Investment Banks, Scope, and Unavoidable Conflicts of Interest ERIK SIRRI The author is a professor of finance and holder of the Walter H. Carpenter Chair at Babson College in Wellesley, Massachusetts. He thanks Jennifer Bethel and Laurie Krigman for helpful discussions. This paper was presented at the Atlanta Fed’s 2004 Financial Markets Conference, “Wall Street Against the Wall: Transparency and Conflicts of Interest.” There are certain sweet-smelling sugar-coated lies current in the world which all politic men have apparently tacitly conspired together to support and perpetuate. One of these is, that there is such a thing in the world as independence: independence of thought, indepen- dence of opinion, independence of action. Another is that the world loves to see independence—admires it, applauds it. —Mark Twain1 he investment banking community has tomers access to the research products of at least recently been the object of scorn, both three independent research firms for five years. on the regulatory front and in the press. These conflicts of interest are nothing new, and Critics have alleged a distinct lack of their existence was widely known throughout the independence in banks’ behavior and financial community. The conflicts are a consequence policies with regard to the objective- of the function of investment banks, which interme- nessT and independence of the research reports and diate the interaction between issuers and investors analyst recommendations. Retail investors, institu- in capital markets. Why the issue came to the fore tional investors, federal and state regulators, and in the last few years is debatable, but certainly con- Congress have expressed outrage over the conflicts tributing factors include the sharp market decline of interest that can exist in these large banks. In after March 2000, the egregiousness of certain rev- particular, they are disturbed that these conflicts can elations about e-mails and business arrangements lead analysts to craft research opinions that differ involving the banks, and the compensation levels from what would be produced by a dispassionate and and brashness of various high-profile bank employ- economically disinterested party. ees. The public was outraged, and it would have its The issue came to a head in April 2003, when ten pound of flesh. investment banks agreed to a set of behavioral and The purpose of this paper is not to debate whether structural reforms, in addition to fines and penalties analysts should be allowed to privately disparage of more than $1.3 billion, to settle charges brought stocks while publicly recommending them as “strong by federal and state regulators and self-regulatory buys” or whether senior executives of corporations organizations (SROs) concerning conflicts of inter- should receive lucrative allocations of initial public est. These reforms included the physical separation offering (IPO) shares as inducement for sending of research and investment banking, changes in the corporate finance business toward the underwriting nature of analyst compensation contracts, and stric- investment banks. Such actions may distort capital tures prohibiting analysts from attending road shows. markets, and they should be discouraged. My con- Investment banks are also required to offer cus- cern here, however, is to consider in some detail Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2004 23 what we really know about the nature of the con- may have proprietary or principal operations, either flicts of interest within investment banks and how, if in trading or merchant banking. at all, these conflicts have actually harmed investors. Abstracting from these institutional activities, I do this by looking at the academic evidence on one can see that banks perform a much smaller set analysts and their work and how the stock market of basic financial functions. Consistent with the reacts to their pronouncements. I also consider the functional framework of Merton and Bodie (1995, effects of certain other institutional arrangements chap. 1), investment banks perform five of the six and potential conflicts of interest that exist in invest- basic functions that they say are required of any ment banks and consider how these affect banks’ well-functioning financial system. These functions practices and incentives. I then use this analysis to are (1) pooling resources and subdividing shares, examine some of the solutions imposed by the reg- (2) transferring resources across space and time, ulators to see if these solutions are sensible and (3) providing mechanisms to manage risk, (4) pro- cost effective and can reasonably be expected to viding information, and especially prices, needed remedy the alleged harms. to coordinate decentralized decision making in the economy, and (5) providing mechanisms to solve problems of asymmetric information, agency