In the wake of some of the biggest corporate scandals in history, the reputations of various lawyers, accountants, bankers and investment managers have recently taken some severe blows - a fatal one in the case of Arthur Andersen as a consequence of its links to Enron.) At best, many were guilty of putting immediate business concerns ahead of issues such as proper due diligence and the potential for conflicts of interest.
Most of the corporate senior executives who have been accused of wrongdoing in recent years simply could not have succeeded for so long if they had not found major market fault-lines and opacity to exploit, and had either direct or implicit assistance from some of the key financial intermediaries and advisers.
Visiting Professor of International Management Ingo Walter considers a range of conflict of interest issues in wholesale and retail financial markets, and in financial services firms. He briefly discusses some of the most serious charges that have been made over the years regarding conflict of interest issues extending from the late, unlamented Robert Maxwell to the "conspiracy of fools" at Enron and the top guns at Parmalat.
In most of these cases, some of the world's biggest and most well-regarded investment banks, audit firms, and law practices were alleged to be not mere facilitators, but active participants in serious financial misconduct. "How could this happen in some of the world's most efficient and transparent financial markets," asks the author. "And what does it say about the efficacy of corporate governance, market discipline and external regulation associated with key elements in the financial intermediation process in modern economies?"
Walter explains the differences between conflicts of interest encountered in wholesale inter-professional markets, on the one hand, and in activities involving retail clients on the other. His analysis reveals why their vulnerability to conflict exploitation varies dramatically, and why some of the most serious cases involve the intersection between these two domains.
He also concludes that there is a near-inevitability that, recent transparency legislation in certain major markets notwithstanding, the broader the scope of activities of a financial firm:
a) the greater the likelihood that the firm will encounter serious conflicts of interest;
b) the higher will be the potential agency costs facing clients and shareholders, and
c) the more difficult and costly will be any internal and external safeguards that may be necessary to prevent conflict exploitation.
In such an environment, "subsequent adverse legal, regulatory and reputational consequences - along with the managerial and operational cost of complexity - can be considered "diseconomies of scope" that may negate some of the benefits of breadth for financial stability, revenue synergies and cost efficiency.
Walter posits that, in general, "regulatory constraints and litigation are relatively blunt instruments" in dealing with financial-services-related conflicts of interest. However, disincentives for crossing important lines of demarcation that are rooted in market discipline can be "substantially more cost-effective and surgical than constraints based on external regulation." Moreover, "given the persistence of market inefficiencies and information asymmetries they can, in combination, have powerful deterrent effects on conflict of interest exploitation, and therefore on the chemistry of corporate governance in general".
As an example of such market discipline proving effective, Walter cites the case of the world's major credit rating agencies. Moodys and Standard & Poor's have between them roughly 80% of the global market for rating services in terms of revenues. Their reputations for competence, transparency, objectivity and impartiality have made giants in their market, and would be completely undone if these were ever lost.
Walter concludes his analysis by considering how regulation and market based discipline to impede exploitation of conflicts of interests can intersect. In his view, market discipline is too often overlooked as an effective deterrent to exploitation of conflicts of interest in banking and financial markets. Properly structured, it can greatly reinforce regulatory sanctions, particularly involving firms that are considered "too big to fail" or when criminal conduct is involved.
European Management Journal, August 2004