The goals of investment banking regulation

According to the primary U.S. regulator, the Securities and Exchange Commission (SEC), “The mission of the U.S. Securities and Exchange Commission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” The SEC attempts to accomplish this by requiring full disclosure of all relevant information related to specific securities and financial advisors. The goal is not to prevent losses by investors, but to allow investors to make informed investment decisions by requiring the disclosure of audited financial and other information.

The concept of a level playing field is central to the regulation of capital markets, thus several aspects of regulation relate to the dissemination of investment information — providing for fair and equal access to investment opportunities across investors. If investors believe that the markets aren’t a fair game — that, for instance, the markets are skewed to the advantage of large institutions and major investors — investors won’t trust them or participate in them, and an inefficient allocation of resources across the economy and stunted economic growth will result. Regulation should provide investors with a sense of trust in the markets.

Why the rules of today are the result of days past

American historian James A. Field, Jr., a professor at Swarthmore College, was quoted as saying that “It is proverbial that generals always prepare for the last war.” The same can be said of regulators with respect to the investment banking industry. Sweeping regulatory changes generally come out of market crises, and the recent past is certainly no different. The two biggest crisis periods of the last 100 years — the market crash of 1929 (and subsequent Great Depression) and the financial crisis that began in 2007 — both resulted in major legislation affecting the financial markets. To say that financial regulation is reactive rather than proactive is a gross understatement. Regulators, it seems, have looked to prevent the last crisis instead of trying to avoid the next one.

How regulations have shaped the investment banking industry

To understand today’s securities regulation, you need to know how it developed. Rules passed decades ago are still binding today. The history of regulation of the investment banking industry begins during the Great Depression with the passage of the Glass-Steagall Act of 1933. The main purpose of this act was to separate investment banking activities (primarily securities underwriting and trading) from commercial banking activities (taking deposits and making loans). This was done because many people felt that commercial bank participation in the stock market was too risky an endeavor and that depositors’ funds shouldn’t be used to speculate in the stock market (sound familiar?). It was widely believed that the combination of commercial and investment banking activities within the same firms contributed to the crash of 1929 and the subsequent Great Depression.

The year 1933, the height of the Great Depression, witnessed another seminal regulatory act with the Security Act of 1933, which guides the industry’s behavior to this day. The main purpose of this act was to regulate the primary securities market — that is, the new issue or IPO market. This piece of legislation required that firms issuing securities must fully disclose all material information concerning the new issue. It also required that investment banking firms provide investors with a prospectus (a formal legal document that contains all relevant information — including audited financial statements and other disclosures) on all new issues.

The very next year witnessed the passage of the Securities Exchange Act of 1934. The primary purpose of this act was to regulate the secondary market (the market where already existing securities are traded). The main points of this act involved setting margin requirements, audit requirements, registration requirements for stocks listed on exchanges, and disclosure requirements. The act also created the SEC as the primary enforcement agency for securities laws.

The final two pieces of major legislation that had its genesis in the stock market crash of 1929 were the Investment Advisors Act of 1940 and the Investment Company Act of 1940. The Investment Advisors Act and subsequent amendments required investment advisors with a minimum asset size under management to register with the SEC. It also provided guidelines regarding the fees and commissions they may collect and detailed the liability of advisors. The Investment Company Act of 1940 detailed requirements for mutual funds (both open- and closed-end) and exchange traded funds (ETFs).

It was near the turn of the century before the next major regulatory change took place. The history of legislation doesn’t simply involve putting more rules on the books — for the investment banking industry, the next big development was the repeal of the Glass-Steagall Act in 1999. The rationale for allowing institutions to engage in both commercial and investment banking activities was to make the large U.S. institutions more competitive on a global basis. Hindsight is, of course, 20/20, but even the staunchest supporters of this repeal would have to believe that it contributed to the severity of the financial crisis that began in 2007. It brought into the common vernacular the concept of financial institutions that are “too big to fail.” That is, allowing firms that are so interconnected to fail would prove disastrous to the overall financial markets and, as a result, prove devastating to the economy.

The types of rules imposed on investment banking

Investment banks are subject to many rules that govern their activities, but the primary focus of regulation is on information flow — ensuring that all investors have equal access to information and one group is not disadvantaged relative to another.

