Approaches to Remedying Conflicts of Interest

In thinking about remedies for specific problematic situations, it is worthwhile to discuss five generic approaches to reconciling conflicts of interest. These approaches are discussed in the order of their intrusiveness, from least intrusive to most intrusive.

Leave It to the Market.

This approach has a powerful appeal to many economists and may be a sufficient response in many cases. Market forces can work through two mechanisms. First, they can penalize the financial service firm if it exploits a conflict of interest. For example, a penalty may be imposed by the market in the form of higher funding costs or lower demand for the firm's services, in varying degrees, even to the point of forcing the demise of the firm. Second, market forces can promote new institutional means to contain conflicts of interest. For example, they can generate a demand for information from nonconflicted organizations. This is exactly what happened in the United States in the 1920s, when security affiliates took preeminence over in-house bond departments in universal banks.

One advantage of market-driven solutions is that they can hit where it hurts the most, through pecuniary penalties. Moreover, they may help avoid the risk of overreaction. It can be hard to resist the temptation to adopt nonmarket solutions to appease a public outcry that may reduce information production in financial markets. Conversely, market-based solutions may not always work if the market cannot obtain sufficient information to appropriately punish financial firms that are exploiting conflicts of interest. Memories may be short in financial markets, as is suggested by the new field of behavioral finance discussed in Chapter 7. Once a triggering event has faded from memory, conflicts may creep back in unless reforms have been "hard-wired" into the system.

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