Conflict of interest

In our day-to-day work we come across several situations where we face severe conflict of interest. If we are in a situation faced with a conflict of interest, ethics demand that we disclose and move away from the situation that creates the conflict. However  if you are faced with a situation where there is a potential  conflict of interest that you note but cannot do anything about it that would probably not be as simple to deal with because the ability to remove the conflict of interest is not within your hands. Here is a simple list of certain conflict of interests that I have observed mostly within finance/commerce space over time and it would be interesting to see how they play out in terms of business decisions.

Credit Rating

This is the mother of all conflict of interest that I have ever observed. The credit rater is paid by the credit rated. In simple words, you take money from a company to provide a rating to the company. This conflict probably was at the heart of global financial crisis. However the model continues to operate the same way. Even now the credit rating companies are paid by credit rated companies and not by any independent agency. Well, to an extent credit rating agency can appear to  be unaffected by this conflict of interest, but I am sure down the line there would be an impact of this direct conflict of interest between the rating agency and the rated company. The best way to resolve this is to create an independent credit rating agency fully funded by government. The government can impose some sort of tax on corporate on overall basis and try to do this as an independent exercise completely devoid of any conflict of interest. A credit rating borne out of such a process can definitely be more unbiased and objective. 

Sell-side research

The brokerage industry thrives on brokerage commissions. Brokerage commissions are derived by the extent of trading by clients (investment companies or asset management companies). In order to elicit the interest to trade, brokerage companies come out with a series of research notes on companies in what is now popularly known as sell-side research. The idea is to trigger either buying interest or selling interest about the client firms so that that the commission earned can be increased.  Obviously this sort of research is not going to be independent or objective because the purpose of this research is basically to trigger trade actions and not to enable unbiased objective investment decision.  There is still no way out of this sell- side research dilemma.  Investment communities still continue to depend hugely on sell-side research even though they see this conflict of interest very clearly. Of course, certain regulators mandate publishing details like investment banking business done in the past one year, number of sell call/buy calls and history of calls along with actual performance. More often than not, these disclosures come in small print! 

Media

Media is probably one of the best examples of a conflict of interest. The most popular newspapers and magazines literally thrive on advertising revenues almost completely. Nearly 90% of their total income accrues from advertising revenues rather than subscription revenues. So obviously this poses a limit on how far you can go to be independent about client companies lest your main source of revenue will be hit. This is true for print media, television channels and digital media too. We all know that views that are being aired about these companies that are their clients can never be independent or objective since their existence depend on continuation of their advertising contracts. And curiously enough, the client list can also include political parties! 

Audit and Consulting

Auditors normally are mandated to be extremely independent and they have to provide independent view on the financial status of the company. Like credit rating agencies, auditors are being compensated by the company that is being audited which itself is a potential conflict of interest, but by virtue of their access to almost all records and status of company, they are also in a position to see what type of consulting mandates can be obtained and executed by the audit firms. Technically they may not do it under the same name but there are ways to get around this. 

Board of Directors

Board of directors can either be independent businessman in which case they would try to push their business opportunities or they could be simply also be a client or vendor for the company. It may not be done directly but there is always conflict of interest between being on the board and trying to influence the company to use the services of the businesses that they are directly or indirectly connected with. 

Financial audit

There may be cases where senior partners of an audit firm can hold some sort of a stake (direct or indirect) in the client company for which they conduct financial audit. This will be definitely be at the back of their mind when they conduct the financial audit because their financial fortunes are tied to the audit opinion and they may not be having the courage to give true opinion about the firm since they hold a stake in the firm. 

Hospitals

Major hospitals and to an extent even clinics of a decent size have their own testing laboratories. These laboratories house expensive, often imported, medical equipment whose capital costs need to be recovered at the earliest. Hence, doctors have implicit incentive to refer patients to sometimes necessary but most of the times unnecessary tests in order to recover the capital investments. I believe in many hospitals doctors have targets when it comes to recommending tests! 

In summary, conflict of interest abounds and surrounds us in everyday lives. It may be a source of intense frustration when it impacts our personal lives (like hospital example given above). In corporate situations, it may affect our performance as investment or portfolio manager where we rely on credit ratings or equity research to make investment decisions. In most of the cases, the cost of conflict of interest is not straightforward or apparent though we know it exists. It may pay well to be conscious of this while making decisions though in many cases it cannot be avoided. By no means, this list is exhaustive. Feel free to suggest other apparent conflict of interest that you have observed.

