Analysts and regulation: Scopes for European policy makers to enhance investor protection

Academic research provides extensive evidence that investors are limited to access and process relevant information and, consequently, follow analyst recommendations when making investment decisions. Sell-side analysts are considered as financial intermediaries who process, transform and transfer information in order to enable investors to make appropriate investment decisions. As a consequence, analysts are frequently referred to as the drivers of market efficiency considering their supportive function in furthering effective asset prices. Over the last few years, however, sell-side security analysts have come under closer supervisory attention given their vulnerability to numerous conflicts of interest that are not transparent to the investor.

It is foremost our motivation to holistically 1) analyze conflicts of interest that emerge in the context of the production of analyst research reports, 2) examine the current regulatory framework for analysts in the European Union (EU) and 3) investigate the practical enforcement of legal sanctions. In this study, we focus on regulatory measures that are relevant for analysts, namely the Market Abuse Directive (MAD) and the Markets in Financial Instruments Directive (MiFID) and outline gaps in the regulatory framework that policy makers should attempt to close in future interventions in order to achieve enhanced investor protection. In the EU these directives were introduced because the European Commission strives for the goal to establish a single market in financial services and, in the same process, to assure market integrity and investor protection.

In this paper we find that European regulators have primarily focused on mitigating conflicts of interest. This approach, however, is only a first step in the right direction. Empirical evidence shows that the scope of MAD and MiFID turns out to be quite narrow and the directives leave considerable issues unaddressed. In order to establish a framework of more sophisticated investor protection, additional regulatory effort is required. Proposals to fill regulatory gaps in the EU are presented and discussed in this paper. Our results indicate that relevant information is not displayed appropriately on analyst research reports. Specifically, the section on the disclosure of conflicts of interest is not prominently specified. We propose that reports should be standardized in a way that investors are enabled to understand the rationale of the recommendation more thoroughly and to compare recommendations between different analysts of different banks. In order to achieve such a standardization and comparability, regulators should specify a predefined length, structure and design of research reports. In addition, an examination of relevant risks associated with the financial product is scarce or even missing in many reports. As a consequence, to date the addressees of the recommendations receive loads of information but are hardly elucidated about risks that might have a substantial influence on the success of the investment. Beyond that, we discuss how organizational and administrative arrangements (“Chinese Walls”) can be enhanced beyond the regulatory measures imposed in the EU.