Diligence and Objectivity, Moral Hazard and Adverse Selection

61 Pages Posted: 12 Jul 2021 Last revised: 7 Mar 2022

See all articles by Rajeev R. Bhattacharya

Rajeev R. Bhattacharya

Washington Finance and Economics

Mahendra Gupta

Washington University, St. Louis

Date Written: March 5, 2022

Abstract

Diligence requires that the analyst-analyst-firm acquire and analyze non-public information, the probability of diligence asymptotically equals one minus the p-value of the Hausman Specification Test of Ordinary Least Squares versus Two Stage Least Squares regression of earnings forecast on management guidance and public information. The empirical probability of objectivity asymptotically equals the p-value of the Wald Test of zero versus non-zero coefficients in 2SLS regression of the earnings forecast residual on publicly available information. The empirical probability of moral hazard is one minus the product of the probabilities of diligence and objectivity. Under the additional condition that actual earnings are revealed at the end of each quarter, we find that ex post normalized accuracy is decreasing in the probability of moral hazard, we index adverse selection as a decreasing function of the residual of the regression of accuracy on the probability of moral hazard after controlling for all relevant public variables, and we index the quality of an analyst forecast as the product of one minus the index of adverse selection and the probability of diligence. We find that the probability of diligence, and the quality of an analyst forecast, improved significantly following FINRA 2241 (2015), albeit just enough to ameliorate the significant deteriorations that followed the Great Financial Crisis and Dodd-Frank, but contrary to regulatory intent, the probability of objectivity or moral hazard, the accuracy, or the index of adverse selection, did not improve significantly following FINRA 2241.

Keywords: Asymmetric Information; Analyst Forecasts; Management Guidance; Earnings; Moral Hazard; Adverse Selection; Diligence; Objectivity; Hausman Specification Test; Wald Test; Normalized Accuracy; Dot-Com Bubble; SOx; Global Analyst Research Settlements; Great Financial Crisis; Dodd-Frank; FINRA 2241

JEL Classification: G12; G14; G24; C23; C26

Suggested Citation

Bhattacharya, Rajeev and Gupta, Mahendra R., Diligence and Objectivity, Moral Hazard and Adverse Selection (March 5, 2022). Available at SSRN: https://ssrn.com/abstract=3883602 or http://dx.doi.org/10.2139/ssrn.3883602

Rajeev Bhattacharya (Contact Author)

Washington Finance and Economics ( email )

United States

HOME PAGE: http://washington-finance.com

Mahendra R. Gupta

Washington University, St. Louis ( email )

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