Chapter 16
What Should We Do About Conflicts
of Interest in the Financial Industry?
◼ Multiple Choice Questions
1. Economies of scope refer to cost savings that arise when the
(a) size of financial transactions increase.
(b) size of financial transactions decrease.
(c) number of different activities undertaken increases.
(d) number of different activities undertaken decreases.
2. A financial institution can achieve cost savings by engaging in multiple activities. These are called
economies of
(a) scope.
(b) scale.
(c) complexity.
(d) information.
3. A financial institution can achieve cost savings in its credit card operations if it increases the number
of cardholders. This is an example of economies of
(a) scope.
(b) scale.
(c) complexity.
(d) information.
4. Which combination of activities within a single financial institution is least likely to lead to conflicts
of interest?
(a) auditing and management advisory services
(b) commercial banking and investment banking
(c) assessment of credit quality and consulting
(d) consumer lending and business lending
202 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
5. Conflicts of interest pose a problem because they
(a) lower the quality of information.
(b) increase problems of asymmetric information.
(c) make the financial system less efficient.
(d) do all of the above.
6. An advantage of providing multiple financial services within one financial institution is that it
(a) lowers information costs.
(b) develops broader long-term relationships with customers.
(c) both (a) and (b).
(d) none of the above.
7. A conflict of interest occurs when
(a) a financial firm sells a service to its customers for a price that exceeds the cost of producing the
service.
(b) lenders prefer higher interest rates and borrowers prefer lower interest rates.
(c) riskier borrowers are the ones who are more likely to apply for loans.
(d) people expected to provide reliable information to the public have incentives not to do so.
8. A conflict of interest between providing impartial research about companies issuing securities and
selling those same securities arises in
(a) investment banking.
(b) commercial banking.
(c) accounting firms.
(d) mutual funds.
9. If potential revenues from underwriting greatly exceed brokerage commissions, there is _________
incentive for investment bank analysts to report _________ information about firms issuing
securities.
(a) stronger; unbiased
(b) stronger; favorable
(c) weaker; unbiased
(d) weaker; favorable
10. Spinning is the practice of
(a) investment banks allowing executives of potential client companies to buy underpriced initial
public offerings of other companies’ securities.
(b) investment bank analysts providing misleading information about a company to encourage more
investors to purchase the company’s securities.
(c) accounting firms encouraging its audit clients to also purchase its manage advisory services.
(d) credit rating agencies providing higher ratings on a company’s securities in order to develop a
long-term relationship with the company.
Chapter 16 What Should We Do About Conflicts of Interest in the Financial Industry? 203
11. Investment banks are guilty of conflict of interest when they
(a) pressure their analysts to produce research favorable to their client firms.
(b) permit executives of client firms to alter analysts’ research on their firms.
(c) prohibit analysts from making negative or controversial comments about client firms.
(d) all of the above.
12. Investment banks serve two client groups,
(a) home buyers and mortgage lenders.
(b) people saving for retirement and pension funds.
(c) issuers of securities and investors in those securities.
(d) mutual funds and investors with relatively small amounts to invest.
13. Auditors attempt to reduce information asymmetry between a firm’s managers and its
(a) customers.
(b) owners.
(c) employees.
(d) competitors.
14. Conflicts of interest in the Arthur Andersen accounting firm intensified when _________ became
the firm’s largest source of profits and large clients pressured _________ office managers to give
favorable audits.
(a) consulting; regional
(b) consulting; national
(c) auditing; regional
(d) auditing; national
15. The potential conflict of interest when a single accounting firm provides both auditing and
consulting services is that the firm can
(a) charge higher fees to its audit clients and lower fees for its consulting services so it can expand
its consulting business.
(b) charge higher fees to its consulting clients and lower fees for its audit services so it can expand
its auditing business.
(c) provide unjustifiably favorable audit reviews for firms that are large clients for its consulting
services.
(d) pressure its clients into paying high fees for both auditing and consulting services.
16. The conflict of interest in credit-rating agencies arises because _________ pay to have securities
rated and, as a result, the agencies’ ratings may be biased _________.
(a) security issuers; downward
(b) security issuers; upward
(c) investors; downward
(d) regulators; upward
204 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
17. Why did credit-rating agencies switch from charging subscribers for security ratings information to
having the security issuers pay for having their securities rated?
(a) They discovered security issuers would pay enormous sums to insure that their securities
received favorable ratings.
(b) Subscribers were concerned that the information they received from the agencies was not
reliable.
(c) Investors could free ride on the information the agencies provided, which cut into the agencies’
earnings.
(d) The big three rating agencies controlled nearly the entire market for security ratings.
18. Since firms issuing new securities pay to have these securities rated, the credit-rating agencies have
incentive to _________ to attract more business.
(a) give favorable ratings
(b) give impartial ratings
(c) lower the fees they charge
(d) practice spinning
19. Universal banking refers to combinations of the activities of commercial banking, investment
banking, and
(a) auditing.
(b) insurance.
(c) credit assessment.
(d) consulting.
20. Universal banking was prohibited for a period of time by the
(a) Federal Reserve Act.
(b) Bank Holding Company Act.