How investment banking rules changed after the financial crisis

Securities laws continue to evolve, and investment bankers need to keep up. In 2010, President Obama signed into law the omnibus Dodd–Frank legislation. The law expanded to a mind-numbing 9,000-plus pages in length, affecting nearly every aspect of the financial markets. Studies have found that while the legislation has improved financial stability and consumer protection, the jury is still out on its influence on the global economy. And as the political winds change, many of the provisions of the original law are being debated and weakened.

For investment banks some of the most important provisions of the legislation include the following:

• Increased transparency in the derivatives markets: Many firms, including investment banks, take huge positions in the derivatives markets. A derivative security — like an option or swap — is simply a security whose value depends on (is derived by) the value of another security. For instance, the value of a call option or put option on a share of stock depends upon the price of that share of stock. The problem with many complex derivatives — like credit default swaps (for more on derivatives and credit default swaps see Chapter 16) — are that these holdings are both difficult to value and difficult to find information on. The failure of Lehman Brothers and the dire financial situation faced by American International Group (AIG) was largely attributed to positions each firm had in derivatives security markets, particularly in credit default swaps. The problem is that many of the transactions in the derivatives market do not take place on organized exchanges where prices and volume levels are disclosed, but they take place over the counter or in private negotiations between the buyer and seller. Thus, there is limited transparency in these markets concerning both the pricing and the volume of the positions. To increase transparency, the Act requires that swaps be cleared through either exchanges or clearinghouses.
• Increased capital requirements: One of the most important provisions of the Dodd–Frank legislation involved increasing the capital (or equity) requirements of banks, effectively lowering the amount of leverage (borrowing) that investment banks can utilize in their operations. Many investment banking firms got into trouble during the crisis — and ultimately were bailed out by taxpayers — because these firms were so highly indebted that when some of their proprietary trading bets went against them, the losses were magnified, and they didn’t have the funds available to absorb the losses. By increasing the amount of firm equity relative to borrowing of investment banks, the intention of the original legislation was to create a more stable and secure banking system. But nothing in banking legislation is permanent. In 2018, the capital requirements for all but the largest banks were once again loosened as the Trump Administration sought to rollback much of Dodd-Frank.
• Limitations of proprietary trading: One of the most contentious areas of the Dodd–Frank legislation involves limitations on proprietary trading by investment banking firms. The so-called Volcker Rule (named after former Federal Reserve Chairman Paul Volcker) restricts banking firms from making speculative investments on their own account, only allowing them to trade on behalf of customers. The investment banking industry fought this provision because proprietary trading was traditionally a profit center for investment banks. Despite years of intense lobbying against the Volcker Rule by financial services firms, it was enacted in 2015. Predictably, this led to a mass exodus of top proprietary traders from large investment banks to hedge funds.

• More intense scrutiny and reform of the credit-rating agencies: Credit-rating agencies such as Moody’s, Standard & Poor’s, and Fitch Ratings provide ratings on a variety of financial securities — from government bonds to corporate bonds and mortgage-backed securities. These ratings are meant to provide investors with a sense of the likelihood that an issuer will default on a particular security. Rating agencies played a central role in the financial crisis, as many securities — particularly mortgage-backed securities — that had been given very high or the highest credit quality ratings defaulted as homeowners defaulted on their residential mortgages. Investment banks are major users of the services of these rating agencies, because it’s much easier to sell highly rated securities to investors because the buyers believe them to be relatively safe. Investment banking firms are the lifeblood of these rating agencies, because investment banks pay the rating agencies to rate the securities.

  There is an obvious conflict of interest with issuer-paid ratings — investment banks want high ratings for the securities they’re putting together, and rating agencies want the continued business of these investment banks. High ratings make both parties happy but can mislead investors who rely on these ratings as part of their investment decision-making process. The Dodd–Frank legislation provides for increased scrutiny of credit-rating agencies.

