Financial Markets and Institutions (2-downloads)

public offerings (IPOs)—that is, shares of newly issued stock—to executives of

other companies in return for their companies’ future business with the investment

banks. Because hot IPOs typically immediately rise in price after they are first pur-

chased, spinning is a form of kickback meant to persuade executives to use that

investment bank. When the executive’s company plans to issue its own shares, he

or she will be more likely to go to the investment bank that distributed the hot IPO

shares, which is not necessarily the investment bank that would get the highest price

for the company’s securities. This practice may raise the cost of capital for the firm,

thereby diminishing the efficiency of the capital market.

Auditing and Consulting in Accounting Firms

Traditionally, an auditor checks the

books of companies and monitors the quality of the information produced by firms to

reduce the inevitable information asymmetry between the firm’s managers and its

shareholders. In auditing, threats to truthful reporting arise from several potential

conflicts of interest. The conflict of interest that has received the most attention in

the media occurs when an accounting firm provides its client with both auditing

services and nonaudit consulting services such as advice on taxes, accounting, man-

agement information systems, and business strategy. Supplying clients with multi-

ple services allows for economies of scale and scope, but creates two potential sources

of conflicts of interest. First, auditors may be willing to skew their judgments and

opinions to win consulting business from these same clients. Second, auditors may

be auditing information systems or tax and financial plans put in place by their non-

audit counterparts within the firm, and therefore may be reluctant to criticize the

systems or advice. Both types of conflicts may lead to biased audits, with the result

that less reliable information is available in financial markets and investors find it dif-

ficult to allocate capital efficiently.

Another conflict of interest arises when an auditor provides an overly favorable

audit to solicit or retain audit business. The unfortunate collapse of Arthur Andersen—

once one of the five largest accounting firms in the United States—suggests that this

may be the most dangerous conflict of interest (see the Mini-Case box).

Credit Assessment and Consulting in Credit Rating Agencies

Investors use

credit ratings (e.g., Aaa or Baa) that reflect the probability of default to determine

the creditworthiness of particular debt securities. As a consequence, debt ratings

play a major role in the pricing of debt securities and in the regulatory process.

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Chapter 7 Why Do Financial Institutions Exist?