Conflicts of Interest in Investment Banking Research
The Review of Financial Studies recently published an online version of Conflicts of Interest and Stock Recommendations: Evidence from the Global Settlement and Related Regulations, a paper co-authored by Assistant Professor Leonardo Madureira. The paper discusses the effects of regulations that attempted to mitigate the interdependence between research and investment bank departments of U.S. banks. Regulators expressed the need for such intervention given the evidence–both from academic studies, as well as the financial press–suggesting that financial analysts would bias their research output in order to attract investment banking business from the firm being covered.
The study looks at the stock recommendations issued by financial analysts. First, it corroborates the concerns of regulators by showing the role of conflicts of interest in shaping the research produced by the analysts: in the period before the regulations were in place, the analysts tended to be more optimistic towards firms for which the analysts’ employer also offered investment banking services.
More importantly, the research shows that the regulations have partially achieved their goal of reducing the conflicts of interest’s influence over analysts’ stock recommendations. After the regulations were adopted, the likelihood of issuing optimistic recommendations no longer depends on affiliation with the covered firm, although affiliated analysts are still reluctant to issue pessimistic recommendations.
That result came at some cost. Madureira and his team report that optimistic recommendations have become less frequent and more informative, whereas neutral and pessimistic recommendations have become more frequent and less informative. Yet, the overall informativeness of the recommendations has significantly decreased following the regulations. These results are consistent with a causal effect of the regulations on the informat iveness of stock recommendations.