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Feedback on Assignment #2

Questions from analysts conflicts

What are the determinants of analysts compensation? How do you measure the quality of an analyst? What is the impact of the Global Settlement on the bias in analysts recommendations?

Lecture 9 Relationship vs. transaction banking

Todays Lecture
What are the benefits and costs of relationship banking? What are the characteristics of a long-term underwriting relationship?
Case study: the collapse of Lehman Brothers

Does increased competition wipe out relationship banking?

Readings: Boot (2000) Boot and Thakor (2000) Burch, Nanda and Warther (2005)

Relationship vs. transaction banking

Relationship banking
Banks obtain customer-specific information over large number of transactions Multiple interactions with same customer over time and/or across products Information not shared with competitors/analysts

Transaction banking
Concentrates on a single transaction With a large number of customers Bank receives information from the interaction with various customers

Relationship banking
Relationship banking usually discussed for the lending of commercial banks Can also be applied to IB Achieve a relationship with customers generate information that can be used in future transactions:
Repeated underwriting of shares/bonds Repeated M&A advisory or other consultancy work Use of financial products (e.g. for risk management) Continued analyst coverage Investments into stock, bank or money market For universal banks with lending activities relationship extends to IB
Lending relationship future underwriting IPO underwriting future lending

What are the benefits and costs of relationship banking?

Better exchange of information between bank and company Benefits related to the contractual features of relationship banking (e.g. flexibility)

Soft-budget constraint problem Hold-up problem (information monopoly)

Information production
Customers more likely to reveal sensitive information and bank more willing to invest in information production Customers get a specific service Information sharing reduces asymmetries Information production is costly but IB can reuse this private information Bank can set much more precise terms for transactions (e.g. IPO or M&A), increasing their reputation and the success of the transaction in the market

Contractual features that relationship lending accommodates:

Long-term relationships allow for flexibility in interpreting contracts or engaging in potential transactions (less incentives to exploit this) Renegotiations of the terms are possible E.g. IB could give informal advice to wait some time for an IPO instead of declining the underwriting or doing it at much less favourable terms Formal agreements (covenants) increase trust Better control of potential conflicts of interest Reducing transaction & agency costs

Proximity between bank and company allows for better monitoring of collateral Can mitigate moral hazard and adverse selection problems Funding of contracts that are not profitable for IB in the short-term (e.g. develop new financial product for the need of the company), but may be profitable in a long-term relationship IB can recover any loss in later transactions Customer may accept less favourable terms of contract that he could get elsewhere Long-term profits for both sides

Costs of relationship banking

Soft-budget constraint: Banks or customers may be forced into transactions that are not beneficial (for both sides) for the sake of the relationship
Contracts are not completely enforced and worsen the situation (increase losses) E.g. a customer convinces his bank to form the counterpart of a derivatives transaction that may cause huge losses without getting an adequate compensation

Hold-up problem: Information monopoly of the bank prevents competitors to offer better terms Customer is locked in his relationship
Existence of switching costs Having multiple relationships (common nowadays) reduces this problem at least partially

Empirical evidence
Relationship banking generates additional value for both IB and customers
Banks acquire information over time Positive impact of announcement effect Even more valuable for small companies
Increase credit availability + reduce funding costs & collateral requirements

Benefits exceed costs (at least in the U.S.)

Duration of the relationship positively affects availability of credit Contract terms improve for the borrower over time Evidence of intertemporal smoothing of contract terms Hold-up problem exists but dominated by other factors
E.g.: Prior IPO underwriting relationship is associated with higher costs for follow-on loans lock-in

What are the characteristics of a longterm underwriting relationship?

Loyalty: measure the strength of the underwriting relationship
Extent to which a firm relies on its primary IB for the provision of underwriting services Frequent issuers of securities (stocks/bonds)

Decline in loyalty since mid-1990s What are the determinants of loyalty? Does it pay to be loyal?

What are the determinants of loyalty?

