Brookings-Wharton Papers on Financial Services 2002 (2002) 93-130
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Wall Street's Credibility Problem:
Misaligned Incentives and Dubious Fixes?
Leslie Boni and Kent L. Womack
DURING 2001 INVESTORS, politicians, regulatory agencies, and the media voiced a common sentiment: Wall Street has a credibility problem. Specifically, can the investing public trust the research, analysis, and recommendations they receive from Wall Street analysts? At issue are the independence and objectivity of sell-side analysts, a term applied to analysts who work for brokerage firms. 1
Spring of 2001 brought media attacks on these analysts, with newspaper headlines such as the Financial Times' "Shoot All the Analysts" and the Wall Street Journal's "Outlook for Analysts: Skepticism and Blame." Fortune even made the credibility of analysts a cover story with the title "Can We Ever Trust Wall Street Again?" 2
This paper attempts to address the questions, What should we make of this brouhaha, and what remedies are appropriate? Major players—namely, the brokerage firms, Congress, the Securities and Exchange Commission (SEC), and the Association for Investment Management and Research (AIMR)—clearly feel that something should be done and have already taken a number of actions. Several proposals have been made [End Page 93] through the trade association—the Securities Industry Association—and some individual brokerage firms have unilaterally changed policies to stem the criticisms of ostensible conflicts of interest. Will the proposals offered by the brokerage industry fix what is broken? And perhaps more important, we should ask the essential first question, What, if anything, is broken?
This paper argues that at the heart of the credibility controversy are the disparate incentives of investment banks' clients: while brokerage clients (investors) want unbiased research, most corporate financing clients (issuers) benefit from optimistic research. As corporate financing revenues dwarf brokerage commissions, investment banks face large incentives to maintain policies that favor issuers over investors. Furthermore, the managements of the corporations—the subjects of brokerage research—provide an additional incentive to analysts: issue positive research and maintain direct access to valuable future information or risk being shut out by management entirely. We conclude that although the fixes proposed and already undertaken may improve credibility, they are unlikely to be substantial remedies because they do not address the critical issue of these misaligned incentives.
We also conclude that institutional investors, aware of analysts' conflicts of interest, are able to de-bias the brokerage research they receive by maintaining their own in-house research staffs and purchasing independent research services. The disenfranchised are largely the individual investors, who lack the awareness or education necessary to adequately filter the recommendations of brokerage research analysts.
We begin our examination by providing background on the controversy. We next summarize the evidence from relevant academic work that demonstrates the value of brokerage research for investors and the limitations of that value. We then discuss explanations for biases toward optimism that have been documented for brokerage earnings forecasts and recommendations, including incentives by and pressures from the analyst's employer, from the companies the analyst reports about, and from institutional investors. Next we analyze a number of proposals and actions that attempt to strengthen the objectivity and independence of brokerage research. Finally, we conclude by raising several issues that we believe are most critical to understanding the credibility controversy, and we cast doubt on the success of recently proposed fixes. [End Page 94]
Not only has the financial press written scathing attacks, but professional investment managers also have expressed increasing doubts over research they receive from Wall Street analysts. In the April 2001 issue of Institutional Investor, Deborah Kuenstner, chief investment officer for large-cap value stocks at Putnam Investments, stated, "Our approach to the market generally has been that sell-side analysts are serving so many masters besides us that we increasingly need to rely on our own research." 3 Money managers also have voiced concern that the recommendations of sell-side analysts are less credible because the analysts sometimes have a personal stake in the stocks they recommend. Discussing...