Conflicts of interest in investment banking


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it explains the difference between ethics and compliance and includes a case study on Goldman Sachs

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  • Didn’t include socialization of information productivity because it decreases the quality of information due to the sources being publically or government funded. These entities do not share the same interest in quality information as firms do
  • Conflicts of interest in investment banking

    1. 1. CIBIS- Consortium of Investment Banking and Institution Standard
    2. 2.  Any organisation in world has to follow some rules and regulations so as to develop a systematical environment for its customers.  Being a part of capital market, Investment Banks play major role in prime activities.  It acts as an intermediary between investor and companies.
    3. 3.  Rules of conduct recognized in respect to a particular class investment banking  It is that branch of philosophy dealing with values relating to human conduct and interest of all, with respect to rightness and wrongness of certain actions and to the goodness and badness of the motives and ends of such actions.
    4. 4.  In general, compliance means conforming to a rule, such as a specification, policy, standard or law. Regulatory compliance describes the goal that corporations or public agencies aspire to achieve in their efforts to ensure that personnel are aware of and take steps to comply with relevant laws and regulations.
    5. 5. Rule 1 – Independence & Objectivity  Members shall maintain independence and objectivity in undertaking all transactions and providing all investment banking and advisory services.  Members shall not allow themselves to be placed in a position of pressure to approve any documents, structures or transactions that do not meet compliance requirements.  Services contracts signed by such members shall either not limit, or proactively provide for, such independent expert discretion of conclusions based solely upon demonstrated objective facts, regardless of any payment for services.
    6. 6. Rule 2 – Anti-Fraud  Economic Security – Members shall not disclose a level of general information that would enable or permit any person to design, improve, perfect or commit any fraud or other unlawful activity in any transaction.  To best support legitimate transactions without violating this rule, any reports given or advisory statements made should be limited to practical recommendations for correcting defects of documentation or structures, or suggestions for obtaining verifiable documents to replace defective documents, strictly on a case- by-case basis.
    7. 7. Rule 3 – Sharing for Collective Capabilities –  Members shall share information on developing trends and practices in investment banking, compliance procedures, anti-fraud measures and transaction controls with CIBIS, for analysis and processing for the collective benefit of members.  Members shall also provide assistance to other members in an unofficial advisory capacity, to maintain a network of collegial professional support, and to facilitate access to external institutional capabilities.
    8. 8. Factors Legal Ethical Ethos Regards ethics as a set of limits and something that has to be done Defines ethics as a set of principles to guide choices Objectives Geared toward preventing unlawful conduct Geared toward achieving responsible conduct Method Emphasizes rules and uses increased monitoring and penalties to enforce these Rules Treats ethics as infused in business practice (leadership, core systems, decision- making processes, etc) Behavioral Assumptions Rooted in deterrence theor y(how to prevent people from doing bad things by manipulating the costs of misconduct) Rooted in individual and communal values (both material and spiritual)
    9. 9.  Conflicts of Interest- a type of moral hazard problem that occurs when a person or institution has multiple objectives (interests) and as a result has conflicts between them.  Conflicts of interest usually take the form of misleading information.  Financial institutions can benefit off of giving out misleading information, hurting the public, while giving the financial institutions greater profits.  Conflicts of interest lead to unethical behavior.  Conflicts of interest occur when an institution or employee serves his interests at the expense of others.  Combinations of services that bring together any group of depository intermediaries, non-depository intermediaries, and brokers, or that allow any of these groups to invest directly in a business, are most likely to lead to conflicts of interest.
    10. 10.  Conflicts of interest can substantially reduce the quality of information in financial markets, thereby increasing asymmetric information problems.  In turn, asymmetric information prevents financial markets from channeling funds into the most productive investment opportunities and causes financial markets and the economy to become less efficient.  The growing economies of scope have led to financial institutions to offer many services under one roof, increasing conflicts of interest and in turn increasing unethical behavior.
    11. 11. •Conflicts of interest become a problem for the financial system when they lead to a decrease in the flow of reliable information, either because information is concealed or because misleading information is spread. •The decline in the flow of reliable information makes it harder for the financial system to solve adverse selection and moral hazard problems, which can slow the flow of credit to parties with productive investment opportunities
    12. 12. • Inappropriately designed compensation plans, for example may produce conflicts of interest that not only reduce the flow of reliable information to credit markets but also end up destroying the firm. • The conflict of interest problem can become even more hazardous when several lines of business are combined and the returns from one the activities, such as underwriting and consulting, are very high for only a brief amount of time. Also, a compensation scheme that works reasonably well in the short term might become poorly aligned in the long run.
