Conflicts of interest (‘COI’) are all the rage in the regulatory efforts to curb and structure unwanted financial advisory services. And while all professions engaged in giving advice for a fee are under an obligation to avoid COIs that are detrimental to their clients, regulation has been particularly strict in the financial industry. Indeed, much of the recent EU legislative initiatives – the Market Abuse Regulation, Markets in Financial Instruments Directives I and II, the Transparency Directive, to mention a few examples – can in large part be seen as attempting to deal with the perceived negative effects of COIs. The same holds true for the recent regulations in the accounting industry.
According to Article 23.1 in the MiFID II Directive, all investment firms must take appropriate steps to avoid COIs. However, in many situations – such as simply having two clients with the same interests, or when a firm has its own positions in the securities it is intermediating – such conflicts are by nature unavoidable unless substantial parts of the firms’ business are shut down. In such cases, Article 23.2 prescribes a remedy, namely the disclosure of the conflict to the client.
The question is whether this regulation is expedient, and the answer to that question seems to be partially ‘no’, both as concerns the ability of the rules to target the problem and its proposed solution, the disclosure. This is because the increasingly rule-based focus on certain COIs can easily result in more skewed and poorer advice being given than would have been the case in the absence of such regulation. Put differently, regulating moral and ethical behaviour – like COIs – can have, as research shows, the effect of substituting moral and ethical judgment with simple rule-following, deteriorating the quality of the very practise it is meant to improve.
Second, the regulation is inapt as concerns the remedy. Due to confidentiality requirements, investment firms cannot disclose enough information to enable clients to discount the value of the conflict, and, even if they could, the likelihood that the next investment firm would be involved in similar conflicts is so great that it puts the client in a difficult spot.
These reflections – which can be found in my article ‘Conflicts of Interest in Finance and Auditing: Can They Be Successfully Regulated, and Does Disclosure Minimize Them?’ – derive from basic insights in moral psychology and business ethics. According to a standard definition of a COI in the literature on business ethics (Davis, 1982) a central feature of a COI is that some interest is interfering with the exercise of judgment on behalf of another. The key element in this regard is ‘judgment’, and the question is what happens to it when it becomes densely regulated. Evidence from moral psychology can throw light on that.
In a series of studies, moral psychologist James Rest has found that what he called ‘moral reasoning capability’ (‘MRC’) varies in the professions. MRC denotes the capacity to independently reason about moral issues, ranging from mere stimulus response and simple rule following to sophisticated ethical and moral theory. Significantly, he also found that auditors and accountants performed worse than expected when compared to other professions, and only at or slightly below the average level of the population, depending on the size of the firm. Other professions, such as practising doctors performed way above the level of auditors. Additionally, researchers have found that, in the general population, women outperform men, and that age and experience also contributes to increasing the MRC score. Subsequent studies, however, have shown that, in competitive auditing firms, the gender difference disappears, and that experience and seniority in the firm reduces, rather than increases, the MRC score.
First, the disappearance of the ‘gender gap’ has been explained by the competitiveness of big firms, attracting certain candidates that are more similar to each other than to the population in general. Another, but not conflicting, interpretation is that the rule-bound behaviour forces the professionals in these firms to suspend independent thinking, and look to the rule-book. Second, the age disadvantage can be attributed to the fact that experience reduces the need for independent and thoughtful consideration of the case at hand. One simply knows how ethics committees will react and knows in advance which cases will pass and which are in the ‘red zone’.
Moreover, although several explanations have been ventured to make sense of the relatively poor performance of public accountants and auditors, an explanation that seems plausible is that when the rule-book gets more and more detailed, reflection is substituted for automation, and operating business ethics becomes strikingly similar to any other legal manoeuvre. Rules, in other words, lead to a reduction in moral reasoning capabilities.
If regulatory density has negative consequences for moral reasoning, it can potentially lead to an increased deterioration of the quality of the business, but not because we expect financial advisers to be moral advisors. Decreased capacity for ethical reasoning is unfortunate because it shifts the focus away from the relevant areas – the truly harmful conflicts of interest – to the areas that are regulated. There are no guarantees that the areas involving the cash flows – kick-back schemes, outsourcing, etc -- are the most important ones to avoid. Loyalties, friendships, family and business relationships, political attitudes, etc can all be as harmful as cash flows when it comes to influencing the judgment of a professional, but none of these factors are considered viable candidates for being regulated through conflict of interest rules. Why not? Because they are difficult to regulate and sanction. And when the rules describe, almost exhaustively, the subject of the conflict of interests’ regulation as the money streams, these important relationships disappear from the sphere of relevance.
Now, what about the proscribed remedy for these conflicts (disclosure)? In my article, I argue that such a remedy is probably rather useless, for two main reasons. First, as mentioned above, the client has no way to discount the value of the conflict that he/she is informed about, due to the unspecific nature of the information. He/she must either choose to trust his broker or auditor or he/she must find someone else, who will inform him/her of the same types of unspecific conflicts. Second, disclosure can also function in two ways; either it can lead to a form of moral licensing, where the professional feels free to ride two horses at once in whatever way he/she sees fit, since the client has somehow accepted it. Or it can lead to overcompensation, where the professional is unusually careful and gives poorer advice than he/she would have if the client had not been informed.
The point here is not that COIs are harmless or exaggerated. They are real and they are detrimental. But the form of regulation currently in vogue misses the target.
Morten Kinander is professor, dr.juris at the Norwegian Business School, BI.