Lars Nyberg: How do conflicts of interest in universal banking emerge and
what are the arguments for a separation of commercial and investment
banking?
Speech by Mr Lars Nyberg, Deputy Governor of Sveriges Riksbank, at a seminar organised by the
Swedish Bankers' Association, the Swedish Securities Dealers Association and Finansinspektionen
(the Swedish financial supervisory authority), Stockholm, 26 August 2004.
* * *
I would like to begin by thanking the Swedish Bankers' Association, the Swedish Securities Dealers
Association and Finansinspektionen (the Swedish financial supervisory authority) for taking the
initiative to organise this seminar. Over the past year, in particular, we have seen the importance of
open and thorough discussion of conflicts of interest in the financial sector. I hope that this seminar will
contribute to an even deeper analysis of the problems we face.
The present discussion has arisen in the wake of a number of international corporate scandals. It is
perhaps sufficient to mention names such as Enron, WorldCom and Skandia to indicate how much
trouble can be caused by conflicts of interest.
In Sweden there are two conflicts of interest in particular that have received attention, although there
are many other, possibly equally serious ones. The first is that many sellers of various financial
services offered by banks and insurance companies have traditionally been presented as investment
advisors rather than salespeople. The risk of a conflict of interest lies in the fact that their suggestions
for investment have been designed more to promote the seller's or the company's interests rather than
to fulfil the needs of the investor. The second example comes from the life insurance sector. When the
life insurance part of a company buys services from the property and liability insurance part, there may
be incentives to deviate from correct internal pricing, especially when one part of the company is a
mutual company and the other is a profit-making company. Another problem in an insurance company
is how a surplus - or a deficit - should be distributed between different groups of insured parties. The
question is whether, for instance, those receiving pensions now should share the burden of the
insurance companies' poorer income, or whether they have had the level of their pension payments
guaranteed.
However, today we have gathered to discuss conflicts of interest in banks, and I have promised to talk
about the classical conflict between commercial banking and investment banking. The conflict lies
within the universal bank's double role as lender and investment adviser. If a bank's borrowers suffer
deterioration in their financial prospects, the bank can reduce its credit risk by helping with new share
issues, etc. This conflict of interest has been discussed in the United States for several decades now,
but in Sweden it has scarcely been mentioned. There is reason to ask why the differences are so
great, and I shall return to this point.
Another example, which has recently led to new legislation in the United States, is the role of analysts
in investment banking. An analyst has the task of providing investors with advice, but if the bank is
more interested in gaining business for its corporate finance activities than safeguarding the investor's
interests, the analyst's assessment may be influenced by this. Here there should traditionally be a
"Chinese wall", but this has in some cases been fairly low and probably eroded considerably over time.
Before I go on to more bank-specific issues, I would like to say a few words about conflicts of interest
in general, and how these can be handled - to the extent that they should be handled. I shall then
move on to more specific conflicts of interest between different types of banking operations,
particularly given the developments in the United States. Finally, I shall draw some conclusions
concerning Sweden.
The fact that different people have different interests is quite natural. A buyer and a seller usually have
different interests in a business transaction. A difference of interest is actually one of the most
important driving forces in a market economy. A difference of interest only becomes a conflict of
interest when one person or organisation has to take into account several different interests and can
promote one at the cost of another. Conflicts of interest are thus based on an agency relationship.
These conflicts exist in almost all businesses. Employees shall usually work in the best interests of the
company, but can in some contexts have interests of their own that are in conflict with the company's
best. Divisional managers within a corporate group may have an interest in promoting their own
division rather than the group as a whole. Company management does not always have the same
aims as the shareholders. Many of these conflicts of interest are common and quite natural elements
of real life, and rarely cause problems. It is important to bear this in mind when discussing methods of
dealing with them.
This does not mean that conflicts of interest in financial operations are irrelevant, quite the reverse.
The relevant question here, however, is which conflicts of interest are real problems and which are
not.
The conflicts without problems are those where there is little incentive to improperly favour one interest
over another. For instance, most employees are usually loyal to their employer - otherwise they risk
losing their jobs. A company that does not take into account the interests of its employees and its
customers risks gaining a bad reputation and losing its competitiveness.
Other conflicts of interest are more problematic. When an agent has a considerable incentive to favour
one party at the cost of another, there could be scope for some form of regulations. Many companies
also have ethical guidelines and rules for dealing with the cases where there is most incentive to take
other interests into account. The discussion on corporate governance is one example of how the
market is trying to find solutions to various conflicts of interest. It is not usually necessary to have any
regulation by the authorities in this area. Usually it is sufficient to have contracts between the parties or
to create norm-based standards within the sector.
However, there is a further dimension to the conflicts of interest that concerns the interests of society.
