The Ethics of Banking: Conclusions from the Financial Crisis (Issues ...

166 10 Disturbance of the Invisible Hand
Conflicts of Interests and Conflicts of Disinterest: Having
an Interest in Credit Enhancement and No Interest
in the Monitoring of It
In past decades, the business ethics and business law discourse was determined by
the thesis of the necessity of avoiding conflicts of interest. Conflicts of interest still
play a major role, as is demonstrated by the danger of self-dealing and the conflicts
between the bank’s interest in obtaining a high launch price for its IPO customers
and its interest in providing its investor advisory clients with the optimum advice.
Firewalls between the divisions of the bank are a means of averting such conflicts,
although the fact remains that the board of the bank has and must have access to all
details from all divisions of its bank, and can never be completely free of conflicts of
interest, because the conflicting interests of divisions of the bank remain the interests
of the bank as a whole.
The expansion of lending and the sale of securitized loans shows, nevertheless,
that banks are not only caught up in a conflict of interests, but also in a conflict of
disinterest. 28 If there is an incentive for the bank to sell its borrowers’ mortgages due
to interest in the proceeds of sale and an interest in reducing the minimum equity,
the collateralized debt obligation (CDO) creates an indirect incentive for disinterest
in the collateral. It encourages disinterest in the mortgage collateral, and hence
in the bank’s debtor. The salability of mortgage-backed securities and mortgage
loans to investors by means of CDOs carries the inherent risk that the bank will
subsequently lose interest in monitoring its debtors and the security of the loans
it has brokered. Thus, a conflict arises between the interest of the finance system
in systematic debtor monitoring and the disinterest of the bank in carrying out this
monitoring. Debtor monitoring is a burdensome duty for the bank, and one in which
it has a disinterest or lack of interest if it sells the risk from the loan. If it can sell
it, it will sell it. The investor, in turn, has a self-interest in carrying out the debtor
monitoring, but he has neither incentives nor means of actually doing so. He does
not possess the same resources and experience to carry out debtor monitoring as a
bank whose primary role is to mediate between savings and investment, deposits and
loans.
In the case of CDOs, the financial system faces the difficulty that they do not
seem to permit the invisible hand of the market to bring about convergence of the
bank’s self-interest and the financial system’s efficiency interest. Instead, a conflict
arises between the interest of the financial system in diligent debtor monitoring and
the disinterest of the bank in undertaking such monitoring in relation to the CDOs.
Yet debtor monitoring matters not only to the lender, but also to the borrower as an
aid to efficiency and self-control. So the net result is a coalescence of disinterest,
28 Cf. BAKER (2008), p. 731: “In the new financial system, the link between lender and borrower
has become increasingly tenuous. How else could mortgage loans emerge with no income documentation
and dramatic interest rate resets built in? How else could leveraged loans appear with so
few covenants?”