Test of equity analysts' recommendation bias when object firms are investment banking clients

The purpose of this study was to determine if the apparent conflict of interest incurred by equity analysts when rating object firms, whom are also their employers' investment banking clients, significantly biases their recommendations. Hereafter, this conflict of interest will be referred to as the IBC conflict of interest. Professional equity analysts are considered the most informed or at least among the most informed investors in the Financial markets. Their recommendations may significantly influence the actions of large institutional as well as other investors. As such, in theory they play a critical role in the achievement of informational efficiency. Hence, any condition compromising the objective, independent recommendations of these equity analysts may impede market efficiency and thus diminish the efficient allocation of capital in the global economy.;Regarding related research on this issue, Carleton, Chen, and Steiner (1998), found that brokerage firm equity analyst recommendations had a significant optimistic bias relative to analyst recommendations from non-brokerage firms. Dugar & Nathan (1995) and Lin & McNichols (forthcoming), determined that equity earnings forecasts and investment recommendations of financial analysts rendered in the presence of the IBC conflict of interest, had a significant bias toward optimism. This was in comparison to the forecasts and recommendations provided by analysts of investment banking firms in the absence of the IBC conflict of interest. The authors also concluded that there were no significant differences between risk-adjusted returns earned from following different investment recommendations of these two groups.;This research endeavored to expand upon the above studies as well as correct for certain research design, data, and methodological deficiencies. The sample database of this study was comprised of three categories: (1) Investment banking firm analysts' recommendations rendered under the IBC conflict of interest; (2) Investment banking firm analysts' recommendations without the IBC conflict of interest; and (3) Non-investment banking firm analysts' recommendations implicitly achieved without the IBC conflict of interest. Additionally, tests were constructed to determine whether the conclusions about the recommendations of investment banking analysts differ for U.S. vs. foreign equity analysts possibly because of institutional differences. Univariate and multivariate tests for the presence of optimism bias and post-recommendation performance validity were conducted.;Results demonstrated that investment banking firm analysts' recommendations rendered under the IBC conflict of interest were significantly more optimistic than the other two groups whom did not have the IBC conflict of interest. Regarding post-recommendation performance tests, which gauge the net performance difference between "Buy" and "Hold"/"''Sell" recommendations, the results revealed no significant difference amongst the three analysts groups. No significant differences in the level of optimism or post-recommendation performances were discovered between the U.S. and foreign investment banking analysts.;In conclusion, it appears that an optimism bias exists amongst investment banking firm analysts with the IBC conflict of interest. This optimism bias may be due to favoritism and/or such analysts having access to superior information. Regardless, post-recommendation performance, possibly due to the equity markets being informationally efficient, is unrelated to this optimism bias. Hence, if the optimism bias is due to favoritism it is inconsequential to performance.