Good Ipos Drive in Bad: Inelastic Banking Capacity and Persistently Large Underpricing in Hot IPO Markets

43 Pages Posted: 10 Dec 2004

See all articles by Naveen Khanna

Naveen Khanna

Michigan State University

Thomas H. Noe

University of Oxford - Said Business School; University of Oxford - Balliol College; Bank of Finland; European Corporate Governance Institute

Ramana Sonti

Indian School of Business

Date Written: March 13, 2005

Abstract

In this paper, we consider the effect of labor market constraints on the Initial Public Offering (IPO) activity of investment banks. We posit that identifying IPO quality requires specialized screening labor that takes time to train. Positive shocks to economy's production frontier stimulate IPO demand. At this higher level of demand, screening labor costs must rise to clear the labor market. This results in underwriters optimally reducing screening quality, in the process encouraging firms with sub-marginal projects to also apply, further straining the screening labor market. In equilibrium, underpricing can be quite significant both because of lower quality screening and because of its role in lowering the quality of the applicant pool. Our model's predictions are consistent with empirical results such as positive correlation between IPO volume and underpricing, reduced information search per project during hot markets, and the persistence of high IPO volume in the face of increased underpricing.

Keywords: IPO, hot markets, underpricing, capacity constraints

JEL Classification: G24

Suggested Citation

Khanna, Naveen and Noe, Thomas H. and Sonti, Ramana, Good Ipos Drive in Bad: Inelastic Banking Capacity and Persistently Large Underpricing in Hot IPO Markets (March 13, 2005). Available at SSRN: https://ssrn.com/abstract=629482 or http://dx.doi.org/10.2139/ssrn.629482

Naveen Khanna

Michigan State University ( email )

East Lansing, MI 48824-1121
United States
517-353-1853 (Phone)
517-432-1080 (Fax)

Thomas H. Noe

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 3BJ
United Kingdom

University of Oxford - Balliol College ( email )

Broad St
Oxford, OX1 3BJ
United Kingdom

Bank of Finland ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

European Corporate Governance Institute ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Ramana Sonti (Contact Author)

Indian School of Business ( email )

Gachibowli
Hyderabad, Andhra Pradesh 500 019
India
914023187103 (Phone)

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