Bargaining power of issuer
More experienced firms are less loyal Certain degree of in-house financial capability from frequent access to financial markets Looking for innovative ways to raise capital Attractive targets for competing banks (low valuation/reputation risk, large offerings) Low investor concern about switching IB

Reputation of underwriter
Clients of larger/more prestigious IB are more loyal Wide range of services/products Add prestige for small companies

Does it pay to be loyal? The benefits and costs of loyalty

Benefits: High certification effect
Bank and client develop a close relationship, lowering the costs of providing additional services If company captures a portion of the savings (relative bargaining powers) lower fees Loyalty results in lower underwriting fees

Costs: Low certification effect

Firms more willing to switch IB to lower fees Underwriting fees increase in loyalty

Benefits higher (lower) for equity (debt) issues

Empirical findings
Benefits of loyalty for common stock offers
Loyalty to a bank decreases fees

Costs of loyalty for debt offers

Loyalty to a bank increases fees

Underwriter certification more important in common stock offers relative to debt offers (third-party debt ratings available)

What are the two main costs of relationship banking? How can customers reduce these costs? What are the determinants of loyalty?

The collapse of Lehman Brothers

14 September 2008 (-94% in 1 day) Was 5th largest IB in the world Huge client base (large and small companies) in different services:
Underwriting (equity/debt) Advisory Research analysts Market making

What is the value of IB relationship for companies?

Impact of Lehmans collapse on its IB clients (above general impact on the market)? Cross-sectional differences in impact across clients?

Impact of Lehmans collapse on its IB clients?

Most significant impact for equity underwriting clients CAR(-5,+1)
-4.85% for Lehman clients -1.91% for clients of other IBs

Underwriting is the principal component of the IB relationship that is irreplaceable without cost Consistent with equity underwriting relationship being valuable for issuers (especially IB with high reputation)
Information production for subsequent offerings IB monitoring + investor base

No abnormal impact for debt underwriting, M&A, analyst coverage and market making clients

Cross-sectional differences in impact across clients?

Issuers lost more value when:
Stronger relationship with IB Smaller and younger More financially constrained (more need for external capital)

Does increased competition wipe out relationship banking?

Banks face competition from
Other banks Capital markets

Impact of increased competition on relationship banking can be 2 ways:

Less relationship banking More relationship banking

Relationship banking should vanish and transaction banking should flourish

Relationship banking Increased competition: Customers more willing to switch to other banks (or to financial markets) for future transactions better conditions Banks less willing to invest into the relationship Customers even more willing to change bank information monopoly non-competitive terms for future transactions

Relationship banking as a competitive edge

Increased competition: Lower margins and higher transaction risks
Losses cant be recovered from other transactions (with same or other customers) Customers information more important to better evaluate risks E.g.: Reputation of the IB in an IPO has to be carefully considered as issuers/investors react more to any change

Relationship banking: Banks can differentiate from competitors, lowering exposure to price competition
Tailoring their service to the needs of customers Need information only available through long-term relationships

Boot and Thakor (2000)

Model combining both relationship and transaction banking 2 types of competition Interbank competition: Each bank can offer either a relationship or a transaction loan
Relationship loan adds more value to borrower but imposes greater cost to the bank

Competition also from capital market underwriting: only transaction banking

Intuition of the model:

More interbank competition changes the nature of relationship banking
Banks make more relationship loans, but each loan has less added value for borrowers

More capital market competition produces the opposite effect

Lower profits for banks reducing entry into banking reduction in interbank competition Less relationship lending but greater added value

Important difference between both types of competition for borrowers welfare

Conclusion on competition
Increased competition has more effect on transaction banking through price competition, while relationship banking allows for differentiation Impact for IB:
Relationship banking becomes more important But profits are reduced through competition

Open question on competition:

Find relevant literature (academic/ professional) and use existing material to assess the current competitive landscape between banks (IB and CB) and capital markets
What happened since 2000? Do clients switch more? Do IBs rely more on relationship banking or transaction banking?

Why is equity underwriting relationship most valuable for issuers?

Next week
External speaker: Azeem Malik Presentation on:
Structured products Asset-liability matching Post-crisis risk management New product ideas?

Readings on Financial Engineering:

Liaw (2006): Ch.9+13