Wall Street’s Credibility Problem: Misaligned Incentives and Dubious Fixes?

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  • 1 January 2002
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      • Published in RePEc
Abstract
During 2001, investors, politicians, regulatory agencies, and the media have voiced a common sentiment: Wall Street has a credibility problem. Specifically, can the investing public trust the research analysis and recommendations they receive from Wall Street analysts? At issue is the independence and objectivity of sell-side analysts, a term applied to analysts that work for brokerage firms. Spring of 2001 brought media attacks on these analysts, with newspaper headlines such as The Financial Times’ “Shoot All the Analysts” and The Wall Street Journal’s “Outlook for Analysts: Skepticism and Blame”. Fortune even made analyst credibility a cover story with the title: “Can We Ever Trust Wall Street Again?” This paper attempts to address the question: What should we make of this brouhaha and what remedies are appropriate? It is quite clear that the major players, namely the brokerage firms, Congress, the Securities and Exchange Commission (SEC), and the Association for Investment Management and Research (AIMR), feel that something should be done and have already taken a number of actions. Several proposals have already been made through the trade association, the Securities Industry Association; and some individual brokerage firms have already unilaterally changed policies to stem the criticisms of ostensible conflicts of interest. Will the proposals offered by the brokerage industry fix what is broken? And perhaps more importantly, we should ask the important first question: What if anything is broken? We argue that at the heart of the credibility controversy are the disparate incentives of investment banks’ clients: while brokerage clients (“investors”) want unbiased research, most corporate financing clients (“issuers”) benefit from optimistic research. As corporate financing revenues dwarf brokerage commissions, investment banks face large incentives to maintain policies that favor issuers over investors. Furthermore, the managements of the corporations, the subjec
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