Section 20 versus Investment House Underwriting of Small Equity IPOs

Nancy Beneda, Ph.D., C.P.A.Associate Professor and Vaalor Insurance Fellow

Department of FinanceUniversity of North Dakota,

Box 7096,Grand Forks, ND 58202-7096, USA

University of North Dakota Finance Department, P. O. Box 7096 Grand Forks, North Dakota 58202-7096 (701) 777-4690 Fax (701) 777-5099 nancy.beneda@und.nodak.edu

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Section 20 versus Investment House Underwriting of Small Equity IPOs

Abstract

This study examines corporate equity initial public offerings (IPOs)

underwritten by Section 20 subsidiaries of commercial banks relative to those

underwritten by non-Section 20 underwriters (investment houses). Consistent with a

‘net certification effect’ for banks, corporate equity IPOs underwritten by Section 20

subsidiaries have lower underpricing than those underwritten by investment houses.

Second, commercial banks bring a relatively larger proportion of small equity IPO issues

to market, during the period of this study. Contrary to the contention that universal

banking stunts availability of financing to small firms, bank underwriting appears to

benefit small firms. Further Section 20s do not increase underwriting fees to offset the

effect on potential profits from lower underpricing. This study also finds that Section

20s’ focus on small IPOs results in a higher quality for the IPOs they underwrite, as

indicated by a lower standard deviation of underpricing.

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I. INTRODUCTION

The bank regulatory system has recently undergone substantial changes. For

many years, Section 20 of the Glass-Steagall Act of 1933 protected the investment

banking industry by preventing commercial banks from underwriting corporate bonds

and equity securities. Over the past 15 years the Federal Reserve Board (FRB) has

gradually relaxed many of the restrictions on non-bank activities1 (Section 20 activities)

imposed on commercial banks by the Glass-Steagall Act of 1933. On August 3, 1996,

the FRB further relaxed the revenue constraints on Section 20 subsidiaries of commercial

banks by raising the limit on revenue from Section 20 activities from 10% to 25% of the

total revenue earned by the Section 20. This action took effect on March 7, 1997. The

recent passage of the Gramm-Leach-Bliley Financial Services Modernization Act

(GFSMA) of 1999 now permits commercial banks to engage in a broader range of

financial activities and services. As a result of these legislative changes, commercial

bank participation in equity IPO underwriting, as a percent of the total dollar volume,

increased from 1% prior to the ineligible revenue expansion to about 18% after.

The expansion of nonbank activities by banks has created controversy for policy

makers and in academics over the benefits and costs of such expansion. This study

contributes to the debate over this controversy by examining the pricing and other

characteristics of equity initial public offerings (IPOs) underwritten by commercial banks

versus other investment houses during a period of significant bank entry into this market.

Insofar as commercial banks have reduced costs of information collection (economies of

scope) and more reputation capital at stake than other underwriters, we should expect

lower underpricing for section 20 underwritten IPOs.2,3,4,5,6,7 Recent empirical studies of

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commercial bank entry into corporate debt underwriting find a ‘net certification effect’

for commercial banks.4,5,8,9 A ‘net certification effect’ means that the underwriter is

motivated to accurately price issues to preserve its reputation.10 The motivation to

accurately price the security outweighs the motivation to underprice the security.

Underpricing occurs to benefit large customers, of the investment banker, who regularly

buy a variety of investment services.11

The study of bank participation in the corporate equity new issues market is

relatively new since participation in this market by commercial banks was practically

nonexistent prior to August 1996. This is the first study to examine the impact of

increased participation of commercial banks in underwriting equity IPOs on underpricing

and underwriter fees of IPOs. The main results of the article are as follows. First, this

study finds that banks underwrite a significantly larger proportion of small IPOs than

investment houses. This finding that banks in bring smaller issuers to the market is

contrary to the contention that universal banking powers may stunt small firm financing.

The second finding of this study is that the underpricing of IPOs underwritten by

commercial banks is significantly less than those of investment houses, during the period

after March 7, 1997 when bank entry into the IPO underwriting market dramatically

increased. While underpricing of IPOs underwritten by commercial banks is lower than

that of investment houses, banks may have sought to offset this effect on their potential

profits by raising underwriter fees.2 However, no difference was found between

underwriting fees of commercial banks vs. investment houses. The evidence of the

positive role of banks in the IPO underwriting market is consistent with the results of

other studies on new debt issues underwritten by commercial banks.2,4,5,6

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II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

By definition, underpricing means that the underwriter sets the offer price of the

new issues well below the expected market price of the security in the secondary market.

