Question

1 a. Discuss how moral hazard influences the financial structure of the bond markets and outline three (3) ways of dealing with the situation    

b. Discuss how the following functions by players in the financial markets could breed conflict of interest suggest ways of managing the conflict in each case.  

i. Underwriting and Research by same Investment Banking

ii. auditing and consulting by the same accounting firm

iii. auditing and consulting by the same accounting firm

Answer 1

Moral hazard is said to exist in the context of a financial market if, after a purchase agreement has been concluded between a buyer and seller of a financial asset:

The seller changes his or her behavior in such a way that the probabilities (risk calculations) used by the buyer to assess the quality of the financial asset are no longer accurate.

It arises because of asymmetric information between buyers and sellers of assets before any purchase agreement takes place. It arises when buyers of assets when they have difficulty assessing the quality of these assets in advance of purchase. Borrowers (sellers of financial assets) generally have private information that is more accurate than the information possessed by lenders (buyers of financial assets) regarding the attributes and prospects of borrowers.

Some examples of Asymmetric Information:

- Transactions costs can hinder flow of funds to people with productive investment opportunities. Bonds get most effected as they generally have $1,000 size.

- Bonds may include covenants that attempt to preclude risk-increasing corporate actions (e.g., mergers), or that ensure that the firm maintains certain financial ratios. Managers’ choice of covenants is determined by cost of debt and the anticipated direct and opportunity cost.

- The covenants are based managerial ability to anticipate future, however off balance sheet derivatives may vitiate the intent of covenants based on on-balance-sheet financial ratios.

- Mortgage results in a legal claim of the mortgage holder on the recovery value of the building up to the value of the mortgage debt, with the general creditors having a claim only on the residual.

Dealing with Moral Hazard:

- Callable bonds: designed to protect bond holders from economic losses should their bonds be called, point to such a managerial motive.

- Government Regulation to Increase Information

- Private Production and Sale of Information

b) Research analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but underpriced, IPOs to executives in return for their companies’ future business.

Many perceive providing auditing and consulting services to the same client as a conflict of interest -- a discrepancy between the private interests and responsibilities of a person in a position of trust. In this case, as auditors, professionals must be objective in order to submit unbiased reports about the company’s financial situation, whereas, as consultants, they might become subjective in order to recommend ways to maximize the company’s profits by circumventing paying high taxes.

US energy giant Enron, whose auditor and consultant Arthur Anderson, signed Enron’s book keeping trick. Andersen applied reckless standards in its audits because of a conflict of interest over the fees it earned from its fast-growing consulting business.