Centre for Economic Policy Research

part by the losses of small retail investors and not by careful economic analysis.
Discussing what is optimal should take into account what is feasible in terms of
political economy analysis.
Genberg returned to the separation of commercial and investment banks in the
Glass-Steagall Act. The evidence shows that it cannot be justified empirically. To
a significant extent this evidence is based on findings that bonds and stocks
underwritten by affiliates of universal banks had lower yields, hence higher prices,
than corresponding liabilities underwritten by independent investment banks.
The idea is that the certification value offered by universal banks lowers the cost
of capital to the borrowing firms. Considerations of conflicts of interest were not
important in the market. To explain the empirical findings, the authors of the
Report state that investment banks had learned to improve their organisational
structure so as to ‘convince the market that they were not taking advantage of
conflicts of interest’. Genberg asked how this statement should be interpreted.
Does it mean that there were no conflicts of interest, or rather that the banks had
convinced the market that there were none? It remains unclear whether 
comparing prices of liabilities underwritten by different institutions shows the
importance of conflicts of interest.
Genberg wondered whether in a market equilibrium model, universal banks
can benefit from exploiting conflicts of interest. On the one hand, this would lead
to added costs for borrowers. On the other hand, the certification benefits lead to
benefits for the borrowers. In equilibrium these effects should offset each other as
banks optimize at the margin. Thus, there should not be any difference in the
prices or yields of the underlying assets depending on which institution has
underwritten them. From this perspective, investors should be neither penalized
nor favoured by the legal structure of the underwriting.
Finally, Genberg commented on the Gramm-Leach-Bliley Financial Services
Modernization Act of 1999. In particular, two issues in this context are relevant
for the discussion contained in the Report. First, the limitation of merchant 
banking embodied in the Act may not be reasonable. Second, the supervisory
challenges inherent in universal banking appear to be particularly important in
the context of the United States. There are separate regulators for separate 
activities and it would be appropriate to discuss this issue in the Report.
Tommaso Padoa-Schioppa 
European Central Bank
Tommaso Padoa-Schioppa touched upon four points. First, the notion of conflict
of interest is useful to catch many of the pathologies that have emerged from the
Enron case. It can be misleading, however, if it is used to transmit implicit 
normative statements, such as the removal of all conflicts of interest whenever
96 Conflicts of Interest in the Financial Services Industry

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they exist; or the fact that every person or institution should serve only one 
interest. Similarly, it would be misleading if remedies were drawn too hastily.
Padoa-Schioppa expressed a more problematic view of conflicts of interest since
they, as well as other concepts like moral hazard or systemic risk, can be managed,
reduced, but cannot, and probably should not, be suppressed. Moreover, conflicts
of interest are not easily distinguished from conflicts of objectives, or trade-offs.
In a world of contractual relations, fraudulent behaviour must be separated from
shrewd business behaviour. Whereas the former is sanctioned by criminal law, the
latter should be controlled by caveat-emptor type of defences. The problem, 
however, is that it remains very difficult to draw the line between these two types
of behaviour; and the delimitation may shift over time along the cycle.
Furthermore, it depends on the profile of the two contracting parties. Overall,
when we must think about conflicts of interest, we must bear in mind that these
cannot be suppressed and must be managed at all levels from the individual agent
to the whole economy. Finally, there is an ethical dimension in this issue that 
ultimately remains part of the world of ethics and not that of legislation.
Second, Padoa-Schioppa recalled that the chapter of the Report on universal
banking deals almost exclusively with the historical experience of the United
States. As such, it is implicitly a chapter on the differences between Europe and
the United States. The response to the crisis of the 1930s was a sharp separation
of activities in the United States whereas no European country enacted any legis-
lation like the Glass-Steagall Act. The problems of conflicts of interest have not
been fundamentally eradicated by this Act, however. More generally, there are
other differences between the two continents, which may give better explanations
of why some of the problems do not seem to be as acute in Europe. The European
context is typically characterized by widespread public ownership of banks and
corporations; less competition in the banking industry; the existence of very 
pervasive public pension systems with little space left for private schemes; a 
smaller equity-based nature of the economy; and principles-based rather than
rules-based accounting standards. Moreover, the European continental system has
a very strict approach that requires a licence for banking business. Such an
approach is weaker in the United States and to some extent in the United
Kingdom. The granting of a licence allows for more activities than under a system
where licensing is softer but the regulation of activities harder. More generally,
there are also broader differences such as a lower degree of social mobility, a 
different measure of success, and some of these factors may explain how players
react in financial markets.
Third, investors are very diverse. Some are very sophisticated, others less so. In
finance, there are different risk-return combinations that are available. Normally,
higher return portfolios should in the long run receive a higher return, and some
face losses. Over the long run investments in equity yield higher returns than
those in risk-free assets. Now the question is: ‘Should access to the more 
sophisticated types of finance be barred to relatively unsophisticated investors?’
There is a problem of somehow discriminating between types of investors, maybe
through a market mechanism, which must be addressed. Clearly, the type of
defence differs across categories of investors.
Finally, Padoa-Schioppa raised the public side of the issue of conflicts of 
interest. It is important to be aware that there are notable conflicts also in the 
public and regulatory sides. The public servant must serve the public interest. In
continental Europe some problems arise from the life-time duration of public
employment. Moreover, price and financial stability must be ensured, even if 
difficult trade-offs are involved. There is a trade-off between opacity and 
transparency. Although central banks were very opaque in the past, transparency