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Investment banks ready to stand on own two feet

By Nancy Huyghebaert (Global Times)

08:22, June 14, 2012

Over the last two decades, the IPO underwriting market in China has been largely shielded from international competition, as foreign investment banks were allowed to underwrite IPOs only through a joint venture (JV) with a local Chinese partner. Up until the end of 2010, these JVs had underwritten only 2.9 percent of total Chinese domestic IPOs, as local investment banks dominated the market.

Investment banks play an essential role in IPOs, by mitigating information asymmetries between issuers and investors. As investment banks repeatedly participate in the IPO market, they can develop a reputation, which allows them to offer certification about the quality of IPOs to investors. As all Chinese investment banks started from scratch, the China Securities Regulatory Commission (CSRC), the country's securities regulator, initially put them under heavy administration and has intervened directly in the IPO market, to guide investment banks to gradually take up a role in certifying the quality of IPO firms. This opened the door for an unequal treatment of investment banks. Research shows that before 2005, investment banks with better political connections were able to grab a larger stake in the IPO underwriting market. However, as of 2005, with the diminishment of direct government intervention, political connections can no longer guarantee a large market share.

As the market forces became more influential, especially as of 2005, we expected that investment banks underwriting high-quality IPO firms would be able to develop their reputation and gain market share. This is not the case. Specifically, the investment banks that set a higher evaluation standard when screening IPO candidates lost part of their stake in the IPO underwriting market. We attribute this to the unique pricing mechanism in Chinese IPOs, where the issue price was capped by a fixed P/E ratio set by the regulator. This regulation has actually incentivized issuers to hire investment banks that apply a low evaluation standard. With a fixed issuing P/E ratio, the only way for issuers to ensure a higher offer price was to boost their historical and/or forecasted earnings. So, by hiring an investment bank with a low evaluation standard, the odds that such exaggerations would go unnoticed were considerably larger.

It was a correct step for the Chinese regulator to give up its interference in setting the issue price in 2009. The abolishment of this mechanism also ensures that investment banks in China will appear from under the mighty shadow of the government after two decades. Specifically, they will now have to take up their role in pricing shares of IPO firms as well as in certifying the quality of IPO firms.

In the process they will probably face more competition from JVs, as up until now IPO candidates had neither the need nor the wish to rely on highly reputable foreign investment banks to certify their quality and to price their stock.

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