Relationship Capital and Competition In the Corporate Securities Underwriting Market

This paper examines how relationship capital drives competition among underwriting banks in the corporate bond underwriting market. The recent deregulation and subsequent re-entry by commercial banks into this market in the U.S. raises policy interest in measuring competitive effect of the deregulation. The theories of relationship and reputation imply that (1) the entrants' products are differentiated from those of incumbents due to their pre-existing relationships with issuers, and (2) the issuers' valuation of relationship capital in turn depends on their own reputation in the capital markets. I investigate these hypotheses by using the methods developed in the empirical industrial organization literature, which have not been applied to the financial context. In doing so the paper also attempts to fill this gap between the two literatures. Using individual issuer data, I jointly estimate a discrete choice model of underwriter demand and a model of issue-specific pricing by individual banks. I find that there is a trade-off between relationships and price in the demand equation and that this trade-off is sharply higher for low- reputation issuers such as junk bond issuers and first-time issuers. The lower is the reputation of the issuer, the more the demander is willing to trade off price for the relationship. This finding is consistent with the certification effect of commercial bank underwriting. Commercial bank entry has increased competition in this market because their client-specific relationship capital has increased product differentiation in the market. And since issuers with low reputation value the relationship capital more, it is for this segment of the market that the competitive effect of the deregulation has been most dramatic.