Conflicts Of Interest,Industry Expertise,and The Effectiveness Of Analysts' Reputation Formation Mechanism

The reputational incentive of sell-side analysts is viewed as an important mechanism to the healthy development of analyst industry,the effectiveness of which will eventually has a significant impact on the information efficiency of security market.The demand for analysts as professional informational intermediaries is much higher in emerging and transitional markets like China,in the meantime,the incentives of informational intermediaries are more easily distorted,resulting in the loss of reputational “self-discipline effect and “strengthening” effect.However,the prospects of analyst industry in Chinese security market are far from optimistic.A variety of “research report gate” incidents and strong atmosphere of stock speculations reveal a number of issues existing in the industry.Nonetheless,an effective external reputational incentive mechanism is able to guide the industry in the right direction.Since the reputation gives a great boost to analysts,the discussion of analyst behaviors should proceed from how they acquire that reputation,while most of the related research strategy are not aimed at distinguishing the effectiveness of reputation incentive itself and few research that study how analysts acquire reputation lack consideration of the special market condition in China and therefore do not draw compelling conclusions.In fact,analysts' ability to obtain reputation is strongly related to institutional investors.As important clients of brokerage to which analysts affiliated,institutional investors have very complicated relationships with analysts,which indicates that the key to explore the effectiveness of analysts' reputational incentive should focus on the exchanges of interests between the two parties.The fact that analysts issue more optimistic reports on stocks that are held by institutions leads to lower quality of analysts' reports,but will the poor reports do harm to their reputation at the same time? The answer to this very question can be a very good explanation for the abnormal performance of analysts with higher reputation and thus provide theoretical reference for how to regulate analyst industry.Since the New Fortune's star analysts ranking is the most important reputation symbol that analysts in China pursues,this paper studies the effectiveness of analysts' reputational incentives and its economic consequences through investigating the important determinants of the probability of analysts ranking in the New Fortune's star list.In light of analysts' reputation,this paper examines the very two features: conflicts of interest and industry expertise,which represent analysts' motivation and ability to deliver information respectively,and further explores the interactions of analysts' reputation and these two features.First,coupled with the institutions dominated analyst ranking system,this paper investigates the determinants of star rankings and dicovers the key determinant that affects analysts' chance to win.Upon this,this paper investigates the impact of reputational incentive distortion on analysts' behaviors including behaviors of conflicts of interest and the motivation to build industry expertise.On one hand,the study investigates the phenomenon that catering to institutional investors' interests causes analysts to issue more optimistic reports and further studies whether analysts' reputation can curb this negative relation.On the other hand,the study examines the relationship between the level of industry expertise and information quality from two aspects of industry expertise: within-industry expertise and supply chain expertise,and further explores whether analysts with higher reputation build industry expertise more actively.Taken together,the results reveal the inconsistency of star analysts' performances and reputation theory,and offer an explanation from the view of how analysts acquire reputation.Lastly,this paper investigates the economic consequences that star analysts bring to the capital market in light of stock price crash risk.This study contributes to the literature in several ways.First,based on the reality that institutional investors are the voters of the star analysts' contest,this paper discovers the key determinants of analysts obtaining star reputation from the perspective of exchanges of interests between analysts and institutional investors.Specifically,this paper finds that the information quality of analysts' reports has no significant effect on obtaining the star title,while the probability of analysts being elected as stars increases with analysts' optimism in recommendations on stocks that are heavily held by related institutional investors,and the relation is stronger when institutional investors and analysts are more strongly related.In addition,the overall optimism of analysts also increases analysts' probability of winning.Moreover,after being elected stars,analysts continue to offer more optimistic recommendations on related stocks.Also,star analysts offer stocks that are held by non-related institutional investors with research reports of lower quality.The results reveal the failure of current star analysts' selection mechanism itself in China and therefore the distortion of the overall reputational incentive system in the analyst industry,providing reasonable explanation for star analysts' incompetent performance.Consistent with Zhou et al.(2016)and Zhang and Yang(2016),this paper also provides evidence for the reputation model hypothesis from the view of failure of analyst reputational mechanism.Furthermore,this study contributes to analyst optimism literature by providing direct evidence on analysts' self-interested motives to issue more optimistic reports.Second,based on analysts' needs to cater to institutional investors,this study hypothesizes that analysts issue optimistically biased ratings on the stocks in institutional investors' portfolios and verifies the fact that conflicts of interest of analysts cause poor information quality of reseach reports.In contrast to Gu et al.(2013)and Firth et al.(2013),this paper further studies the restraining role of analyst reputation in behaviors of conflicts of interest.Specifically,this paper finds that analysts issue more favorable reports on stocks that are held by affiliated institutional investors,and compared to non-star analysts,star analysts issues more optimistically biased reports.This study also examines the market reactions to analysts' recommendations and finds affiliated or unaffiliated recommendations from star analysts both cause stronger market reactions upon announcement but yield poorer long-run returns.Moreover,this study adds to the literature that examines reputation's role in restraining analysts' conflicts of interest activities by focusing on analysts' individual reputations.Third,analysts' industry expertise is the very feature that reflects their core values,yet remains an under-researched issue in the literature.Our study explores this aspect from both analysts' within-industry expertise and supply chain expertise and adds to the literature that studies analysts characteristics.Specifically,the approach to measure analysts' industry expertise is to examine whether investors can obtain abnormal yields by following their recommendations.We find that industry expertise can increase information quality of their reports.In addition,star analysts do not build industry expertise more actively.In light of market reactions,we find that investors do not pick on this expertise of analysts.This study sheds light on the information spillovers of firms linked along the same supply chain on analysts' information quality.In contrast to Guan et al.(2015)and Luo and Nagaranjan(2015),this study shows that instead of following firm's top customer,processing a higher level of expertise in industries of the covered firms' key customers or suppliers will be valuable to analysts' information quality and contributes to the literature on information spillovers along the supply chain on third party decision-making.Lastly,this study deepens the understanding of the role of star analysts in China's security market.The extant literature focuses on the information revealing role of analysts in capital market,and in particular,studies whether analysts reduces stock price synchronicity through delivering more firm-specific information to the market(Chan and Hameed,2006;Zhu et al.,2007;Zhou et al.,2016),yet few studies examines the economic consequences of analysts from the perspective of stock price crash risk.In light of the distortion of analyst reputational incentive mechanism,star analysts exhibit more severe optimistic biases which may results in higher crash risk.Therefore,this paper examines the relationship between star analysts' coverage and scrash risk and finds that greater star analysts coverage increases crash risk.Further,this study contributes to the literature that examines the relationship between institutional investors and crash risk,which explore this aspect from view of management monitoring,herding,information competition(Xu et al.,2013;Callen and Fang,2013;Kong and Wang,2016),while this paper shows institutional investors' positive effects on crash risk are partially due to analysts' needs to cater to them thus provides new explanations for institutional investors' positive effects on crash risk.