Incentives to innovate and financial crises

In this paper I develop a model of a competitive financial system with unrestricted but costly entry and an endogenously determined number of competing financial institutions (“banks” for short). Banks can make standard loans on which plentiful historical data are available and unanimous agreement exists on default probabilities. Or banks can innovate and make new loans on which limited historical data are available, leading to possible disagreement over default probabilities. In equilibrium, banks make zero profits on standard loans and positive profits on innovative loans, which engenders innovation incentives for banks. But innovation brings with it the risk that investors could disagree with the bank that the loan is worthy of continued funding and hence could withdraw funding at an interim stage, precipitating a financial crisis. The degree of innovation in the financial system is determined by this trade-off. Welfare implications of financial innovation and mechanisms to reduce the probability of crises are discussed.     

Analyst coverage and earnings management

What is the role of information intermediaries in corporate governance? This paper examines equity analysts’ influence on managers’ earnings management decisions. Do analysts serve as external monitors to managers, or do they put excessive pressure on managers? Using multiple measures of earnings management, I find that firms followed by more analysts manage their earnings less. To address the potential endogeneity problem of analyst coverage, I use two instrumental variables based on change in broker size and on firm's inclusion in the Standard & Poor's 500 index, and I find that the results are robust. Finally, given the number of covering analysts, analysts from top brokers and more experienced analysts have stronger effects against earnings management.     

Inside the “Black Box” of Sell‐Side Financial Analysts

Our objective is to penetrate the “black box” of sell‐side financial analysts by providing new insights into the inputs analysts use and the incentives they face. We survey 365 analysts and conduct 18 follow‐up interviews covering a wide range of topics, including the inputs to analysts’ earnings forecasts and stock recommendations, the value of their industry knowledge, the determinants of their compensation, the career benefits of Institutional Investor All‐Star status, and the factors they consider indicative of high‐quality earnings. One important finding is that private communication with management is a more useful input to analysts’ earnings forecasts and stock recommendations than their own primary research, recent earnings performance, and recent 10‐K and 10‐Q reports. Another notable finding is that issuing earnings forecasts and stock recommendations that are well below the consensus often leads to an increase in analysts’ credibility with their investing clients. We conduct cross‐sectional analyses that highlight the impact of analyst and brokerage characteristics on analysts’ inputs and incentives. Our findings are relevant to investors, managers, analysts, and academic researchers.     

The First‐ and Second‐Hand Effect of Analysts' Stock Recommendations: Evidence from the Swiss Stock Market

This paper empirically investigates the impact of both the first release of analysts' stock recommendations to a limited clientele and the subsequent dissemination of the same information in a major newspaper to a broader audience. For a sample of 1460 stock recommendations published in FuW, Switzerland's major financial newspaper, significant positive abnormal returns on the day of the original release of buy recommendations and on the day of publication in FuW are documented. Tests of the price pressure and information hypotheses reveal that analysts' recommendations contain new information, which is quickly incorporated in the stock prices on the first release of this information. In contrast, the statistically significant announcement effects associated with the subsequent publication can be primarily ascribed to price pressure in the underlying securities.     

A comparison of buy‐side and sell‐side analysts

There is very little research on the topic of buy-side analyst performance, and that which does exist yields mixed results. We use a large sample from both the buy-side and the sell-side and report several new results. First, while the contemporaneous returns to portfolios based on sell-side recommendations are positive, the returns for buy-side analysts, proxied by changes in institutional holdings, are negative. Second, the buy-side analysts' underperformance is accentuated when they trade against sell-side analysts' recommendations. Third, abnormal returns positively relate to both the portfolio size and the portfolio turnover of buy-side analysts' institutions, suggesting that large institutions employ superior analysts and that superior analysts frequently change their recommendations. Abnormal returns are also positively related to buy-side portfolios with stocks that have higher analyst coverage, greater institutional holding, and lower earnings forecast dispersion. Fourth, there is substantial persistence in buy-side performance, but even the top decile performs poorly. These findings suggest that sell-side analysts still outperform buy-side analysts despite the severe conflicts of interest documented in the literature.     

Analyst characteristics, timing of forecast revisions, and analyst forecasting ability

We first examine whether analysts with certain characteristics that prior research has identified are related to superior forecasting ability systematically time their forecast revisions later in the fiscal quarter. We then examine whether this superior ability persists after controlling for the timing advantage by using relative forecast error, a measure that largely eliminates the timing advantage of recent forecasts. Using a sample of quarterly earnings forecast revisions over the 20-year period from 1990 to 2009, we find that analysts with more firm-specific and general experience and more accurate prior-period forecasts, analysts employed by larger brokerage firms, and analysts who follow fewer industries and companies tend to revise forecasts later in the quarter. We also find that analyst characteristics that are positively correlated with revision timing are negatively related to relative forecast errors. These results are consistent with analyst characteristics being useful proxies for analyst forecasting ability and analysts with greater ability revising forecasts later in the quarter.     

