Financial services: Conflicts of interest endemic
IHT August 8
By Philip Bowring
Hongkong: Investment banks are, at last, under public scrutiny
for their role in the technology stock bubble. Merrill Lynch has settled
one suit and doubtless more will follow as class action lawyers work
on the bona fides of research put out by the "bulge bracket" (industry
jargon for the leading houses) tipsters. But important issues are not
Beyond the culpability of specific firms and analysts is the bigger
question of the structure of the financial services industry and its
relationship to the media. It has taken an extraordinary episode to
awaken public and officialdom to the conflicts of interest which are
endemic in the relationship between investment banker and stockbroker.
Yet anyone who has worked for the research department of an investment
banker/broker knows that the "Chinese walls" which are supposed to separate
the two functions are bamboo curtain.
Investment bankers thrive on fees which mostly flow from the propagation
of "good news" regardless of the interests of the investors who are
also their clients. Regulatory bodies have long turned a blind eye to
all but the most blatant abuses of separation of functions often relying
on the good faith of the compliance officers of the investment banks
themselves.The industry also has a record of crushing those researchers
who draw attention to unethical but highly profitable behavior of the
sort which leads to huge bonuses for participants.
Hopefully the tech fall-out will lead to a clean up. But one has to
ask (not for the first time) why greed has been so long allowed to triumph
over ethics at revered institutions which are presented to the world
as the standard bearers of western capitalism. Hopefully too the bust
will lead to new laws, a modern Glass-Steagall, which create real walls
between financial functions, at least between investment banking, broking,
mutual fund management and insurance, and between auditing and consultancy.
Glass-Steagall itself, a product of the 1929 crash, ceased to be effective
years before its demise in 1999. But the concept remains valid. Financial
services combines create conflicts of interest within organizations.
Clients of brokers get supposedly professional advice which is actually
nothing but a sales pitch for the investment banking part of the business,
and captive mutual funds get stuffed with shares left over from failed
public offerings. Profits come before duty of trust. Neither does bigger
mean safer. The opposite is true. Moral hazard increases with vertical
integration and systemic risk increases with size.
In practice also the capital of banks is being exposed not just to
plain vanilla lending risks and normal forex and share offering exposure
but to the super-charged risks in derivatives and such newer products
such as collateralized debt obligations which have been growing at an
astonishing rate. As American Express recently had the courage to admit,
the risks are hard even for major participants to understand.
Financial combines are also, by definition, less transparent than
single business entities, and thus prudential supervision of them is
that much more difficult. At the same time they become "too big to fail",
threatening a repeat of the mega bank bailouts seen in Japan. Likewise
the fewer large auditing firms there are, and the more reliant they
are on consultancy fees, the less likely they are to quarrel with the
accounting policies of big companies. In the US, the Securities and
Exchange Commission has been making an effort to discipline the big
firms. But the bigger they are the more political clout they have to
fend off the regulators.
The media needs scrutiny too. It may now be baying for analysts' blood,
but its was celebrity journalism as much as Wall Street which created
the idols of the techno bubble and made heroes out of humdrum research
analysts. Taking their cue from Dr Goebbels, the brighter ones noted
the more outrageously bullish their analyses the more attention they
got for themselves and their firms' corporate clients.
Meanwhile stodgier publications threw away their journalists' gut skepticism
away in favor of reportage the publishers expected would - and for a
while did - generate advertising from the "new economy" stars. Oiling
the wheels were the wire services. It is an awkward truth that the leading
global providers of news get most of their revenue from a smallish group
of banks, investment banks, brokers and foreign exchange dealers. Naturally
they want to be close to their clients, to reflect their views.
Thus comment on the politics of, say, Indonesia comes not from a seasoned
local expert but from a brokerage analyst -perhaps a 28-year-old who
has been there for three months. This financial sector bias enters the
news chain at an early stage. It is now being magnified by the vertical
integration which has taken place in the media and communications industry.
When the number of players diminishes, there is increased tendency for
myths to become received wisdom, for the psychology of the crowd to
replace reasoned discussion. So, while welcoming actions against those
who exploited investor credulity it would be wise to look at the institutional
roots of the techno bubble, whose fall-out will last a generation. Ends