Saudi Arabia and its US dollar peg dilemma

This Article was Published in The National

The fall in oil prices has strained Arabian Gulf countries’ cur­rency policy, and increased the cost of carrying a US dollar peg.

Most GCC countries are pegged to the US dollar to avoid currency fluctuation and eliminate uncertainties in international transactions (Kuwait is pegged to a basket of currencies dominated by the US dollar).

This comes at the expense of monetary policy flexibility. Stable domestic currency and a fixed exchange rate imply that traders do not have to face currency risks, and therefore will be more willing to invest and facilitate trade. Since oil is the chief commodity in the GCC, and the oil price is fixed in dollars, any exchange rate fluctuation could drastically reduce revenue if the currencies were unpegged.

With the US economy expanding, the Federal Reserve has begun hiking interest rates gradually, and plans to achieve a target of 3 per cent by the end of 2018.

While the US is expected to ride a growth wave over the next few years, the GCC economies, especially the oil exporters, are facing contraction because of low oil prices. Declining oil revenue, subdued global growth, liquidity crunch and geo­political issues are some of the challenges facing the region.

These differences are starker in countries such as Saudi Arabia, the world’s largest oil producer and exporter, where more than 73 per cent of government revenues come from the hydrocarbon sector, according to the Institute of International Finance industry group.

In such a scenario, Saudi Arabia can either follow the monetary policy direction set by the US or deviate from it.

If it opts for the former, the kingdom maintains the peg but sacrifices its growth, as it will tighten monetary conditions during a period of low growth. According to the kingdom’s central bank, the Saudi Arabian Monetary Agency (Sama), a 100 basis point increase in the Saudi Interbank Offered Rate (Sibor) leads to a decline of 90 basis points in GDP in the subsequent quarter and 95 basis points in the quarter after that.

If it opts for the latter, then there will be a gap in interest rates between the US and Saudi Arabia, leading to arbitrage opportunities. To counter this, Sama will have to buy Saudi ­riyals in the open market by selling US dollars from its reserves. And as the Fed increases the interest rate, Sama has to keep depleting its forex reserves until it runs out of dollars. Hence there is a cost involved with ­either choice.

The oil price fall since mid-2014, has reduced the kingdom’s revenue, incurring a deficit of $98bn in 2015, and it is estimating a further $87bn deficit in 2016. The Saudi government had funded this deficit by drawing down its central bank deposits, reducing its forex reserves to $602bn; a drop of $132bn, in the year to this January.

During the last Fed hike, Saudi Arabia, along with ­other GCC countries, raised its interest rates tracking the US monetary policy. According to Moody’s, the kingdom has large foreign currency reserves that provide ample room to maintain the pegged exchange rate regime for several years, even in an adverse oil price scenario. At present, Sama holds about 80 per cent of its investments in US Treasury bills.

While this should have been a clear indication of Sama’s dir­ection, early this year the forwards market for the Saudi riyal sprang to life with speculation that the kingdom could be forced to abandon its three- decade peg to the US dollar. The market expected a 12-month forward exchange rate of 3.85 riyals to the dollar, a 2.7 per cent devaluation from the 3.75 level that has, in essence, held since 1986.

Sama doused the speculation by reiterating that it will continue to stick with its currency peg, and ordered banks in the kingdom to stop offering options contracts on riyal forwards to their clients.

Other GCC countries with sufficient SWF assets and central bank reserves, such as Kuwait, Qatar and the UAE, could also maintain the peg with little difficulty.

However, Oman and Bahrain do not enjoy this luxury, and could potentially run out of reserves in less than three years. Both these countries have resorted to issuing debt to extend the longevity of their reserves.

For Saudi Arabia, speculation about the possibility of depegging its currency from the US dollar may have been premature, but it has provided an opportunity to analyse the costs incurred by the kingdom in maintaining the peg, and whether an alternative exists to the current scenario. While the low oil price does not seem to have affected the peg much, thanks to the presence of ample forex reserves, it could have severe repercussions in the future, if the low prices persist.

Looking ahead, cost benefit analysis, stress and scenario testing are a must to gauge the extent to which the status quo is preferable. While the advantages of maintaining the peg are manifold, so are the costs. Ergo, Saudi must also chart out a road map and prepare for a time where depegging from the US dollar is a preferable option to continuing with an expensive peg.