Centre for Economic Policy Research

4.8
Conclusion
Our overall conclusion is that conflicts of interest at rating agencies, while not to
be dismissed, have so far been more latent than overt. Market discipline, working
through the need for agencies to retain their reputational capital, has been 
instrumental in maintaining this situation. Nevertheless, there are troublesome
aspects of the way in which the industry has developed, and the potential exists
for conflicts to assume greater significance in the future. To guard against this, we
believe it is important to ensure that market disciplines are provided with full
scope to work in their intended way. This means an emphasis on transparency,
and possibly supervisory oversight of new activities being developed by the 
agencies; a reduction in the scope of regulatory recognitions granted to approved
ratings; and a diminution of barriers to entry of qualified new entrants to the
industry. 
54 Conflicts of Interest in the Financial Services Industry

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5 
Conflicts of Interest in Universal Banking
5.1
Introduction
Unlike the conflicts of interest in investment banking and accounting firms that
played a central role in the recent financial scandals, the conflicts that arise from
universal banking have had a long history in the United States.
43
Until a few years
ago, these conflicts of interest seemed to have vanished, as the remedy of separa-
tion by creating distinct classes of financial institutions, each with its own niche
of intermediation, seemed to eliminate them. As the barriers between commercial
banking, investment banking and insurance have disappeared, however, concerns
about conflicts may arise again. We focus on the United States because conflicts
of interest have been discussed in greater depth in the context of US firms and
have attracted greater public attention.
Although commercial banks, investment banks and insurance companies arose
in nineteenth-century America as distinct intermediaries, by the turn of the twen-
tieth century there were obvious economies of scope that could be attained by
their combination. At a time when information costs were extremely high, com-
mercial banks thrived because of their ‘special’ ability to collect information and
monitor borrowers, overcoming adverse selection and moral hazard 
problems. In the absence of standardized accounting methods and rating 
agencies,
44
commercial banks had a decided advantage because their customer 
relationships provided detailed and specific information not available elsewhere.
Commercial bank loans are still regarded as ‘special’ today, assisting borrowers
who have poor or no credit reputations. Even for established firms, the market
construes the announcement that they have been approved for new bank loans as
a positive signal.
45
There are fixed costs of investigating a borrowing firm. If the
firm turns out to be a good credit risk, it may be able to raise money from the 
securities market later. For a bank that has a lending relationship with a firm, it
should be less expensive to perform due-diligence analysis for underwriting a new
issue because of the reusability of information. 
Economies of scope may also exist in building a reputation for financial 
institutions. If a universal bank can use the reputation acquired in one business to
enter another, it will have an advantage over specialized banks.
46
There may also
be economies of scope in serving the large customer bases that commercial banks,
investment banks, brokerages and insurance companies create. The considerable
overlap in the information they collect may reduce the cost of supplying these
services jointly. Proprietary information obtained by information in securities
issue and lending should improve the quality of their portfolios. Universal bank-
ing also increases the point of contact a bank has with a firm, expanding the
number of services and improving its information acquisition and monitoring. 
55

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Universal banks thus offer many possible economies of scope that lower the
cost of providing financial services. Yet, given that activities within a firm serve
multiple departments, there are many potential conflicts of interest. If the 
potential revenues from one department surge, there will be an incentive for
employees in that department to distort information to the advantage of their
clients and the profit of their department. For example, issuers served by the
underwriting department will benefit from aggressive sales to customers of the
bank, while these customers are hoping to get unbiased investment advice. A bank
manager may push the affiliate’s products to the disadvantage of the customer,
fail to offer dispassionate advice, and limit losses from a poor public offering by
placing them in bank managed trust accounts. A bank with a loan to a firm whose
credit or bankruptcy risk has increased has private knowledge that may encourage
it to have the bank’s underwriting department sell bonds to the unsuspecting 
public, paying off the loan and earning a fee. On the other hand, a bank may
make below market loans to investors to finance the purchase of securities 
underwritten by an affiliate. A bank may also try to influence or coerce a borrow-
ing or investing customer to buy insurance products (Saunders and Walter, 1994).
Given the multiple services provided by a universal bank, there are multiple
opportunities for departments or individuals to benefit from the conflicts of inter-
est. While other countries had long permitted some form of universal banking,
the United States only recently re-opened the doors. Breaking down the barriers
imposed by the Glass-Steagall Act, the Gramm-Leach-Bliley Financial Services
Modernization Act of 1999 permits banks, securities firms, and insurance 
companies to affiliate within a new structure – the financial holding company
(FHC).
47
Most of the research on conflicts of interest in universal banking has thus
been focused on the pre-1933 era when commercial banking deeply penetrated
the securities business.