Centre for Economic Policy Research

6 Conflicts of Interest in the Financial Services Industry

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1.6.1 
Market discipline
This approach has a powerful appeal to many economists, and this may be 
a sufficient response in many cases. Market forces can work through two 
mechanisms. They can penalize the service provider if they exploit conflicts 
of interest. For example, a penalty may be imposed by the market in the 
form of higher funding costs or lower demand for its services, even to the 
point of forcing demise of the firm. Second, market forces can promote new 
institutional means to contain conflicts of interest, for example, by 
generating a demand for information from organizations structured to reduce
conflicts. 
The advantages of market-driven solutions include the fact that they can hit
where it hurts most, through pecuniary penalties. Moreover, they may help avoid
the risk of over reaction. In the face of public outrage to perceived conflicts of
interest, it may be hard to resist the temptation to adopt non-market solutions
that may reduce information production in financial markets. On the other hand,
market-based solutions may not always work if the market cannot obtain 
sufficient information to appropriately punish financial firms that are exploiting
conflicts of interest. Memories may be short in financial markets; once a 
triggering event has faded from memory, conflicts may creep back in unless
reforms have been ‘hard-wired’.
1.6.2 
Mandatory disclosure for increased transparency
A competitive market structure usually develops mechanisms to provide 
information that is needed by market participants. This information 
should include financial data and disclosure of the existence of any relationship
that may give rise to conflicts of interest that induce agents to distort or 
conceal data. 
The gathering of information is costly, and any individual economic agent will
only gather information if the private benefit outweighs the cost. When the 
information collected immediately becomes available to the market, the free-rider
problem may become serious. Information thus has the attribute of a public good,
which may be undersupplied in the absence of some public intervention.
Mandatory disclosure of conflicted relationships increases investors’ ability to
judge how much weight to place on information provided by an agent. Although
mandatory information disclosure can alleviate information asymmetries it can
also create problems if it reveals so much proprietary information that the 
financial institution is unable to profitably engage in the information production
business. The result could then be less information production rather than more
and an intensification of the informational asymmetry between insiders and
other market participants.