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Financial services: Conflicts of interest endemic

IHT August 8

By Philip Bowring

Hongkong: Investment banks are, at last, under public scrutiny for their role in the technology stock bubble. Merrill Lynch has settled one suit and doubtless more will follow as class action lawyers work on the bona fides of research put out by the "bulge bracket" (industry jargon for the leading houses) tipsters. But important issues are not being addressed.

Beyond the culpability of specific firms and analysts is the bigger question of the structure of the financial services industry and its relationship to the media. It has taken an extraordinary episode to awaken public and officialdom to the conflicts of interest which are endemic in the relationship between investment banker and stockbroker. Yet anyone who has worked for the research department of an investment banker/broker knows that the "Chinese walls" which are supposed to separate the two functions are bamboo curtain.

Investment bankers thrive on fees which mostly flow from the propagation of "good news" regardless of the interests of the investors who are also their clients. Regulatory bodies have long turned a blind eye to all but the most blatant abuses of separation of functions often relying on the good faith of the compliance officers of the investment banks themselves.The industry also has a record of crushing those researchers who draw attention to unethical but highly profitable behavior of the sort which leads to huge bonuses for participants.

Hopefully the tech fall-out will lead to a clean up. But one has to ask (not for the first time) why greed has been so long allowed to triumph over ethics at revered institutions which are presented to the world as the standard bearers of western capitalism. Hopefully too the bust will lead to new laws, a modern Glass-Steagall, which create real walls between financial functions, at least between investment banking, broking, mutual fund management and insurance, and between auditing and consultancy.

Glass-Steagall itself, a product of the 1929 crash, ceased to be effective years before its demise in 1999. But the concept remains valid. Financial services combines create conflicts of interest within organizations. Clients of brokers get supposedly professional advice which is actually nothing but a sales pitch for the investment banking part of the business, and captive mutual funds get stuffed with shares left over from failed public offerings. Profits come before duty of trust. Neither does bigger mean safer. The opposite is true. Moral hazard increases with vertical integration and systemic risk increases with size.

In practice also the capital of banks is being exposed not just to plain vanilla lending risks and normal forex and share offering exposure but to the super-charged risks in derivatives and such newer products such as collateralized debt obligations which have been growing at an astonishing rate. As American Express recently had the courage to admit, the risks are hard even for major participants to understand.

Financial combines are also, by definition, less transparent than single business entities, and thus prudential supervision of them is that much more difficult. At the same time they become "too big to fail", threatening a repeat of the mega bank bailouts seen in Japan. Likewise the fewer large auditing firms there are, and the more reliant they are on consultancy fees, the less likely they are to quarrel with the accounting policies of big companies. In the US, the Securities and Exchange Commission has been making an effort to discipline the big firms. But the bigger they are the more political clout they have to fend off the regulators.

The media needs scrutiny too. It may now be baying for analysts' blood, but its was celebrity journalism as much as Wall Street which created the idols of the techno bubble and made heroes out of humdrum research analysts. Taking their cue from Dr Goebbels, the brighter ones noted the more outrageously bullish their analyses the more attention they got for themselves and their firms' corporate clients.

Meanwhile stodgier publications threw away their journalists' gut skepticism away in favor of reportage the publishers expected would - and for a while did - generate advertising from the "new economy" stars. Oiling the wheels were the wire services. It is an awkward truth that the leading global providers of news get most of their revenue from a smallish group of banks, investment banks, brokers and foreign exchange dealers. Naturally they want to be close to their clients, to reflect their views.

Thus comment on the politics of, say, Indonesia comes not from a seasoned local expert but from a brokerage analyst -perhaps a 28-year-old who has been there for three months. This financial sector bias enters the news chain at an early stage. It is now being magnified by the vertical integration which has taken place in the media and communications industry. When the number of players diminishes, there is increased tendency for myths to become received wisdom, for the psychology of the crowd to replace reasoned discussion. So, while welcoming actions against those who exploited investor credulity it would be wise to look at the institutional roots of the techno bubble, whose fall-out will last a generation. Ends