Promoting one party at the cost of another usually entails a redistribution of economic resources. This
may be morally dubious without always involving large costs to society. There is a bigger problem
when conflicts of interest hide or distort information. This leads to real economy decisions being made
on the basis of inferior or incorrect information. The recent scandals are serious because the people
who were supposed to provide investors with reliable information had incentive to conceal this
information in order to promote their own interests, or those of their company.
It is the role of the financial sector as distributor of information in the economy that makes financial
conflicts of interest particularly interesting. People in the financial sector are responsible for assessing
which companies are robust and which are therefore granted access to growth capital. If conflicts of
interest within the financial companies disturb this control function, it may lead to substantial costs to
society.
Which measures need to be taken to ensure that conflicts of interest do not lead to financial agents
concealing, distorting or incorrectly using information? There are some different potential solutions. I
have already observed that the market itself is often capable of solving the problems. This can be
achieved, for instance, by customers making demands for information on various conflicts of interest.
However, the collection and distribution of information is not free. And as information contains a strain
of public goods, there is a risk that the market solution will generate too little information. It may
therefore be necessary in certain contexts to have regulations stipulating that information on conflicts
of interest must be made public. Regulations concerning greater insight into various persons'
incentives may limit the effects of different conflicts of interest. It would help outsiders to assess the
quality of the information provided. A more drastic solution would be to require that activities exposed
to conflicts of interest should be managed by different companies, or even different groups. The Glass
Steagall Act in the United States, for instance, required that investment banks and commercial banks
must be legally separated.
However, there are clear disadvantages with forcing a separation of different activities through
legislation. All regulation also entails costs - both explicit and implicit costs. It is important from
society's point of view that these costs do not exceed the usefulness of the regulation. One cost of
separating various activities is that it makes it difficult, or impossible, for financial intermediaries to
benefit from synergies and economies of scale.
A clear example of this is contained in the conflict between traditional commercial banking and
investment banking, which is my subject today. A bank that lends money to a company normally gains
access during the credit application process to special information about the company - information
that is not publicly available. The bank makes an investment in the information on the company and
therefore usually has an information advantage in relation to other banks and outside parties. This
investment can also mean that the bank can offer the company investment banking services in a more
efficient manner. The fact that a company seeking funding in the capital market has access to bank
credit is often regarded by the market as a positive signal. It means that a professional agent has
analysed the company and found it creditworthy, i.e. been willing to risk his or her own capital in it. The
information about the credit functions is a quality signal or a certification.
At the same time, opportunities arise to make use of conflicts of interest when a bank functions as
both credit-granting institution and adviser or guarantor in new issues. If the prospects for a company
that has loans with the bank deteriorate, it may be in the interests of the bank to reduce some of its
credit risk by aiding the company with a new share issue. In this way, the bank can pass on some of
the credit risk to the shareholders. From society's point of view, there must be a balance between
potential efficiency gains and risks of exploitation in conflicts of interest. Whether or not legislation is
required depends on the seriousness of the conflict of interest and the size of the incentives to
promote one's own interests.
Examples in the United States
The clash between utilising economies of scale and limiting the damaging effect of conflicts of interest
goes back a long way, particularly in the United States. Following the stock market turbulence in 1929,
there was intensive discussion of these conflicts of interest. Now they have come into focus once
again, following a new stock market crisis. It appears as though fewer people care about the conflicts
of interest when earnings are high.
The US 1930s example began back in the mid-1920s, when stock market prices soared. Many people
who bought shares during this period were convinced that this long upturn meant a new epoch with
permanently higher earnings on shares. The insight that prices could not continue to rise at the same
rate spread gradually and the stock market fell heavily in autumn 1929. The fall continued for several
years. After three years, the value was down to 15 per cent of the previous figure. Many investors felt
that they had been deceived by the banks who had sold them shares and bonds. In several cases it
was the new universal banks that had been most active in mediating securities. These universal banks
combined traditional bank lending with various forms of investment banking activities. By using
economies of scale from these different areas, they were able to offer competitive prices - but also to
exploit various conflicts of interest.
When prices fell, the banks were accused of having contributed to issues of securities of dubious
quality and of having painted an overly bright picture of the companies' future in their prospectuses.
The commercial banks were also accused of having converted loans lacking creditworthiness into
shares, by contributing to new issues, where shares were sold to an uninformed public. In addition, it
was claimed that certain company management had lined their own, and their families', pockets in
various ways.
Although it was difficult to prove that the banks had knowingly and systematically misled the general
public, it was revealed that prominent figures in various banks had earned large sums at the cost of
their customers, and in some cases at the cost of the banks. This contributed to the introduction of the
Glass Steagall Act in the United States in 1933. The Act required complete legal separation of
commercial banks and investment banks. A commercial bank could not be included in the same group
as a bank that mainly conducted operations in the securities markets.
