Centre for Economic Policy Research

Discussion and Roundtables 97

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has taken increasing importance. In general, there should be two agencies that
preside over two objectives.
Angel Ubide 
Tudor Investment Corporation
Angel Ubide recalled the definition of a conflict of interest as a decline in 
available information that lowers the efficiency of financial markets. There is thus
a trade-off between the benefits of certification (economies of scope in
information collection) and the (perceived) cost of conflicts of interest. The
Report assesses whether underwriting activity is affected by such conflicts. The
yield is typically lower when a commercial bank has a lending stake in the issuing
firm. Moreover, universal banks are biased towards smaller firms, thus increasing
the access to market for these firms.
With a worldwide trend toward universal banking, interest-rate margins are
compressed to very low levels. The main strategy in banking currently seems to be
to focus on fee-based activities and to use lending as a strategy to secure new 
business. Lending has become a crucial activity: customers demand credit in
return for mergers and acquisitions and underwriting business, and banks are
offering credit below current market rates as a sweetener to win investment 
banking contracts. As a result, this practice artificially improves the balance-sheet
of corporations while increasing the risks on the balance-sheet. Is this really a 
conflict of interest as defined in the Report? Or is it a supervisory concern? Or
both?
The increase in the use of derivatives has been dramatic. A first result is that the
activity is highly concentrated in a few banks: the top three derivatives dealers
hold 88% of total US bank derivatives notionals; 89% of contracts which are not
related to interest rates; 88% of apparently unmatched positions; and about 75%
of credit exposure. Furthermore, although some activity is directed at hedging,
there are large unmatched market values inside the banks. Are universal banks
playing with the safety net? Moreover, there has been a large expansion in credit
default swaps. A conflict of interest might arise if the credit default swap 
department of the bank is pricing an issue, which involves the use of bond and
loan information from the commercial banking part of the conglomerate.
In certain countries, banks can hold equity stakes in non-financial firms. In
many cases bank managers sit on the board of the firms to which they lend. Even
in the United States, a third of large corporations have bank directors on their
board. It remains unclear whether such a situation is good or bad from the point
of view of conflicts of interest. Long-term equity stakes increase the incentive to
cooperate with the borrower in case of financial distress. Studies of Keiretsu show
how banks went out of their way to help distressed borrowers. On the other side,
the arrangement allows for an improvement in the monitoring of credit risks,
which is beneficial. Another issue is that the interest rate charged is based on a
long-term assessment of the firm rather than on the intrinsic risk of particular
projects. Having a stake in a company reduces the conflict of interest between
shareholders and the lender by aligning incentives. In the end, there is better
monitoring but a less transparent pricing of risks. Does this increase or reduce the
information that is available for the market?
Are there lessons to draw from the European experience with universal banking
over 50 years? European banking is based on reputation to ensure a steady flow of
future business, while the Anglo-Saxon arm’s length banking relies more on courts
to enforce explicit contracts. Relationship banking is largely self-governing,
whereas arm’s length banking is heavily regulated. The legal and cultural 
98 Conflicts of Interest in the Financial Services Industry

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superstructure is key: governmental influence, notably through national 
champion strategies, accounting based on principles rather than rules, more 
concentration in the banking sector, and a regulatory framework tilted towards
larger banks. Can universal banking avoid the exploitation of conflicts of interest
without changing this superstructure towards relationship banking?
Finally, conflicts of interest must be related to Basel II. There will be greater 
discretion to determine capital needs and as a consequence, the scope for conflicts
of interest may widen. It should, however, put a higher value on enhanced 
monitoring and relationship banking, thereby bringing about a higher level of
information. The supervisory review process should enhance the control of incen-
tives, although it is not clear that supervisors will deal with conflicts of interest.
Finally, market disclosure will bring additional information. In the end, will Basel
II increase or decrease the potential for conflicts of interest in universal banking?