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Conflicts of Interest - Do you know?

Discussion in 'Economy/Finance stuff' started by Chaupham, Jul 8, 2012.

  1. Chaupham

    Chaupham Member MBA Family

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    Today I'd like to touch on a very key topic of financial management: conflicts of interest. I'm certain that you've studied it, or pass by it sometimes. But to whom who really want to know how it's looked like in terms of financial theory, here you go:


    What are conflicts of interest and why are they important?

    Firstly, we agree that financial intermediaries engage in a variety of activities to:
    1) collect information.
    2) produce reports based on the information they collect.
    3) distribute information.

    By providing multiple services, they realize economies of scope.
    Economies of scope refer to the efficiency improvements that a firm can get from increasing their range of products / services.
    Services may be competing with one another, and this creates the potential for a conflict of interest.

    The conflicts of interest may arise as the concealment of information or the dissemination of misleading information.
    For example you might not tell your employer that the interviewee was your brother :)>-


    We care about these conflicts of interest because a reduction in the quality of information increases the presence of asymmetric information.
    Conflicts of interest generate incentives to provide false or misleading information.

    Ok. Take it away, would you? Next time, we will discuss about 4 areas of financial service activities that have the greatest potential for generating conflicts of interest.
    1) Underwriting and research in investment banking
    2) Auditing and consulting in accounting firms
    3) Credit assessment and consulting in credit-rating agencies
    4) Universal Banking
     
  2. luulamhong

    luulamhong Member MBA Family

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    This reminds me one thing, the primary conflict of interest is up-front fees and commissions. I add here the conflict of brokers first: Their customers (who should best buy US Treasury and mutual funds) are often encouraged by their brokers to buy penny stocks since the penny stocks always result in higher commission and also up-front fees.

    The second is underwriting. Brokers and investment bankers collect higher fees from underwriting than from resales in secondary markets. Therefore they will try to underwrite even the overpriced or high risky stocks because of this higher fees. This fee is so attractive that investment bankers even create their underwriting clients - and that what we call "closed-end mutual funds" :). For example, you can buy AAPL with $500 per share directly but you have to pay $700 for that apple when you buy under a closed-end fund. The $200 is spent for broker commission and management fees.
     
  3. Chaupham

    Chaupham Member MBA Family

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    It's just great to begin the part of Underwriting and research in investment banking with excellent pratical example from Hong. Given the case when paying extra $200 for $500 in value apple, I suggest that the Broker violates III (A) and VI (A) Standard (CFA).

    So, let see how it looks like with regard to Underwriting and research in investment banking:

    When revenues from underwriting exceed brokerage commissions:
    – Favourable research will attract more business, this is at the expense of unbiased recommendations to the investing public.

    Investment banks also face conflicts of interest with respect to IPO’s
    _ Initial public offerings (floatation on stock market)
    _ Underwritten by investment bank
    _ Usually underpriced to ensure full take up

    In initial public offerings of equity, underwriters direct the new shares as they wish, typically to their best clients or potential new clients. Since most IPOs are underpriced, many of these shares are immediately sold for a profit (called spinning).

    This immediate “profit” opportunity has been used in the past to encourage company executives to place future business with a bank.

    2) Auditing and consulting in accounting firms

    _ Auditors supposed to provide an unbiased view of the financial reports
    _ Crucial to reduce asymmetric information between the firm’s management and the investing public.

    The big players in the accounting field are multi-faceted consultancies
    – Provide tax advice / planning
    – Corporate financial services
    – Economic appraisals

    The auditor has an incentive to misrepresent the audit result if the fees from other services are substantial.
    _ Auditors also have a conflict of interest since they are paid by the firm they audit.
    _ Auditing is a competitive businesses

    If the auditor gives an unfavorable audit report, the auditor may lose the auditing business as well. A well known case of the failure of auditors to provide unbiased reports was Arthur Andersen’s audit of Enron:
    – Securities and Exchange Commission(SEC) (US regulator) began to worry about financial irregularities and launched an investigation
    – Andersen employees on the Enron engagement team were instructed to destroy documentation relating to Enron
    – ‘Big 5’ accounting firms became the ‘Big 4’
    – Loss of credibility ruined Andersen
    – Indictment barred them from auditing public companies putting them out of business
     
  4. luulamhong

    luulamhong Member MBA Family

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    Are you sure? :))
     
  5. Chaupham

    Chaupham Member MBA Family

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    Well, I am absolutely certain with that statement. Fortunately, I carried out some researches relating to what you have asked.

    Here, just for you.

    IPO underpricing

    (Ritter, 2010)
    Average first day return of IPOs was 11.9% between 2001 and 2009
    Reached 64.4% during Dot-Com bubble
    Suggests that shares in IPOs are consistently offered to subscribers at too low a price, resulting in high returns when they get listed.

