Conflicts of Interest, Intermediation, and the Pricing of Underwritten Securities

When commercial banks both lend to, and underwrite securities for a firm, does this result in higher or lower prices for the underwritten securities, compared to investment houses’ underwritings? Investment houses have an incentive to underinvest in costly information production. Banks obtain such information form their lending activities and hence do not have a similar incentive to underproduce information, instead they have an incentive to misrepresent this information because of bad loan exposure to the issuing firm. The paper models these differing incentives and weighs them against mitigating reputation effects, to determine prices in equilibrium. It finds conditions where banks’ underwritings can result in higher realised prices and derives implications for the pricing differential. In particular, even when both intermediaries have similar reputations ex-ante, banks are likely to have a pricing advantage when information collection costs are high, e.g., for junior and information sensitive securities. The paper also examines implicit costs of bank underwriting by quantifying the level of rent extraction by banks. It finds conditions under which firms go to banks first and then to the public markets, and for banks and investment houses to co-exist.