Analyst Investment Banking Incentives: The Impact of Regulation on Analyst and Investor Behaviour and Deal Flow

Abstract

In 2002 and 2003, a series of regulatory reforms (e.g. the Global Settlement or the ‘GS’; the Self-Regulatory Organization Rules or the ‘SRO Rules’) were introduced which intended to curb analysts’ potential conflicts of interest arising from their investment banking incentives. My thesis examines whether and how the 2002/3 reforms affect the quality of primary analyst outputs and their consequent impacts on investors and brokers’ investment banking deal flow. Specifically, I focus on the effect of three regulatory provisions. The first provision is the disclosure requirements of NASD 2711 under the SRO Rules in 2002, which induced many brokers to change their recommendation ratings systems from a five-tier to a three-tier scale. The second provision is the five-year mandatory procurement of independent research required by the GS and expired in 2009, which aimed to enhance analyst independence and eliminate bias in analyst reports. The third provision is the relaxation of restrictions imposed in 2002/3 on analyst involvement in equity underwriting activities entailed in the JOBS Act of 2012. With regards to the impact of these provisions on analyst optimism, I find a reduction in analyst optimism of recommendations issued by analysts whose employer changed rating systems from a five-tier to three-tier system following the disclosure requirements of NASD 2711. I find neither an increase in the optimism of analysts employed by the GS signatories following the 2009/10 expiration nor an increase in the optimism of affiliated analysts covering emerging growth companies (‘EGCs’) following the JOBS Act. With regards to the impact of these provisions on informativeness and profitability of recommendations. I find no significant difference in informativeness of recommendations following the 2002/3 reforms no matter whether or not analysts changed to use the three-tier ratings system following NASD 2711. Further, I find a reduction in the informativeness of ‘buy-type’ post-IPO/SEO recommendations issued by analysts employed by GS-signatory brokers following the 2009/10 expiration and an increase in the informativeness of the ‘hold and sell-type’ recommendations issued by affiliated analysts covering EGCs after the JOBS Act, together providing some evidence suggesting an increase in the perceived bias of these analysts. I find no significant effect of three provisions on improving the profitability of analysts’ ‘buy-type’ recommendations. Finally, with regards to the impact of these provisions on the extent to which analyst optimism affects brokers’ subsequent deal flow. I find that less extent of the association between historical optimism and brokers’ future deal flow in equity underwriting business after the 2002/3 reforms for brokers who switched to use the three-tier ratings system following the disclosure requirements of NASD 2711. I also find the 2009/10 expiration of funding independent research does not affect this association in this regard. Show more