Analysts’ and Investors’ Reactions to Consistent Earnings Signals

We investigate (1) whether the trajectory of the current‐quarter earnings expectation path (defined by the signs of the forecast revision and the earnings surprise) provides information about future firm performance, and (2) the extent to which analysts and investors react to that information. Our results indicate that analysts underreact more to earnings information revealed by consistent‐signal earnings expectation paths than to earnings information communicated by inconsistent‐signal expectation paths. We also find that the current earnings expectation path provides incremental explanatory power for future abnormal returns, even after controlling for the sign and magnitude of the earnings surprise. Overall, our evidence is consistent with underreaction stemming from analysts’ and investors’ bias in processing the information in consistent‐signal earnings expectation paths.     

Shiller's CAPE: Market Efficiency and Risk

Robert Shiller shows that Cyclically Adjusted Price to Earnings Ratio (CAPE) is strongly associated with future long‐term stock returns. This is often interpreted as evidence of market inefficiency. We present two findings contrary to such an interpretation. First, if markets are efficient, stock returns should be higher than the risk‐free rate. We find that even when CAPE is in its ninth decile, future 10‐year stock returns, on average, are higher than future returns on 10‐year U.S. Treasurys. Thus, the results are largely consistent with market efficiency. Second, consistent with a risk–return tradeoff, we find that CAPE is negatively associated with future stock market volatility.     

Market ambiguity and individual investor information demand

We examine whether ambiguity in the market leads to an increase in information demand by individual investors. Drawing on the asset-pricing model proposed by Mele and Sangiorgi (2015), which incorporates market ambiguity, we measure individual information demand using daily Google searches and measure market ambiguity using a metric based on the market trades of institutional investors. We find that individual investors increase their information demand during periods of greater market ambiguity. We also provide evidence that information demand from individual investors spikes around earnings announcement days primarily when market uncertainty is driven by net-selling activity. Overall, these results suggest that the disagreement among institutional investors either represents uncertainty or contributes to the uncertainty related to a stock, leading to increased demand for information from individual investors.     

Uncertainty,Incentives, and Misallocation

This paper identifies a new propagation mechanism by which the effects of business cycle shocks amplify in the context of the dynamic stochastic general equilibrium framework. Business cycle shocks, such as heightened uncertainty, and positive monetary shocks endogenously magnify the cross-sectional dispersion in idiosyncratic productivity. This induces entrepreneurs, who have asset substitution incentive, to distort the quality of an investment project, which amplifies the response of investment and output. Moreover, lenders reallocate credit from firms with a high marginal product of capital, in which the asset substitution problem is more prevalent, to firms with a low marginal product of capital, which in turn further depresses aggregate economic activities. A policy that subsidizes lenders to firms with a high marginal product during a recession improves the allocation of loans. Empirical evidence from the NBER-CES Manufacturing Industry Database provides support for the model's predictions.     

Discipline and Liquidity in the Interbank Market

Using 20 years of panel data, I demonstrate that high-risk banks have consistently paid more than safe banks for interbank loans and have been less likely to use these loans as a source of liquidity. The economic importance of this effect was relatively small until the mid-1990s, when regulatory and institutional changes began to impose more of the costs of bank failure on uninsured creditors. Subsequently, interbank-market price discipline roughly doubled, and risk-based rationing effects increased by a factor of six. In imposing this discipline, lenders seem to care most about credit risk at borrowing institutions.     

Do Analyst Stock Recommendations Piggyback on Recent Corporate News? An Analysis of Regular‐Hour and After‐Hours Revisions

Analysts often update their recommendations following corporate news. Questions have been raised regarding analysts’ ability to generate new information beyond recent corporate events. Employing a comprehensive database on corporate news, we show that only a small minority, or 27.9%, of all recommendation revisions directionally confirm the information in the preceding corporate events and even these “confirming revisions” facilitate the information discovery of corporate events and thus cannot simply be dismissed as “piggybacking.” Our analysis further shows that analysts not only facilitate price discovery to corporate news through issuing trending revisions but also help reverse prevailing market sentiments following corporate news by issuing contrarian revisions. Our study is the first to investigate short‐window intraday market reactions to revisions issued after hours, which account for 70% of all recommendation revisions in our sample period. Analysts’ incentives to issue revisions after hours appear to reflect demands from large institutional clients, who dominate after‐hours trading. More importantly, we show that the after‐hours revisions are associated with significantly greater price reactions and different price reaction patterns than revisions issued during regular trading hours. Collectively, our evidence indicates that analysts are a significant source of new information beyond recent corporate news and they also help shape the market's assessment of corporate disclosures.     

