When headlines announced that most of the major Wall Street banks agreed to pay huge fines without admitting that financial analysts lied in their research reports, McIntire Professor Bill Wilhelm took a contrarian position about what should be done.

“I wouldn’t hop on the bandwagon for dramatically changing the way we regulate the interface between investment banks and research,” says Wilhelm, disagreeing with a media outcry for increased government oversight.

No Reward in Stretching the Truth

“We looked for evidence that analysts’ overstating their case in research reports had a significant bearing on the chances the bank they were working for would get the deals they were seeking,” says Wilhelm, who studied more than 16,000 U.S. debt and equity offerings sold between December 1993 and June 2002.

In fact, Wilhelm and his colleagues, McIntire Associate Professor Felicia Marston and Alexander Ljungqvist from the Leonard N. Stern School of Business at New York University, found very little evidence that analysts’ behavior served the interests of the banks. In some instances, that behavior may even have undermined the banks’ chances of winning business.

“There is no doubt that some of these analysts were reaching, and there is no doubt that they were under pressure from the investment banks,” says Wilhelm. “But this conflict of interest has always been around.”

Unraveling the Complexity

So, if analysts and their banks did not achieve gains, then why the pain of lost reputations and business? Wilhelm believes several factors upset the equilibrium in the investment banking scene.

“With the substantial deregulation of the commercial banking industry in the last decade, commercial banks, with their bigger balance sheets and greater lending capacity, became powerful competitors of investment banks, particularly
in the debt markets,” says Wilhelm. “Commercial banks were offering issuing firms loans on relatively good terms but tying those terms to the firms’ securities underwriting transactions. That’s where they were earning the big fees.”

According to Wilhelm, the investment banks could not match commercial banks’ lending capacity, but they did have a deep reserve of reputation capital. “When analysts overstate their case, they are essentially liquidating their reputation capital,” he says. “On the whole it was not an effective strategy, but taking a narrow view in some cases, it looked like an effective way of fending off the competition.

“Other factors were the huge influx of naïve retail investors in the market during the dot-com boom and the enormous number of transactions that created a larger fee pool from which analysts were compensated. That further tilted the balance that made analysts willing to sacrifice their reputations.”

Taking a longer historical view, however, Wilhelm thinks the problem is probably a transitory one and that market forces will bring the conflict in check without increased government oversight. In fact, it is Wilhelm’s unique historical perspective that informs his research on how financial intermediaries — bankers, brokers, and market makers, for example — adapt to changes in technology and regulation.

Bankers Out of a Job?

Wilhelm’s recent book, Information Markets, co-authored with Joseph Downing and published in 2001 by Harvard Business School Press, charts the implications of the tremendous growth in both information technology and in financial theory — and the intersection of the two.

“I view the interface between finance and technology as a first-order consideration right now,” he says.

Wilhelm makes the case that as financial knowledge is codified and written into computer programs, the people responsible for conveying that information to their clients—investment bankers, for example — may be out of a job, or at least the job as it is currently defined. In a new book in progress, Wilhelm explains the history of investment banking from a technological point of view, emphasizing how technological advances are changing the very structure of the industry.

For Wilhelm’s McIntire students, his research has important implications both in the classroom and beyond. In a recent cross-disciplinary collaboration, students from Wilhelm’s finance class and students from Assistant Professor Stefano Grazioli’s IT class divided into mixed teams. Each team built financial software that would facilitate maintaining the value of a $20 million portfolio over a period of turbulent market conditions.

Wilhelm’s students learned several lessons from the competition. “I wanted them to have a firsthand experience of how powerful financial theory is. It is why program trading is becoming so important. Of course, in order to codify, you need to understand the theory very clearly, so the competition was a good way of making these ideas stick in their minds. It also gave my finance students an opportunity to work with technical people, IT students, which is what they’ll do in the real world.”

Equally important, students became aware that in areas where financial knowledge is easily codified, certain skills will not be as highly valued as they are now. “The big money and the opportunity for careers in the most creative areas of finance, and really in any industry, are in those areas that aren’t so readily codified,” he says. “That’s where McIntire students should direct their career path.”