1. Conflicts of interest arise when financial service firms or their employees are serving multiple interests and develop incentives to misuse or conceal information needed for the effective functioning of financial markets. If taking advantage of conflicts of interest substantially reduces the amount of reliable information in financial markets, asymmetric information increases and prevents financial markets from channeling funds to those firms with the most productive investment opportunities.
2. Four types of financial service activities have the greatest potential for conflicts of interest that reduce reliable information in financial markets: (1) underwriting and research in investment banking, (2) auditing and consulting in accounting firms, (3) credit assessment and consulting in credit-rating agencies, and (4) universal banking.
3. Even though conflicts of interest may exist, they do not necessarily have to reduce the flow of reliable information, because the market provides strong incentives for financial service firms to avoid damaging their reputations. The evidence suggests that the market often succeeds in constraining the incentives to exploit conflicts of interest. However, conflicts of interest still pose a threat to the efficiency of financial markets.
4. Two major policy measures deal with conflicts of interest: the Sarbanes-Oxley Act of 2002 and the Global Legal Settlement arising from the lawsuit by the New York Attorney General against the ten largest investment banks.
5. Two basic propositions are critical to evaluating what should be done about conflicts of interest: (1) The fact that a conflict of interest exists does not mean that the conflict will necessarily have serious adverse consequences. (2) Even if incentives to exploit conflicts of interest remain strong, eliminating the conflict of interest may be harmful if it destroys economies of scope, thereby reducing the flow of reliable information. Five approaches to remedying conflicts of interest, going from least intrusive to most intrusive, have been suggested: (1) leave it to the market, (2) regulate for transparency, (3) provide supervisory oversight, (4) mandate separation of functions, and (5) require socialization of information.
6. Sarbanes-Oxley and the Global Legal Settlement help increase the flow of reliable information in financial markets by requiring the CEO and CFO to certify financial statements, corporations to disclose offbalance-sheet transactions and entities, and investment banks to make public their analysts' recommendations, and by requiring increased disclosure of potential conflicts of interest. Sarbanes-Oxley increases supervisory oversight by establishing the Public Company Accounting Oversight Board (PCAOB) and by increasing the resources available to the SEC. The act also reduces conflicts of interest in auditing by making the audit committee independent of management. The Global Legal Settlement eliminates the conflict of interest inherent in spinning. The $1.4 billion fine and harsher criminal penalties imposed by Sarbanes-Oxley provide incentives for investment banks not to exploit conflicts of interest in the future. The more radical parts of Sarbanes-Oxley and the Global Legal Settlement, which involve separation of functions (research from underwriting, and auditing from nonaudit consulting) and socialization of research information, may ultimately reduce the information available in financial markets.