Conflicts of Interest and Market Discipline Among Financial Services Firms

Abstract

There has been substantial public and regulatory attention of late to apparent exploitation of conflicts of interest involving financial services firms based on financial market imperfections and asymmetric information. This paper proposes a workable taxonomy of conflicts of interest in financial services firms, and links it to the nature and scope of activities conducted by such firms, including possible compounding of interest-conflicts in multifunctional client relationships. It lays out the conditions that either encourage or constrain exploitation of conflicts of interest, focusing in particular on the role of information asymmetries and market discipline, including the shareholder-impact of litigation and regulatory initiatives. External regulation and market discipline are viewed as both complements and substitutes – market discipline can leverage the impact of external regulatory sanctions, while improving its granularity though detailed management initiatives applied under threat of market discipline. At the same time, market discipline may help obviate the need for some types of external control of conflict of interest exploitation. JEL G21, G24, G28, L14. Keywords: Conflicts of interest.  Financial regulation. Financial services. Banking.

Potential conflicts of interest are a fact of life in financial intermediation. Under perfect competition and in the absence of asymmetric information, exploitation of conflicts of interest cannot rationally take place. Consequently, the necessary and sufficient conditions for agency costs associated with conflict of interest exploitation center on market and information imperfections. Arguably, the bigger and broader the financial intermediaries, the greater the agency problems associated with conflict-of-interest exploitation. It follows that efforts to address the issue through improved transparency and market discipline are central to creating viable solutions to a problem that repeatedly seems to shake public confidence in financial markets.