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In my recent article, published in a fortnightly business magazine, I focused on lack of quality research in the financial sector of Pakistan. The article got frowns from some, whose examples I had drawn in order to prove my hypothesis. I think I should accept the critique that my views are more of confessions from perhaps a disillusioned member of the financial community. However, the truth, no matter how bitter it may be, is that the biggest market failure in the capital market is an information failure.
There are no regulation or standardisation of research products and as a result there is no quality controls. In a market, where brokers are themselves running huge books, a clash of interests is bound to occur. There is an urgent need of State intervention to solve this market failure.
The SECP needs to draft regulations for research departments and set up independent agencies, which could authenticate, evaluate and rank equity research. There is also a need for some kind of professional code of conduct and certification, which would ensure that only qualified people are allowed to provide investment recommendation to public.
Due to information failure in the capital market, KSE are degenerated into a rumour-driven market, where a few players have access to superior information. Good research in such a market is more of a search for information, which is not public yet, which would have an impact on the share price. In a developed country, this would be categorised as a financial fraud, however such insider information is a trick of the trade at KSE.
It is inherently a corporate governance problem. Most equity research is being done by brokerage houses where the owners (and management) have their own vested investment interests. A research analyst whose investment recommendations are not aligned with the portfolio interests of the management (or the owner) would certainly not be favourite employee in his workplace. There are hardly any compliance requirements for research analysts and the firewalls between management, ownership, sales and research are either very weak or do not exist at all.
This problem is more prevalent at places where the brokers maintain their own books. I think the solution to this incentives problem is to separate research from brokerage. The SECP should mandate that all research departments should be separated from the brokerage arm and should act as independent companies, with their own board of directors. In case of asset management companies and brokerage firms it is already being implemented. I believe that the same should be done for research departments.
The second possible solution to the information failure is to set up institutions to control the quality of research. Rating agencies, which could authenticate, evaluate and rank research houses, could do the job.
These ratings would allow investors to evaluate which research analyst is credible and authentic. Currently, the CFA Institute provides ranking of Equity Research. However, this ranking should be done by a panel of independent evaluators under the aegis of SECP.
There should be professional certification of research analysts and the analysts should adhere to a code of conduct. There should be tests to ensure that only qualified people are allowed to give investment recommendation to the public. It might not be a bad idea to mandate brokerages to get affiliations with foreign brokerage houses just like asset management companies need foreign joint ventures.
In Pakistan currently only one brokerage research has a technical joint venture with a foreign firm and that brokerage house too has been unable to publish its research with the brand name of its foreign partner! Is this reflecting lack of quality? The foreign partner would ensure that only quality research is allowed to be printed and is distributed to the clients.
The aim of this article is not to belittle or to defame the research house. I am myself a member of this small community of analysts and I am sure my colleagues have great moral strength and technical skills. However, I aim to highlight an incentives problem, which plagues research.
It is improbable to expect independent research where the incentives of the management and the research analysts are not aligned. It is imperative, not only for future development of research industry but also for the maintenance of its credibility, that this agency problem (as it is called) is resolved.
The growth of the stock market in large is dependent on corporate governance and other reforms. These reforms should ensure that every player, small or privileged, should have equal access to market information, research and investment. There is a huge role of the SECP required to resolve this market failure. Hopefully, the regulator would divert its attentions beyond fighting out on issues of badla and futures to address this issue as well.

Copyright Business Recorder, 2005

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