• Risk retention of asset-backed securities: One of the most criticized practices of some investment banking firms that came out of the financial crisis was that firms put together securities (primarily mortgage-backed securities) of questionable quality and sold them to clients. In fact, what has been dubbed “the greatest trade ever” was when hedge-fund manager John Paulson effectively short-sold the U.S. housing market through a series of trades that several investment banks helped him engineer. Clients of the investment banking firm were on the other side of these trades. The Dodd–Frank legislation addresses this issue by mandating that a firm that puts these securities together retain at least 5 percent of the credit risk of those assets. In other words, investment banks are required to have some “skin in the game,” and if the value of these securities goes south, the investment banking firm will suffer similarly to the client who purchased the assets.
• Executive compensation: One of the raging debates in business today involves the level of executive compensation, particularly within the financial services industry. Many people were outraged with the salary and bonus packages provided to executives from firms in the financial services arena that received government bailouts. Although not placing any dollar restrictions on salary and bonuses of executives, the Dodd–Frank legislation requires that companies must include, at least once every three years, a resolution in their proxy statements approving the compensation of top executives. It also requires that firms disclose certain statistics regarding executive pay, for instance, the ratio of CEO pay to median employee compensation. While requiring more disclosure will increase the scrutiny on executive pay packages, it seems to have done little to curb the growth of executive pay.

Why rules were needed

Investors and potential investors look to security analysts to provide them with professional, unbiased opinions on the investment potential of a stock. After all, the analyst is assumed to have the knowledge and skills to investigate and form a recommendation — generally “buy,” “sell,” or “hold” — on a stock’s future potential. Many analysts are highly trained individuals who went to the top business schools and were taught various state-of-the-art valuation techniques. Professional certifications (such as the Chartered Financial Analyst [CFA] designation) train analysts on the ins and outs of analyzing companies, and these qualifications signal to investors that these individuals have the skill set to provide sound advice.

Given all this training, what could possibly go wrong? Why around the turn of the recent century did stock analysts earn reputations that rivaled used-car salesmen or elected officials? It all centered on behavior that resulted from conflicts of interest that were inherent in the role of analysts at investment banking firms and led to changes in regulation meant to curb abuses and mitigate these conflicts.

During the time of the Internet boom, many analysts — like Jack Grubman, Mary Meeker, and Henry Blodget — became media darlings and commanded multimillion-dollar annual compensation packages. A positive report on a company, or an upgrade of the company’s stock to a “buy” or a “strong buy” by one of these rock-star analysts, could result in significant increases in the price of that company’s stock. Although few and far between (more about that later), a negative report or the downgrade of a company’s stock to a “sell” recommendation or even from a “sell” to a “hold” could result in the price plunging as investors sell their holdings.

The not-so-delicate balancing act analysts play

Stock analysts are employed by investment banking firms that do more than simply issue buy, sell, and hold recommendations on individual stocks to investors. Investment banking firms are paid to bring companies public by underwriting IPOs. These firms advise corporate client firms on strategies to increase firm value such as during mergers and acquisitions or in leveraged buyouts.

Without clients, investment banking firms wouldn’t exist. Like any company in any industry, the lifeblood of an investment banking firm are clients or customers. Customers want to be happy and investment banking firms want them to be happy. What makes investment banking customers really happy is when their company stock price increases. Stock prices generally don’t rise when analysts issue negative or neutral recommendations on stocks. Perhaps that explains why analysts are overwhelmingly bullish, and the ratio of buy to sell recommendations by Wall Street firms is typically in the area of 10-to-1. By the way, this isn’t an issue that is isolated to U.S. markets. In the Chinese and Korean markets, buy-sell recommendation ratios can approach 20-to-1. In fact, rather than issue a negative recommendation, it’s common for some investment banking firms to simply drop coverage of a firm.

Corporate firms want a relationship with an investment banking firm that will continue to increase demand for the company’s stock even well after the IPO. Corporations are less likely to maintain a relationship with an investment banking firm that doesn’t provide favorable coverage on its stock. Thus, there is pressure on analysts to issue favorable recommendations on the firms with which they have investment banking relationships. Perhaps this explains why, for instance, Henry Blodget allegedly referred to Internet search company InfoSpace as a “piece of junk” and a “powder keg” in internal e-mails, while simultaneously recommending the stock to investors.

Providing advice to both the corporation and investors in that corporation would appear to represent a conflict of interest. This has led many critics of investment banking firms to wonder if it’s really possible for these firms to effectively serve two masters — the corporations and the investors. This is the tightrope that the investment banking firm attempts to navigate.

