Investment Bank Reputation, Information Production, and Financial Intermediation

TLDR

Entrepreneurs sell shares in an asymmetrically informed equity market, either directly or via an investment bank, and strict evaluation standards that are unobservable to investors impose costs on banks, creating moral hazard. The study models how investment banks acquire reputation in the equity market. The model assumes banks repeatedly evaluate entrepreneurs’ projects and report to investors for a fee, setting strict evaluation standards that are unobservable to investors. The model shows that banks’ credibility hinges on their equity‑marketing history, and that evaluation standards, reputations, underwriter compensation, market value of equity sold, and entrepreneurs’ choice between underwritten and nonunderwritten issues all emerge endogenously.

Abstract

ABSTRACT We model reputation acquisition by investment banks in the equity market. Entrepreneurs sell shares in an asymmetrically informed equity market, either directly, or using an investment bank. Investment banks, who interact repeatedly with the equity market, evaluate entrepreneurs' projects and report to investors, in return for a fee. Setting strict evaluation standards (unobservable to investors) is costly for investment banks, inducing moral hazard. Investment banks' credibility therefore depends on their equity‐marketing history. Investment banks' evaluation standards, their reputations, underwriter compensation, the market value of equity sold, and entrepreneurs' choice between underwritten and nonunderwritten equity issues emerge endogenously.