making local government more ethical

Don't Underestimate the Effects of Conflicts of Interest II - Oversight by Friends and Those You Trust

Last month, I wrote about the conflict of interest that led credit agencies to ignore the risk inherent in mortgage-backed securities. A front-page article in today's New York Times shows how a different sort of conflict of interest at Citigroup allowed the risks involved in these securities to be ignored. No crimes, no politics, just plain old conflict of interest. With an extremely big price tag for our society.

The Citigroup conflict takes two forms. First, for a while risk managers (the ones who are supposed to monitor investments and put the brakes on when the risk is determined to be too high) were reporting not only to the senior risk officer, but also to the head of trading. You can't be allowed to manage people who are supposed to be monitoring you. Or, from the other point of view, you can't be asked to monitor your boss.

But another conflict appears to have been more damaging. The senior risk manager came up through the Citigroup ranks with two men, one of whom became the head of trading, the other of whom became the deputy to this man, in charge of trading mortgage-related securities. The risk manager and the deputy were close friends, commuting together, fishing together, etc.

According to the article, this friendship between monitor and monitee "raised eyebrows inside the company among those concerned about its controls." People knew that if you wanted to push an especially risky investment, you went to the deputy, who would convince his friend that it was a risk worth taking. Considering losses of $65 billion, so far, there appear to have been an awful lots of risks one friend convinced the other to allow him to take.

One former executive from this group told the Times that risk management "has to be independent, and it wasn't independent at Citigroup."

The same thing goes for government. Conflicts of interest can be extremely damaging when they involve people who are supposed to be providing oversight. This is true in a number of areas, including procurement, finance, pensions, bonds, and legal advice. Take procurement. Politicians will often try to play games with procurement contracts, but they can do so only if there is no independent person overseeing procurement, that is, saying no to procurement practices that don't meet ethical or practical standards.

This also applies to consultants, for example, insurance specialists brought in to write or amend the specifications for the rebidding of an insurance contract. If such a specialist is somebody's friend or business associate, as so often happens, the specifications may be skewed toward one or another broker or company. It's easy to do this when the person overseeing the process is more interested in the interests of the person who hired him than in the public interest in getting the best price for insurance.

But, an official will protest, I'm going to hire someone I trust, not someone I don't know. But there are two kinds of trust: personal trust and professional trust. Hiring someone with a record of success and good recommendations will usually give you someone trustworthy, but not someone who will do your bidding. Who you trust should not be about who you know, but who will protect the interests of the public. Even if the person you know does great work and stands up to you, the appearance will be that the government is rewarding friends, and the friends are doing what the official asks them to do.

Robert Wechsler
Director of Research, City Ethics