Analyst reputation and management earnings forecasts

Prior studies show that analysts with high reputation are influential in the market. This paper examines whether managers consider analyst reputation in shaping their voluntary disclosure strategy. Using Institutional Investor magazine’s All-American (AA) rankings as a proxy for analyst reputation, we find that the coverage of AA analysts is positively associated with the likelihood of quarterly management earnings forecasts (MEFs). We also find that AA analysts’ forecast optimism is more positively associated with the likelihood of MEFs than non-AA analysts’ forecast optimism when the firm is covered by AA analysts. Analyses based on AA analyst coverage changes and AA status changes confirm the relation between analyst reputation and MEFs. We further find that analyst reputation influences other MEF properties, such as forecast news, bias, and revisions, and that our results are robust to alternative measures of analyst reputation. Further analyses show that market reactions at quarterly earnings announcements are more positive (negative) when firms meet/beat (miss) AA analysts’ forecasts than when firms meet/beat (miss) non-AA analysts’ forecasts. Collectively, our findings suggest that managers strategically provide voluntary forecasts by taking into account the reputation of individual analysts following their firms.     

Disclosure frequency and earnings management

We examine the relation between disclosure frequency and earnings management, and the impact of this relation on post-issue performance, for a sample of seasoned equity offerings (SEOs). We contend that firms with extensive disclosure are less likely to face information problems, leading to less earnings management and better post-issue performance. Our results confirm that disclosure frequency is inversely related to earnings management and positively associated with post-issue performance. We also find that transparency-reducing disclosure is concentrated in firms that substantially, but temporarily, increase disclosure prior to the offering. Such firms exhibit more earnings management and poorer post-SEO stock performance, on average.     

Market reaction to optimistic bias in the recommendations of chaebol-affiliated analysts

Using the setting of chaebol industrial organizations in Korea, which allows for the study of a unique affiliation between a chaebol group and financial analysts, we examine whether investors react to an optimistic bias in affiliated analysts’ recommendations. Our initial market return tests, abnormal trading volume tests and independent analysts’ reaction tests suggest that investors and independent analysts recognize and discount an optimistic bias in chaebol-affiliated ‘buy’ recommendations. However, long-term market returns are more profitable in terms of affiliated analysts’ ‘buy’ recommendations than independent analysts’ recommendations, which suggests that investors excessively discount chaebol-affiliated ‘buy’ recommendations in the short-term.     

Underwriter reputation,earnings management and the long‐run performance of initial public offerings

This study contributes to the extant literature on the nature of earnings management surrounding initial public offerings (IPOs) by investigating the role of underwriter reputation. We argue that prestigious underwriters will protect their reputation by carefully monitoring and certifying financial information on IPO firms, thereby limiting any potential earnings manipulation. As a result, those IPO firms that are associated with more prestigious underwriters are likely to exhibit substantially less‐aggressive earnings management. Conversely, we find the existence of a negative relationship between earnings management and the post‐offer performance of an IPO firm’s stocks only for those firms associated with less‐prestigious underwriters.     

Analyst Reputation,Communication, and Information Acquisition

Earlier studies have shown that reputational concerns tend to reduce agents' opportunistic behavior. However, a recent study by Morris argued that analysts' (experts') reputational concerns may discourage truthful communication when they try to avoid being perceived as being misaligned with investors. In this paper, I examine the effect of reputational concerns on communication in a setting where analysts can choose their precision endogenously. Because both misaligned and aligned analysts want investors to trust their reports in the future, both will aim to build a reputation for being aligned. In equilibrium, aligned analysts will acquire more information than misaligned analysts. As a result, investors may favorably update their beliefs about the analysts' type when the report is proven to be accurate. Therefore, both types of analysts will have reputational incentives to communicate truthfully. The paper also derives conditions under which the analysts' reputational concerns have a nonmonotonic impact on aligned analysts' equilibrium precision choices and investors' welfare.     

CDS trading and analyst optimism

This paper investigates whether and how the initiation of Credit Default Swaps (CDS) trading affects analyst forecast optimism. First, we document that the initiation of CDS trading curbs analyst forecasts optimism. Second, we find that the dampening effect of CDS on analyst optimism is stronger for firms with negative news and for firms with poorer financial performance or higher leverage, supporting a “correction effect” of CDS on non-strategic optimism. Moreover, we find that CDS also has a “disciplining effect” on strategic optimism that arises from incentives to cultivate relation with management or to please institutional investors. Overall, our evidence shows that the CDS market not only provides important information for analysts, but also alters analysts’ reporting incentives and enhances their objectivity. Additional analysis shows that this effect has disappeared after the Dodd-Frank Act.