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CONFLICTS OF INTEREST IN INVESTMENT BANK Bachkaniwala Priyanka(04) Lalwani Sonam (51) Patolia Pooja (82) Shah Nirmal (97) Shah Siddharth (99)
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Conflicts of interest in investment banking

Nov 11, 2014

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it explains the difference between ethics and compliance and includes a case study on Goldman Sachs
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Page 1: Conflicts of interest in investment banking

CONFLICTS OF INTEREST IN INVESTMENT BANK

Bachkaniwala Priyanka(04)

Lalwani Sonam (51)

Patolia Pooja (82)

Shah Nirmal (97)

Shah Siddharth (99)

Page 2: Conflicts of interest in investment banking

ETHICS AND COMPLIANCE

FOR IBCIBIS- Consortium of Investment Banking and Institution Standard

Page 3: Conflicts of interest in investment banking

Any organisation in world has to follow some rules and regulations so as to develop a systematical environment for its customers.

Being a part of capital market, Investment Banks play major role in prime activities.

It acts as an intermediary between investor and companies.

Page 4: Conflicts of interest in investment banking

ETHICS FOR INVESTMENT BANK  Rules of conduct recognized in respect t

o a  particular class investment banking

It is that branch of philosophy dealing with values relating to human conduct and interest of all, with respect to rightness and wrongness of certain actions and to the goodness and badness of the motives and ends of such actions.

Page 5: Conflicts of interest in investment banking

COMPLIANCE In general, compliance means

conforming to a rule, such as a specification, policy, standard or law. Regulatory compliance describes the goal that corporations or public agencies aspire to achieve in their efforts to ensure that personnel are aware of and take steps to comply with relevant laws and regulations.

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DO’S AND DON'TSRule 1 – Independence & Objectivity Members shall maintain independence and

objectivity in undertaking all transactions and providing all investment banking and advisory services. 

Members shall not allow themselves to be placed in a position of pressure to approve any documents, structures or transactions that do not meet compliance requirements. 

Services contracts signed by such members shall either not limit, or proactively provide for, such independent expert discretion of conclusions based solely upon demonstrated objective facts, regardless of any payment for services.

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Rule 2 – Anti-Fraud  Economic Security – Members shall not disclose

a level of general information that would enable or permit any person to design, improve, perfect or commit any fraud or other unlawful activity in any transaction. 

To best support legitimate transactions without violating this rule, any reports given or advisory statements made should be limited to practical recommendations for correcting defects of documentation or structures, or suggestions for obtaining verifiable documents to replace defective documents, strictly on a case-by-case basis.

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Rule 3 – Sharing for Collective Capabilities –

Members shall share information on developing trends and practices in investment banking, compliance procedures, anti-fraud measures and transaction controls with CIBIS, for analysis and processing for the collective benefit of members. 

Members shall also provide assistance to other members in an unofficial advisory capacity, to maintain a network of collegial professional support, and to facilitate access to external institutional capabilities.

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Factors Legal Ethical

Ethos Regards ethics as a set oflimits and something thathas to be done

Defines ethics as a set ofprinciples to guide choices

Objectives Geared toward preventingunlawful conduct

Geared toward achievingresponsible conduct

MethodEmphasizes rules and usesincreased monitoring andpenalties to enforce theseRules

Treats ethics as infused inbusiness practice(leadership, core systems,decision-making processes,etc)

Behavioral Assumptions Rooted in deterrence theory(how to prevent peoplefrom doing bad things bymanipulating the costs ofmisconduct)

Rooted in individual andcommunal values (bothmaterial and spiritual)

Page 10: Conflicts of interest in investment banking

WHAT ARE CONFLICTS OF INTEREST?

Conflicts of Interest- a type of moral hazard problem that occurs when a

person or institution has multiple objectives (interests) and as a result

has conflicts between them.

Conflicts of interest usually take the form of misleading information.

Financial institutions can benefit off of giving out misleading information,

hurting the public, while giving the financial institutions greater profits.

Conflicts of interest lead to unethical behavior.

