Ramesh S Arunachalam
If one
looks closely at many of the past financial crisis situations (like
the 2008 global financial crisis fuelled by the US sub-prime), it is clear
that they can be linked to lax and laissez-faire regulatory and supervisory
frameworks that had either been
developed by industry insiders with commercial interests and/or been created
with significant input from such insiders - both with a view to benefit
the overall financial industry concerned!
In other
words, these regulatory and supervisory frameworks created had serious “conflict
of interest situations” that led to such lax and laissez-faire regulatory and
supervisory frameworks being developed in the first place! This was corruption
at its best indeed and there can be no two doubts about that.
Despite all that has happened, even today, there is a puzzling
lack of attention given to the role played by conflicts of interest in the
corruption saga and especially with regard to the larger financial sector. Look
at the United Nations Convention Against Corruption (UNCAC). Even the UNCAC only
makes a fleeting mention about the role played by conflicts of interests,
despite it being very important to understanding and unearthing corruption
worldwide.
Nevertheless,
it is my humble opinion that conflicts of interest are of significant
importance to regulatory ethics and this is something that all central banks
need to note with urgency because if not eliminated, these conflict of interest
situations could spell disaster for the larger financial sector as they could (result
in corruption and) ultimately, lead to financial crisis caused by laissez-faire
regulation and supervision
First,
let us look at what is meant[i]
by “conflict of interest”?
A ‘conflict of interest’ is a conflict
between the duty, roles and responsibilities and private interests of any
official, which could improperly and unfairly influence the performance of
his/her official roles and responsibilities.
By
private interests I mean the following…
Private interests include
financial, pecuniary and other interests[ii]
which generate a direct personal benefit to the public official as also
personal affiliations, associations, and family ties, that could (practically
be considered as likely to) improperly and unfairly influence the official’s
performance of his/her roles, duties and responsibilities.
Defined
in this way, conflict of interest has the potential to undermine the proper
functioning of institutions (public, private, not-for-profit), governments and
the like by:
•
Weakening adherence by officials to the ideals of
impartiality, objectivity, fairness and legitimacy, in decision-making, and
•
Distorting the rule of law, the development and application
of policy, the functioning of organizations and markets, as well as the
allocation of resources.
And
what indeed is the difference between conflict of interest and corruption?
Conflicts
of interest situations exist where officials could abuse their position
(s) for personal and private gain. On the other hand, corruption exists where
officials have abused their position (s) for personal and private
gain. Put differently, conflicts of interest situations DO NOT always
lead to corruption. However, where there is corruption, you can be sure that conflicts
of interest INDEED exist!
OK, Why do
we need to attach so much importance to conflicts of interest with regard to
regulation and supervision in the financial sector? This is because if it is
not entirely eliminated and/or at least properly reduced, the conflicts of
interest can lead to corruption in regulation and supervision and thereby even
threaten the entire financial system.
At least,
this is what past crises situations have taught us. In fact, if there is a
single most recurring theme in financial crises and scandals globally, it is
the failure to manage conflicts of interest. And here are some examples:
Let us
look this with regard to the larger financial sector in the United States and
India, which provide very useful learning with regard to conflicts of interest
and their relationship to crisis situations. They hold very important lessons
for Central Banks globally!
As described by former SEC Chairman Arthur
Levitt, “Bank involvement in the securities markets came under close
scrutiny after the 1929 market crash. The Pecora hearings of 1933, which
focused on the causes of the crash and the subsequent banking crisis, uncovered
a wide range of abusive practices on the part of banks and bank affiliates. These
included a variety of conflicts of interest; the underwriting of unsound
securities in order to pay off bad bank loans; and "pool operations"
to support the price of bank stocks.”
In fact,
as Levitt has further argued, it is the significant revelations
of ‘uncontrolled conflicts of interest’ (please note this carefully)
that provided the basis and rationale for the passing of many subsequent
regulations - the Securities Act (1933), the Securities Exchange Act (1934),
and the Glass-Steagall Banking Act (1933). In fact, it appears that
conflicts of interest were also the major reason for the enactment of the Investment
Company Act (1940) and the Investment Advisor Act (1940).
Closer to
the 1990s, when I lived in the United States for several years, I personally
saw numerous examples of conflicts of interest leading to a crisis:
- The insider trading scandals (such as, the Ivan Boesky and Dennis Levine scandals in the 1980s), the closure of Drexel Burnham Lambert (the investment bank) and the associated (criminal) conviction of its famous employee (Michael Milken) are still fresh in my memory.
- And then there were more financial scandals in the early 2000s – for example, the internet bubble in 2000/2001 exposed problems with dubious high flying research analysts (with very significant conflicts of interest) whose reports were in fact influenced by their own institutions’ investment banking interests. This, in fact, led to specific provisions in the Sarbanes-Oxley Act that dealt with conflicts of interest among research analysts.
- And just about a decade ago, in 2003, SEC found that the use of brokerage commissions to facilitate the sales of fund shares [was] widespread among funds that relied on broker-dealers to sell fund shares. This led to the adoption of new rules to prohibit funds from this practice[iii].
And then,
we had the mother of all financial crises in the recent times—the global financial crisis of 2008,
which was again based on significant conflicts of interest in many areas such
as the production and sale of mortgage-backed securities, rating of these
instruments and so on.
