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  1. 1. <ul><li>Investment Banks, </li></ul><ul><li>Scope Economies, and Unavoidable Conflicts of Interest </li></ul><ul><li>Erik R. Sirri </li></ul><ul><li>Babson College </li></ul><ul><li>Atlanta Fed Conference </li></ul><ul><li>Sea Island, GA </li></ul>
  2. 2. To be an investment bank is to be conflicted Retail Advisory Asset Management Merchant Banking Proprietary Trading Underwriting M&A Sales & Trading Structured Finance Research  Flow of information is a first-order issue in a bank Investment Bank
  3. 3. 2003 Revenue of investment banking industry Source: Securities Industry Association
  4. 4. Revenue of investment banks For UBS, “Other” includes Commissions, Principal transactions, and NIP
  5. 5. What do analysts do? <ul><li>Forecasts of earnings and prices </li></ul><ul><li>Buy/Sell recommendations </li></ul><ul><ul><li>An implied trust guarantee here (a la Corrigan)? </li></ul></ul><ul><li>Due diligence work on transactions </li></ul><ul><li>Filtering of investment banking deals </li></ul><ul><li>Provide institutional investors access to research companies and corporate finance clients </li></ul>
  6. 6. Analysts inside the investment bank <ul><li>Research is universally regarded as a cost center. How do you want to pay for it post-1975? </li></ul><ul><li>It was commonly known that analysts spent huge amounts of their time of investment banking (> 80% as cited in Inst. Inv. in 1992) </li></ul><ul><li>Compensation was traditionally funded by levies on investment banking and equity trading (retail and institutional) </li></ul>
  7. 7. Early work on banking vs. research conflicts <ul><li>Buy recommendations are at least seven times more likely than sell recommendations </li></ul><ul><li>Lead underwriter analysts issue more buys than non-underwriter analysts </li></ul><ul><li>BUT , later research painted a much more complete picture as questions became more focused and datasets expanded….. </li></ul>
  8. 8. Comparison of “investment banking,” “brokerage only,” and “pure research” firms <ul><li>Analysts at large banks have the least optimistic earnings forecasts </li></ul><ul><li>Analysts at large banks have the most accurate earnings forecasts </li></ul><ul><li>Analysts at large banks have earlier forecasts than research firms </li></ul><ul><li>Price-target forecasts of underwriter analysts are least optimistic </li></ul>
  9. 9. Comparison (continued) <ul><li>Upgrades of recommendations by investment banks are more informative than the other groups, and long-term performance is “+” </li></ul><ul><li>When analysts move from “pure research” or “brokerage only” firms to “investment banks,” recommendations and forecasts do not change </li></ul><ul><li>“Brokerage only” firms appear to be the least accurate and most optimistic of the three groups </li></ul>
  10. 10. Banking vs. brokerage conflicts <ul><li>74% of CFOs of firms about to IPO say that research quality of the investment bank is one of if not the most important trait in selecting an underwriter (and some interview the analysts!!) </li></ul><ul><li>55% of firms that switch underwriters between IPO and secondary offering cite bank research quality and reputation as the key reason </li></ul><ul><li>Using ten years and over 16,500 underwritings, researchers find no evidence than analyst recommendation behavior affects likelihood of the bank winning the underwriting mandate </li></ul>
  11. 11. Investment banks face other conflicts <ul><li>Conflicts that are wholly internal to the bank </li></ul><ul><ul><li>Sales/trading vs. research (peeking) </li></ul></ul><ul><ul><li>Prop. trading vs. retail advisory (retail order flow) </li></ul></ul><ul><li>Conflicts that are exacerbated by incentives of bank customers </li></ul><ul><ul><li>Institutional investors vs. research (analyst downgrades) </li></ul></ul><ul><ul><li>Underwriting and sales/trading (IPOs and laddering) </li></ul></ul><ul><ul><li>Research vs. retail advisory (sponsored research) </li></ul></ul>
  12. 12. Terms of the global settlement <ul><li>Separation of banking and research </li></ul><ul><ul><li>Physical, economic, and informational separation </li></ul></ul><ul><ul><li>Investment banking has no say in research’s budget </li></ul></ul><ul><ul><li>Analyst comp. not based on banking results </li></ul></ul><ul><ul><li>No analyst role in road shows or selling deals </li></ul></ul><ul><li>Provision of additional information </li></ul><ul><ul><li>Warnings, disclosures, analyst track records </li></ul></ul><ul><ul><li>Investor access to independent research </li></ul></ul>
  13. 13. Observations <ul><li>There is little evidence that actions of conflicted analysts harmed investors </li></ul><ul><ul><li>Judge Pollack and Merrill Lynch case </li></ul></ul><ul><ul><li>Morgan Stanley and LVMH </li></ul></ul><ul><li>Academic evidence indicates that bank analysts are the most conservative, and the market adjusts for analyst biases </li></ul><ul><ul><li>Look to the brokers for retail harm, not the analysts </li></ul></ul><ul><li>Post settlement, buy/sell ratios are 3.8 for the ten settlement banks and 8.1 for seven other mid-sized banks </li></ul>
  14. 14. Fewer scope economies mean less research <ul><li>The isolation of analysts will diminish their use to the bank and may result in a decrease of scope economies (due diligence, access for clients, knowledge of markets and issuers, etc.) </li></ul><ul><ul><li>As usage falls, so does analysts’ marginal product and thus their wage </li></ul></ul><ul><ul><li>This will likely attract fewer good analysts to the sell side </li></ul></ul><ul><ul><li>The same bank could say “buy” while it is selling, or may perhaps produce conflicting but independent statements </li></ul></ul><ul><li>These analysts were the least optimistic and most accurate! </li></ul>
  15. 15. What are we to make of the settlement’s emphasis on “independent” research? <ul><li>Q : Why is there no real independent research presence today? (P. Healy says .1% of calls) </li></ul><ul><li>A : Because there is no business model for the sale of pure research (Hirshleifer 1971) </li></ul><ul><ul><li>Sell it at what price </li></ul></ul><ul><ul><li>How to sell it a second time </li></ul></ul><ul><ul><li>If it is good information, use it as principal </li></ul></ul>
  16. 16. What do existing “research” firms do? <ul><li>Rating agencies </li></ul><ul><ul><li>Give away the core research for free and get paid by issuers that they rate </li></ul></ul><ul><ul><li>Missed Enron, WorldCom, the 1990s bubble anyway, even with a Reg. FD exemption </li></ul></ul><ul><li>Morningstar  loses money with 90+% market share of fund flows and needs a new revenue model </li></ul><ul><li>Third-party research firms </li></ul><ul><ul><li>Directed brokerage (S&P, Bernstein) </li></ul></ul><ul><ul><li>Soft dollars, the subject of a separate set of reforms, that could end up favoring large banks </li></ul></ul>
  17. 17. The settlement requires independent research without a viable and scalable business model for such a product, while at the same time promoting other potentially serious conflicts, and isolates the class of analysts that provided the least biased and most accurate investment pronouncements
  18. 18. Summary <ul><li>Stock price reactions to analyst pronouncements recognize and adjust for analyst conflicts of interest </li></ul><ul><li>Separation of banking and research may lead to a drop in research quality and precision with little or no gain in investor welfare—it is just one of MANY conflicts! </li></ul><ul><li>No viable model or basis for elevating independent research at the expense of other types of research </li></ul><ul><li>Before casting the settlement into rules and law, look at the data and the institutional realities </li></ul>