prob- lems, and incentives.3 Notable for the purposes of In the pure investment banking or corporate this discussion is Merton and Bodie’s emphasis on the information-based functions required of financial finance relationship, investment banks’ fun- systems. As applied to investment banks, the tasks damental purpose is to lower the frictions of pricing securities and brokering information involved in issuing new securities. between counterparties to a transaction, whether a share issuance or a capital markets transaction, are vital to banks’ operations. The completeness of the financial functions offered within a large integrated investment bank is a con- What Do Investment Banks Do? sequence of the scope economies that arise from n their book Doing Deals, Eccles and Crane define housing various institutional functions under one Ithe function of an investment bank as “mediating roof. For example, for a successful issuance of new the flow of assets between issuers and investors” stock, the bank must be able to distribute new (1988, chap. 2). In the pure investment banking or shares into the hands of its investment clients. To corporate finance relationship, investment banks’ execute this function well, the shares should be fundamental purpose is to lower the frictions distributed broadly and held by an investor base involved in issuing new securities.2 These frictions whose traits are acceptable to the corporate issuer. arise because the two primary parties to the trans- Accomplishing this function requires an established action are generally geographically separate, have network with the trading desks and portfolio man- no or only limited knowledge about the other party, agers of large buy-side investment firms. Corporate and have opposing interests in the precise terms of issuances are too infrequent for relationships with the transaction. For example, issuers prefer a higher banks to grow by themselves, but the day-to-day price for their securities while investors would pre- trading operations of banks naturally tie the bank to fer to buy the paper at a lower price. the institutional investor. Similarly, the information Institutionally, however, banks do far more than produced by the analyst who works in the research aid in the issuance of securities. Though issuance is department can be of use to the bank’s investment an important corporate finance function, banks also bankers, the proprietary trading operations of the provide advice in mergers and acquisitions and aid bank, the block trading operations of the bank, and in designing customized securities to suit issuers’ the bank’s retail and institutional clients. needs through structured finance. Banks generally Of course, not all of the scope economies discussed have extensive sales and trading operations across above are permitted under the law. The reason is that asset classes and frequently operate money man- they present substantive conflicts of interest for agement operations on an agency basis for institu- the bank. These conflicts are unavoidable for any tional clients. For the purposes of this paper, it is bank that chooses to be in the broad menu of the insti- important to note that a large class of investment tutional businesses discussed in the paragraphs above. banks also have retail operations, providing broker- By operating in these business lines, the banks in age services to individual investors. Finally, banks turn perform some or all of the five financial functions 24 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Fourth Quarter 2004 TABLE 1 Securities Industry Income Statement In $millions As a percentage Revenue 1999 2001 2003 1999 2001 2003 Commissions 29,310.5 26,825.2 25,661.4 16.0 13.8 17.8 Trading gain (loss) 36,422.8 24,914.1 23,136.5 19.9 12.8 16.0 Investment account gain (loss) 2,379.2 297.5 2,115.7 1.3 0.2 1.5 Underwriting revenue 16,026.3 15,630.9 15,090.0 8.7 8.0 10.4 Equity underwriting revenue 3,791.3 3,921.0 3,697.8 2.1 2.0 2.6 Mutual fund sale revenue 6,663.4 6,329.0 6,064.9 3.6 3.2 4.2 Fees, asset management 11,450.3 13,196.6 11,761.6 6.2 6.8 8.1 Research revenue 156.6 183.6 170.0 0.1 0.1 0.1 Commodities revenue –8,723.3 4,907.6 –1,902.4 –4.8 2.5 –1.3 Other revenue related to the securities business 66,719.2 79,714.8 47,898.3 36.4 40.9 33.1 Other revenue 9,546.5 9,923.2 9,743.1 5.2 5.1 6.7 Total revenue 183,367.3 194,766.2 144,516.0 100.0 100.0 100.0 Source: Securities Industry Association, 2003 delineated by Merton and Bodie. Though formal and industry as a whole. Table 1 reports the revenue for obvious structures that violate conflict of interest rules the investment banking, trading, proprietary trad- may readily be prohibited, subtle ways to circumvent ing, underwriting, asset management, and research the prohibitions, especially restrictions based on infor- segments of the business for 1999, 2001, and 2003.