Wednesday, April 28, 2010

Conflict of Interest

During the recent grilling of Goldman Sachs's management I was struck by an oft-repeated question about whether they were concerned more about the welfare of their clients or of the firm. It seems the deeper question, assuming that the answer was one or the other, is how a firm that has a divergence between its interests and those of its clients can continue to exist? If a firm were to have a known divergence of interests with its clients and is still in business, a number of conclusions might be drawn.

It could be possible that for this type of business no one has come up with a way in which to align the interests of both parties. This problem is one of knowledge, and might especially plague industries in which results are difficult to evaluate or are not evident until a much later date - medicine comes to mind. Or it may be that there are known ways of aligning interests, but they are illegal. For example, it is my understanding that it is illegal for stock brokers to cover client losses on stock recommendations. Finally, in a corollary to the latter case, regulations and mandates may create such a barrier to entry that innovative business models that would potentially align the interests of clients and the firm more closely are unlikely to be tried. This condition effectively produces a cartel of the already-existing enterprises that then provide uniformly mediocre services. How many times has your bank angered you, and you decide against changing because "they are all the same?"

In a free market "consumer sovereignty" has a meaning, and firms that ignore it are destined for the trash heap.

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