Academic journal article Financial Management

Determinants of Underwriting Fees by New Entrant Banks: Evidence from the Japanese IPO Underwriting Market

Academic journal article Financial Management

Determinants of Underwriting Fees by New Entrant Banks: Evidence from the Japanese IPO Underwriting Market

Article excerpt

This article analyses how commercial banks expand market shares after entering the underwriting market, focusing on the fee structure. Although traditional studies base their arguments on information asymmetry, we examine strategic behavior by bank entrants into the underwriting market. This argument is supported by evidence from the period during which commercial banks were allowed to enter the underwriting market in Japan. The findings reveal that investment banks that have no previous business experience in underwriting and no reputation discount fees regardless of the degree of private information about issuers.

Two hypotheses are proposed. First, the information advantage hypothesis states that in preparing an issuance, underwriters play an important role in mitigating asymmetric information between firms and investors and certifying the quality of issuers for investors (Booth and Smith, 1986; Carter and Manaster, 1990; Chemmanur and Fulghieri, 1994). If a bank has private information about the quality of an issuer, it can avoid the costs of acquiring private information, resulting in discounted fees, whereas an underwriter normally experiences increased costs for acquiring such private information (Fang, 2005; Kutsuna, Smith, and Smith, 2007). This cost increases as the degree of asymmetric information between insiders and outsiders increases (Puri, 1996; Fang, 2005). Thus, a long-term relationship with an issuer enables a bank to obtain private information about a firm (Diamond, 1984; Hoshi, Kashyap, and Scharfstein, 1990; Petersen and Rajan, 1994). In contrast, bank underwriters without private information must pay obtain private information, which increases fees. Based on this argument, only underwriters with private information about issuers can discount their fees, and the discount is more pronounced for firms with higher information asymmetry.

Second, the strategic discounting hypothesis predicts that banks will offer lower underwriting fees for all customers. This argument is based on the managerial economics and marketing literature (Tellis, 1986; Raman and Chatterjee, 1995), which argues that in some settings, entrant firms discount fees to expand their market share. Because commercial banks are entrants in the underwriting business and have no reputation in the market, they have an incentive to offer lower fees to attract clients and to compete with other investment banks that have long histories in the market. In this situation, underwriting fees from entrant bank underwriters are lower for all firms regardless of the degree of asymmetric information between the bank and issuer.

Our empirical findings support the strategic discounting hypothesis. Results show that banks discount underwriting fees not only when they have private information about the issuers but also when they do not have this information. Two measures are used to define firm-bank relationships. The first is equity investment history by banks or subsidiary venture capital; if the banks invested before the initial public offering (IPO), they can acquire private information about the issuer. The second is main bank information, which refers to the bank that has the longest transaction history with and most private information about an issuer. Based on both measures, we find that banks discount fees for both high and low degree of asymmetric information, which is measured by firm size. The discount for small firms is pronounced. For example, we find that a decrease of one standard deviation of firm size leads to a 0.25-standard-deviation discount in the underwriting fee. Importantly, the discount for small firms is observed by bank underwriters both with and without private information implying that the existence of private information does not matter for the determination of underwriting fee.

A subsample analysis is also conducted by dividing the sample into two periods: 2002-2005 and 2006-2011. If banks use private information, as the first hypothesis predicts, fees should be discounted throughout the sample periods. …

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