Centre for Economic Policy Research

Endnotes
1
Full disclosure includes revealing the identity and relationships of highly 
compensated employees, shareholder rights beyond those of ordinary stockholders, 
insider loans, fairness of contracts between the company and insiders, stock options,
pensions, stock purchase plans, up to five years of audited earnings, and ‘comfort 
letters’ from accountants attesting to the dependability and accuracy of the 
financial information (Bloch, 1986).
2
For one theoretical treatment of how synergies arise between brokerage and 
underwriting, see Stefanadis (2003).
3
Customers may also reward a firm with overall trading business rather than trading
in a specific stock. Also large traders may place orders with multiple broker-dealers 
to avoid fully revealing their intentions.
4
There are also European, Latin American, Japanese and other Asian polls.
5
The rankings are posted on the Institutional Investor’s website, 
www.institutionalinvestor.com. 
6
For example, AT&T chose the lead underwriter for Lucent Technologies IPO on the 
basis of investment bank analysts reports on AT&T (Wall Street Journal, 13 July 
1995).
7
One CFO of a company making a new IPO remarked: ‘Since nobody knows you, and 
all of your numbers are pro forma, the analyst must paint the picture for 
prospective investors’ (Galant, 1992).
8
For IPOs, technology firms are defined to include companies in the internet, 
computer software and hardware, communications, medical and electronic 
equipment, but not biotechnology, see Ritter and Welch (2002).
9
See Loughran and Ritter (2002) for a survey of the literature.
10
D’Avolio et al. (2001) argue that the growing number of newer, younger investors 
reduced the market’s sophistication. Likewise the quality of analysts declined as 
they grew in number.
11
One Wall Street observer, James Grant acidly commented: ‘Honesty was never a 
profit center on Wall Street, but the brokers used to keep up appearances. Now they
have stopped pretending. More than ever, securities research, as it is called, is a 
branch of sales’ (quoted in Shiller, 2000).
12
In 2001, the US House of Representatives Financial Services Committee’s 
Subcommittee on Capital Markets, Insurance and Government-Sponsored 
Enterprises held hearings on analysts and their conflicts of interest. The chairman,
Richard H Baker, opened the meetings stating: ‘As a free-market conservative, I am 
the last person interested in government putting the market on trial…. However, the 
foundation of the free-market system is the free flow of straight-forward, unbiased 
information. And I must say I am deeply troubled by evidence of Wall Street’s 
erosion of the bedrock of ethical conduct’ (quoted in Boni and Womack, 2002, 
p. 96). Surveying the practice of spinning, Rep. John LaFalce (D NY) ranking 
member of the House Financial Services Committee commented: ‘The fact that 
investment banks can hand out IPO shares to individual clients who generate more
underwriting business for the banks creates potential conflicts of interest across the 
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entire investment banking industry that we cannot simply ignore’ (Wall Street 
Journal, 3 September 2002, p. C1).
13
If firms find that their reputations have been impaired, meaning that their ability to 
compete for investment banking business is weakened, they may restructure the 
firm to signal to the market that they are controlling conflicts.
14
In a simple exercise to attempt to distinguish between conflict of interest and 
selection (and implicitly cognitive) bias, Michaely and Womack (1999) conducted a
survey of MBAs in investment management and investment banking, asking them 
to interpret their empirical results as the result of one effect or the other. Although 
the sample was small, all 13 investment managers and 10 out of 13 investment 
bankers believed that the differences in their study were attributable to conflicts of 
interest.
15
If investors were caught up in a bubble mentality, they may not have paid attention
to fundamentals even if the correct information was readily available.
16
In the commercial banking industry, prudential supervision is already in place to 
assess risk management. The movement towards a reorganization of the US 
financial industry as a universal banking system implies some complementary 
expansion of prudential supervision.
17
Boni and Womack (2002) report that most institutional investors do not believe that
firewalls exist currently or that they could be credibly enforced.
18
The firms are Bear Stearns, Credit Suisse First Boston, Deutsche Bank, Goldman 
Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon 
Smith Barney, UBS Warburg.
19
The most rudimentary form of accounts are known to have existed since ancient 
times (O’Connor, 2002).
20
The largest audit firm in Germany was Deutsche Treuhand Gesellschaft, managed by 
Deutsche Bank before regulation forced it to become ‘independent’. This firm 
eventually merged with KPMG Peat Marwick.
21
Sutton (1997) notes that in 1933 the US Congress was contemplating the 
establishment of a corps of government auditors; but Congress was persuaded by the 
existing accounting societies that they could fulfil the role. In other countries with 
less developed private accounting organizations, statutory auditors played a more 
significant role.
22
The United Kingdom went through a similar evolution moving from the ICAEW 
and ICAS to the UK Accounting Standards Board. In continental Europe and Japan 
the accounting practices were based on more formal commercial laws, including 
European 4th and 7th Directives. More recently, the International Accounting 
Standards Board, organized along the lines of the FASB, has been given authority to
establish standards for listed European companies beginning in 2005.
