Thursday, June 23, 2005

Conflicts of Interest, Regulations, and Stock Recommendations by Leonardo Madureira

Does regulation change behavior? That is the question that Madureira asks. To examine this question Madureira examines whether regulations on sell-side research recommendations changed following the "increased scrutiny of their equity research business regarding conflicts of interest driven by investment bank relationships."

And the answer? Yes. Behavior (at least in the short run has changed.)

SSRN-Conflicts of Interest, Regulations, and Stock Recommendations by Leonardo Madureira

Some highlights:

The paper investigates "changes in the behavior of brokerage houses through recommendations they issued for US common stocks between July 1995 and December 2003"

The author summarizes the paper:
"Prior to the new regulations, brokerage houses disproportionately issued upbeat (strong buy and buy) recommendations-- with sell recommendations being virtually absent from the sample....However, the period after regulations were adopted reveals significant changes in these distributions. Every brokerage house started issuing more hold and pessimistic (underperform or sell) recommendations and less
optimistic (strong buy and buy) ones, but the big difference is in the cross-sectional dimension. Big 10 brokerage houses now issue pessimistic recommendations much more aggressively. "
An important aspect of this is whether the recommendations matter. The author replies, yes they do matter (shock) and that prior to these changes, investors were somewhat tricked by the recommendations. From the paper:
"there is evidence that heterogeneous investors use sell-side research
differently (Boni and Womack (2002b, 2003b), Malmendier and Shanthikumar (2004)), with retail investors acting naively by failing to adjust for clear biases in analystsÂ’ stock recommendations. That conflicts of interest matter highlights the importance of investigating the impact of regulations specifically designed to cope with them."
It is duly noted (in a footnote) that this appears to conflict with the findings of Agrawal and Chen who find that investors could see through the conflicts and hence discounted biased recommendations.

Another interesting piece (which may weaken the claim that investors were duped) is that there was no initial reaction to the new ratings. Again from the paper:
"Analysis of market reactions to recommendations when the new regulations took effect indicates that investors were initially dismissive of the increase in pessimistic recommendations by the big 10 brokerage houses. Returns associated with recommendations during the adoption of new ratings systems-- when the new patterns of more balanced distribution were achieved--— do not show the usual pattern of positive (negative) event and future returns associated with optimistic
(pessimistic) recommendations."

Cool paper.

Madureira, Leonardo, "Conflicts of Interest, Regulations, and Stock Recommendations" (November 2004).

No comments: