggle to channel funds toward the most productive investment opportunities, leading to reduced efficiency in both financial markets and the broader economy.

  • Underwriting and Research in Investment Banking: Investment banks engage in both research and underwriting, catering to the informational needs of issuing firms and investors. However, the two client groups have conflicting information requirements. Overcoming this conflict often necessitates a “Chinese wall” to prevent communication between investment banking, equity research, and trading, but critics argue that it isn’t always foolproof.
  • Credit Assessment and Consulting in Rating Agencies: Rating agencies play a pivotal role in guiding investment decisions and regulatory processes. Conflicts may arise as issuers pay for ratings, creating incentives to bias these assessments upward. Furthermore, the provision of consulting services by rating agencies poses additional conflicts by motivating favorable ratings to secure consulting business.
  • Auditing and Consulting in Accounting Firms: Auditors monitor the quality of information produced by firms, reducing information asymmetry. However, conflicts of interest emerge when accounting firms offer non-audit consulting services, potentially pressuring auditors to bias their judgments or evaluate systems implemented by their non-audit counterparts.
  • Universal Banking: Universal banks combine commercial banking, investment banking, and insurance services. With various departments serving multiple clients, conflicts of interest are inevitable. The potential for departments to prioritize their clients’ interests may distort information and hinder efficient credit allocation.

In summary, financial institutions grapple with an array of conflicts of interest, some confined within their walls and others extending into the broader financial landscape. Addressing these conflicts is pivotal to maintaining trust and promoting transparency in the financial world.