As noted
in the 2007 report of the Financial Crisis Inquiry
Commission (“FCIC”), conflicts of interest that existed among rating agencies
in evaluating collateralized debt obligation (“CDO”) deals was investigated by
the SEC which subsequently issued a report in June 2008 that stated that conflicts
of interest at Moody’s was indeed a very, very major issue. And I quote
from this report:
“We introduce some of the most
arcane subjects in our report: securitization, structured finance, and
derivatives—words that entered the national vocabulary as the financial markets
unravelled through 2007 and 2008. Put simply and most pertinently, structured
finance was the mechanism by which subprime and other mortgages were turned
into complex investments often accorded triple-A ratings by credit rating
agencies whose own motives were conflicted. This entire market depended on
finely honed computer models—which turned out to be divorced from reality—and
on ever-rising housing prices. When that bubble burst, the complexity bubble
also burst: the securities almost no one understood, backed by mortgages no
lender would have signed 20 years earlier, were the first dominoes to fall in
the financial sector.” (Page 28)
Just as an aside, I would like to state there are
huge problems with securitisation in the Indian micro-finance sector as well
and hope India’s central bank, the RBI, takes note of the same.
Getting
back to the FCIC report, it cited several other conflicts underlying the crisis
such as: a) underwriters assisting CDO managers in selecting collateral; and b)
hedge fund managers selecting collateral from their funds to place in CDOs that
they offered to other investors. The FCIC report notes in the above connection
that:
“The SEC investigated the rating
agencies’ ratings of mortgage-backed securities and CDOs in 2007, reporting its
findings to Moody’s in July 2008. The SEC criticized Moody’s for, among other
things, failing to verify the accuracy of mortgage information, leaving that
work to due diligence firms and other parties; failing to retain documentation
about how most deals were rated; allowing ratings quality to be compromised by
the complexity of CDO deals; not hiring sufficient staff to rate CDOs; pushing
ratings out the door with insufficient review; failing to adequately disclose
its rating process for mortgage-backed securities and CDOs; and allowing
conflicts of interest to affect rating decisions.” (Page 212)
Yet
another conflict cited in the report was about Citigroup offering “liquidity
puts” that gave it significant fees in the short term but placed significant
financial risk on it in the long term. And I quote the following on Citigroup
from the report –
“There is a potential conflict of
interest in pricing the liquidity put cheep [sic] so that more CDO equities can
be sold and more structuring fee to be generated.” The result would be losses
so severe that they would help bring the huge financial conglomerate to the
brink of failure, as we will see.” (Page 139)
Another
high profile example of conflict of interest in the recent years is the
settlement that the SEC reached with Goldman Sachs, in which that firm paid
$550 million to settle charges filed by the Commission, and acknowledged
that disclosures made in marketing a subprime mortgage product contained
incomplete information as they did not disclose the role of a hedge fund client
who was taking the opposite side of the trade in the selection of the CDO. And
I quote
“2. Goldman acknowledges that the
marketing materials for the ABACUS 2007-ACI transaction contained incomplete
information. In particular, it was a mistake for the Goldman marketing
materials to state that the reference portfolio was "selected by" ACA
Management LLC without disclosing the role of Paulson & Co. Inc. in the
portfolio selection process and that Paulson's economic interests were adverse
to CDO investors. Goldman regrets that the marketing materials did not contain
that disclosure. (http://www.sec.gov/litigation/litreleases/2010/consent-pr2010-123.pdf , Page 2, point 3)”
After the
2008 financial crisis, there are a couple of examples of problems that arose
from poorly controlled conflicts of interest. One is the famous case of
Barclays Bank, which acknowledged misconduct related to ‘possible
collusion’ to artificially set LIBOR (the London Interbank
Offered Rate). As all of us know, LIBOR is a very significant benchmark that is
used to set short-term interest rates on different financial instruments
including derivates.
Second is
the 2010 Andhra Pradesh (AP) micro-finance crisis which is again a classic
example of the conflict of interest problem! In the 2010 AP crisis, the lax
regulation and laissez-faire supervision of the NBFC MFIs (done at the behest
of the micro-finance industry at large and NBFCs in particular and RBI’s own
misplaced trust in NBFC MFIs as Dr Y V Reddy, former Governor has admitted) led
to the eventual crisis on the ground.
To
summarise, what needs to be emphasized here is the fact that the ‘broad
industry of financial services’ which needs to be regulated surely cannot
decide on its own regulation. In fact, many of the past crisis situations given
earlier, can be linked to lax and laissez-faire regulatory/supervisory
frameworks that had either been developed by industry insiders with commercial interests
and/or been created with significant input from such insiders - both with a
view to benefit the overall industry concerned!
And
central banks must guard against this and specifically, they must attempt to protect
independent committees (an instrument often used by central banks) that
are looking into regulation/supervision of the larger financial sector from
the influence of the companies (institutions) operating in the same financial
markets. This is a strong prerequisite to ensure effectiveness of the regulatory
architecture being developed.
Otherwise,
the threat arises that, instead of being guided by public and larger client
interests, such so-called independent committees (at central banks) will
promote the interests of those companies and institutions whose activities are
supposed to be regulated and supervised in the first place, which, in the
long-term may lead to the collapse of the entire financial system (as it
happened in 2008). And central banks (globally)
can ignore this important fact at their own peril!
Thank
You and have a nice day!
[i] These
definitions have been compiled from several sources including OECD and other
material found on the web, which are far too numerous to quote. These are
gratefully and sincerely acknowledged.
[ii] The negotiation of future
employment by an official (for himself/family/friends) prior to his leaving his
present office is one example here and there is many more examples that I could
provide. This is like negotiating a job with a vendor. For example, an official
may say, “I will make rules governing X
and Y situations very lenient provided you make my nephew the CEO in another
project of yours.”
[iii] Please see http://www.sec.gov/rules/final/ic-26591.pdf - Prohibition on the Use of Brokerage Commissions
to Finance Distribution, Investment Company Act Release 26591 (Sept. 2, 2004),
69 Fed. Register 54728, 54728 (Sept. 9, 2004).
