Conflicts of Interest in Finance

“What is the virtue of a proportional response?”
President Josiah Bartlet, The West Wing, Season I, Episode 3, 1999.

Angered by a foreign downing of a U.S. airliner, and frustrated by the ineffectiveness of customary retaliation, fictional West Wing President Bartlet challenged his military advisors to devise a “disproportional response” that would go beyond “the cost of doing business” to deter future attacks and make Americans safe.

Financial corruption does not put our lives directly at stake. Yet, it is easy to imagine how widespread and recurring corruption could lead a future U.S. President – frustrated by the failure of markets, regulators, and the courts to change financial intermediaries for the better – to ask her financial and legal advisors for a similar disproportional response to make Americans safe.

The corruption exposed in recent years is breathtaking in its scale, scope, and resistance to remedy. We have seen traders collude to manipulate LIBOR, the world’s leading interest rate benchmark, and the foreign exchange (FX) market, where daily transactions exceed $5 trillion. We have seen firms facilitate tax evasion and money laundering. We have seen financial behemoths taking concentrated risks that undermine their capital and their funding, threatening the financial system as a whole until they are bailed out by public support. And we have witnessed what are arguably the largest Ponzi schemes in history (see our earlier post).

The policy response also has been wide-ranging. Congress enacted the most far-reaching financial reform since the 1930s. Regulators leaned on financial firms to diminish risk-taking incentives in their compensation schemes. Prosecutors, regulators and private litigants obtained ever-larger pecuniary settlements – the total since 2009 is now approaching $200 billion.

Previously frustrated by the “too big to jail” taboo (following the 2002 collapse of Arthur Andersen), in 2014 prosecutors again moved beyond simply seeking monetary settlement without admission of guilt and charged a bank with criminal behavior. They are also pursuing individual traders in the LIBOR and FX scandals in the criminal courts. Finally, leading regulators are openly warning the largest U.S. institutions that a failure to improve their ethical culture could lead policymakers to seek a dramatic downsizing of their firms to ensure financial stability.

So far, the most obvious response from the financial sector has been on the employment side: firms have hired or will hire thousands of compliance officers and risk managers to police the behavior of their employees (see here, here, and – if you have Wall Street Journal access – here).

We will be delighted if these reforms work to reduce corruption dramatically, but we remain skeptical.

The economic problem is one of incentives, typically arising from a principal-agent (or agency) problem. If they can conceal their behavior, financial employees and their firms (the agents) have enormous incentives to behave in ways that are not in the interests of their employers or their clients (the principals). Unless the principals (or the government) can prevent such concealment at a reasonable cost, one shouldn’t be surprised to see agents behave “unethically.”

Agency problems are particularly rampant in finance because both the rewards to exploitation and the cost of detection can be very high (see, for example here). The incentive problems appear most severe in the largest, most complex intermediaries that engage in multiple activities.

Put simply, multiple activities breed conflicts of interest and make them more difficult to contain. As our colleague, Ingo Walter, puts it, “the broader the activity-range in the presence of imperfect information, (1) the greater the likelihood that the firm will encounter conflicts of interest, (2) the higher will be the potential agency costs facing clients, and (3) the more difficult and costly will be the internal and external safeguards necessary to prevent conflict exploitation.” (See his analysis here and here.)

To be sure, there exist many financial activities that – pursued simultaneously by the same firm – rarely trigger serious conflicts of interest. For example, most banks and brokers engage without harm in: (1) the safekeeping of assets; (2) providing access to the payments system; and (3) offering accounting services to track transactions and balances. Even here, however, major frauds occasionally arise. Bernie Madoff’s clients may have thought that the lack of an independent asset custodian (a service that mutual funds, but not brokers, must hire) reduced their costs (that would be an economy of scope). Instead, allowing Madoff to serve both as custodian and broker helped him to conceal his fraud for decades.

Other activities – pursued together – frequently trigger widespread and costly conflicts. Perhaps the most notorious is the mix of equity underwriting, equity research, and equity sales. The incentive problem is simple: With large underwriting fees at stake, brokers are motivated to issue blithe equity analysis to attract issuers, even if that means selling overvalued stocks to unwitting clients. Yet, more than a decade after the legal “research settlement” that compelled brokers to fortify costly “Chinese walls” between their investment banking and research staffs, we still read of repeated and widespread violations (see, for example, here or here).

New sources of conflict arise all the time, usually in association with financial innovations. One recent example in the news (see gated story here) is that of activist hedge funds that lend to financially distressed corporations in order to influence them to default on some other source of credit. Having purchased insurance (in the form of credit default swaps) that exceed the amount of the loan, the investors stand to profit from the default. This seems a bit like having someone buy fire insurance on your house that exceeds its value and then paying you to burn it down. We doubt that this mix of activities results in an efficient use of resources.

So, where does this all leave us? The most serious issues arise in the context of large, complex intermediaries, whose failure threatens the financial system as a whole. Unfortunately, the combination of increased transparency, improved market discipline, enhanced regulation, massive financial penalties, and criminal proceedings has thus far failed to halt repeated, large-scale misbehavior arising from conflicts of interest.

Policymakers once thought that the incentive of the largest firms to guard their reputations would motivate them to prevent misbehavior, lest they lose the trust of counterparties. The crisis of 2007-2009 exposed such views as wishful thinking. Even its May 2014 felony plea may have little lasting impact on the willingness of Credit Suisse clients to transact: Its stock price actually rallied for a month after the settlement was announced. In the end, the temptation has been too large and the costs too small to force dramatic change.

What to do?

The only major alternatives we see are either to break up large institutions into smaller ones with restricted scope, to hold individuals more accountable, or some mix of both. Limiting activities is the strategy of the 1930s Glass-Steagall segmentation of commercial and investment banking. While that particular mix no longer appears threatening, regulators may wish to consider segmentation wherever short-run, private benefits are likely to be offset by long-run, social costs resulting from conflicts of interest. We wonder if equity research and underwriting provide a useful example.

Our preferred approach emphasizes a version of the second remedy: hold managers collectively more accountable for the actions of their firm. For example, we hope to see an increase in the personal financial liability that managers face for their firm’s excesses. One naturally would start with top management. Large settlements that punish stockholders who have negligible control over managerial activity may do little more than raise the cost of capital for all big firms. In contrast, partnerships, where owners face unlimited liability for their own and their partners’ actions, foster strong incentives to police bad behavior. Compensation arrangements that create partnership-like downside risks for years after a risk has been taken – even for middle-level managers with risk-taking authority – ought to be a common feature in large, systemic intermediaries. Naturally, this would rule out the golden parachutes that were prevalent during the financial crisis. For similar reasons, more frequent criminal prosecutions (such as those for LIBOR and FX manipulation) promote individual accountability and eventually may increase deterrence.

One can hope that with their financial solvency really at stake, managers would become more aggressive in policing behavior inside of their organizations. Either that, or they will simply refuse to engage in activities where conflicts are most likely to arise. So much the better.

Unfortunately, there exists no panacea for containing conflicts of interest. Regulators and prosecutors must continue to experiment with new remedies, acknowledging that past efforts have proven remarkably ineffective. And, they must remain vigilant as the financial system evolves and adjusts.

Would a West Wing-like disproportional response from the Department of Justice help? Perhaps, but we’ve already seen cases where severe (actual or prospective) punishment sped the dissolution of major firms (think Arthur Andersen and Drexel) without a dramatic reduction in financial corruption elsewhere. If such disproportionate action were to inadvertently lead to systemic distress, it might even buttress the too-big-to-jail fears that encourage corruption. In the end, even President Bartlet chose the proportional response: “It’s what we do.”

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