Centre for Economic Policy Research

part of an implicit understanding between underwriter and issuer. Positive rec-
ommendations after an IPO may also ensure that an underwriter will be chosen
to lead the firm’s next issue. As a result, by helping to attract issuers, analysts
make important contributions to a bank’s revenue; and thus their compensation
may be linked to the bank’s underwriting activity. 
Analysts’ specialized knowledge also leads them to facilitate meetings between
institutional investors and companies. In addition, some analysts provide an 
additional service to underwriters by screening companies that are coming to 
market. By watching specific industries, analysts observe and gather information
about firms, sometimes long before they are ready to issue securities. This 
activity puts them in a position to encourage or discourage investment bankers to
assist these firms with corporate financing.
If they are compensated by both the brokerage and underwriting departments,
there is a strong conflict of interest potential for analysts. Analysts may offer
excessively bullish opinions about stocks to attract new corporate issuers, at the
expense of investing customers. Even if incentives are correctly aligned, there may
be pressure to bias their reports from corporate finance departments that desire
analysts to follow issues and maintain positive recommendations of a current or
potential issuer. The conflict of interest will be most acute if the IPO market is
highly profitable relative to brokerage. Thus, the short-term payoff for an analyst
may outweigh the benefits of investing in a long-term reputation in a soaring
Investment Banking: Conflicts of Interest in Underwriting and Research 15

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market. The temptation would be to seize the reputational rents with a short-term
guaranteed contract while promoting ‘hot’ issues. 
Given the important role and booming IPO markets of the 1990s, it is not 
surprising that a huge amount of attention in the financial media was devoted to
analysts’ pronouncements. When prices appeared to deviate from their historic
relationship with fundamentals, meeting earnings expectations or changes in 
ratings or price targets had dramatic effects on investor sentiment. Whereas 
analysts were little known in the past, some became media stars in the 1990s,
reaching out to millions of investors via television and the internet and attaining
celebrity status. The financial press dubbed the 1990s, the ‘Age of the Analysts’
(Hong and Kubik, 2003). There appears to have been rising pressure on analysts as
the market began to soar. Some who did not join in the optimistic promotion of
stocks were dumped by banks in favour of more bullish analysts. One often cited
example is the rise of Henry Blogdet. In late 1998, most analysts held that
Amazon.com was overvalued at $240; Jonathan Cole of Merrill Lynch believed
$50 to be a reasonable price. Henry Blodget at Oppenheimer and Co. set a price
target of $400. When Amazon.com surpassed it, he was hailed as a guru; Cole
departed and Merrill Lynch hired Blodget.
The multiple uses of research creates a potential problem if analysts’ compen-
sation is not set appropriately. Unfortunately, information on the compensation
of analysts is not easy to obtain. Hong and Kubik (2003) were, however, able to
compile data on the movement of analysts from job to job to higher or to lower
status brokerage houses, enabling them to study the determinants of upward and
downward mobility. Examining the brokerage house employment and earnings
forecasts of 12,000 analysts working for 600 brokerages between 1983 and 2000,
they found that accuracy of earnings forecasts was important, and relatively 
accurate forecasters were more likely to move up to higher status and presumably
higher compensation brokerage houses. But, controlling for accuracy, analysts
who were more optimistic than the consensus were also more likely to experience
favourable job separations. Furthermore, when analysts covered stocks 
underwritten by their firms, the outcome of job separations depended less on
accuracy and more on optimism. Breaking their sample into 1983-95 and 1996-
2000, they found that job separation outcomes became more sensitive to 
optimism and less to accuracy in the stock market boom of the late 1990s.