Platt Perspective on Business and Technology

Conflict of interest and the need for layered due diligence regulatory separations in the age of online social media

Posted in macroeconomics by Timothy Platt on August 4, 2012

I recently finished writing and posting a 14 part series on the costs and benefits of regulatory oversight (see Macroeconomics and Business, postings 64 and loosely following) and at the end of Part 14 of that, I said that I was going to come back to the complex of issues that I had started discussing there. Some more recent events and a lot of further thought have prompted me to do so now. And I return to the issues of risk remediation and due diligence for financial institutions, and of minimum required standards as would be specified through regulatory oversight, with recent incidents in mind. And I begin this discussion by laying out a basic framework of issues and concerns.

• Regulatory law is by its very nature, reactive. Regulatory law in specific and law in general always address problems and concerns that have arisen in the past, even when that means reacting to very recent events.
• New channels of information and value sharing and of value creation build new arenas for developing and distributing positive value. But they also create new areas of opportunity for abuse and for the types of events that in retrospect, would lead to new regulatory law and oversight – retrospectively and after those adverse events and after harm has been done.
• I made note of our emerging and still expanding interactive online capabilities and of social media in the title to this posting and cite that here as one of many sources of change taking place in the marketplace and in society in general that serve to accelerate the rate of change that law and regulatory law have to try to keep pace with.

I wrote in my regulatory series about how dubious mortgages and other real estate based investments where bundled into larger opaque derivatives, and about how these assembled investment instruments were rated as of high investment grade by the ratings agencies – until the houses of cards they were built upon collapsed and we all fell into the Great Recession.

I have also written recently about the failure to separate analysis and evaluation of investment options from sale of those investments, and of the conflicts of interest inherent there.

Now we are all witnessing the embarrassment of another large financial institution that should know and do better, for the way its sales force has been pushing investment options to customers as being safe and secure and of high investment value, that their own internal documents showed they saw as worthless and risky.

• When one institution does this – acts so recklessly and from such personal, short sighted greed, this tarnishes that institution and its reputation.
• If a point is reached where sufficient numbers financial institutions get their consumer-facing business practices wrong, so that a tipping point is reached where the public in general begins to lose confidence in the entire industry, that risks undercutting the entire economy.

The term “business ethics” comes to mind in this context, but here, this is not about the rule or what should be acceptable behavior, as much as it is about the exception, and businesses that as a matter of practice would knowingly cut corners. And this is about good businesses that seek to, as a matter of ongoing practice, follow prudent ethical standards and policies – but where they have one or a few key employees would cut those corners for their own advantage.

• The principle role of financial industry regulatory law can be viewed as removing incentives to cut corners at the expense of clients and investors.
• Such law will, of necessity, remain reactive and certainly in the face of new and emerging channels of opportunity – positive and negative.
• But even reactive regulatory law can address what should be viewable as simple new variations on old and familiar bad practices themes.
• And effective regulatory law can be built so as to offer a system of layered defenses against short sighted and high risk-creating activities.
• Here, it is not so much necessary that a specific action be disallowed, and by statute that is specifically directed towards it, as it is that potential risk takers see enough uncertainty for themselves if they proceed, that they do not see it as worth their risk to try.

This means reducing bad practices from the level of institutional policy to the level of the occasional bad-apple employee who violates company policy when cutting corners. And it means reducing the sense of opportunity for those employees too, so they are less likely to pursue bad business practices anyway.

And for financial institutions, the most powerful regulatory tools are enforced separations and selective uncoupling of activity from reward.

• This means clearly separating investment analysis and investment product review from investment sales as some regulatory laws seek to do now.
• This should also mean restrictions as to what marketing materials, members of the sales force turn to when pitching the products they do offer, and requiring institutional transparency as to where reviews and evaluations of investment worth come from.
• And if an investment business bundles and assembles its own investment instruments, disinterested third party evaluations as to their merits should be offered and required before that company can push or sell its own products.
• And any third party reviewer should be firewalled away from receiving any direct financial incentives from their ratings and review decisions. The businesses that assemble and produce investment instruments should not be in a position to in any way directly financially or otherwise compensate the review and ratings agencies. The businesses that sell those instruments should be financially disconnected from the ratings and reviews providers too.
• How would review and ratings agencies be compensated then? I would argue in favor of their compensation coming from pooled funds, contributed to from all participating financial institutions that would aggregate or otherwise assemble, or sell investment products. And that these funds should be collected by government agency for distribution – and with strong restrictions as to the private sector affiliations that involved government employees and regulators can hold with any of the involved organizational parties they oversee. This would mean nailing shut the private sector/public sector revolving door system where government regulators involved in this would be acting with their own future private sector career paths in mind.

Note that the goal here is not to eliminate investor risk, as realistic and fairly marketed and offered investments carry risks as well as potential for positive returns. The goal here is to reduce the occurrence of the types of risk/benefits asymmetries discussed in detail in Considering a Cost-Benefits Analysis of Economic Regulatory Rules (see Macroeconomics and Business, postings 64 and loosely following), and as specifically created by the types of bad business practice that I address here.

I fully expect to come back to this topic area in future postings, just as I have been returning to it up to here. Meanwhile, you can find this and related postings at Macroeconomics and Business.

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