    13. 13.  Threats to truthful reporting in an audit arise from several potential conflicts of interest.  The conflict of interest that has received the most attention in the media occurs when an accounting firm provides its client with auditing services and non-audit consulting services, commonly known as Management Advisory Services, such as advice on taxes, accounting or management information systems, and business strategies
    14. 14. • Conflicts of Interest can substantially reduce the quality of information in financial markets, thereby increasing asymmetric information problems. • These asymmetric information problems prevent financial markets from channeling funds into the most productive investment opportunities and causes financial markets and the economy to become less efficient.
    15. 15. Analysts in investment banks are persuaded to distort their research to please the underwriting department of their bank and the corporations issuing the securities which undermines the reliability of information investors use for financial decisions and diminishes the efficiency of securities markets.
    16. 16.  Spinning occurs when investment banks allocate underpriced shares of newly issued stock to executives of other companies in order to lure them to use that investment bank  When the executives company plans to issue its own securities it uses that investment bank as an underwriter.  This causes a rise in the cost of capital for the firm and hinders the efficiency of the capital market.
    17. 17.  A bank may make loans to a firm on overly favorable terms to obtain fees from it for performing activities such as underwriting the firms securities  A bank with an outstanding loan to a firm whose credit or bankruptcy risk has increased has private knowledge that may encourage the bank to use its under-writing department to sell bonds to the unsuspecting public, thereby paying off the loan and earning a fee.  These conflicts of interest decrease the amount of accurate information and hinders the banks ability to promote efficient credit allocation
    18. 18. Probably conflicts of interest can arise by investment banks like:  Goldman Sachs  Kotak Finance  SBI
    19. 19. Goldman Sachs Group Inc. is under investigation by the Securities & Exchange Commission for fraud in a mortgage securities transaction. Was there a conflict of interest in this transaction?
    20. 20.  Goldman Sachs purchased many mortgages from the US housing market.  They then converted them into mortgage backed securities.  They advised clients to buy these mortgages.  At the same time they sold these mortgage securities short as either a hedge against their portfolio to reduce risk or as a major position anticipating a drop in value in the US housing market.
    21. 21.  Goldman Sachs has an obligation to offer investments that it believe are in the clients best interest.  They are also legally obligated to know their client, as well as what is a suitable investment for their client.  In this case the clients of Goldman Sachs were knowledgeable investors (i.e. International banks and hedge funds)  Did Goldman Sachs disclose, to the clients purchasing these mortgage products, that they were also shorting these same securities?  If they did not, Goldman Sachs was acting in their own best interest as opposed to that of their clients. This is a conflict of interest.
    22. 22.  Shorting Its Own Securities  Failing to Disclose Key Information to Investors.  Failing to Disclose Client Involvement  Selling Securities Designed to Fail.  Misrepresenting Assets.  Using Poor Quality Loans in Securitizations.  Concealing Its Net Short Position.
    23. 23.  Goldman Sachs, a premier investment banking firm, may be heavily fined, broken up and/or lose their clients trust, which is Goldman Sachs Group Inc. most valuable asset.
    24. 24.  Sarbanes-Oxley Act of 2002  Global Legal Settlement of 2002
    25. 25. Sarbanes-Oxley Act of 2002 Global Legal Settlement of 2002  Increased supervisor oversight to monitor and prevent conflicts of interest  Directly reduced conflicts of interest  Produced incentives for investment banks not to exploit conflicts of interest  Instituted measures to improve the quality of information in financial markets  Directly reduced conflicts of interest  Produced incentives for investment banks not to exploit conflicts of interest  Instituted measures to improve the quality of information in financial markets
    26. 26. Leave It To The Market Regulate for Transparency  The market may punish the firm exploiting conflicts of interest by causing them to have higher funding costs or decreased demand for services  Open market forces can create means to contain conflicts of interest through information demanded from non conflicted organizations  Mandatory information disclosure decreases information asymmetries  This in turn reveals if conflicts of interest are being exploited  Could be bad because of free-loader effect  If regulated too much can cause loss in information production and profitability for the firm
    27. 27. Supervisory Oversight Separation Of Functions  Supervisors can review financial information without revealing it to competitors  This maintains profitability & information production  Supervisors can then take actions to control the exploitation of conflicts of interest and enforce ethical standards  Poor supervisors allow for exploitation to continue  Reduces economies of scope through regulation  Information sharing between departments is regulated  Separates departments and adds firewalls to ensure that the firms agents are not responding to multiple principals  Results in a trade off between information production and reducing conflicts of interest
    28. 28.  The existence of a conflict of interest does not mean that it will have serious adverse consequence.  Even if incentives to exploit conflicts of interest remain strong, eliminating the economies of scope that create the conflicts of interest may be harmful because it will reduce the flow of reliable information.