The investment banker stands to gain through underpricing as it increases the probability

of selling out the issue without affecting the fixed underwriting spread (fee). An

underwriting fee of $3 at a bid-offer price spread of $45 and $48 produces the same gross

revenue (spread) of $3 per share to the underwriter as a bid-offer price spread of $58 and

$61. Underpricing of equity IPOs by investment bankers is undisputed and well

documented in the literature.11,12,13,14,15,16,17,18,19 These studies, in general, suggest that

investment bankers are motivated to underprice IPO securities so they can be allocated to

their large customers who regularly buy a variety of investment services from them.

Consequently both the underwriter and the outside investor may benefit from

underpricing; the loser is the firm issuing the securities because it obtains lower proceeds.

The costs of issuing equity IPOs includes underwriter fees and underpricing, of which

underpricing is the predominate cost. During 1995 through 1998, average underpricing

of corporate equity IPOs was 19.8% of the offering, whereas average underwriter fees for

the same period amounted to 6.8% of the offering.

Informational opacity is inherent in small private companies since they do not

issue traded securities that are continuously priced in public markets, nor are they

registered with the Securities and Exchange Commission (SEC). For these companies,

going public gives the company more access to a vast pool of untapped capital, as well as

helping to stabilize its capital structure. The underlying concern of policy makers and in

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academics is that firms whose investment opportunities outstrip operating cash flows, and

which have used up their ability to issue low-risk debt, may be forced to forego good

investments, because of the inherent risks and costs involved with going public.20

Theory and prior empirical studies suggest the existence of a ‘net certification

effect’ by commercial banks of the new issues that they bring to the market.

Commercial banks should be able to offer new equity securities at lower costs (better

prices/lower underpricing) than investment houses because of the information that arises

from being a lender to the firm.2,3 A commercial bank with a lending or other banking

relationship with the issuer has the potential to efficiently obtain and disseminate more

accurate information on firms going public than an investment house, which has no

banking exposure to the firm.5,21 If investors believe they are receiving more accurate

information about the firm going public, they will be willing to pay a higher price for the

security.

The reputation capital theory suggests that commercial banks would be inclined to

provide more accurate pricing for new equity issues that they underwrite, thereby

disseminating more accurate information on firms going public. Recent literature on the

reputation capital hypothesis suggests that underwriters who have more reputation capital

at stake (larger more reputable underwriters) are more motivated to accurately price

IPOs.5,10,12,13,22,23,24,25,26 These studies show that IPO underpricing is quite costly to issuers

and hence an issuer with low risk tends to employ a prestigious underwriter to convey

their low risk to the market. Conversely, underwriters with a good reputation will only

market low risk IPOs in order to protect their reputation. This in turn, reduces the

uncertainty of aftermarket prices of IPOs and information asymmetry between informed

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and uninformed investors. If a reputable investment banker continues to heavily

underprice IPOs, it will eventually lose its reputation, which is too costly for the

investment banker. The association of Section 20 investment bankers with commercial

banks suggests that these underwriters have more reputation capital at stake in their

underwriting, since the underpricing could negatively effect the larger organization, as

well. Thus we would expect Section 20 underwriters to provide more certification,

resulting in lower underpricing for the IPOs which they underwrite.

On the other hand, the commercial bank, in its role as underwriter, could try to

misrepresent the quality of the security to potential buyers in favor of its customer (the

issuing company). The conflict of interest is created by the commingling of lending and

underwriting and stems from the possibility that commercial banks may have an incentive

to underwrite securities for its poorer quality borrowers and use the proceeds to pay down

these loans.27 If investors perceive an absence of conflicts of interest then they will be

willing to pay higher prices for the new securities (lower underpricing).5 The empirical

work, to date, suggests that conflicts of interest are not present in the operations of

commercial banks. Two studies, in particular, one by Kroszner and Rajan and another

by Puri, examined new corporate debt securities issued prior to the Glass-Steagall Act of

1933 and find that commercial bank underwritten debt securities had a better default

record in the long term than investment house underwritten securities.6,9 Another study

conducted by Gande, Puri, Saunders, and Walter examined corporate debt securities of

lower credit rated firms during the post Section 20 period and finds that securities

underwritten by commercial banks resulted in relatively higher prices than those

underwritten by investment houses. The findings of these studies suggest that

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commercial bank underwritten securities are of a higher quality than non-bank

underwritten issues and are consistent with the absence of conflicts of interest.

