Tuesday, 23 September 2008

Banks’ blurry categorisations – have your cake and eat it too

"Animals are divided into (a) those that belong to the Emperor, (b) embalmed ones, (c) those that are trained, (d) suckling pigs, (e) mermaids, (f) fabulous ones, (g) stray dogs, (h) those that are included in this classification, (i) those that tremble as if they were mad, (j) innumerable ones, (k) those drawn with a very fine camel's hair brush, (l) others, (m) those that have just broken a flower vase, and (n) those that from a long way off look like flies."

This categorisation was quoted by Jorge Borges in his book Other Inquisitions, from an ancient Chinese encyclopaedia. Glad that in the world of business, when it comes to analyst recommendations whether to buy, sell or hold the shares of certain companies, we use rather more unambiguous classifications, don’t we! Or do we…?

Analysts, as you likely know, often face a potential conflict of interest. In principle, they are expected to offer solid and impartial advice on whether they think it’s worth buying the shares of a particular company (because they forecast that the share price will go up) or whether they think it is time to offload any stock you bought in the past (because they forecast that its price will go down). However, their employer – the investment bank – quite often also serves this company as a client, for instance to advice them on their M&A, equity and debt deals. The tricky thing is, companies don’t quite like it (and this is a euphemism) when their own investment bank issues a negative (i.e. “sell”) recommendation for their shares…

How do investment banks deal with this? In the past, I guess, they often didn’t. As research indicates, they would shamelessly issue a “buy” recommendation for a company just to secure them as a client. However, this is a bit tricky – to say the least – because the truth can eventually come out (we’ve seen examples of informal e-mail exchanges between bank employees in which they mock clients who they formally recommended to “buy”), brokerage watchdogs have become quite focused on such behaviour and banks’ long-term reputation may suffer if they make recommendations (e.g. “buy”) which later turn out to be quite wrong, loss-making and plain stupid.

So, how do banks resolve this tricky dilemma…? Anne Fleischer – an assistant professor at the University of Toronto – undertook an intriguing piece of analysis. She looked at ambiguity in banks’ equity ratings systems and how it was related to such conflicts of interest.

You have to realise that banks use different classification schemes, in their advice regarding the attractiveness of certain stocks, and these vary in terms of how ambiguous they can be. For example, “buy; sell; hold” is simple enough isn’t it? But many firms use 5 categories, including a “strong buy” and “clear sell” or so. Still pretty unambiguous, right? But what about “buy/high risk” versus “buy/low risk”; a bit trickier, not? Or “buy; positive; hold; neutral; negative”? Or what about the difference between “buy” and “accumulate” (also found within one and the same classification scheme)?! Some banks have up to 16 different categories, advising us to buy or not. But why would they create such opaque, blurry schemes to advise us in the first place?!

Might it have anything to do with covering their back when they face a conflict of interest…? Could it perhaps enable them to get away with not offering an unambiguous “sell” advice on a client (risking to piss them off) while in reality their analysts are quite pessimistic about the company’s prospects…? After all, if they recommend an unambiguous “buy” but the share price plummets, they will look incompetent if not worse. However, what if they had recommended us a “speculative buy”…? Guess that might divert the blame a bit and get them off the hook... Perhaps such ambiguous schemes help banks make blurry recommendations that keep both angry investors and overbearing clients at bay? Would banks really be that devious…?

Anne didn’t just think; she looked at the facts: She had some financial specialists rate how ambiguous the rating schemes were of 207 brokerage firms. Then she computed to what extent these firms faced a potential conflict of interest, because they were both providing purchase advice and securing the same companies as clients underwriting their debt and equity offerings or supporting their M&A activity. The results were clear: Those investment banks that faced a conflict of interest developed more ambiguous classification schemes to “advise” us on the purchase and sale of company shares.

Evidently, these equity rating systems are not just created with the aims of unequivocal advice and clarity in mind; quite the contrary, sometimes banks don’t want to create clarity at all. Blurring the boundaries helps them cover their tracks, make money on both sides of the table, and thus have their cake and eat it too.

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