Research

Reminder That it's a Short Week This Week - Oct 13, 2009 7:54:25 AM

17. Financial Analysts' Response to the revelation of ESG-related misconduct of their brokerage houses (with Hui Grace Wang, Yaxin Wen, and Luo Zuo) New draft on SSRN soon!

We study how employees respond when their employers’ negative ESG incidents are revealed to market participants. Using the setting of financial analysts and brokerage houses, we find that following negative ESG news, analysts provide higher quality research by producing more accurate earnings forecasts and reliable stock recommendations. This improvement is mostly driven by analysts dialing down previous overly optimistic assessments, and it is absent when their prior assessments are relatively pessimistic. Analysts largely stay with their employing brokers confronted by ESG incidents; among the ones leaving to join other brokers, we do not observe a significant improvement of their research quality at the new jobs. Our results highlight that the revelation of brokers’ negative ESG profile has a silver lining: it improves analysts’ research and alleviates potentially biased assessments. Because ESG constitutes an important part of firms’ intangible assets, our study has broader implication on how employees react to negative events affecting the value of  intangible assets.

Summary of Studies:

My research examines incentive distortions in the financial markets, and their consequences for financial institutions, corporations, and households: 

• For credit rating agencies, I study their incentives to inflate credit ratings due to the “issue-pays” rating model, contrast these biased ratings to the ones under the “investor-pays” model, and derive implications of such rating-inflation incentives in rating analysts’ career path and investor returns. (Papers 1, 2, 5, 6 above)

• For banks, I study how their incentives to monitor borrowers – one of the most important roles played by financial intermediation – is compromised when they face opportunities to unload loans through securitization, such as CLOs and other ABS. (Paper 3)

• For other financial institutions (such as insurance companies), I provide evidence that managers’ incentive to identify risk may be weakened by high-yielding ABS – which often bear inflated credit ratings to conceal the fundamental risk. This weakened incentive hampers risk management’s efficacy in curbing risk taking. Remedial regulations, through the combination of capital regulation and reporting rules, may be necessary. (Paper 7)

• For institutional investors, I show that their ownership structure across industrial firms and information intermediaries (such as media companies) may distort the intermediaries’ incentives, resulting in slanted news and skewed information disclosure at the expense of less informed market participants. (Paper 14)

• For households, I study how conflicts of interest among one specific type of financial institution – the servicers of student loans (constituting a large part of U.S household debt) – can lead to borrowers’ mismanagement of these loans, resulting in excess debt burden.  (Paper 10)

The incentive distortions do not always arise deliberately due to institutions' internal policies; they can arise unintendedly from external public policies: 

• For example, for households with student loans, the government’s (Biden administration) recent efforts in promoting income-driven student loan repayment (IDR) plans – which ties loan payment to borrower income and aims to lower debt burden in bad states – may have an unindented effect to discourage households' labor supply ex ante, due to a household debt overhang problem (Papers 12, 15)

• Likewise, government procedures in determining eligibility of student loan borrowing may foster students’ to divert from studying challenging yet essential courses (such as STEM) amid financial shocks, causing distortion in their human capital decisions. (Paper 13) Interestingly, the adverse impact of such financial shocks is more prominent among male students than femal students. (Paper 16)

• For corporations, government subsidies – such as R&D tax credits – create technology spillovers, allowing firms to better absorb peers’ technological advancement. Such spillovers, however, may dampen firms' incentives in creating innovation that breaks the ground and instead, sidetrack them to follow peers’ suit and focus on incremental innovation. Firms facing technology spillovers attain fewer superstar inventors among their human capital – the important drivers of breakthrough technology advancement.   (Papers 8, 9)

• Along the supplier chain, government subsidies benefiting small businesses may spill over to these businesses’ rivals through the presence of common suppliers, unintendedly eliciting the rivals’ tactic response in order to “avoid feeding the mouth that bites.” (Paper 17)

Incentive distortions also exhibit nuances. The sources giving rise to incentive distortions may also bring up the "bright spots":

• For example, even though institutional investors’ common ownership structure may bias information providers'  incentive (Paper 14) , such ownership can meanwhile facilitate information pass-through in corporate loan markets, alleviating the hold-up problem and lowering borrowers’ loan interest rates. (Paper 11)