(c) Gramm-Leach-Bliley Financial Services Modernization Act.
(d) Glass-Steagall Act.
21. A review of the different sources of conflicts of interest suggests that the _________ the number of
financial activities within an institution and the _________ the number of clients, the _________ is
the potential for conflict of interest.
(a) greater; greater; greater
(b) smaller; smaller; smaller
(c) greater; greater; smaller
(d) smaller; smaller; greater
Chapter 16 What Should We Do About Conflicts of Interest in the Financial Industry? 205
22. Research shows there is a _________ correlation between credit ratings and default probabilities,
which suggests that credit rating agencies _________ the potential conflict of interest.
(a) low; exploit
(b) low; do not exploit
(c) high; exploit
(d) high; do not exploit
23. The market value of credit assessments is highest when the rating agencies give _________ ratings,
which _________ their incentives to exploit potential conflicts of interest.
(a) favorable; decreases
(b) favorable; increases
(c) impartial; decreases
(d) impartial; increases
24. To maintain their reputations, during the 1920s universal banks
(a) shifted their underwriting activities from departments within the bank to separate affiliates.
(b) focused more on securities of well-known issuers.
(c) both (a) and (b).
(d) none of the above.
25. Which of the following has not been a major factor contributing to financial conflict of interest
scandals in recent years?
(a) inappropriately designed compensation mechanisms
(b) poor economic conditions
(c) employees of a financial firm profiting from activities that diminish a firm’s reputational rents
(d) poor management
26. The Sarbanes-Oxley Act of 2002 included all the following provisions except
(a) establishment of the Public Company Accounting Oversight Board.
(b) a ban on accounting firms providing non-audit services to an audit client.
(c) a requirement that a firm’s chief executive officer and chief financial officer certify that the
firm’s accounting statements fairly represent its operations and financial conditions.
(d) a requirement that members of a firm’s audit committee be managers in the firm.
27. (I) The marketplace may be able to control conflicts of interest in some instances because there is a
high value to a firm’s reputational capital. (II) Eliminating multiple activities within financial firms
may lower the cost of reliable information.
(a) (I) is true; (II) is false.
(b) (I) is false; (II) is true.
(c) (I) and (II) both are true.
(d) (I) and (II) both are false.
206 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
28. The most intrusive remedy for conflicts of interest is
(a) regulatory oversight.
(b) mandatory disclosure of information.
(c) socialization of information production.
(d) enforcing separation of functions within financial firms.
29. The Global Legal Settlement of 2002 dealt with conflicts of interest in
(a) accounting firms.
(b) investment banks.
(c) credit rating agencies.
(d) all of the above.
30. Which of the following provisions of legislation to deal with conflicts of interest does not increase
the flow of information in financial markets?
(a) requiring a firm’s chief officers to certify its financial statements and other disclosures
(b) requiring investment banks to make their analysts’ recommendations public
(c) requiring disclosure of off-balance sheet transactions
(d) increasing resources available to the Securities and Exchange Commission to supervise financial
markets
Chapter 16 What Should We Do About Conflicts of Interest in the Financial Industry? 207
◼ True/False
1. Conflicts of interest are examples of the broader problem of moral hazard.
2. Conflicts of interest are unethical, but they do not affect the ability of financial markets to allocate
funds to their most productive uses.
3. For failing to provide an honest audit of Enron, the accounting firm Arthur Andersen was prohibited
from conducting audits of publicly traded corporations.
4. Regulations that enforce separation of financial functions into separate affiliates or firms will reduce
conflicts of interest.
5. Regulations that enforce separation of financial functions into separate affiliates or firms will reduce
the costs of producing information.
6. The conflict of interest that arose in investment banking was that analysts reported favorable
research results to firms issuing securities and unfavorable results to investors who were potential
purchasers of those securities.
7. The conflict of interest that arose in the accounting industry was that accounting firms who earned
consulting revenues from their audit clients had incentives to provide favoarable audits of those
clients.
8. The conflict of interest that may arise in credit rating is that the rating agencies are paid by investors
and have incentives to rate firms unfavorably so that investors can buy the firms’ securities at lower
prices.
9. Conflicts of interest are a serious problem when they are visible to the market.
10. Reputational rents are profits firms earn because they are trusted by the marketplace.
11. The Sarbanes-Oxley Act of 2002 was passed in response to scandals in the investment banking
industry.
12. The Sarbanes-Oxley Act of 2002 provides for oversight of accounting firms but makes no provisions
for increasing the flow of information to financial markets.
13. The Sarbanes-Oxley Act of 2002 and the Global Settlement of 2002 both have the potential to
reduce economies of scope.
208 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ Essay
1. Why should we be concerned abut conflicts of interest in the financial services industry?
2. What conflicts of interest can arise in investment banking?
3. What conflicts of interest can arise in accounting firms?
4. What conflicts of interest can arise in credit rating agencies?
5. What conflicts of interest can arise in universal banking?
6. How are conflicts of interest related to the concepts of moral hazard and principal-agent problems?
7. Evaluate the major provisions of Sarbanes-Oxley and the Global Settlement as remedies for conflict
of interest problems.