Conflict or Credibility: Analyst Conflicts of Interest and the Market for Underwriting Business

Abstract:     
This paper argues that, contrary to conventional wisdom, conflicts of interest among equities research analysts (i.e., where investment banks would offer positive analyst research in quid pro quos for underwriting business) were beneficial to the capital markets. First, conflicted analyst research credibly signaled positive inside information that is otherwise too costly to communicate under 1933 Act liability, correcting adverse-selection problems. Second, conflicted analyst research mitigated agency costs between issuer and underwriter by allowing the underwriter to credibly commit to seek a higher offering price than the underwriter would prefer. Third, analyst research quid pro quos took the form of a competitive bidding market among underwriters, and may have improved competition in the underwriting industry. In light of these conclusions, recent reforms prohibiting analyst conflicts of interest do more harm than good. Preferable modes of regulation include liberalizing 1933 Act liability, increasing mandatory disclosure of conflicts, and increasing fraud penalties.

Keywords: investing, equities, research analysts, capital markets

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