The Usual Suspects: A Primer on Investment Banks

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The Usual SuspectsA Primer on Investment Banks
Recommendations and Emerging Markets

• Javier Santiso
• Chief Economist and Deputy Director
• OECD Development Centre

Sebastián Nieto Parra Chaire Finances
Internationales Sciences Po Paris
11th LACEA annual meeting ITAM (Instituto
Tecnológico Autónomo de México) Mexico ?
November 2-4 2006
http//www.financesinternationales.sciences-po.fr/
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Objective of the paper
I
Overview of the literature
II
Description of the data
III
Investments banks business and research
publications
IV
Emerging markets capital flows and research
publications
V
Conclusions
VI
3
Two core questions

• Do recommendations given by investment banks have
  an impact on the allocation of portfolio flows in
  the emerging markets?
• That reveals the influence of analysts
  recommendations on investors behaviour.
• Above all, do recommendations are related with
  the business of investment banks?
• Information provided by banks to investors could
  depend on their own objective that sometimes
  could differ from those of investors.

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Objective of the paper
I
Overview of the literature
II
Description of the data
III
Investments banks business and research
publications
IV
Emerging markets capital flows and research
publications
V
Conclusions
VI
5
Investment banks recommendations

• The impact of investments banks recommendations
  on capital markets has been concentrated in OECD
  countries.
• Womack (1996), Jackson (2005), Boni and Womack
  (2002), Barber et al (2001), Asquith et al
  (2005),
• Variety of results
• Analysts are confronted by a trade-off between
  sending true signals and optimistic signals.
• Larger number of buy recommendations than sell
  recommendations.
• Market reaction to upgrades is less pronounced
  than the market reaction to downgrades by
  analysts.
• Impact of the measures introduced by the NYSE and
  NASDAQ, but also the sanctions established by the
  SEC in 2002.

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Investment banks recommendations

• Research literature on emerging markets is scarce
  and concentrated in the equity market
• Seasholes (2000), Bae et al (2005) Accuracy of
  local vs foreign forecast analysis.
• Bacmann and Bollinger (2001) Boom of the stocks
  covered by analysts between 1993 and 2000.
• Empirical studies of the relationship between the
  recommendations and underwriters are scarce and
  concentrated to OECD countries
• - Krigman, Shaw and Womack (2001) and Womack and
  Michaely (1999). Results suggest that there is a
  conflict of interest between investment banking
  and research department.

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Capital Flows to Emerging Countries

• A large body has studied the determinants of
  capital flows
• Push factors or global factors literature
  First half of the 90s Fernandez-Arias (1996) and
  Calvo et al (1993)
• Pull and Push factors Taylor and Sarno
  (1997), World Bank (2001), Alfaro et al (2005),
• Most of the results conclude that local factors
  combined with external factors explain capital
  flows (FDI, foreign banks lending, bond and
  equity flows,).
• In addition to pull and push factors, recent
  empirical literature has studied the impact of
  information and distance on capital flows
• Ghosh and Wolf (1999), Savastano (2000),
  Papaioannou (2004) and Portes and Rey (2005).
• In particular Portes and Rey (2005) develop an
  empirical model in which international
  information flows are a significant aspect to
  explain international equity flows.

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Our research

• By using untapped and rich dataset, the purpose
  of this study
• First, it is an attempt to analyse the
  determinants of the recommendations given by
  investment banks in the sovereign emerging bond
  market.
• Second, it allows to determine the impact of
  information on capital flows. For that we take
  into account investment banks recommendations as
  an additional factor to explain capital flows.

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Objective of the paper
I
Overview of the literature
II
Description of the data
III
Investments banks business and research
publications
IV
Emerging markets capital flows and research
publications
V
Conclusions
VI
10
Investment banks recommendations

• Construction of a unique database containing the
  recommendations given by the major investment
  banks to the Latin American bond markets.
• Direct and strict link between financial
  intermediaries and investors (not public
  information).
• First publication that studies the impact that
  investment banks recommendations may have on
  Latin American Capital Markets.
• Period July 1997 - July 2006.
• Frequency Monthly Reports

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Investment banks recommendations

• We have taken the recommendations given by 10
  investment banks. All of them important players
  in the emerging bond markets.

