Underwriting by Commercial Banks: Incentive Conflicts, Scope Economies, and Project Quality

Abstract

The authors study the issue of commercial bank underwriting of securities. Their analysis examines the incentive conflict faced by intermediaries that both lend and underwrite securities, thereby imposing a cost on their customers seeking to raise capital. Despite this cost, firms may choose to use such an intermediary if there are sufficiently large scope economies in combined lending and underwriting. The authors demonstrate that the regulatory separation of such combined intermediation may be optimal if firms recognize the intermediary's subsequent incentive conflict when choosing projects to be funded and if there is a social cost to bank funding of poor quality projects. They also examine the conditions for intermediaries' reputation building to mitigate the incentive conflict, without the need for regulation.

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