THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 220

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PA R T I I I

Financial Institutions
neously serve two client groups the security-issuing firms and the securitybuying investors. These client groups have different information needs. Issuers
benefit from optimistic research, whereas investors desire unbiased research.
However, the same information will be produced for both groups to take advantage of economies of scope. When the potential revenues from underwriting
greatly exceed the brokerage commissions from selling, the bank will have a
strong incentive to alter the information provided to investors to favour the issuing firm s needs or else risk losing the firm s business to competing investment
banks. For example, an internal Morgan Stanley memo excerpted in the Wall Street
Journal on July 14, 1992, stated, Our objective . . . is to adopt a policy, fully
understood by the entire firm, including the Research Department, that we do not
make negative or controversial comments about our clients as a matter of sound
business practice.
Because of directives like this one, analysts in investment banks might distort
their research to please issuers, and indeed this seems to have happened during
the stock market tech boom of the 1990s. Such actions undermine the reliability
of the information that investors use to make their financial decisions and, as a
result, diminish the efficiency of securities markets.
Another common practice that exploits conflicts of interest is spinning.
Spinning occurs when an investment bank allocates hot, but underpriced, initial
public offerings (IPOs) that is, shares of newly issued stock to executives of
other companies in return for their companies future business with the investment
bank. Because hot IPOs typically immediately rise in price after they are first purchased, spinning is a form of kickback meant to persuade executives to use that
investment bank. When the executive s company plans to issue its own shares, he
or she will be more likely to go to the investment bank that distributed the hot IPO
shares, which is not necessarily the investment bank that would get the highest
price for the company s securities. This practice may raise the cost of capital for
the firm, thereby diminishing the efficiency of the capital market.
Traditionally, an auditor

checks the books of companies and monitors the quality of the information produced by firms to reduce the inevitable information asymmetry between the firm s
managers and its shareholders. In auditing, threats to truthful reporting 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
both auditing services and nonaudit consulting services such as advice on taxes,
accounting, management information systems, and business strategy. Supplying
clients with multiple services allows for economies of scale and scope, but creates
two potential sources of conflicts of interest. First, auditors may be willing to skew
their judgements and opinions to win consulting business from these same clients.
Second, auditors may be auditing information systems or tax and financial plans put
in place by their nonaudit counterparts within the firm, and therefore may be reluctant to criticize the systems or advice. Both types of conflicts may lead to biased
audits, with the result that less reliable information is available in financial markets
and investors find it difficult to allocate capital efficiently.
Another conflict of interest arises when an auditor provides an overly
favourable audit to solicit or retain audit business. The unfortunate collapse of
Arthur Andersen once one of the five largest accounting firms in the United
States suggests that this may be the most dangerous conflict of interest.

AUDITING AND CONSULTING IN ACCOUNTING FIRMS