Centre for Economic Policy Research

10 Conflicts of Interest in the Financial Services Industry

---

1.8
Plan of the study
The next four chapters discuss the conflicts of interest in each of the four types of
financial service activities discussed above. These discussions are followed by a
final chapter which provides an overview of our analysis of conflicts of interest
and the policy remedies that may help to reduce these conflicts of interest, 
making the financial system more efficient.
What Are the Issues? 11

---

---

2 
Investment Banking: Conflicts of Interest 
in Underwriting and Research
2.1
Information synergies and conflicts of interest
Investment banks provide a varied array of financial services that bridge informa-
tional asymmetries in the primary and secondary capital markets. In the primary
market, they float new and seasoned securities and advise on mergers and 
acquisitions; in the secondary markets, they act as brokers or dealers, providing
research for both markets (Bloch, 1986). Joined with market making and 
proprietary trading, these services have important complementarities in the 
collection and use of information that encourage their joint provision. Taken 
altogether, investment banks, as intermediaries, play a central role in the 
formation of capital and provision of liquidity to the markets.
When a new issue is floated by a syndicate of investment banks, the bank that
serves as the lead underwriter engages in intense information collection. The bank
needs to provide information to build a book of committed investors, set the price
of the initial public offering (IPO) and create a secondary market. The lead 
underwriter of an IPO syndicate is the delegated monitor not only for individual
investors who are considering purchasing newly issued equities but also for the
other members of the syndicate. This underwriter incurs quasi-fiduciary responsi-
bilities to other members of the syndicate and risk from holding the largest share
of the issue. Moving a firm ‘from the closet to the goldfish bowl’ gains the lead
underwriter an information advantage, which is greatest at the beginning when
there is relatively little public information. This advantage can form the basis for
a long-term relationship with the issuing firm. In addition, to promote 
transparency, the Securities Act of 1933 imposes legal sanctions to ensure that the
lead bank energetically pursues all material information in a process called due
diligence.
1
The investment bank’s research analysts who have been part of this discovery
process should be able to offer better buy/sell recommendations and superior
forecasts of the firm’s performance. Market making in the secondary markets for
brokerage customers, provides investment banks with skills to manage the sale of
IPOs. The lead underwriter is the dominant market maker, taking a substantial
inventory, while co-managers play a negligible role (Ellis et al., 2000). Even if there
are other market makers, many lead underwriters act as market makers after the
offering is completed and the syndicate is dissolved because it takes time for the
market to deepen. The information gained will be additionally valuable if the firm
issues more securities.
The information synergies from underwriting, research and market making
thus provide a rationale for combining these distinct financial services.
2
The 
success of an investment bank’s combination of these activities will contribute to
13

---

its reputation, thereby enhancing its future business in this information intensive
industry.
There are potential conflicts of interest between these activities, however. For
example, proprietary trading may conflict with the fiduciary responsibility of an
investment bank to its brokerage clients for the best execution of trades. While
this is a potential problem, the greatest focus of public concern has centred on the
perceived conflicts between underwriting and brokerage, where investment banks
are serving two clients, the issuing firm and investors. Issuers may benefit from
optimistic research while investors should desire and seek unbiased research. If
the incentives for these two activities are not appropriately aligned, there will be
a temptation for employees on one side of the firm to distort information to the
advantage of their clients and the profit of their department. When the potential
revenues from underwriting greatly exceed brokerage commissions, there will be
a strong incentive to favour issuers over investors or risk losing the former to 
competitors. Yet, these conflicts may not be exploited because investment 
banking is an information intensive industry, where reputation is a key element
in a firm’s long-term success, and conflicts of interest are potentially damaging to
reputation. 
Given the multiple services that are provided, informational advantages and
conflicts of interest will be present to some degree in an investment bank. The
concern is whether costly conflicts of interest may dominate the benefits from the
informational synergies. Conflicts of interest may be minimized either by a firm’s
desire to maintain and build its reputation or by legal sanctions. An investment
bank’s reputation is vital to attract and retain customers. If it is concerned about
the discipline of the market, it will devise various structures and incentives to 
prevent the exploitation of conflicts that would alienate customers. In the United
States, the law recognizes the potential for conflicts and attempts to discourage
corporate finance departments from exerting inappropriate influence on analysts.
Although the Investment Advisers Act of 1940 does not require a firewall to 
prevent information transmission between departments, the idea was endorsed by
the Securities and Exchange Commission (SEC) in its rules promulgated under the
Securities Act of 1933 and the Securities Exchange Act of 1934. The 1940 Act and
the Codes of Ethics and the Standards of Professional Conduct of the Financial
Analysts Federation required that if a firm provides corporate finance services to a
company, the analysts must disclose this information in research reports (Dugar
and Nathan, 1995). In spite of these sanctions and the threat of market discipline,
conflicts of interest were not suppressed in the late 1990s, imposing costs on
many individual customers. Furthermore, damage appears to have been done to
the capital markets and economy by the diminished reputation and confidence in
investment banks as intermediaries.