Identify where the commercial banking, securities services and investment banking arms of a bank may have conflicts of interest, and recommend ways to resolve them.
The idea
A universal bank combines commercial banking (deposits and lending), securities services such as brokerage, research, custody and asset management, and investment banking such as underwriting and advisory work. Conflicts arise because the arms serve clients with opposing interests and hold confidential information. In one case, a lender learns that a borrower is weak while the underwriting desk is selling that borrower's bonds. In another, research analysts are pressed to rate investment banking clients favourably. In a third, the asset management arm is steered into securities the bank is underwriting. In a fourth, the bank advises on a takeover of a company it lends to. Remedies include information barriers (Chinese walls) with compliance oversight, separate reporting lines and pay for research and investment banking, and restricted and watch lists. Others are disclosure with informed consent, and declining a mandate when the conflict cannot be managed. Exam point: a wall controls the flow of information only, so conflicts of duty also need disclosure or abstention.
A practice question
Which of the following is a recognised conflict of interest in a bank that combines investment banking and research?
- The custody unit records client assets in accounts that are separate from the bank's own.Why not: This is a safeguard that reduces conflicts, not a conflict.
- The bank's lending and deposit-taking staff share a common salary scale across the firm.Why not: A common salary scale is not a conflict of duty.
- Research and lending staff both use the same market data vendor for prices and news.Why not: Sharing a data vendor involves no conflicting duty to clients.
- Analysts may be pressed to publish favourable research on investment banking clients. - correct
A research analyst's duty is to investors, but the investment bank earns fees from the issuers being covered, which creates pressure for favourable ratings.
A harder one
A bank's lending officers learn privately that a borrower's covenants are about to be breached. Another desk of the same bank is preparing to underwrite that borrower's bond issue. What is the most appropriate response?
- Keep the information behind a barrier and let compliance decide whether the bank can underwrite. - correct
- Share the information with the underwriting and sales desks so they can price the issue accurately.Why not: Passing confidential lender information to other desks is the misuse the barrier is meant to prevent.
- Proceed as normal, since the lending and underwriting arms are one legal firm and no conflict exists.Why not: Being one legal entity does not remove duties of confidentiality to the borrower or to investors.
- Announce the covenant problem to bond investors on the lending unit's own authority.Why not: Disclosing a client's confidential information without authority breaches the duty owed to the borrower.
The bank owes confidentiality to the borrower and fair dealing to bond investors. The remedy is an information barrier plus a compliance decision, which may be to abstain from the underwriting.
The hardest tier
Which pairing of a conflict of interest and an appropriate mitigation is correct?
- Front-running of client orders by the trading desk: raise the bank's regulatory capital buffers across all units.Why not: Capital buffers do not address misuse of client order information; trade surveillance and information controls do.
- Lending to a client the bank also advises: remove confidentiality agreements so the teams can share information freely.Why not: Removing confidentiality creates the misuse of information instead of managing it.
- Research pressured by investment banking: separate reporting lines and pay not tied to investment banking revenue. - correct
- Custody of client assets: allow the custody unit to lend them to the trading desk without client consent.Why not: Using client assets without consent is itself a conflict, not a mitigation.
The right mitigation targets the mechanism of the conflict. For research it is organisational independence and pay that does not reward investment banking business.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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