This motivation for this study is threefold: 1) the significant changes in bank

regulations, 2) the recent empirical findings regarding a higher quality of new corporate

debt securities underwritten by commercial banks, and 3) the increased participation of

commercial banks in the new equity issues market. An important question relates to the

characteristics and pricing of equity IPO securities underwritten by commercial banks

relative to investment houses. This study addresses the following issues: (i) What are the

characteristics of equity IPOs underwritten by banks as compared to those underwritten

by investment houses? (ii) Is there a difference in the pricing of bank and investment

house IPO underwritings? This article differs from the previous empirical literature in

that it focuses on commercial bank participation in underwriting equity IPOs during a

period of significant bank entry into this market. Bank participation in the new equity

issues market was practically nonexistent prior to March 7, 1997.28

This study examines the underpricing of equity IPOs for the period March 7, 1997

to December 31, 1998. The significance of this time period is that the Federal Reserve

Board (FRB) raised the limit on revenue of Section 20 subsidiary activities from 10% to

25% on August 3, 1996. This ruling took effect on March 7, 1997. Furthermore,

during 1997, the FRB removed many of the firewalls (regulatory barriers between the

bank and its Section 20 securities affiliates to protect the bank from the risks of the

affiliate’s securities activities) which had been enacted in 1987 along with the

establishment of Section 20 subsidiaries at that time. As a result of these legislative

changes, commercial bank participation in equity IPO underwriting as a percent of the

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total dollar amount increased from 1% prior to the ineligible revenue expansion to 18%

after.

II. REGULATORY ENVIRONMENT FOR COMMERCIAL BANKS

Much of the restrictions imposed on commercial banks by the Glass-Steagall

Act of 1933 have been relaxed. In 1968, Congress authorized banks to underwrite

municipal revenue bonds used to finance housing, university and dormitory construction.

In April 1987, the Federal Reserve Board approved proposals by banking organizations

to underwrite and deal on a limited basis in specified classes of “bank ineligible”

securities and authorized commercial bank holding companies (BHC’s) to establish

separate Section 20 affiliates. Section 20 subsidiaries would not violate Section 20 of

the Glass-Steagall Act (1933) as long as the revenue generated from the subsidiaries’

ineligible securities activities amounted to no more than 5% of the total revenues they

generated. In September 1989, the Federal Reserve Board raised the limit on revenue

from section 20 activities to 10% and eventually to 25% on August 3, 1996. This last

ruling took effect on March 6, 1997.

Under the Glass-Steagall Act of 1933, there were fifty-one Section 20 subsidiaries

in the US, as of December 31, 1998 (Federal Reserve Board, 1998). Thirty-seven of

these Section 20 subsidiaries had corporate debt and equity underwriting and dealing

powers (Tier II authority). The remaining fourteen Section 20 subsidiaries have only

Tier I authority, which permits them to engage only in underwriting and dealing in

certain types of debt securities (i.e. commercial paper and municipal revenue bonds), but

not corporate debt and equity underwriting and dealing. From examination of IPO

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listings and their respective underwriters from Investment Dealers Digest, only twelve

Section 20 subsidiaries participated in equity IPO underwriting during the four-year test

period of this study. See Schedule 1 for a listing of these Section 20 affiliates.

… Insert Schedule 1 here …

III. DATA AND SAMPLE SELECTION

The sample developed for this study will be used to examine the characteristics

and underpricing of IPOs underwritten by commercial banks relative to those

underwritten by investment houses. The sample needs to consist of both bank and

investment house firm-commitment IPO underwritings after bank entry and must consist

of a non-trivial number of IPOs underwritten by banks, to ensure that the test results are

representative. The sample period is March 7, 1997 to December 31, 1998. Data for the

period January 1, 1995 through March 7, 1997 was also obtained to examine trends in

average issue size by Section 20 underwriters versus other underwriters.

Data on variables, such as industry, size of issue, underwriting fee, offer price,

and first-day market price must be available for the entire sample. Financial firms (one-

digit SIC code 6) are excluded from the study since the nature of pricing and any conflict

of interest among financial firms may be significantly different from that among

nonfinancial firms.29 Additionally, I focus on the top 20 underwriters (rankings based on

dollar value of underwritings) of IPOs during the study period to eliminate bias from

including very small investment bankers. Six of the top 20 underwriters included in the

sample are Section 20 subsidiaries, namely J.P. Morgan Securities, Bankers Trust Alex

Brown Inc., BankBoston Robertson Stephens, NationsBank Montgomery Securites,

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Citigroup’s Salomon Smith Barney, and Canadian Imperial Bank of Commerce’s

Oppenheimer Corp. The sample consists of 408 IPOs, 104 underwritten by Section 20s

and 304 underwritten by investment houses.

