Leslie Boni ([email protected]) and Kent L. Womack ([email protected]),
“Wall Street’s Credibility Problem: Misaligned Incentives and Dubious Fixes?” Forthcoming in The Brookings–Wharton Papers in Financial Services, 2002. http://mba.tuck.dartmouth.edu/
Investors, politicians, regulatory authorities, and the media have voiced growing concern that conflicts of interest undermine the quality of research and stock recommendations of Wall Street brokerage houses’ sell-side analysts. These analysts have lost credibility, especially among small investors who feel they are victims of biased research.
According to two academics who have researched the issue, the disparate needs of investment banks’ different clients are at the heart of the controversy. “While brokerage clients (investors) want unbiased research, most corporate finance clients (issuers) benefit from optimistic research,” note Leslie Boni, assistant professor of finance at the Anderson Schools of Management at the University of New Mexico, and Kent L. Womack, associate professor of finance at the Amos Tuck School of Business Administration at Dartmouth College. This, they argue, creates “misaligned incentives” that undermine the objectivity of analyst research.
Professors Boni and Womack examined a number of pressures analysts may face. There are internal pressures from analysts’ employers to increase brokerage commissions or investment banking business. And there are external pressures from the management of the firms the analyst covers (i.e., management can restrict access to privileged information if the analyst fails to toe the company line). Analysts must also answer to institutional investor clients who may not want a company’s stock downgraded if they have a substantial holding. In addition, analysts’ personal investments can cause conflicts of interest.
In their analysis, the authors emphasize three points. First, the main reason brokerage firms employ analysts to do investment research is to encourage client transactions in stocks and bonds, and to facilitate underwriting. In reality, analysts are marketers earning commissions and fees on the volume of transactions, rather than independent truth tellers.
Second, the management of the firms covered by Wall Street analysts decides which analysts will receive so-called nonmaterial information, such as information about strategy or long-term plans. Analysts who make recommendations unfavorable to those firms risk being cut out of the loop.
Third, the authors argue, professional fund managers understand the biases inherent in the system and are able to read between the lines. They filter and interpret the analysts’ recommendations — and often employ their own analysts. Small investors, on the other hand, do not necessarily understand the pressures acting on analysts or the nuances of their signals. “Without adequate education,” the authors conclude, “[small investors] will continue to be disadvantaged when they do not understand that ‘buy’ may not mean ‘buy’ and ‘hold’ definitely means ‘sell.’”
Reforms currently proposed by regulators and brokerage firms include restricting analysts’ personal investments, increasing disclosure requirements, reinforcing “Chinese firewalls” that separate investment banking from research, better investor education, and expanding independent research services. But unless reforms confront the issue of misaligned incentives, professors Boni and Womack argue, they are unlikely to restore Wall Street’s research credibility.
Public Policy Impacts Innovation
Scott D. Anthony ([email protected]), Erik A. Roth ([email protected]), and Clayton M. Christensen ([email protected]), “The Policymaker’s Dilemma: The Impact of Government Intervention on Innovation in the Telecommunications Industry,” Harvard Business School Working Paper Number 02-075, April 2002. www.hbs.edu/dor/abstracts/0102/02-075.html
Policymaking is fraught with difficulties. Even the best intentions can have unintended consequences. The problems are especially acute when it comes to crafting public policy to promote competition and innovation in highly regulated industries.
Applying his considerable experience to this issue is Clayton M. Christensen, the Robert and Jane Cizik Professor of Business Administration at Harvard Business School and author of The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail (Harvard Business School Press, 1997). Professor Christensen and two Harvard research associates, Scott D. Anthony and Erik A. Roth, use the U.S. telecommunications industry to analyze the relationship between government intervention and innovation. Their conclusion is that although government action can have a large impact on the market for innovation, the relationship between policy and innovation is more complex than was previously understood.