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Economic Analysis of Financial Structure - Conflicts of interest

4 important questions on Economic Analysis of Financial Structure - Conflicts of interest

What are conflicts of interests and why do we care?

Allthough the presence of economies of scope may substantially benefit financial institutions it also creates conflicts of interest. Conflicts of interest are a type of moral hazard that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts between those objectives. Occur especially when financial institutions provide multiple services.

Conflicts of interest primarily arise between three types of financial services: underwriting and research in investment banks, auditing and consulting in accounting firms, credit assessment and consulting in credit-rating agencies.

Why is there a conflict of interest between consulting and accounting?

auditors might be willing to skew their judgements and opinions to win consulting business form these clients.
auditors may be auditing information systems or tax and financial plans put in place by their non-auditiong counterparts within the firm, and therefor may be reluctant to criticise the systems or advice.

Why is there a conflict of interest when credit rating agencies asses credit and consult?

When multiple users with divergent interests (in short term) depend on credit ratings, issuers need a favourable rating, investors and regulators a fair rating.

Another conflict occurs when debt issuers ast rating agencies to advice them on how to structure debt, with the goal of securing favourable ratings. No longer allowed these days.

What has been done to cope with conflicts of interest?

In the US a major policy measure has been implemented to deal with conflicts of interest: the Sarbanes-Oxly Act of 2002. In the EU, directives dealing with conflicts of interest and transparency have been proposed but not uniformly implemented.