Conflicts of interest occur when an institution or employee serves his

interests at the expense of others.

Combinations of services that bring together any group of depository

intermediaries, non-depository intermediaries, and brokers, or that allow

any of these groups to invest directly in a business, are most likely to lead

to conflicts of interest.

Page 11: Conflicts of interest in investment banking

WHY DO WE CARE ABOUT CONFLICTS OF INTEREST?

Conflicts of interest can substantially reduce the quality

of information in financial markets, thereby increasing

asymmetric information problems.

In turn, asymmetric information prevents financial

markets from channeling funds into the most productive

investment opportunities and causes financial markets

and the economy to become less efficient.

The growing economies of scope have led to financial

institutions to offer many services under one roof,

increasing conflicts of interest and in turn increasing

unethical behavior.

Page 12: Conflicts of interest in investment banking

PROBLEMS CONFLICTS OF INTEREST CAUSE

•Conflicts of interest become a problem for the financial system when they lead to a decrease in the flow of reliable information, either because information is concealed or because misleading information is spread.

•The decline in the flow of reliable information makes it harder for the financial system to solve adverse selection and moral hazard problems, which can slow the flow of credit to parties with productive investment opportunities

Page 13: Conflicts of interest in investment banking

PROBLEMS CONFLICTS OF INTEREST CAUSE (CONT)• Inappropriately designed compensation plans,

for example may produce conflicts of interest that not only reduce the flow of reliable information to credit markets but also end up destroying the firm.

• The conflict of interest problem can become even more hazardous when several lines of business are combined and the returns from one the activities, such as underwriting and consulting, are very high for only a brief amount of time. Also, a compensation scheme that works reasonably well in the short term might become poorly aligned in the long run.

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PROBLEMS CONFLICTS OF INTEREST CAUSE (CONT) Threats to truthful reporting in an audit

arise from several potential conflicts of interest.

The conflict of interest that has received the

most attention in the media occurs when an accounting firm provides its client with auditing services and non-audit consulting services, commonly known as Management Advisory Services, such as advice on taxes, accounting or management information systems, and business strategies

Page 15: Conflicts of interest in investment banking

Problems conflicts of interest cause (cont)

• Conflicts of Interest can substantially reduce the

quality of information in financial markets, thereby

increasing asymmetric information problems.

• These asymmetric information problems prevent

financial markets from channeling funds into the

most productive investment opportunities and

causes financial markets and the economy to

become less efficient.

Page 16: Conflicts of interest in investment banking

UNDERWRITING PROBLEMS IN INVESTMENT BANKING

Analysts in investment banks are

persuaded to distort their research to

please the underwriting department of

their bank and the corporations issuing

the securities which undermines the

reliability of information investors use

for financial decisions and diminishes

the efficiency of securities markets.

Page 17: Conflicts of interest in investment banking

PROBLEMS CAUSED BY SPINNING Spinning occurs when investment banks

allocate underpriced shares of newly issued stock to executives of other companies in order to lure them to use that investment bank

When the executives company plans to issue its own securities it uses that investment bank as an underwriter.

This causes a rise in the cost of capital for the firm and hinders the efficiency of the capital market.

Page 18: Conflicts of interest in investment banking

EXAMPLES A bank may make loans to a firm on overly

favorable terms to obtain fees from it for performing activities such as underwriting the firms securities

A bank with an outstanding loan to a firm whose credit or bankruptcy risk has increased has private knowledge that may encourage the bank to use its under-writing department to sell bonds to the unsuspecting public, thereby paying off the loan and earning a fee.

These conflicts of interest decrease the amount of accurate information and hinders the banks ability to promote efficient credit allocation

Page 19: Conflicts of interest in investment banking

EXAMPLES OF CONFLICTS OF INTEREST

Probably conflicts of interest can arise by

investment banks like:

Goldman Sachs

Kotak Finance

SBI

Page 20: Conflicts of interest in investment banking

CURRENTLY:

Goldman Sachs Group Inc. is under investigation by the Securities &

Exchange Commission for fraud in a mortgage securities transaction.