Information about these IPOs, such as issuing company name, date offered,

gross offer amount, number of shares offered, underwriting fee percent, offer price per

share, and lead underwriter was obtained from the “Corporate Market Data” section of

the Investment Dealer’s Digest over the period January 1995 to December 1998. Best-

efforts offerings, IPOs below $1 are excluded.

For each IPO, the first day “quoted” closing price was obtained for IPOs with

offer dates from April 1996 to December 1998 from Hoover’s Online IPO Central after

Market Performance. Since this database only goes back to April 1996, the first day

closing prices for offerings prior to April 1996 were obtained from Standard and Poor’s

(S&P) Daily Stock Price Record.

For each IPO, the S&P market index return was calculated as:

S&P Market Return = [Index (close) – Index (offer)]/Index (offer).

Index (offer) is the S&P Index for the first date the IPO issue is offered and Index (close)

is the S&P Index for the first date the IPO issue goes public. Standard and Poor’s

Indices for 1995 to 1997 were obtained from the S&P Security Price Index Record

(SPIR), page12. S&P Indices for 1998 were obtained from the Statistical Service

Supplement to the S&P SPIR, page 40. Standard and Poor’s 500 composite is a value-

weighted index, having a broad industry coverage and is used extensively by professional

money managers and in academics. For each IPO, a raw initial percent return is

calculated as:

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Raw initial percent return = (Closing Price – Offer Price)/Offer Price

The closing price represents the closing price on the first day of after market trading for

which a quotation could be found. The offer price is the offer price as reported in

Investment Dealer’s Digest. The underpricing (market-adjusted initial percentage

return) is calculated for each IPO as follows:

Market-adjusted initial percent return = raw initial percent return –

S&P market return.

IV. METHODOLOGY

IV.A. Characteristics

To examine the characteristics of IPOs underwritten by commercial banks

relative to those underwritten by investment houses, univariate t tests and probit

regression models are used. The dependent variable for the probit regression is SECT20,

which is a dummy variable that takes the value of 1 if the lead underwriter is a Section 20

subsidiary of a commercial bank and 0, otherwise (investment house). The independent

variables are:

LN(AMOUNT): The natural log of the size of the issue (in millions of dollars).LN(NUMISS): The natural log of the number of issues underwritten by the underwriter during the test period.INDUSTRY: Stands for a set of industry dummy variables based on one-digit primary SIC codes. For example, if the primary SIC code is 3469, the one-digit primary SIC code is 3. The corresponding dummy variable is 1 and all other industry dummy variables are 0 for that IPO.QUARTER: Stands for a set of quarterly dummy variables based on the quarter during the sample period in which the IPO was brought to market. For example, if the IPO was brought to

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market on March 12, 1997, the designated quarter would be Q1. The corresponding dummy variable is 1 and all other quarter dummy variables are 0 for that IPO.

LN(AMOUNT) and LN(NUMISS) are used to represent IPO quality and

underwriter reputation. Previous research shows that issue size is inversely related to

underpricing.14,16,30 Other research has shown that market share and number of issues of

the investment banker is highly related to the underpricing of the underwriter.12,31

INDUSTRY and QUARTER are used as control variables as it has also been shown that

underpricing varies according to industry and time period.13,16,22 Specifically I run the

following probit regression5:

SECT20 = 0 + 1 LN(AMOUNT) +2 LN(NUMISS) + 3 INDUSTRY

+ 4 QUARTER

(1)

IV.B. Underpricing of Banks vs. Investment Houses

To examine the underpricing of IPOs underwritten by commercial banks relative

to those underwritten by investment houses, linear regression models are used. The

dependent variables are underpricing (UNDERPRICE) and underwriting fee (FEE). The

computation of underpricing is described above in the data and sample selection section.

