Conflict of interest in universal banking: Bank lending, stock underwriting, and fund management

Using a newly constructed data set on Israeli Initial Public Offering (IPO) firms in the 1990s, we study costs and benefits of universal banking. We f ind that a firm whose equity was underwritten by a bank affiliated underwri ter, when the same bank was also a large creditor of the firm in the IPO ye ar, exhibits significantly better than average post-issue accounting perfor mance, but that its stock performance during the first year following the I PO is considerably lower than average. When an investment fund managed by t he same bank is heavily involved in the IPO as buyer of the newly issued eq uity, the stock performance during the first year following the IPO is even lower. This, together with negative first day returns, is indication of IP O overpricing. We interpret these findings as evidence that universal banks : use their superior information regarding client firms to Boat the stock o f the 'cherries'. not the 'lemons' (as measured by post-issue accounting pe rformance), but that bank managed funds pay too much for bank underwritten IPOs, at the expense of the investors in the funds. These results suggest t hat there is conflict of interest in the combination of bank lending, under writing, and fund management. (C) 2001 Published by Elsevier Science B.V.