Are Chinese walls around bank credit analysts porous?–Yes, say Profs.Ting Chen and Xiumin Martin

the authors

Ting Chen is a professor at Baruch College, City University of New York.  Xiumin Martin is a professor at the Olin Business School, Washington University of St. Louis. Together, they authored an extremely well-done article entitled “Do Bank-Affiliated Analysts Benefit from Lending Relationships?”, published in the February issue of the Journal of Accounting Research. (Thanks to Neil Schoenherr of the Olin School’s Office of Public Affairs for providing me with a copy.)

the study

The Chen/Martin paper analyzes what happens when a company makes an initial loan from a banking conglomerate that also has a brokerage arm. In theory, the bank’s credit analysis department keeps all loan-related information confidential—even from other parts of the bank.  The Chen/Martin conclusion is that in practice this doesn’t happen at all. Instead, their evidence strongly suggests that this confidential information ends up  in the hands of the equity securities analysts who cover the borrowing companies for the bank’s affiliated brokerage houses. It also makes its way into their published equity research.

conclusions

The main takeaways from the article are:

    • The accuracy of earnings estimates by bank-affiliated equity securities analysts of a company that is a bank loan customer improve significantly after the company takes out its first loan with the bank.
    • The increase in accuracy is greater if the company is small and information about it is not easily available.
    • Estimates also become better when the company is likely to report bad news, when it’s considered a high credit risk, or when the bank insists on covenants in the loan.  All these areas are, of course, ones that credit analysts would zero in on. In addition to this, however, covenants are of particular note.  They’re restrictions on company activity that the borrower agrees to have written into the loan documents—like that it will maintain a certain minimum level of working capital. What makes them important here is that the borrower must submit periodic financial reports demonstrating that it is not in violation of any. This gives the bank’s credit department a continuing stream of fresh financial and operating data about the borrower.
    • In the case where the loan comes from a syndicate of several banks, the improvement in earnings estimates only shows up with securities analysts employed by the lead arranger, that is, the bank that does the credit analysis and gets the covenant reports.
      • A somewhat wider statement—the improvement in earnings estimate accuracy shows up only with the bank-affiliated analyst, none of his competitors.  This suggests that the impetus for this improvement doesn’t come from publicly available information.
        • Also, the increase in earnings forecasting accuracy for the bank-affiliated analyst applies only to his estimates for the company borrowing from his bank, not the rest of his coverage in the same industry. Here, I think the authors want to establish that the source of the analyst’s inspiration is not some industry-wide development or information gleaned from another company in coverage. How so?  …because there’s no evidence of such insights in his analysis of other companies.  The result can be read in another way, however.  To me, it’s very striking that the analyst doesn’t learn from the information.  It’s even possible that the analyst doesn’t really know why his new-found information is correct, but rather only that it is.  …Hmm.

          earlier work in the same vein

          As the authors point out, this study follows on earlier academic work that suggests that information gathered by credit analysts makes its way into:

          –trading in credit default swaps,

          –the positioning of bank-affiliated mutual fund complexes, and

          –the merger and acquisition section of the bank’s investment banking arm.

          Why don’t borrowers complain?

          One possibility is that, until this article at least, affected companies didn’t realize what has been going on. As the authors suggest, the companies may feel any allegations of illegal activity would be hard to prove.  And, of course, the company may actually benefit, through a higher stock price, from the securities analysts efforts to publicize it. Or they might regard the information leakage as one more cost of getting a loan, something that’s part of the price of entry.

          Where’s the SEC?

          Due to “lack of staff,” this kind of thing is a potential violation that the agency “rarely” looks at.

          my thoughts

          I have two:

          –this is an unusually well thought out and persuasive analysis. 

          –welcome to the real world.

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