Centre for Economic Policy Research

5.8.3
Reputation, transparency and prudential supervision
Except for the problem posed by the subsidization of intermediaries by the US
government’s too-big-to-fail doctrine, some economists are convinced that the
market offers sufficient monitoring discipline to ensure that conflicts of interest
are minor problems at worst. Rajan (1995) argues that the belief in the ‘naïve
investor’ who is prey to conflicts of interest is a ‘patent fallacy’. Empirical studies
of universal banking in the United States before 1933 and in the 1990s find that
the market offered the correct incentives. Universal banks appear to have been
rewarded for their greater ability to certify new issues with higher initial prices,
and the investors were rewarded by their superior performance. The market also
displayed a preference for the securities issued by affiliates over internal bond
departments where conflicts of interest may have been greater. Affiliates thus
became the pre-eminent form of corporate structure. In both periods, given that
they could signal a reduced likelihood of conflict of interest, subsidiaries were able
to underwrite more junior, more information-intensive securities, thereby
improving the efficiency of the financial system. 
For the German banking system, where market discipline rather than 
regulation is allowed to discipline conflicts of interest, the Monopolies
Commission Report (1976) and the Gessler Commission Report (1979) found no
evidence of exploitation of conflicts by universal banks. There are, however, few
studies of the German system, and as Saunders and Walter (1994) point out, the
official studies have been treated with some skepticism.
Looking at the UK financial system, Benston (1998) makes a similar case for the
sufficiency of market discipline through reputation. Disparaging government reg-
Conflicts of Interest in Universal Banking 73

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ulation of financial products and contracts and mandatory disclosure, he 
concludes that: 
The ability of the market to adequately monitor and discipline financial interme-
diaries depends, however, on the disclosure of information to the market. Apart
from the costs of disclosure, firms may not be willing to provide all the needed
information if some of it is proprietary and its disclosure would reduce the gains
from information collection. Banks should disclose their commercial banking
terests in a firm to their investment bank/brokerage clients and vice versa.
Mandatory disclosure of these relationships will ensure that information asym-
metries are reduced, limiting the ability to exploit them. Nevertheless, there are
some cases, such as mergers and acquisitions, where banks may not be able to
divulge information of a relationship without giving an advantage to their com-
petitors. Supervisory oversight is then necessary if disclosure is limited to protect
propriety information. 
Banking supervisors already have powers to supervise universal banks and to
monitor universal banks’ internal control procedures to make sure that they do
not take on excessive risk. Bank supervision has been expanded in recent years to
focus on so-called operational risk, and conflicts of interest can easily be viewed
as a particular form of operational failure. Thus, having bank supervisors focus on
universal banks’ internal controls and compensation mechanisms with regard to
conflicts of interest is a natural direction to follow. Controlling conflicts of inter-
est in universal banks also has a growing importance for preserving the safety and
soundness of banks (and so is important from a prudential perspective) because
banks now may have strong incentives to make loans on overly favourable terms
in order to obtain fees from activities like underwriting securities. Just as bank
supervision has become more oriented to focus on risk management in recent
years, it needs to increase its focus on control of conflicts of interest.
The general acceptance that the market, combined with appropriate disclosure
and prudential supervision, should be the primary remedy to restrain the 
exploitation of conflicts of interest between commercial and investment banking
represents a remarkable change in the United States. The stock market collapse of
the 1930s induced the acceptance of the most extreme remedy – complete 
separation. A key lesson of this episode is that the panic to find a remedy 
resulted in the adoption of a very costly solution when more modest remedies
would have sufficed. The potential problems from deposit insurance dictate that
investment banking should be separated from commercial banking in a 
separately capitalized intermediary. This degree of separation may, however, be
close to a market solution for some firms, as indicated by the evidence from the
1920s. While the market can discourage the exploitation of conflicts of interest
and set appropriate incentives for managers and banks, mandatory disclosure of
multiple banking relationships will help to ensure that information asymmetries
are reduced. Coupled with regulatory and supervisory oversight, conflicts of 
interest in universal banking can thus be limited.
74 Conflicts of Interest in the Financial Services Industry
‘most financial institutions have considerable investments in their charters
and in customer goodwill. Hence, they have strong incentives to treat 
customers fairly. In the event that they do not, either because of corporate 
policy or inability to control salespersons’ mis-statements, they can be sued
and be subject to judgments, which reinforces their incentives to avoid 
engaging in fraud and misrepresentation. Probably of greater importance,
however is that at low cost consumers can shift their businesses from suppliers
with doubtful reputations to their competitors, because similar financial 
products are delivered by many firms. Thus, financial product institutions
have strong incentives to maintain reputations for honesty and fairness.’
(Benson, 1998, pp. 55-6)

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