However, during the 1960s and the 1980s the regulations in the United States were gradually
loosened up. Commercial banks were given increasing opportunities to conduct investment banking
activities, albeit on a limited scale. During the 1990s, a debate arose in the United States as to how far
these exceptions could be made and whether the universal bank was to be or not to be. A number of
scientific studies showed that in the trade-off that existed between benefiting from economies of scale
within different types of banking activities and increasing the risks of exploiting conflicts of interest, the
benefits of economies of scale weighed heaviest. For instance, it was shown that the shares and
corporate bonds issued between January 1927 and September 1929 gave lower earnings if they were
issued by a commercial bank than if they were issued by an investment bank. This indicated that
investors required a lower risk premium if a commercial bank managed the issue than if an investment
bank was responsible. The investors appear to have trusted commercial banks more, and fear of
exploitation of the conflicts of interest does not appear to have dominated. The investors appear to
have had most confidence in the issue when the commercial bank had outsourced its investment
banking activities in a separate company. This would indicate that the investors were aware of the
conflicts of interest, but that they considered the commercial banks' greater capacity for certification
outweighed these. In 1999 these regulations were completely removed by the introduction of the
Gramm-Leach-Bliley Act.
After the fall in share prices we have seen over the past four years, the focus of the general debate
has once again landed on the conflicts of interest that exist between the different areas of a bank's
operations. The repealing of all parts of the Glass Steagall Act is now being questioned, and there
have once again been demands for different types of regulation.
What bearing does this have on Sweden?
The question is what we in Sweden can learn from the American example. In my opinion, it shows that
there are potentially dangerous conflicts of interest between traditional commercial banking and
investment banking. The question is whether we need to do anything about this in Sweden. Can these
conflicts be handled by means of the markets, by sector norms and standards, or is some form of
public regulation required? I draw four conclusions here.
Let me take the most important one first. I do not believe that it is appropriate to use regulation to
forbid dealings between traditional commercial banks and investment banks. Nor do I believe that it is
necessary at present to introduce regulation that would force different legal entities to be formed for
investment banks and traditional commercial banks. They should be able to remain departments in the
same legal entity. There are two arguments in favour of this. The first argument against regulating to
separate banking activities is that it could limit the positive economies of scale and synergies. The
second argument is that there is no evidence that conflicts of interest between the parts of our
Swedish banks conducting investment banking activities and the traditional lending activities have led
to abuse.
One can, of course, speculate as to why abuse of this type of conflict of interest does not occur in
Sweden in the same way as in the United States. I have no clear answer to that. However, there are a
couple of institutional differences. Share issues in Sweden have rarely been guaranteed or syndicated
in the same way as they are in the United States. The role of the Swedish investment banks in share
issues has therefore often been less comprehensive than that of their US counterparts. This may have
limited the problem.
Another institutional difference is that the bank market is more concentrated in Sweden. This may
make the banks more anxious of their credibility than US banks are. If a Swedish bank were to pass
on its own credit risks to investors in a share issue, there is a greater risk that this would seriously
damage the bank's credibility. The number of large Swedish investors is fairly small and it would
quickly become known if anyone felt they had been cheated. The incentives to exploit a conflict of
interest have quite simply been much lower here than in the United States. This does not necessarily
mean that Swedish bankers are more honest than American ones, just that the advantages of
exploiting conflicts of interest are less and the costs are greater.
My second conclusion is that it is important that all significant conflicts of interest should be discussed
openly and publicly. There are justifiable claims for reliable information on borrowers and issuers, but
the same applies to information on the measures taken by the banks to avoid exploiting conflicts of
interest. I believe that there are relevant market solutions in most cases, as long as the conflicts of
interest are clear.
Thirdly, I would like to encourage the Swedish banks to carefully follow international developments
within the field of compliance - i.e. the routines to ensure that internal and external rules are adhered
to. In many cases the requirements have become much more stringent in recent years, and it is
important to thoroughly assess developments in other countries. For instance, the Chinese wall has
been repaired in the United States, and is now higher than ever. This has been achieved through
legislation. It remains to be seen whether the Swedish banks can solve these problems themselves.
Fourthly, I believe that the supervisory authorities play an important role with regard to identifying and
overseeing potential conflicts of interest. Our Finansinspektion has begun to do this to a greater
extent, not only with regard to banks but for the financial sector as a whole. Although the market itself
can manage most of the conflicts of interest, it may take some time before a common practice is
established. Experience also shows that good practice and good ethics can be eroded rather quickly
in certain market situations. This is where the supervisory authority can help to develop and maintain
confidence