Underwriting fee is the gross spread between the offered amount of the IPO and the

proceeds to the issuer, as a percent of the offered amount. The independent variables for

the linear regression models are the same as those described above with SECT20 used as

an additional independent dummy variable that takes the value of 1 if the lead

underwriter is a Section 20 subsidiary of a commercial bank and 0 otherwise (investment

house). Specifically, the following regressions are attempted:

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UNDERPRICE = 0 + SECT20 + 2 LN(AMOUNT) +3 LN(NUMISS)

+ 4 INDUSTRY + 5 QUARTER

(2)

FEE = 0 + SECT20 + 2 LN(AMOUNT) +3 LN(NUMISS)

+ 4 INDUSTRY + 5 QUARTER

(3)

VI. EMPIRICAL RESULTS

V.A. Characteristics

Commercial banks underwrite a larger proportion of small IPOs than investment

houses. From Table 1, 67% (70 out of 104 IPOs) of bank underwritings were less than

or equal to $45 million, whereas 32% (98 out of 304 IPOs) of investment house

underwritings were less than or equal to $45 million. A univariate test of the difference

in average issue size of Section 20 and investment house underwritings is also conducted.

The mean issue size of bank underwritings was $49 million and that of investment houses

was $159 million. The difference is statistically significant (p<0.01). This result is

consistent with the view that commercial banks focus on underwriting small issues. To

further analyze the trend that banks may be establishing in their focus on small issues, the

trends in average issue size underwritten by banks relative to investment houses over

time are examined. The average issue size of IPOs underwritten by investment houses

increases over the four years reported, whereas the average issue size of Section 20s

decreases. See Table 2. A probit estimation (model 1) is also performed. See Table 3.

The probit results suggest that the main factor determining whether the underwriter is a

Section 20 or investment house is small issue size. The coefficient for LN(AMOUNT) is

significant (p < 0.01). The coefficient on LN(NUMISSUE) is not significant, indicating

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that number of issues of underwriter is not a significant determinant of whether the

underwriter is a Section 20 or not.

…Insert Tables 1,2,3…

It might be argued that Section 20s are new to IPO underwriting and may be

forced initially to focus on smaller issues to gain expertise, before gaining larger clients.

However, according to a statement by Alan Greenspan, Chairman of the Federal Reserve,

in 1995, the intention of commercial bank entry in securities dealing and underwriting

has been to promote funding of smaller firms.32 Further the results of Gande’s study

corroborate the findings of this study with a similar conclusion about banks focusing on

small new debt issues.4 Their sample period starts four years after the granting of debt

underwriting powers. Although a repeated study on bank participation in equity IPOs, in

several years, after banks have had a chance to gain expertise might reveal different

results, the current evidence does not support the contention that greater universal

banking powers has stunted financing to small firms.

V.B. Underpricing results

To examine pricing characteristics of corporate equity IPOs underwritten by

Section 20s versus investment houses, a multivariate regression (model 2) of type of

underwriter on underpricing is performed. The regression results indicate that

underpricing is lower for Section 20 underwritten IPOs than investment house IPOs

during the sample period, controlling for IPO and underwriter quality, industry and time

period offered. The coefficient on SECT20 (dummy variable) is negative and

statistically significant (p < 0.05). See Table 4. Although not highly significant, the

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results are consistent with a net certification affect for commercial bank underwritten

equity IPOs.

… Insert Table 4 …

While the results of the tests indicate underpricing of IPOs underwritten by

commercial banks is lower than that of investment houses, banks may have sought to

offset this effect on their potential profits by raising underwriter fees.2 Therefore a

multivariate regression (model 3) of type of underwriter on underwriting fees is

performed. The coefficient on LN(AMOUNT) is negative and statistically significant (p

< 0.01), indicating that underwriting fees are based on the offer size of the IPO. See

Table 5. The regression results indicate that there is no difference between underwriting

fees of Section 20s versus Investment Houses. The coefficient on SECT20 is not

significant. Thus Section 20s do not raise underwriter fees to offset the effect on

potential profits from lower underpricing.

…Insert Table 5…

As a further illustration of the differences between IPOs underwritten by Section

20s versus investment houses, a sub-sample of small to medium sized IPOs (IPOs less

than $90 million) is observed. The sub-sample consists of 295 IPOs (73% of the sample

IPOs), of which 94% of IPOs underwritten by Section 20 are under $90 million and

included in this sample. Sixty-five percent of IPOs underwritten by Investment Houses

are under $90 million and included in the sub- sample. For IPOs smaller than $90

million, the mean underpricing of those underwritten by Section 20s is 17.9% versus

23.9% for those underwritten by investment houses. Further the standard deviation of

underpricing of IPOs underwritten by Section 20s is 31.3% versus 55.8% for IPOs

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underwritten by investment houses. Standard deviation of underpricing is an indication

of the accuracy of pricing of an IPO and has been used as an indication of underwriter

quality in prior studies.12,26 This further illustrates the focus of commercial banks on

small equity IPOs and their ability to underwrite higher quality small IPOs than those of

investment houses.