Was there a conflict of interest in this transaction?

Page 21: Conflicts of interest in investment banking

OVERVIEW Goldman Sachs purchased many

mortgages from the US housing market. They then converted them into mortgage

backed securities. They advised clients to buy these

mortgages. At the same time they sold these

mortgage securities short as either a hedge against their portfolio to reduce risk or as a major position anticipating a drop in value in the US housing market.

Page 22: Conflicts of interest in investment banking

OVERVIEW Goldman Sachs has an obligation to offer

investments that it believe are in the clients best interest.

They are also legally obligated to know their client, as well as what is a suitable investment for their client.

In this case the clients of Goldman Sachs were knowledgeable investors (i.e. International banks and hedge funds)

Did Goldman Sachs disclose, to the clients purchasing these mortgage products, that they were also shorting these same securities?

If they did not, Goldman Sachs was acting in their own best interest as opposed to that of their clients. This is a conflict of interest.

Page 23: Conflicts of interest in investment banking

THE GOLDMAN SACHS CASE STUDY IDENTIFIES A NUMBER OF PRACTICES THAT RAISE CONFLICT OF INTEREST CONCERNS. THOSE PRACTICES INCLUDE THE FOLLOWING.

Shorting Its Own Securities Failing to Disclose Key Information to

Investors. Failing to Disclose Client Involvement Selling Securities Designed to Fail. Misrepresenting Assets. Using Poor Quality Loans in

Securitizations. Concealing Its Net Short Position.

Page 24: Conflicts of interest in investment banking

IF THEY ARE FOUND GUILTY: Goldman Sachs, a premier investment

banking firm, may be heavily fined, broken up and/or lose their clients trust, which is Goldman Sachs Group Inc. most valuable asset.

Page 25: Conflicts of interest in investment banking

WHAT HAS BEEN DONE TO REMEDY CONFLICTS OF INTEREST?

Sarbanes-Oxley Act of 2002

Global Legal Settlement of 2002

Page 26: Conflicts of interest in investment banking

PUBLIC ACTION- REFORMSarbanes-Oxley Act of 2002 Global Legal Settlement of 2002

Increased supervisor oversight to monitor and prevent conflicts of interest

Directly reduced conflicts of interest

Produced incentives for investment banks not to exploit conflicts of interest

Instituted measures to improve the quality of information in financial markets

Directly reduced conflicts of interest

Produced incentives for investment banks not to exploit conflicts of interest

Instituted measures to improve the quality of information in financial markets

Page 27: Conflicts of interest in investment banking

REMEDY APPROACHESLeave It To The Market Regulate for Transparency

The market may punish the firm exploiting conflicts of interest by causing them to have higher funding costs or decreased demand for services

Open market forces can create means to contain conflicts of interest through information demanded from non conflicted organizations

Mandatory information disclosure decreases information asymmetries This in turn reveals if

conflicts of interest are being exploited

Could be bad because of free-loader effect

If regulated too much can cause loss in information production and profitability for the firm

Page 28: Conflicts of interest in investment banking

REMEDY APPROACHESSupervisory Oversight Separation Of Functions

Supervisors can review financial information without revealing it to competitors This maintains profitability

& information production Supervisors can then

take actions to control the exploitation of conflicts of interest and enforce ethical standards Poor supervisors allow for

exploitation to continue

Reduces economies of scope through regulation Information sharing

between departments is regulated

Separates departments and adds firewalls to ensure that the firms agents are not responding to multiple principals Results in a trade off

between information production and reducing conflicts of interest

Page 29: Conflicts of interest in investment banking

A FRAMEWORK FOR EVALUATING POLICIES TO REMEDY CONFLICTS OF INTEREST The existence of a conflict of interest does not

mean that it will have serious adverse consequence.

Even if incentives to exploit conflicts of interest remain strong, eliminating the economies of scope that create the conflicts of interest may be harmful because it will reduce the flow of reliable information.

Page 30: Conflicts of interest in investment banking

THANK YOU