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Investment banks recommendations

• Main aspects concerning the recommendations given
  by investment banks
• Composed only by sovereign emerging debt.
• We have classified three types of
  recommendations Overweight (1), neutral (0) and
  underweight (-1).
• These recommendations are assimilated to the
  cases of buying, maintaining and selling with
  respect to a portfolio (the index EMBI
  calculated by JP Morgan)
• Given portfolio restrictions a buying
  recommendation must be compensated by a selling
  advice.

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Investment banks recommendations

• Example Average of the recommendations given to
  Brazil by the investment banks (lhs) with respect
  to the weight of Brazil in the EMBI Global index
  (rhs).

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Investment banks recommendations

• We have taken 11 Latin American countries that
  represent nearly 95 of the GDP of the region.
  The total number of recommendations is over
  3,400.

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Objective of the paper
I
Overview of the literature
II
Description of the data
III
Investments banks business and research
publications
IV
Emerging markets capital flows and research
publications
V
Conclusions
VI
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Investment banks business

• Banks are faced with a trade-off concerning
  recommendations
• While sell side business could have the incentive
  to build reputation by giving accurate
  information in the long term .
• . in the short term recommendations could be
  biased in order to obtain short term profits.
• Additionally, investment banking activities could
  be motivated to recommend optimistically the
  assets which they are participating as
  underwriters in an IPO.

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Underwriters recommendations

• Recommendations given by banks that have been
  underwriters for Latin American sovereign bond
  issues.
• - 90 of the underwriters recommend at the
  announcement date of the issue to buy or to
  maintain in their portfolio the bonds issued by
  the countries where they are acting as
  underwriters.

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Size of the market and recommendations

• Objective of the sell side business to sell
  portfolios to a large variety of financial
  intermediaries. The percentage invested in these
  portfolios increases relative to the size of each
  country.
• High correlation between recommendations and
  size of the market too big to underwrite
• Credit risk is not a relevant variable to
  determine the recommendations

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Objective of the paper
I
Overview of the literature
II
Description of the data
III
Investments banks business and research
publications
IV
Emerging markets capital flows and research
publications
V
Conclusions
VI
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Determinants of capital flows

• In order to test the impact of recommendations on
  capital flows (Bond flows and Equity flows
  respectively), we have used the following two
  panel data regressions models
• (i)
• (ii)
• where and percentage
  allocated by funds in country i with respect to
  the total amount invested in emerging economies.
• the average of the investment banks
  recommendations given to country i .
• Pull macroeconomic variables defined
  by capital markets (exchange rate, spread of
  sovereign bonds and rate of return of equity).

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Determinants of capital flows

• Pull macroeconomic variables that are
  strongly influenced by real sector (economic
  activity, inflation rate and interest rate).
• country invariant variables which capture
  global factors (US nominal rates and US
  industrial production).
• Period of the analyses 1997-2005 for equity
  flows
• 2002-2006 for bond flows
• Frequency Monthly
• Countries Argentina, Brazil, Chile, Colombia,
  Mexico, Peru and Venezuela
• OLS and FE estimation. Since OLS estimation are
  known to deal inadequately with time series and
  cross-section heterogeneity, we reported also
  Fixed Effects estimates (FEM estimators).

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Determinants of capital flows

• In order to determine if a Random Effects Model
  (REM) was an adequate econometric model for this
  analysis we realised the Hausman Test. The null
  hypothesis underlying the Hausman Test (FEM and
  REM estimators do not differ substantially) was
  rejected.
• In order to avoid problems of endogeneity between
  independent and dependent variables we have also
  taken into account the first lag of each of the
  explanatory variables in the regressions. In
  fact, by taking the lagged explanatory variable
  we could solve causality problems which are
  common to capital flows analysis.
• We present only the results of FE estimators with
  lagged explanatory variables (see annex for the
  others results).

