Issuing equity research reports raises interest and encourages trading in a particular stock. Brokers earn commissions on these trades, regardless of the ex-post accuracy of their research. If analysts working for brokerage houses are rewarded based on induced trading commissions rather than on their accuracy, there is a conflict of interest between investors and brokers: An analyst uses her expertise to issue trade-inducing, not just return-predictive, recommendations. An investor expects recommendations to be return-predictive. In the EU, the Markets in Financial Instruments Directive II (MiFID II) aims to limit such misaligned incentives, but these are likely to remain in the other jurisdictions. Before tackling the problem, regulators should evaluate its magnitude. Yet, not only the magnitude but also the existence of this broker-turnover/analyst-compensation link has not yet been empirically examined due to highly protected access to information on personal income and typically aggregated trading data.
In my recent paper entitled ‘Incentives of Financial Analysts: Trading Turnover and Compensation’, I use a unique combination of personal income and broker-level trading data to study the extent to which broker companies reward sell-side security analysts for trade-inducing equity research. The Swedish setting provides an excellent laboratory to evaluate this question. Its stock market is sizeable, well-developed, and attractive to international investors, as many Swedish companies have cross-listings on foreign stock exchanges. Consistent with global trends, brokerage houses in Sweden issue relatively optimistic forecasts and analysts’ incomes are significantly higher than the mean population income.
I document a strong relationship between analysts’ compensations and the turnover that their research generates. For example, before the advent of MiFID, an analyst working for a large Swedish financial institution, Swedbank, changed a recommendation for Ericsson stock from hold to buy in 2002. The positive news raised the broker’s turnover by SEK 3.5 billion. According to my estimates, an analyst could expect a SEK 70,000 (about USD 9,000) reward for issuing such a trading-enhancing recommendation. European regulators have recently limited such trade-enhancing incentives with MiFID II. Other jurisdictions should follow this lead and also take into account that the turnover-pay relationship may vary in several scenarios.
First, the link varies across types of recommendations. Apparently, analysts receive a higher pay on turnover generated when they issue optimistic rather than accurate recommendations. A reward for optimistic research may raise a conflict of interest between analysts and investors. Analysts may be willing to give positive recommendations and benefit from additional trading commissions that they generate for the broker even though investors expect to receive return-predictive recommendations.
Second, turnover-pay relationship varies over time. In particular, I show that this link is sensitive to the changing importance of trading commissions in the research department’s total revenues. In the US, the ‘Global Analyst Research Settlement’ (GARS), an enforcement agreement between regulators and large investment firms aiming to address such conflict of interests, prohibited funding research departments with revenues from brokerage’s underwriting business, thereby raising the importance of revenues from trading commissions. Consistent with expectations, my findings indicate that the turnover-pay link was statistically insignificant in the pre-GARS sample period but became significant after GARS. The result is consistent with brokerage houses responding with commission-related bonuses to retain and reward analyst talent since underwriting-related analyst compensation had been restricted.
Third, turnover-pay relationship varies with broker-stock relations. Broker houses may have special relationships with some of the firms they cover. For example, when a full-service investment bank underwrites a firm’s security offering, the firm becomes closer to the financial institution and its research department. I show that in the after-GARS period, the turnover-pay link is almost eight times stronger when analysts’ research induces trading in investment banking clients’ stocks than in other stocks. This result is consistent with brokers indirectly compensating analysts for covering affiliated stocks after the direct compensation for covering such stocks was restricted.
My findings suggest that the GARS has had a strong effect on analyst compensation structure, the existence of conflicts of interest, and the quality of their research. Analysts face misaligned incentives, which are related to the trade-encouragement channel, and demand regulators’ attention. With the trading commissions falling over time, the importance of such trade encouragement may rise even further.
This study contributes to a current regulatory debate and supports the recent MiFID II framework, which requires investment firms to unbundle research fees from other fees and commissions. Such unbundling may help reduce the importance of the trading-turnover channel to pay for research services, which is an example of brokers’ misaligned incentives.
Egle Karmaziene is an Assistant Professor in Finance at the Vrije Universiteit Amsterdam.