Investment Banks, Scope Economies, and

Unavoidable Conflicts of Interest

Erik R. Sirri

Babson College

Atlanta Fed Conference

Sea Island, GA

To be an investment bank is to be conflicted

Retail Advisory

Investment Bank

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

2003 Revenue of investment banking industry

Source: Securities Industry Association

Commissions 17.8%Trading Gain (Loss) 16.0%Investment Account Gain (Loss) 1.5%Underwriting Revenue 10.4% --- Equity Underwriting Revenue 2.6%Mutual Fund Sale Revenue 4.2%Fees, Asset Management 8.1%Research Revenue 0.1%Commodities Revenue -1.3%Other Revenue Related to the Securities Business 33.1%Other Revenue 6.7%TOTAL REVENUE 100.0%

Revenue of investment banks

For UBS, “Other” includes Commissions, Principal transactions, and NIP

Merrill MSDW UBS

Asset management 23.2% 19.8% 55.2%Commissions 22.2% 15.9% 0.0%Principal transactions 15.2% 33.2% 0.0%Investment banking 13.1% 13.1% 6.5%Net interest profit 20.2% 15.5% 0.0%Other 6.1% 2.4% 38.3%

100.0% 100.0% 100.0%

What do analysts do?

Forecasts of earnings and prices

Buy/Sell recommendations– An implied trust guarantee here (a la Corrigan)?

Due diligence work on transactions

Filtering of investment banking deals

Provide institutional investors access to research companies and corporate finance clients

Analysts inside the investment bank

Research is universally regarded as a cost center. How do you want to pay for it post-1975?

It was commonly known that analysts spent huge amounts of their time of investment banking (> 80% as cited in Inst. Inv. in 1992)

Compensation was traditionally funded by levies on investment banking and equity trading (retail and institutional)

Early work on banking vs. research conflicts

Buy recommendations are at least seven times more likely than sell recommendations

Lead underwriter analysts issue more buys than non-underwriter analysts

BUT, later research painted a much more complete picture as questions became more focused and datasets expanded…..

Comparison of “investment banking,” “brokerage only,” and “pure research” firms

Analysts at large banks have the least optimistic earnings forecasts

Analysts at large banks have the most accurate earnings forecasts

Analysts at large banks have earlier forecasts than research firms

Price-target forecasts of underwriter analysts are least optimistic

Comparison (continued)

Upgrades of recommendations by investment banks are more informative than the other groups, and long-term performance is “+”

When analysts move from “pure research” or “brokerage only” firms to “investment banks,” recommendations and forecasts do not change

“Brokerage only” firms appear to be the least accurate and most optimistic of the three groups

Banking vs. brokerage conflicts

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!!)

55% of firms that switch underwriters between IPO and secondary offering cite bank research quality and reputation as the key reason

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

Investment banks face other conflicts

Conflicts that are wholly internal to the bank– Sales/trading vs. research (peeking)– Prop. trading vs. retail advisory (retail order flow)

Conflicts that are exacerbated by incentives of bank customers– Institutional investors vs. research (analyst

downgrades)– Underwriting and sales/trading (IPOs and

laddering)– Research vs. retail advisory (sponsored research)

Terms of the global settlement

1. Separation of banking and research– Physical, economic, and informational separation– Investment banking has no say in research’s

budget– Analyst comp. not based on banking results– No analyst role in road shows or selling deals

2. Provision of additional information– Warnings, disclosures, analyst track records– Investor access to independent research

Observations There is little evidence that actions of conflicted

analysts harmed investors– Judge Pollack and Merrill Lynch case– Morgan Stanley and LVMH

Academic evidence indicates that bank analysts are the most conservative, and the market adjusts for analyst biases– Look to the brokers for retail harm, not the analysts

Post settlement, buy/sell ratios are 3.8 for the ten settlement banks and 8.1 for seven other mid-sized banks

Fewer scope economies mean less research

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.)– As usage falls, so does analysts’ marginal product and thus

their wage– This will likely attract fewer good analysts to the sell side– The same bank could say “buy” while it is selling, or may

perhaps produce conflicting but independent statements

These analysts were the least optimistic and most accurate!

What are we to make of the settlement’s emphasis on “independent” research?

Q: Why is there no real independent research presence today? (P. Healy says .1% of calls)

A: Because there is no business model for the sale of pure research (Hirshleifer 1971)– Sell it at what price– How to sell it a second time– If it is good information, use it as principal

What do existing “research” firms do?

Rating agencies– Give away the core research for free and get paid by issuers

that they rate– Missed Enron, WorldCom, the 1990s bubble anyway, even

with a Reg. FD exemption

Morningstar loses money with 90+% market share of fund flows and needs a new revenue model

Third-party research firms– Directed brokerage (S&P, Bernstein)– Soft dollars, the subject of a separate set of reforms, that

could end up favoring large banks

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

Summary

Stock price reactions to analyst pronouncements recognize and adjust for analyst conflicts of interest

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!

No viable model or basis for elevating independent research at the expense of other types of research

Before casting the settlement into rules and law, look at the data and the institutional realities