    (Loughran and Ritter, 2002)
    Money ‘left on the table’ defined as:
    first day price gain * number of shares sold
    Represents the additional amount that companies could have raised if shares had been offered at the ‘market’ price
    $27 billion left on table between 1990 and 1998
    The direct costs of investment banker fees was $13 billion
    Average profits of these companies was just $8 billion

    (Brau and Fawcett, 2006)
    1) Underwriter Risk and Effort
    Underwriters may have more information than the issuing company
    By offering shares in an IPO at a low price the underwriter can minimise its own risk and effort.
    2) Winners’ Curse
    For underpriced IPOs there will be high demand, and each subscriber will only receive a fraction of the shares they asked for
    For overpriced IPOs there will be low demand, and each subscriber will receive the full allocation they asked for
    Uninformed investors who cannot distinguish underpriced from overpriced, will on average receive more shares in the overpriced firms, and may have negative returns
    To attract any uninformed investors there must be systematic underpricing
    3) Avoid Legal Action
    Underwriters are required to provide all relevant information about an IPO, and perform due diligence
    If they fail in this regard they could be sued
    They may be less likely to get sued later, if they offer the shares at a low price
    Underpricing may be a form of insurance against legal action
    4) Marketing Function
    Underpricing can cause a domino effect (cascade) amongst investors, which leads to much higher demand
    May allow other types of cost savings in trying to attract investors
    5) Broadens Ownership
    Underpricing can lead to oversubscription, which implies more investors are seeking shares
    A wide ownership base may be less likely to have control of management
    Management may accept underpricing if it protects their own position
    6) Spinning and Flipping
    May offer underpriced shares to attract institutional investors
    Underwriters may spin underpriced shares to potential clients in an attempt to gain their favour
    The buyers may then engage in flipping, by selling the shares on the first day for a quick profit

    So jo happy my friend :)
     
  6. Chaupham

    Chaupham Member MBA Family

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    Credit Assessment and Consulting in Credit-Rating Agencies

    1) Credit rating agencies rate the issuer of debt on the basis of how likely it is to go bust
    _Moody’s
    _Standard & Poor’s
    _Fitch

    Credit ratings are assigned from lowest risk to highest risk
    AAA, AA, A, BBB, BB, B, CCC

    The information rating agencies produce is vital to debt markets and prices tend fluctuate in response to downgrades / upgrades. However, ratings are only provided when the firm pays the agency. Until the early 1970’s the investor paid the agency to find out the rating

    _ Free-rider problem (e.g. cheap photocopying of reports) ate into revenues
    _ Business model changed

    Agencies, then, have an incentive to provide “better” ratings to attract business. Rating agencies have also started providing firms with other services. They give advice on how to structure debt issues to attract favourable ratings. This in effect would be auditing their own work, a similar conflicts of interest as auditors who offer both auditing and consulting services.

    Credit Rating Agencies in 2007-2009 financial crisis.
    • Rating agencies, such as Moody’s and Standard and Poor, were caught in this game during the housing bubble.
    • Firms asked the rater to help structure debt offering to attain the highest rating possible. When the debt subsequently defaulted, it was difficult for the agency to justify the original high rating.
    • Perhaps it was just error. But few believe that—most see the rating agencies as being blinded by high consulting fees
    • Criticisms of the rating agencies led to the SEC proposing comprehensive reforms in 2008.
    • New regulation prohibits rating agencies from rating a security that they helped structure.
    • Rating agencies have also been made more accountable.
    • Regulation requires they produce a detailed description of how they determine ratings.
    • Both measures were hoped to increase transparency in the ratings process.

    2) Universal Banking
    Commercial banking, investment banking and insurance services traditionally developed as separate functions of separate institutions. Institutions soon realised that economies of scope (and corresponding efficiency gains) by conducting all three could be realised.
    • This type of consolidation was banned in the US by the 1933 Glass-Steagall Act
    • Result of problems in the banking sector that became obvious in the Great Depression
    • Glass-Steagall Act repealed in 1999
    • Universal banking reappeared
    • One institution, multiple service lines
    • Conflicts of interest can emerge
    • Functions of different departments can be at odds with each-other:
    • Conflicts of interest reduce the amount of accurate information
    • Thus they may hinder efficient credit allocation

    Universal Banking and the Financial Crisis 2007-2009
    • Their European counterparts have been ravaged as well.
    • Fortis, trying to stabilize after last year’s indigestible takeover of ABN-Amro, collapsed in 2008 and was bailout out by the Dutch, Belgium and Luxembourg governments.
    • UBS has been rescued in a massive bail-out by the Swiss government and Credit Suisse has been forced to raise additional capital.
    • Uni Credit seems shaky despite Italy’s assertion that all is well.
    • The British government had to take over Royal Bank of Scotland and HBOS, recapitalize Lloyds TSB.

    It would be nice if any feedback is given with the aim of contributing this topic :)
     
  7. duykhang

    duykhang New Member

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    I'm quite suspicious about "IPO most of the time under-priced". If it's simple as share price is going to hike after get listed then neither it will say anything new or predictable nor one can fore-say the price will be ... under-priced.

    In fact, IPO is much a process / mechanism to explore the share price. No one can say, during that mechanism, the IPO is under-priced or fair or over-priced. And with so many reason posted in your earlier post, I understand that IPO price is fair with expectations and secret agenda or norms behind. Simply, we don't know it right until it happens and we might fall trap into "data crawling" bias while doing data crawling. Hope it's not the case here.
     

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