As we note earlier, a change in analyst recommendation — particularly from a prominent analyst — from a “hold” to a “buy” or from a “buy” to a “hold,” for instance, can lead to dramatic stock price changes following the release of the recommendation. A pending recommendation change is valuable information that is coveted by market participants. Investment banking firms have large clients who would benefit from advance notice of any recommendation changes. Suffice it to say, the investment banking side of the business is very interested in developments from analysts.

If the conflict of interests outlined here weren’t enough, there may be other incentives that have driven analysts to make certain recommendations on stocks that are not driven by the fundamentals of the company. In a widely reported scandal, Salomon Smith Barney telecommunications analyst Jack Grubman raised his rating on AT&T from a “neutral” to a “buy” rating in 1999. Grubman later admitted in an internal e-mail that his decision was motivated, at least in part, by a desire to get his children placed in an exclusive NYC preschool program. Conflicts, it seems, like ice cream, come in a variety of flavors.

What disclosure and compliance are required

The result of the conflicts outlined earlier and the belief that analysts don’t always operate independently but can be influenced by factors other than the desire to make an objective determination of an investment’s prospects, resulted in a call for increased regulation of the analyst profession. Former Supreme Court Justice Louis Brandeis once said, “Sunlight is said to be the best of disinfectants; electric light the most effective policeman.” In the spirit of Brandeis, a series of regulatory changes — including both disclosure of conflicts of interests and prohibitions of actions — has transformed the analyst profession.

As an indication of the seriousness of the problem, in April 2003, ten of the largest investment banks agreed to pay a pretty steep price — $1.4 billion in total — and were forced to abide by a series of regulations governing their behavior.

There is recognition by the regulatory authorities and the industry that while not all these conflicts of interest can be completely eliminated via stricter regulations, they need to be properly disclosed. The following represents a synopsis of the major changes to regulations and required disclosures governing analysts:

• A prohibition on analysts receiving compensation for investment banking activities: Analyst compensation cannot be tied directly to a specific investment banking activity. Going even further, if any part of the compensation of analysts is tied to general investment banking activity at the firm, that must be disclosed in the firm’s research report. The intent is to tie an analyst’s compensation solely to the quality of his research and not to how much investment banking business may result from continuing coverage.
• A prohibition on promises of favorable research: Investment banking firms cannot promise a favorable research rating or a specific price target to secure investment banking business. Firms are also prohibited from issuing a report on a company within 40 days after an IPO.
• A prohibition on analysts being involved in soliciting investment banking business: Prior to the change in regulations, star analysts often accompanied investment bankers on their recruiting trips when seeking new or maintaining existing investment banking clients.
• A prohibition on influence by investment bankers: Analysts are prohibited from being supervised by the investment banking departments of their firms. In addition, analysts cannot discuss research reports with investment bankers prior to distribution.
• A requirement to certify analyst reports: Specifically, Regulation Analyst Certification (Reg AC) requires analysts to certify that their views accurately reflect their beliefs about the future performance of the subject company. This is similar to the requirement that CEOs and CFOs certify the accuracy of their financial statements.
• A requirement to disclose firm compensation: Investment banks issuing research reports must disclose in the report if they managed or co-managed a public offering or received any compensation for investment banking services in the past year. Such a disclosure signals to investors that the firm may have a vested interest in the performance of the company.
• A requirement to disclose holdings or investment banking ties during public appearances: How often have you wondered if the analysts appearing on TV touting a stock hold positions in that stock? Analysts must disclose if they or their firms have a position in the stock or if the company is an investment-banking client. This helps the viewer form her own opinion about the validity of the recommendation.
• A requirement to disclose financial interests on reports: On research reports, analysts must disclose if they own shares of the companies.
• A requirement to disclose what the firm’s ratings mean: Firms must fully explain — in plain English — what any ratings terms like buy, sell, or hold mean. Firms must also disclose the percentage of the ratings that they have in each category, and also disclose the percentage of investment banking clients that they have in each category.
• Limitations of personal trading by analysts: Analysts are investors too. But they aren’t allowed to trade on the companies they follow during blackout periods. Specifically, analysts can’t trade for 30 days before and 5 days after they issue a research report. They’re also prohibited from trading against their most recent recommendation. That is, an analyst cannot issue a “buy” recommendation, watch the stock run up, and then, once the blackout period is over, sell her holdings in the stock.