Can Relationship Banking Reduce Firm's IPO Underpricing?

Abstract

IPO underpricing harms pre-existing shareholders and reduces the capital firms can raise to fund their growth. This paper shows that relationship banking can reduce IPO underpricing by decreasing information uncertainty. I develop a theoretical model showing that good firms – those with a lower dispersion of market value – are harmed and bad firms benefit from IPO price uncertainty when there is no borrowing and, thus, no distinguishing information on firm quality. When investors receive signals about firm value only from publicly observable transaction lending, good firms benefit while bad firms suffer. However, when firms have access to loans through relationship banks and when such lending decisions are kept confidential, firms experience reduced IPO price uncertainty, which benefits both good and bad firms. I confirm this result empirically through difference-in-differences and reduced form instrumental variable regression designs. I use variation in the strength of the lending relationship between IPO firms and their underwriters generated by the repeal of the Glass-Steagall Act in 1999, which allowed commercial banks with close ties to their client firms to underwrite those firms’ equity issuances.