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VI Conclusion

Insofar as commercial banks have reduced costs of information collection

(economies of scope) and more reputation capital at stake than other underwriters, we

should expect lower underpricing for section 20 underwritten IPOs.2,3,4,5,6,7 This study

examines corporate equity initial public offerings (IPOs) underwritten by Section 20

subsidiaries of commercial banks relative to those underwritten by non-Section 20

underwriters (investment houses). Consistent with a net certification effect for banks,

corporate equity IPOs underwritten by Section 20 subsidiaries have lower underpricing

than those underwritten by investment houses. This finding is consistent with previous

literature which find a net certification effect in the underwriting of debt securities.4,6,,7,8,9

Second, commercial banks bring a relatively larger proportion of small equity

IPO issues to market. Contrary to the contention that universal banking stunts

availability of financing to small firms, bank underwriting appears to benefit small firms.

Further Section 20s do not increase underwriting fees to offset the effect on potential

profits from lower underpricing. The focus Section 20s focus on small IPOs results in a

higher quality for the IPOs they underwrite, as indicated by a lower standard deviation of

underpricing.

If investors perceive an absence of conflict of interest, they will be willing to

pay higher prices for the securities. The higher prices (lower underpricing) of new

equity securities underwritten by commercial banks, found in this study is consistent with

the absence of conflicts of interest, which has also been documented in previous

studies.4,5,6,9

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Schedule 1

Schedule 1 reports the section 20 subsidiaries and the parent organizations (as of December 31, 1998) that participated in equity IPO underwriting during one of the years included in this study (1995-1998)

Section 20 subsidiary Parent organization

ABN AMRO Inc. ABN AMRO BankBankBoston Robertson Stephens BankBoston Corporation

BT Alex, Brown, Inc. Bankers Trust NY CorporationCIBC Oppenheimer Corp Canadian Imperial Bank

Of CommerceDeutsche Bank Securties Inc. Deutsche Bank

Fifth Third Securities Fifth Third BancorpJ.P. Morgan Securities J.P. Morgan & Co., Inc.

Montgomery Securities NationsBankNesbitt Burns Securities, Inc. Bank of MontrealPiper Jaffray, Inc. U.S. BancorpSalomon Smith Barney, Inc. CitigroupSG Cowen Securities Corporationa Societe Generale

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A SG Cowen Securities Corporation did not issue any equity IPOs since their formation as a section 20 subsidiary in June 1998.

Table 1Descriptive Summary of Sample

Section 20 No. Mean issue size ($k)

Investment House No. Mean issue size ($k)

All issues in sub-sample

Small Issues (less than or equal to $45m)

Large Issues (greater than $45m)

104 49,279

70 31,909

34 85,041

304 159,355

98 32,107

206 219,891

This table classifies the bank sample based on issue size into small (less than or equal to $45 million) and large (greater than $45 million) categories. k represents thousands.

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Table 2Aggregate issue size over time and by underwriter type

YearSection 20

Percent Mean issue < $45 million size ($m)

Investment House Percent Mean issue < $45 million size ($m)

1995

1996

1997

1998

All issues

not reported

67% $63

67% $51

68% $46

57% $70

51% $93

42% $121

25% $205

This table presents the average issue size (in millions of dollars) and the percent of IPOs under $45 million of initial public offerings underwritten by Section 20s and investment houses for four years, 1995-1998.

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Table 3Probit estimations – commercial bank versus investment house IPOs

Variable Coefficient t valueInterceptLN(AMOUNT)LN(NUMISSUE)

0.745-0.133 0.046

4.946a

-5.508a

1.195

F value 6.648 p-value 0.000a

Observations 408 R2 .131

This table presents results of the probit regression (model 1). The dependent variable is a dummy variable, SECT20, assigned the value one if the lead underwriter is a Section 20 subsidiary of a commercial bank and zero otherwise. The independent variables are as follows: LN(AMOUNT) is the natural logarithm of the offered amount of the initial public offering. LN(NUMISSUES) is the natural

