Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Wednesday, March 23, 2016

Financial Crisis, Corruption and Conflicts of Interest: What Central Banks Need to Understand in Regulating and Supervising the Financial Sector!

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).

No comments:

Post a Comment