23
Typical of this view is an article by then SEC Commissioner Steven Wallman, 
‘Accounting and financial reporting are linchpins to the success of our capital 
formation process and accountants…are the gatekeepers of our financial markets’ 
(Wallman, 1996, p. 77).
24
Mansi et al. (2003) use firm-level bond price data and find that use of a Big 6 
auditor reduces the rate of return required by investors and that this effect is almost
three times larger for non-investment grade issuers. The value of the audit opinion
is difficult to measure empirically because by the time an auditor discovers problems
and gives a qualified opinion, the market may already have absorbed much of the 
negative information in the stock price (Healy and Palepu, 2001). Furthermore, 
qualified opinions, do not have a standardized measure, and it is also a rare event 
when a qualified opinion expresses a serious difference between the auditors and the 
company’s management, as each will work hard to avoid such qualifications.
25
Prior to the 4th Directive practices differed in each country. For example, in 
Germany the audit opinion was basically one sentence indicating whether the 
financial statements complied with the law.
26
Simunic (1984) noted that ‘any situation which alters incentives such that a self-
interested auditor is more likely to ignore, conceal, or misrepresent his findings is 
described as decreasing the auditor's independence’ (p. 679). 
108 Conflicts of Interest in the Financial Services Industry

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27
Former SEC Commissioner Wallman states: ‘I recognize and agree with the view that 
auditors can provide advisory services well in part because of the knowledge gained 
during the course of an audit…however, knowledge about a business that would 
further the audit function is imparted to accountants through the performance of 
advisory services. The two positions, far from being mutually exclusive, are 
complementary and consistent’ (Wallman, 1996, p. 81).
28
Andersen Consulting had to give up the Andersen name as part of the court 
settlement and was renamed Accenture, which had an initial public offering in 
2001. 
29
Many of the largest accounting firms have similar examples. We focus on Arthur 
Andersen because of its unique role as auditor of Enron, Worldcom, Qwest, 
Sunbeam and Waste Management, and its spectacular demise.
30
For a detailed description of Enron’s problems and demise see Healy and Palepu 
(2003).
31
Antle et al.’s (2002) findings are robust to preliminary tests with US data.
32
They also found that audit risk associated with litigation risk cannot be efficiently 
priced. See also O’Keefe et al. (1994).
33
For example, see Wall Street Journal (1996). See also Toffler and Reingold (2003).
34
In addition to the Andersen clients, recent cases of Adelphia and Healthsouth are 
likely examples of office-level fee dependence for other firms. 
35
Reynolds and Francis (2001) have attempted to analyse the influence of large clients
on office-level auditor reporting decisions. Looking at differences by client size, they
find no evidence of dependence on large clients influencing accruals and argue that
the evidence is consistent with Big 5 auditors reporting more conservatively for 
larger clients because these clients pose greater litigation risk and hence more 
reputational risk. DeFond et al. (2002) draw a similar conclusion.
36
Several studies, notably Dye (1993), Palmrose (1998, 1991) and Carcello and 
Palmrose (1994), discuss the rise of litigation risk and its impact on the practice and
cost of auditing.
37
Trading by banks was also recorded on this basis.
38
This is a manifestation of the Akerlof (1970) lemons problem.
39
In early 2003, the SEC recognized a fourth firm, Dominion Ratings, as an NRSRO.
40
For example, see Hand et al. (1992).
41
Equity prices move in the opposite direction, which Kliger and Sarig interpret as 
evidence that a ratings upgrade does not change the market’s overall assessment of
the value of the firm, but affects the division of value between debt-holders and 
equity interests.
42
We do not discuss here the even more extreme possibility of publicly provided or 
funded ratings. This remedy has not been seriously suggested as a remedy for 
potential conflicts and would have, in our opinion, obvious drawbacks.
43
The term universal banking is used here to refer to financial services conglomerates. 
Sometimes universal banking is defined to include when a financial intermediary 
may hold equity positions in firms.
44
Moody’s Manual of Industrial and Miscellaneous Securities was first published in 
1900; analysis of security values began in 1909. For a brief history see
www.moodys.com.
45
Fama (1985), Diamond (1991), and Berlin and Mester (1992).
46
Unfortunately, while there is a general belief in the existence of economies of scope 
there is little empirical evidence. Few studies have produced empirical evidence that
substantial economies of scale exist, much less economies of scope. There are 
significant problems in testing for these effects given limitations of data, but they 
may also be elusive because the standard approach to estimate production or cost 
functions failed to account for risk and the endogenity of risk. Hughes et al. (2001) 
argue that risk-taking may mask scale economies that result from better 
diversification.
47
The Act permits ‘well-capitalized and well-managed’ national banks, with a 
satisfactory or better Community Reinvestment Act rating, to conduct most 
financial activities through an operating subsidiary. The aggregate consolidated