Are Analysts’ Recommendations for Other Investment Banks Biased?

• Author: Erik Devos
• DOI: http://doi.org/10.1111/fima.12031
• Date: 01 June 2014
• Published date: 01 June 2014

Are Analysts’ Recommendations for

Other Investment Banks Biased?

Erik Devos∗

This paper provides evidence of a “Potential conflict of interest by equity analysts” who issue

recommendations for investment banks that are related to their own bank through syndication.

Analysts issue significantly more optimistic recommendations for investment banks with which

their bank is syndicated. Recommending banks upgrade their recommendations just before a

relation is initiated, suggesting that they use analyst optimism as a means of currying favor with

the syndicate lead in hopes of being invited to join. It also appears that as part of a quid pro quo

of sorts, relatively optimistic recommendations are rewarded with more syndicate appointments

in the year after the recommendations.

Given the enormous fees generated by underwriting bond and stock offerings,1it is not

surprising that investment banks compete vigorously to lead or be members of syndicates chosen

to bring issues to the market. In addition, lower rankedinvestment banks are motivated to become

members of syndicates since being even a lower ranked syndicate member can be a precursor

to becoming a lead manager for later issues (Ljungqvist, Marston, and Wilhelm, 2009). Hence,

good relations with other syndicate banks, particularly good relations with lead managers who

create syndicates,2can be of critical importance.

The incentive to establish and maintain good relations with other banks creates a potential con-

flict of interest for analysts who workfor one investment bank and recommend the stocks of other

investment banks.3,4 This paper provides evidence that this potential conflict is manifest in the

recommendation behavior of analysts by demonstrating that recommending banks are relatively

optimistic regarding the stocks of covered banks to which they are related through syndication

(i.e., both banks participate in the same syndicate(s) in the year prior to the recommendation). I

discover two reasons for this optimistic bias. First, it appears that banks are more optimistic in

order to gain admission to syndicates. Second, remaining optimistic once within the syndicate is

I thank two anonymous refereesGauri Bhat (AAA discussant), Liz Devos, Bill Elliott, Srinivasan Krishnamurthy, Stephan-

nie Larocque, Rajesh Narayanan,Andrew Prevost Raghu Rau (editor), Keke Song (FMA discussant), and seminar partic-

ipants at the University of New Mexico,the University of Texas at El Paso,AAA meetings, and FMA meetings for valuable

comments. I would like to thank He Li, Shofiqur Rahman, and Jim Schneringer for providingexcellent research assistance

and Wendy Jenningsfor providing editing services. I gratefully acknowledge the contribution of Thomson Financial for

providing earnings per share forecast data available through the Institutional BrokersEstimate System. This data have

been provided as part of a broadacademic program to encourage earnings expectations.

∗Erik Devos is the WellsFargo Professor of FinancialServices and Professor at the University of Texas at El Paso,in El

Pas o, TX .

1For example, in 2003, the combined fees of debt and equity underwriting were $15.4 billion (Thomson Financial

Securities Data).

2In recent years, issuers may have had a more activerole in picking the other syndicate members; however, one would

expect that the lead manager still has substantial influence in choosing the rest of the syndicate.

3I use the term “bank” to refer collectively to pure-playinvestment banks as well as diversified financial institutions such

as JP Morgan Chase and Bank of America.

4In this light it is important to note that relatively optimistic recommendations lead to substantially higher stock price

increases (e.g., Kadan et al., 2009, among many others).

Financial Management •Summer 2014 •pages 327 - 353

328 Financial Management rSummer 2014

Figure 1. The Relative Importance of Investment Bank Recommendations

This figure illustrates the relative importance of recommendations for investment banks from 1994 to 2010.

The figure indicates the ratio of all recommendations for investment banks to all recommendations for US

firms (from IBES), both raw and weighted, by equity value(from CRSP). The f igure also presents the ratio

of the equity market cap of these investment banks relative to all US firms and relative to all US financial

firms (one-digit SIC code equals 6 from CSRP).

rewarded as a quid pro of sorts with future syndicate membership. I find no convincing evidence

that the underwriter rankings or credit ratings of investment banks are of much importance with

regard to my results.

Although the analysis in this paper is based on a subset of all recommendations (i.e., those

issued for investment banks), they represent a surprisingly large part of the US economy. Fig-

ure 1 reports that the percentage of recommendations issued for investment banks is about

2% of all recommendations that are issued during the sample period. However, when these