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Motivated to Change: Implications of the Global Analyst Research Settlement

June 28, 2017

Two of the primary functions of investment banks are company and market analysis, and traditional investment banking with capital raising services. Analysts provide research covering growth opportunity, earnings outlooks, and provide buy, sell or hold ratings. Meanwhile, the investment bankers are responsible for selling securities, providing loans, mergers and acquisitions, as well as other fee-related activities. When an investment bank is trying to acquire a business and its' analysts are rating the same business, the opportunity for bias becomes apparent.

"It's well documented that banks that have relationships with firms provide biased coverage. So if I have a lending relationship with you, and I provide analyst coverage, my analysts are on average a little more optimistic than the average analyst," Associate Professor and Chair of the Department of Finance, Insurance & Real Estate Mike Stegemoller said. "It's very much like me convincing someone to come to Baylor… I'm a little biased."

In the late 1990s, during the tech bubble, bias was prevalent. In what was referred to as "pumping and dumping," analysts would bolster ratings for the betterment of the investment banking side of the company.

"Before the stock went public, the analyst coverage would be, ‘Oh, this is going to be a great stock! You should buy, buy, buy.' And then, the same firm who was providing that analyst coverage would take the firm public, and then these analysts would tell their best clients to dump the stock. So it's pump it up, take it public, then dump," Stegemoller explained.

Led by the then New York Attorney General Eliot Spitzer, Wall Street conflicts of interest were uncovered and put to an end with the 2003 Global Analyst Research Settlement, which required 12 of the top investment banks and analysts to be heavily fined ($1.2 billion amongst them). Simultaneously, new regulations designed to separate analysts from bankers were put into place.

Now, nearly 15 years later, Stegemoller sought to examine the prevalence of bias before and after the settlement.

"After the settlement, the bias in those top 12 banks, essentially, disappears," he said. "They don't provide overly optimistic coverage. The other banks, that didn't have to pay out penalties, they get worse. They get more biased, actually."

With co-authors Shane Corwin and Stephannie Larocque of the University of Notre Dame, Stegemoller found the evidence consistent with the financial penalty for the 12 creating a change in their company culture. The expected costs of biased coverage outweighed the expected benefit, so they adapted. The effect increased over time as new analysts and bankers were hired and trained according to the new regulations imposed by the Securities and Exchange Commission (SEC).

But, with smaller firms that were not given consequences for biased policies, the researchers found there was little to no behavioral change. Without discipline, the evidence suggested, those investment bankers and analysts who were not penalized continued their questionable tactics and mutually beneficial relationships.

"What we're saying is, you can't just give people rules if they're doing something wrong, you have to penalize them," Stegemoller said. "Our paper basically shows that the expected benefits of this biased coverage didn't outweigh the expected costs for those 12 firms because they knew what the costs were."

The article, "Investment Banking Relationships and Analyst Affiliation Bias: The Impact of Global Settlement on Sanctioned and Non-Sanctioned Banks," was published in the Journal of Financial Economics.

The article utilized a relationship measure created by Stegemoller and Corwin, which provides a comprehensive evaluation of banks' relationships with debt, mergers and acquisitions, equity and other factors. The measure itself has been a labor of love; Stegemoller remarks that the duo began work on it before his now 9-year-old twins were born.

"Our relationship measure is a very comprehensive measure," he said. "I'd say it is the best measure of the relationship between banks and firms."

He plans to continue in this line of research, with the aid of the robust relationship measure, looking into how the investment banking industry has changed over time and how it continues to change as the industry consolidates.

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