A conflict of interest arises when someone is not in a position to independently carry out their role or function. Independence is a necessary element in finance to prevent fraud or maintain credit quality. When someone cannot be independent in their role as an underwriter or lender, there is no telling what can happen.
In finance, you may see this manifested when a manager may be especially close with the loan applicant (perhaps a friend or family member). The applicant may expect the loan to be approved because of this close relationship, and the underwriter may fear they will upset their manager by not approving the loan. In this situation, the underwriter cannot make an independent decision. Or, even if he/she did make the decision independently, that independence is called into question.
Another way conflicts of interest come about is when a person has multiple roles to fulfill. For example, a bank or CU manager may also find themselves investing in commercial real estate. If that manager tries to get a real estate loan at the bank or CU he manages, what are the odds he will turn down his own loan? Here the manager is playing both the role as manager and borrower, calling into question whether he can truly make an objective decision keeping the institution’s best interest in mind over his own personal gain.
In banking, this conflict of interest is the basis for Regulation O, or Reg O for short. The Regulation limits how much a banking executive may borrower from the bank they supervise. This is done so the managers and board members don’t treat the bank as their personal funding source to finance projects, which may not have been adequately reviewed for credit risk.
The NCUA does limit some insider borrowing, but mostly stipulates they cannot get preferential treatment when borrowing. Reg O has similar provisions, which mostly state that insiders must pay the same interest rates and fees as everyone else.
Like all regulations, there gets to be a gray area with interpretation. Often, it isn’t clear if a board member or their businesses should be treated as insiders. However, the same conflict of interest issues arise. How would it look if a director of an institution has a business loan at that institution? Did the managers make that decision independently? Can they make that decision without fearing negative consequences professionally?
While there aren’t rules and regulations for every ethical dilemma, it is often best to simply avoid entangling your staff and managers in the debate. If the practice seems questionable, or there is clearly an area where independence can be debatable, often it is easier to make it internal policy to bow out.
While nobody likes to pass up good business opportunities, it is far more unpleasant to foreclose on directors or friends and families of managers. This will do more to damage relationships in the long run than any short-term decision to avoid insider issues.