22

logarithm of the number of IPOs brought to market by the lead underwriter of the IPO issue. INDUSTRY is a set of industry dummy variables based on one digit SIC codes. QUARTER stands for a set of quarterly dummy variables based on the quarter during the sample period in which the IPO was brought to market. The point estimates and t values for the industry and quarter dummies are not reported, though are included in the regressions. a, b, and c stand for significant at 0.01, 0.025, and 0.05

Table 4Multivariate tests for underpricing of commercial bank versus investment house

underwritings of IPOs

Variable Coefficient t valueInterceptSECT20LN(AMOUNT)LN(NUMISSUE)

56.533-8.533-2.310 0.800

3.619a

-1.692c

-.916.207

F value 6.042 p-value 0.000a

23

Observations 408 R2 .132

This table presents results of the multivariate regression analysis (model 2). The dependent variable is the underpricing of the IPO. The independent variables are as follows: SECT20 is a dummy variable, assigned the value 0 if the lead underwriter is a Section 20 subsidiary of a commercial bank and zero otherwise. LN(AMOUNT) is the natural logarithm of the offered amount of the initial public offering. LN(NUMISSUES) is the natural logarithm of the number of IPOs brought to market by the lead underwriter of the IPO issue. INDUSTRY is a set of industry dummy variables based on one digit SIC codes. QUARTER stands for a set of quarterly dummy variables based on the quarter during the sample period in which the IPO was brought to market. The point estimates and t values for the industry and quarter dummies are not reported, though are included in the regressions. a, b, and c stand for significant at 0.01, 0.025, and 0.05.

Table 5Multivariate tests for underwriting fees of commercial bank versus investment

house underwritings of IPOs

Variable Coefficient t value

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InterceptSECT20LN(AMOUNT)LN(NUMISSUE)

8.767-0.040-0.502 0.016

38.683a

-0.559-12.568a

0.303

F value 12.746 p-value 0.000a

Observations 408 R2 .422

This table presents results of the multivariate regression analysis (model 3). The dependent variable is the underwriting fee of the IPO. The independent variables are as follows: SECT20 is a dummy variable, assigned the value 0 if the lead underwriter is a Section 20 subsidiary of a commercial bank and zero otherwise. LN(AMOUNT) is the natural logarithm of the offered amount of the initial public offering. LN(NUMISSUES) is the natural logarithm of the number of IPOs brought to market by the lead underwriter of the IPO issue. INDUSTRY is a set of industry dummy variables based on one digit SIC codes. QUARTER stands for a set of quarterly dummy variables based on the quarter during the sample period in which the IPO was brought to market. The point estimates and t values for the industry and quarter dummies are not reported, though are included in the regressions. a, b, and c stand for significant at 0.01, 0.025, and 0.05.

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Table 6Descriptive Summary of Small to Medium IPOs

Num. Percent Mean Standard Deviation ofIssues of Total Underpricing Underpricing

IPOs under $90 million

Section 20

Investment House

295 73% 21.9% 49.1%

98 94% 17.9% 31.3%

197 65% 23.9% 55.8%

This table classifies the bank sample based on issue size into small (less than or equal to $90 million) and large (greater than $90 million) categories.

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References

(1) Non-bank activities are also referred to as Section 20 activities and ineligible activities. These activities include, primarily, underwriting and dealing in corporate securities. Other ineligible activities include selling real estate, insurance, and computer services.

(2) Puri, M. (1999) ‘Commercial Banks as Underwriters: Implications for the Going Public Process’, Journal of Financial Economics 54, 2, pp. 133-163.

(3) Kanatas, G. and Qi, J. (1998) ‘Underwriting by Commercial Banks: Incentive Conflicts, Scope Economies, and Project Quality’, Journal of Money, Credit, and Banking 30, 1.

(4) Gande, A., Puri, M., Saunders, A. and Walter, I. (1997) ‘Bank Underwriting of Debt Securities: Modern Evidence’, The Review of Financial Studies 10, 4, pp. 1175-1202.

(5) Puri, M. (1996) ‘Commercial Banks in Investment Banking: Conflict of Interest or Certification Rule?’, Journal of Financial Economics 40, pp. 373-401.

(6) Kroszner, R. and Rajan, R. (1994) ‘Is the Glass-Steagall Act Justified? A study of the U.S. Experience with Universal Banking Before 1933’, American Economic Review 84, pp. 810-832.

(7) Benston, G. (1990) ‘The Separation of Commercial and Investment Banking’, Oxford: Oxford University Press.

(8) Gande, A., Puri, M. and Saunders, A. (1999) ‘Bank Entry, Competition, and the Market for Corporate Securities Underwriting’, Journal of Financial Economics 54, 2, pp. 165-195.

