Wall Street’s Credibility Problem: Misaligned Incentives and Dubious Fixes?

During 2001, investors, politicians, regulatory agencies, and the media have 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 is the independence and objectivity of sell-side analysts, a term applied to analysts that work for brokerage firms. 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 analyst credibility a cover story with the title: “Can We Ever Trust Wall Street Again?” This paper attempts to address the question: What should we make of this brouhaha and what remedies are appropriate? It is quite clear that the major players, namely the brokerage firms, Congress, the Securities and Exchange Commission (SEC), and the Association for Investment Management and Research (AIMR), feel that something should be done and have already taken a number of actions. Several proposals have already been made through the trade association, the Securities Industry Association; and some individual brokerage firms have already 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 importantly, we should ask the important first question: What if anything is broken? We argue 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 while 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, and consequently maintain their own in-house research staffs and purchase independent research services. The disenfranchised are largely the individual investors, who lack the awareness or education necessary to adequately filter brokerage research recommendations. We begin our examination by providing background on the controversy. We next summarize the evidence from relevant academic work that demonstrates the value brokerage research can have for investors and the limitations of that value. We then discuss explanations for optimism biases 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 increase brokerage research objectivity and independence. 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.