Explain why conflicts of interest arise in underwriting and research in investment banking.
Investment banks perform many functions, but two main important functions are research and underwriting. The investment bank will research companies issuing securities and at the same do the underwriting of the securities through selling the securities to the public on behalf of the issuing firm. Through research, the investment bank serves one group of clients on the other hand in selling it serves another group of clients. These two groups have different information needs. When the potential revenues from underwriting greatly exceed the brokerage commissions from selling, the bank will have a strong incentive to alter the information provided to investors to favor the issuing firm s needs or else risk losing the firm s business to competing investment banks.
The investor needs unbiased research while the issuer wants optimistic research. As a result, investment banks may distort their research to please the issuer, and at the expense of the investor, which undermine the reliability of the information that investors use in making their financial decision and thus undermine the efficiency of securities markets.