Conflict of Interest in Commercial Bank Equity Underwriting

Abstract

This paper examines the pricing characteristics of initial public offerings underwritten by commercial banks. Assuming IPO underpricing is directly related to ex ante uncertainty, if the market rationally perceives these commercial banks to have a conflict of interest, these securities should have more underpricing than non-commercial bank underwritten initial public offerings (all else being equal). On the other hand, if the market believes that commercial bank involvement signals firm quality, less underpricing should be observed. This topic has recently gained in importance with the passage of the Financial Services Reform Act in November 1999. We find that the underpricing of commercial bank underwritten initial public offerings in which the firm had a previous banking relationship with the underwriter is significantly less than those underwritten by investment banks.

Commercial Banks in Investment Banking

“…The foregoing study complements Hebb (2002) by examining a longer time series and also provides evidence on long-term performance of commercial bankunderwritten securities vis-à-vis investment bank-underwritten securities. One caveat for this study is that it does not condition on the existence of any underlying lending relationship (the source of potential conflict of interest), even though such data were available for the 1991-97 sample period.…”

“…Initial Public Offerings Hebb (2002) examines the pricing characteristics of initial public offerings underwritten by commercial banks from 1995 to 1998. Initial Public Offerings Hebb (2002) examines the pricing characteristics of initial public offerings underwritten by commercial banks from 1995 to 1998.…”

Selection Bias and the Underwriter Certification of the Largest Shareholders in Seasoned Equity Offerings

“…The willingness of the largest shareholder to accept the price risk, conveyed by public announcements to market participants, reveals that his private information about future earnings prospects of his firm is favorable. While investment banks as underwriters have an incentive to avoid high certification costs, as argued by Hebb (2002), the largest shareholder who has information advantages about his issuing firm could provide better credibility than investment banks for seasoned issues. 7 Underwriters who have information advantages about issuing firms, on the other hand, might have incentives to misuse their private information.…”

“…The various prior relationships proposed in the literature include the lending relationship between underwriters and issuing firms prior to debt or equity underwritings (e.g., Puri ; Gande et al . ; Hebb ; Schenone ), the equity stake of underwriters prior to equity underwritings (e.g., Gompers and Lerner ), and the initial public offering (IPO) underwriting relationship prior to SEOs (e.g., James ).…”

“…For IPOs, Hebb () and Schenone () find that the IPOs underwritten by commercial banks, which have a pre‐IPO banking relationship with issuing firms, are significantly less underpriced than IPOs underwritten by investment banks without the relationship. For SEOs, Drucker and Puri () report that issuing firms benefit from reduced underwriting fees if the underwriters, including commercial banks and investment banks, concurrently lend to the issuing firms and underwrite their public securities offerings.…”