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Determinants of bond flows
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Determinants of equity flows
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Objective of the paper
I
Overview of the literature
II
Description of the data
III
Investments banks business and research
publications
IV
Emerging markets capital flows and research
publications
V
Conclusions
VI
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Determinants of capital flows

• 3 conclusions concerning the determinants of
  capital flows
• The impact of investment banks recommendations
  on capital flows is positive and significant.
• The impact of the recommendations given to
  external public debt goes beyond sovereign bond
  flows. Indeed, although their influence is minor,
  these recommendations also affect private equity
  flows.
• 3. This new microeconomic variable improves the
  fit of capital flows regressions more than some
  traditional macroeconomic variables such as
  interest rates, economic growth and inflation
  rate.

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Investment banks recommendations

• We can not reject the hypothesis that the
  information transmitted to investors could depend
  on investment banks business with the purpose to
  obtain short term profits and to recommend
  optimistically the assets which banks are
  underwriters in an IPO.
• Further research
• The results are preliminary. We have in part
  neglected the role of the recommendations in the
  sell side long term business.
• Indeed, further research must be done concerning
  the performance of these recommendations in terms
  of investment value and to contrast them with the
  underwriting activity.

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Policy Lessons

• There is a need for more detailed information
  disclosure by investment banks in order to
  determine if recommendations are related to
  macroeconomic and financial variables or whether
  they are associated with their business in
  emerging economies.
• Government agencies should do a strategic
  monitoring on what market is writing about their
  respective country vulnerabilities.
• Given that banks recommendations and portfolio
  flows are related, an international co-operation
  scheme needs to be established to encourage
  investment banks to cover more countries.

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ANNEXES
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Investment banks recommendations

• An example of the recommendation given by one of
  the most important actor in the Latin American
  Bond Market.

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Underwriters recommendations

• 415 underwriters or Lead managers and 215
  sovereign issues. Almost 75 of the underwriters
  are located in Brazil, Argentina, Colombia and
  Mexico.

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Underwriters recommendations Argentinean case

• The Argentinean case is very useful, interesting
  and special case
• 67 per cent of the recommendations were to
  maintain the positions in Argentinean External
  Debt (prior 2001)
• Some of the comments given by banks months before
  the crisis were unrealistic
• Morgan Stanley We are maintaining our Market
  Perform recommendation on Argentine
  bonds.Relaxation of fiscal targets and an
  innovative IMF-led financial package from
  creditors both improve Argentinas credit
  outlook. Argentina needs to raise an estimated
  2.6 billion to fulfil its first quarter
  financing requirements. New issues are expected
  to total 5.6 billion in 2001. Growth and fiscal
  performance are becoming the focus of investors
  attention. January 26, 2001.
• Salomon Smith Barney (Citigroup) The successful
  implementation of the IMF support package with
  the associated debt management transactions and
  the change in the global outlook probably
  increases the chances that economic activity will
  pick up in the second half of the year. We
  therefore recommend a neutral position in
  external bonds and local currency instruments.
  January 17, 2001

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Underwriters recommendations

• Underwriters recommendations vs.
  Recommendations given by other investment banks
• - 75 of the Lead mangers advice was higher
  than or equal to that made by other investment
  banks.

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Underwriters recommendations

• What is the incentive that no-underwriters could
  have to give an equal or higher recommendation
  than underwriters?
• For most of the Latin American countries 90 of
  the issues were realised by 10 investment banks

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Underwriters recommendations

• By calculating the HHI we obtained the same
  results
• Theoretically, this market could be characterised
  by an imperfect competitive market in which
  underwriters are playing a repeated game.
• By taking investment banks recommendations as a
  marketing product, it is then advantageous to
  investment banks to recommend a country even if
  at that period they have not been underwriters.

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Determinants of bond flows
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Determinants of bond flows
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Determinants of bond flows
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Determinants of equity flows
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Determinants of equity flows
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Determinants of equity flows