Investment banking, securities analysis, and regulatory over-reaction

Remember Spitzer’s billion and half buck settlement and all the rules about separating investment banking and securities analysts? There's some recent data that casts doubt on whether investors were actually hurt, and therefore on whether all that regulation and litigation was justified.

The data is in a paper by McNichols, O’Brien & Pamukcu, That Ship has Sailed: Unaffiliated Analysts' Recommendation Performance for IPO Firms.  Here’s the abstract:

We examine whether unaffiliated financial analysts' Buy recommendations after IPOs earn higher returns than those of affiliated analysts during the 1994-2001 time period, when analysts working at investment banks are alleged to have been influenced by conflicts of interest. We extend the work of Michaely and Womack (1999), who studied 1990-1991 IPOs. While we confirm their result that investors tend to discount the recommendations of affiliated analysts, we do not find unaffiliated analyst recommendations earning higher abnormal buy-and-hold returns than recommendations from affiliated analyst at intervals of three, six or twelve months after the recommendation. Rather, our results show that the results vary considerably from year to year, with no evident time trend. Overall, we find that affiliated recommendations do not discriminate between good and bad IPO stocks, but unaffiliated recommendations generally arrive too late to provide useful trading advice.

The authors carefully state in their conclusion:

Our results do not mean that no investors were harmed by investment banking conflicts of interest, nor do they necessarily imply that recent regulatory changes were unwarranted. Our results do suggest, however, that the widely-cited MW result that affiliated analysts’ Buy recommendations lead to lower excess returns than those of unaffiliated analysts does not generalize outside their 1990-91 sample period. In particular, it does not generalize to the 1994- 2001 period when affiliated analysts allegedly succumbed to conflicts of interest and egregiously misled investors.

Although the authors don't draw a conclusion, I will: If investors who followed affiliated analysts were not hurt during 1994-2001 relative to those who followed unaffiliated advice, it's very difficult to justify the regulatory reaction. 

Comments

[Christine Hurt]

I don't have time to compare the two studies, but note that Barber, Lehavy and Trueman have come to the opposite conclusion studying 335,000 recommendations issued on more than 11,000 companies by 409 securities firms from 1996 to 2003. (Not just IPOs, which may shed light on the differences.) Both the buy recommendations and hold/sell recommendations of the independent research firms exceed the return for the investment banks significantly. the difference is exacerbated in bear markets. Brad M. Barber, Reuven Lehavy, & Brett Trueman, Comparing the Stock Recommendation Performance of Investment Banks and Independent Research Firms, available on SSRN. Just fuel for thought.