In Chapter 8, we saw how how financial institutions play a key role in the financial system. Specifically, their expertise in interpreting signals and collecting information from their customers gives them a cost advantage in the production of information. Furthermore, because they collect, produce, and distribute this information, financial institutions can use the information over and over again in as many ways as they would like, thereby realizing economies of scale. By providing multiple financial services to their customers, they can also realize economies of scope—that is, they can lower the costs of information production for each service by applying one information resource to many different services. A bank, for example, can evaluate the creditworthiness of a corporation when making a loan to it, which then helps the bank decide whether it would be easy to sell the bonds of this corporation to the public. Additionally, by providing multiple financial services to their customers, financial institutions can develop broader and longer-term relationships with firms. These relationships further reduce the cost of producing information and, therefore, enhance economies of scope.

Although economies of scope may substantially benefit financial institutions, they also create potential costs in the form of conflicts of interest. Although conflicts of interest arise in almost all aspects of our lives, we need to be precise about the conflicts of interest that concern us here. Given the crucial role of information in financial markets, we focus on those conflicts of interest that arise when financial service firms or their employees have the opportunity to serve their own interests, rather than the interests of their customers, by misusing information, providing false information, or concealing information.

Conflicts of interest may occur within financial institutions that provide a specialized service, but they are most problematic when an institution provides multiple financial services to a given client or to many clients. The competing interests of these services may lead employees or a department of a financial institution to conceal information or disseminate misleading information to financial markets. Combinations of services that bring together any group of depository intermediaries, no 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.

Why Do We Care About Conflicts of Interest?

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 productive investment opportunities and causes financial markets and the economy to become less efficient.

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