Centre for Economic Policy Research

xx Conflicts of Interest in the Financial Services Industry

---

1 
What Are the Issues?
1.1
Introduction
This year, 2003, is the 70th anniversary of the Glass-Steagall Act, passed in the
depths of the depression in 1933. The stock market crash of 1929 initiated a long
decline in the market, which fell over 80% from its peak.
Those who had bought into the exuberant bull market of 1928-9 were confi-
dent that the long expansion of the 1920s represented a new era of permanent
growth and eagerly bought up new issues of what were then high tech companies.
When the market collapsed, shareholders felt cheated by the bankers, or as the
pundits called them ‘banksters’, who had sold them the stocks and bonds that
were now worthless or nearly so. The most aggressive promoters of securities were
the newly formed universal banks. Their ability to shift intermediation from one
part of the bank to another offered considerable synergies but also had the 
potential for exploiting conflicts of interest.
The crash revealed stories of the extraordinary greed of some of the formerly
esteemed leaders of the financial industry, who profited at the expense of their 
customers and sometimes their own firms. Problems were not confined to 
banking and a young reforming accountant, by the name of Arthur Andersen,
denounced the slipshod and deceptive practices that had enabled companies to
fool the investing public. 
Bankers’ exploitation of conflicts of interest became part of the popular legend
of the excesses of the era. The response from Congress was the Glass-Steagall Act,
which completely separated commercial and investment banking, reaffirming the
US regulatory tendency to separate financial institutions forcibly by function.
Decades later, financial journalists cited these prominent cases as evidence of the
dangers of universal banking, and they were used as justification for the 
continued existence of the Glass-Steagall Act. 
For the second time in a century, a stock market bubble, fuelled by a belief in
a ‘new economy’ and ‘new tech’ companies, has ended in an extraordinary crash.
Although the European ‘tech’ bubble was not as large as in the United States,
European economies shared much of the run-up and subsequent collapse in share
prices. Moreover, just as occurred 70 years ago, financial markets have been 
jolted by one corporate scandal after another. The cycle began with the spectacu-
lar bankruptcy of Enron Corporation in December 2001, once valued as the 
seventh largest corporation in the United States, and the indictment of Enron’s
auditor, Arthur Andersen, one of the big five accounting firms. Subsequently,
there have been revelations of misleading accounting statements at numerous
other corporations, including WorldCom, Tyco Industries and more recently
Ahold, which have added to doubts about the quality of accounting information
1

---

in the corporate sector. Legal settlements have imposed fines on investment banks
for encouraging their stock analysts to hype stocks that they had serious doubts
about and which turned out to be disastrous investments.
These scandals have received tremendous public attention, not only because
resulting bankruptcies have cost the employees of these firms their jobs and even
their pensions, but also because of the accompanying stock market declines –
measured at 43% for the S&P500, 72% for Nasdaq, and 61% for the EuroSTOXX50
from March 2000 to March 2003. 
A contributory factor in these scandals may have been conflicts of interest 
in which agents who were supposed to provide the investing public with reliable
information had incentives to hide the truth in order to further their own goals.
What are these conflicts of interest and how serious are they? What role have 
they played in the financial markets’ recent woes? What should be done 
about them?
This report seeks to provide some answers to these questions. This introductory
chapter provides a framework for answering these questions by first discussing the
crucial role of information in financial markets. This analysis will then enable us
to define the conflicts of interest that concern us here, explain why we should care
about them, and develop a framework for thinking about policies to remedy them.
The chapter then briefly outlines the types of conflicts of interest that will be
analysed later in the report.