Regulating the Financial Analysis Industry: Is the European Directive Effective?

Abstract

In recent years, the US and the EC have witnessed the adoption of new regulations focused on financial analysts. This study investigates whether the European regulation, known as the Market Abuse Directive (MAD), changed the distribution of recommendations and increased their credibility. We find that the proportion of favorable recommendations significantly decreased and, to a lesser extent, that the proportion of unfavorable recommendations increased after the adoption of MAD. However, MAD did not completely eliminate overly optimistic recommendations emanating from financial institutions facing conflicts of interest. Concerning the market reaction to recommendations, we find that "Upgrades" and "Positive initiations" generated more positive abnormal returns post-MAD. Conversely, "Downgrades" generated more negative abnormal returns. We show that differences in investor protection across EC countries explain abnormal returns associated with analyst recommendations. We also find that financial institutions with reputation capital at stake were less prone to optimism and that conflicts of interest were not a significant determinant of the stock market reaction to recommendations either pre-or post-MAD. Finally, we examine whether the US regulation, adopted about two years before MAD, spilt over into the EC, making MAD redundant. Our results show that favorable recommendations on stocks listed on an EC stock exchange became dramatically less positive, and unfavorable ones became more negative following the adoption of the US regulations. However, investors reacted to this change only when MAD was adopted. Therefore, MAD has its own legitimacy, not because it changed analysts' behavior but because it heightened investor awareness of the change in analysts' behavior.