Centre for Economic Policy Research

2.2
The problem of analysts’ compensation
The difficulty in setting appropriate compensation for analysts is a key factor 
contributing to the conflict of interest between research and underwriting. An
underlying problem is the appropriateness of the analysts’ information. The 
information generated by analysts for a bank’s investing customers is not a 
purely private good. Like the information produced by the ratings agencies, it is
to some degree a public good. As the disseminated information cannot be 
confined to the firm’s clients, it is difficult to set a price and charge them for the
information. Typically, brokerages do not charge clients for research, and research
14 Conflicts of Interest in the Financial Services Industry

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reports are usually provided free to institutional investor clients (Dugar and
Nathan, 1995). A further problem arises in the evaluation of analysts’ perform-
ance when there are divergences between their success at picking stocks and at 
correctly forecasting earnings and other fundamentals. During the recent boom,
some stock prices appeared to move far away from fundamentals, burnishing the
reputation of those who successfully picked stocks at the expense of those who
were more focused on fundamentals. 
Analysts’ research is thus often treated as an overhead and generates little direct
profit. If analysts operated only to advise investors, it might be desirable to tie
their compensation to the trading they help to generate. Michaely and Womack
(1999) caution, however, that many customers use the research information and
trade at firms that offer the best bids and offers independent of the source of 
information; and external reputation is often more important for analysts’ 
compensation.
3
External reputation is influenced by the annual Institutional
Investor’s All-American Research Team poll (Stickel, 1992).
4
The poll is based on
a questionnaire sent to money managers and institutions that asks them to rank
analysts on buy/sell recommendations, earnings forecasts, reports and overall
service. By industry, analysts are ranked one, two and three, and runner-ups.
5
Providing external certification, directors of equity research often use these results
to help set compensation levels. Yet, there remains considerable variation among
banks because of their differing emphasis on stock picking and earnings forecasts.
Because of these varied problems, it is difficult to set the compensation for the
analysts and there is considerable variation in compensation and promotion
schemes among firms, creating potential incentive problems.
Analysts’ reputation is important not just for attracting and retaining brokerage
customers.
6
Well-known analysts are considered to be an essential marketing tool
for investment banks in the IPO market. For example, when bankers do not have
an established relationship with a potential issuer, they often use the Institutional
Investor polls to promote their firm. In surveys of CEOs and CFOs whose firms
issued IPOs in the 1990s, approximately 75% indicated that the reputation of the
research department and the analysts in their industry were key factors in 
selecting a lead underwriter (Galant, 1992).
7
Analysts’ support is often considered