Conflicts of interest in finance. Does regulating them reduce moral judgment, and is disclosure harmful?
| Date | 09 July 2018 |
| DOI | https://doi.org/10.1108/JFRC-12-2016-0108 |
| Published date | 09 July 2018 |
| Pages | 334-350 |
| Author | Morten Kinander |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial compliance/regulation |
Conflicts of interest in finance
Does regulating them reduce moral judgment,
and is disclosure harmful?
Morten Kinander
Department of Law and Governance, BI 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 conflicts of interests in the financial industry is based on misguided assumptions, and that
the trend of increasingly detailed rule-making, supervisionandsanctioninginthisareamightbe
counter-effective. This should cause financial 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 conflictofinterest,andthatsuchanobligationcanonlybebasedontheclient’s
right to know about the conflict. 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 financial services professionals, as well as the interplay between judgment and
rules in the finance 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 finance industry.
Findings –Regulationmight lead to a decrease in moral reasoning, which is the premise of properhandling
of conflicts of interest.Additionally, disclosure of unavoidable conflicts of interestmight even strengthen the
negativeconsequences of such conflicts.
Research limitations/implications –More research should be conductedwithin the financial 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 financial services industry.
Originality/value –The paper synthesises existing research within different fields –such as moral
psychologyand analytic business ethics –and applies it to financial regulation.
Keywords Business ethics, Conflict of interest, Financial services, Financial regulation,
Compliance and regulation
Paper type Research paper
1. Introduction
Conflicts of interest have moved to the forefront of the regulatory initiatives to curb
unwanted financial advisory services. And while all professions engaged in giving advice
for a fee are under an obligation to avoid conflicts of interests that are detrimental to their
advice, regulation has recently been particularly strict in the area of financial 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 conflictsof 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 conflicts 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 insufficient, the information about the conflict
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 conflicts of
interests in finance –as we have seen in the EU and USA –only regulates a certain aspectof
such detrimental conflicts, namely, the cash flows, 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 fiduciaryduties and other requirements when giving counsel, of whicha
ban on conflicts 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 conflicts of interests as the
regulatory regime leaves a vast area of potentially harmful conflicts untouched, in its
relative one-sided focus on the cash flows. When such a vast area is unregulated, or not
captured sufficiently 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 conflictsof interest.
The article consists, therefore, of two related arguments, one general and more specific:
generally, there are reasons to believe that rule following deteriorates judgment, and that
specific and exclusive regulation of money flows can lead to neglect of equally important
other conflicts of interest.
Section 2 gives a short overview of the basic regulatory framework for the regulation of
conflicts of interests, especially within the recent EU-legislative agenda in the aftermath of
the financial crisis. Section 3 will present and outlinethe features of the recent philosophical
definitions of conflicts of interest within the realm of business ethics, with its emphasis on
the exercise of judgment as a necessary ingredient in the conflict of interest situation. The
article then analyses the current regulation of conflicts of interests within finance
(Section 3.2). Thereafter, it is argued that this regulatory density, coupled with its one-
sidedness, has the potential to “crowd out”judgment that is so central to the proper
handling conflicts 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 conflicts 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 conflicts 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. Conflicts of interest in regulation of the financial sector and unintended
effects
2.1 The recent development of the regulatory concept of “conflict of interest”
In recent years, the Enron, WorldCom and PWC scandals have highlighted conflicts of
interest as a distinct conflict category in the financial industry. These scandals resulted in
the 2002 US Sarbanes–Oxley Act[1]. The Act imposed a strict regulation of conflicts of
interest as many of the scandals could be tracedback to the lacking (financial or structural)
independence of the auditorsfrom their clients, thus leading to poorer adviceharming firms,
markets, stockholders and customers and ultimately the client itself. All because such
financial incentivesare at odds with the intereststhat auditors are entrusted to protect.
Conflicts of
interest in
finance
335
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