Conflicts of interest in finance. Does regulation of them reduce moral judgment, and is disclosure harmful?

Author:Morten Kinander
Position:Department of Law and Governance, The Norwegian Business School, Oslo, Norway
Pages:334-350
SUMMARY

Purpose Relying on research from social psychology and business ethics, this paper aims to argue that the current massive regulatory regime surrounding the attempts to curb what is perceived to be damaging conflicts of interests in the financial industry is based on misguided assumptions, and that the trend of increasingly detailed rule-making, supervision and sanctioning in this area might be counter-effective.... (see full summary)

 
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Conicts of interest in nance
Does regulation of them reduce moral judgment,
and is disclosure harmful?
Morten Kinander
Department of Law and Governance, The Norwegian Business School, Oslo, Norway
Abstract
Purpose Relying on research from social psychology and business ethics, this paper aims to argue
that the current massive regulatory regime surrounding the attempts to curb what is perceived to be
damaging conicts of interests in the nancial industry is based on misguided assumptions, and that
the trend of increasingly detailed rule-making, supervisionandsanctioninginthisareamightbe
counter-effective. This should cause nancial services legislators and regulators to be cautious when
proposing more detailed rules as solutions to perceived problems. The paper argues that disclosure is no
remedy for a harmful conictofinterest,andthatsuchanobligationcanonlybebasedontheclients
right to know about the conict. This right, however, does not, in itself, justify all the extensive and
detailed regulation in the area. The paper ends with a recommendation for more research into the moral
reasoning ability of nancial services professionals, as well as the interplay between judgment and
rules in the nance industry.
Design/methodology/approach The paper relies on research within behaviouralmoral psychology,
and applies it to businessethics with the aim of discussing the impact of regulation on moral reasoning within
the nance industry.
Findings Regulationmight lead to a decrease in moral reasoning, which is the premise of properhandling
of conicts of interest.Additionally, disclosure of unavoidable conicts of interestmight even strengthen the
negativeconsequences of such conicts.
Research limitations/implications More research should be conductedwithin the nancial services
sector aboutthe effect of regulation on individual judgment.
Practical implications The paper proposes that care should be exercised when proposing increased
and complex regulationto avoid unintended and adverse consequences forthe nancial services industry.
Originality/value The paper synthesises existing research within different elds such as moral
psychologyand analytic business ethics and applies it to nancial regulation.
Keywords Business ethics, Conict of interest, Financial services, Financial regulation,
Compliance and regulation
Paper type Research paper
1. Introduction
Conicts of interest have moved to the forefront of the regulatory initiatives to curb
unwanted nancial advisory services. And while all professions engaged in giving advice
for a fee are under an obligation to avoid conicts of interests that are detrimental to their
advice, regulation has recently been particularly strict in the area of nancial services.
Indeed, much of the recent EU legislativeinitiatives the Market Abuse Directive, Markets
in Financial Instruments DirectivesI and II and the Transparency Directive, to mention but
a few examples can, in large parts, be regarded as attempts to deal with the perceived
negative effects of conictsof interests. The sameholds true for the recent regulations in the
accounting industry, such as the Sarbanes Oxley and the Dodd Frank Acts. According to
recent regulation, such conicts of interests are to be reduced to the minimum through
JFRC
26,3
334
Journalof Financial Regulation
andCompliance
Vol.26 No. 3, 2018
pp. 334-350
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-12-2016-0108
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
organisational arrangements,and if those are insufcient, the information about the conict
of interest must be disclosed to the client.
The issue discussed in this article is whether this massive regulation is successful, and
the answer to that is partly a no. This is because the present regulation of conicts of
interests in nance as we have seen in the EU and USA only regulates a certain aspectof
such detrimental conicts, namely, the cash ows, and it does so intensely. This article
argues that this intense and partial regulation has the potential for producing some
unintended consequences on independent judgment, which is a central condition for the
proper discharge of duciaryduties and other requirements when giving counsel, of whicha
ban on conicts of interests is a central feature.Massive rule formation, in other words, can,
as indicated by empirical research on moralreasoning, crowd out moral judgment. That is a
problem, even if the regulation is successful in regulating conicts of interests as the
regulatory regime leaves a vast area of potentially harmful conicts untouched, in its
relative one-sided focus on the cash ows. When such a vast area is unregulated, or not
captured sufciently well by the existing regime, the amount of regulation has a
deteriorating effect on that kind of moral reasoning that is necessary to avoid harmful but
unregulated conictsof interest.
The article consists, therefore, of two related arguments, one general and more specic:
generally, there are reasons to believe that rule following deteriorates judgment, and that
specic and exclusive regulation of money ows can lead to neglect of equally important
other conicts of interest.
Section 2 gives a short overview of the basic regulatory framework for the regulation of
conicts of interests, especially within the recent EU-legislative agenda in the aftermath of
the nancial crisis. Section 3 will present and outlinethe features of the recent philosophical
denitions of conicts of interest within the realm of business ethics, with its emphasis on
the exercise of judgment as a necessary ingredient in the conict of interest situation. The
article then analyses the current regulation of conicts of interests within nance
(Section 3.2). Thereafter, it is argued that this regulatory density, coupled with its one-
sidedness, has the potential to crowd outjudgment that is so central to the proper
handling conicts of interests, leading to a legalistic attitude to basic moral issues and
possibly also a deterioration of the moral reasoning ability (Section 3.3). This is especially
harmful given the inability of agents to adequately understand their conicts of interests,
which is the subject of Section 3.4. Section4 draws on the relative extensive recentempirical
scholarship demonstrating the prescribed remedy of disclosure does not ameliorate the
problems connected with the conicts of interest in any way near what is presupposed by
regulation. Indeed, disclosure may worsen the problems. Section 5 ends the article with a
meagre hope, and a warning about excessivehopes that regulation will produce results that
closely match the intention of the regulation.
2. Conicts of interest in regulation of the nancial sector and unintended
eects
2.1 The recent development of the regulatory concept of conict of interest
In recent years, the Enron, WorldCom and PWC scandals have highlighted conicts of
interest as a distinct conict category in the nancial industry. These scandals resulted in
the 2002 US SarbanesOxley Act[1]. The Act imposed a strict regulation of conicts of
interest as many of the scandals could be tracedback to the lacking (nancial or structural)
independence of the auditorsfrom their clients, thus leading to poorer adviceharming rms,
markets, stockholders and customers and ultimately the client itself. All because such
nancial incentivesare at odds with the intereststhat auditors are entrusted to protect.
Conicts of
interest in
nance
335

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