Separation of Functions.

Where the market cannot obtain sufficient information to constrain conflicts of interest—because there is no satisfactory way of inducing information disclosure by market discipline or supervisory oversight—the incentives to exploit conflicts of interest may be reduced or eliminated by regulations enforcing separation of functions. Several degrees of separation are possible. First, activities may be separated into different in-house departments with firewalls between them. Second, the firm may restrict different activities to separately capitalized affiliates. Third, regulations may prohibit the combination of activities in any organizational form.

The goal of separation of functions is to ensure that agents are not placed in the position of responding to multiple principals. Moving from relaxed to more stringent separation of functions, conflicts of interest are reduced to an increasing degree. Of course, more stringent separation of functions also reduces synergies of information collection, thereby preventing financial firms from taking advantage of economies of scope in information production. The resulting increased cost of producing information could, in turn, lead to a decreased flow of reliable information because it becomes more expensive to produce it. Deciding on the appropriate amount of separation therefore involves a trade-off between the benefits of reducing conflicts of interest and the cost of reducing economies of scope in producing information.

Socialization of Information Production.

The most radical response to conflicts generated by the existence of asymmetric information is the socialization of the provision or the funding source of the relevant information. For example, much macro-economic information is provided by publicly funded agencies, because this particular public good is likely to be undersupplied if left to private provision. It is conceivable that other information-providing functions—for example, credit ratings and auditing— could also be publicly supplied. Alternatively, if the information-generating services are left to the private sector, they could be funded by public sources or by a publicly mandated levy to help ensure that information production is not tainted by obligations to fee-paying entities with special interests.

Of course, the problem with this approach is that a government agency or publicly funded entity may not have the same strong incentives as private financial institutions to produce high-quality information. Forcing information production to be conducted by a government or quasi-government entity—although it may diminish conflicts of interest—may reduce the flow of reliable information to financial markets. Furthermore, government agencies may have difficulty paying the market wages required to attract the best people. This problem may become even more serious if economies of scope are affected. For example, analysts in an investment banking firm are likely to receive additional compensation when their research has multiple uses. By contrast, a government agency that is interested in only one use of research may not provide a level of compensation sufficient to produce high-quality information. In addition, the government might not provide sufficient funds for information collection. Indeed, government provision of important series of macroeconomic data has already been discontinued because of a lack of funding.

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