Centre for Economic Policy Research

1.6.4
Separation of functions
When the market cannot obtain sufficient information to constrain conflicts of
interest because there is no satisfactory way of inducing information disclosure 
by market discipline or supervisory oversight, the incentives to exploit 
conflicts of interest may be reduced or eliminated by regulations enforcing 
separation of functions. There are several degrees of separation. First, is the 
separation of activities into different in-house departments with firewalls 
between them. Second, is the organization of different activities into separately
capitalized affiliates. Third, is the prohibition of a combination of activities in any 
organizational form. 
Separation by function has the goal of ensuring that ‘agents’ are not placed in
the position of responding to multiple ‘principals’. Moving from less to more
stringent separation of functions, conflicts of interest are reduced. More stringent
separation of functions weakens synergies of information collection, however,
thereby preventing financial firms from taking advantage of economies of scope
in information production. Deciding on the appropriate degree of separation thus
involves a trade-off between the benefits of reducing conflicts of interest and the
cost of lowering economies of scope in producing information.
1.6.5 
Socialization of information production
The most radical response to conflicts of interest generated by asymmetric 
information is to socialize the provision or the funding source of the relevant
information. For example, much macroeconomic information is provided by 
publicly funded agencies, recognizing the argument that this particular public
good is likely to be undersupplied if left to private provision. It is conceivable that
other information-providing functions, for example credit ratings and auditing,
could also be publicly supplied. Alternatively, if the information-generating 
8 Conflicts of Interest in the Financial Services Industry

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services are left to the private sector, they could be funded by public sources or by
a publicly mandated levy to ensure that information production is not tainted by
obligations to fee-paying entities with special interests.
Of course, the problem with this approach is that a government agency or 
publicly funded entity, not operating in a competitive market, may not have the
same incentives as private financial institutions to produce high quality 
information. Forcing information production to be conducted by a government
or quasi-government entity may reduce conflicts of interest, but it may lower the
flow of information to financial markets. Furthermore, as a practical matter, there
is a compensation problem in government agencies because they may be 
constrained from paying market wages to attract the best people.