(9) Puri, M. (1994) ‘The Long-Term Default Performance of Bank Underwritten Security Issues’, Journal of Banking and Finance 18, 2, pp. 397-418.

(10) Chemmanur, T. and Fulghieri, P. (1994) ‘Investment Bank Reputation, Information Production and Financial Intermediation’, Journal of Finance 49, pp. 57-79.

(11) Rock, K. (1986) ‘Why New Issues are Under-Priced’, Journal of Financial Economics 15, pp. 187- 212.

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(12) Carter, R. and Dark, F. and Singh, A. (1998) ‘Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stock’, Journal of Finance 53, 1, pp. 285-311.

(13) Michaely, R. and Shaw, W. (1994) ‘The Pricing of Initial Public Offerings: Tests of Adverse Selection and Signaling Theories’, The Review of Financial Studies 7, pp. 279-319.

(14) Chalk, A. and Peavy, J. (1989) ‘Understanding the Pricing of Initial Public Offerings’, in Chen, editor: Research in Finance (JAI Press, Greenwich, CT)

(15) Miller, R. and Reilly, F. (1987) ‘An Examination of Mispricing, Returns, and Uncertainty for Initial Public Offerings’, Financial Management 16, 2, pp. 33-38.

(16) Ritter, J. (1984) ‘The ‘Hot Issue’ Market of 1980’, Journal of Business 57, pp. 215-40.

(17) Ibbotson, R. (1975) ‘Price Performance of Common Stock New Issues’, Journal of Financial Economics 2, pp. 235-272.

(18) Ibbotson, R. and Jaffe, J. (1975) ‘“Hot issue” Markets’, Journal of Finance 30, pp. 1027-1042.

(19) Logue, D. (1973) ‘On the Pricing of Unseasoned Equity Issues: 1965-1969’, Journal

of Financial and Quantitative Analysis 8, pp. 91-103.

(20) Myers, S. and Majluf, N. (1984) ‘Corporate Investment and Financing Decisions When Firms Have Information that Investors Do Not Have’, Journal of Financial Economics 13, pp. 187- 222.

(21) James, C. (1987) ‘Some Evidence on the Uniqueness of Bank Loans’, Journal of Financial Economics 19, pp. 217-236.

(22) Nanda, V. and Yun, Y. (1997) ‘Reputation and Financial Intermediation: An Empirical Investigation of the Impact of IPO Mispricing on Underwriter Market Value’, Journal of Financial Intermediation 6, pp. 39-63.

(23) Lin, T. (1996) ‘The Certification Role of Large Block Shareholders in Initial Public Offerings: The Case of Venture Capitalists’, Quarterly Journal of Business and Economics Spring, 35, 2, pp. 55-66.

(24) Lin, T. and Smith, R. (1995) ‘Insider Reputation and Selling Decision: The Unwinding of Venture Capital Investment’, Working Paper, National Chung Cheng University and Arizona State University.

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(25) Megginson, W. and Weiss, K. (1991) ‘Venture Capitalist Certification and Initial Public Offerings’, Journal of Finance 46, pp. 879-904.

(26) Carter, R. and Manaster, S. (1990) ‘Initial Public Offerings and Underwriter Reputation’, Journal of Finance September, pp. 1045-1067.

(27) This is the fundamental argument that motivated prohibition of bank underwriting and imposition of the Glass-Steagall Act of 1933.

(28) Ten IPOs were underwritten by Section 20 subsidiaries of commercial banks prior to March 7, 1997. Nine were underwritten by J. P. Morgan and one was underwritten by BankBoston Robertson Stephens.

(29) Financial firms (SIC one-digit code 6) are excluded from the study since the nature of pricing of financial firms has been shown in studies by Gande, Puri & Saunders and Michaely & Shaw to be significantly different from that among nonfinancial firms.8,13 Also the focus of this study is on corporate IPOs.

(30) Beatty, R. and Ritter, J. (1986) ‘Investment Banking Reputation and the Under-

pricing of Initial Public Offerings’, Journal of Finance and Economics 15, pp. 213-232.

(31) Beatty, R. and Welch, I. (1996) ‘Issuer Expenses and Legal Liability in Initial Public Offerings’, Journal of Law and Economics 39, pp. 545-602.

(32) Greenspan, A. (1995) ‘Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives’, February 28, 1995, Federal Reserve Bulletin, 81, 4, pp. 349-355.

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