A Model of the Demand for Investment Banking Advising and Distribution Services for New Issues

This paper presents a theory of the demand for investment banking advising and distribution services for the case in which the investment banker is better informed about the capital market than is the issuer, and the issuer cannot observe the distribution effort expended by the banker. The optimal contract under which the offer price decision is delegated to the better-informed banker in order to deal with the adverse selection and moral hazard problems resulting from the informational asymmetry and the observability problem is characterized. The model demonstrates a positive demand for investment banking advising and distribution services and provides an explanation of the underpricing of new issues. AN INVESTMENT BANKER PERFORMS three functions which may be of value to an issuer of new securities: underwriting, advising, and distribution. This paper presents a theory of the demand for investment banking advising and distribution services based on an informational asymmetry between an issuer of new securities and an investment banker. Ultimately, a theory of the organization of the financial intermediary industry is required that would predict which firms would use which types of financial intermediaries for which purposes, and which firms would raise capital without engaging the services of a financial intermediary. Only a limited set of such predictions are developed here in the context of a model of a fixedprice offering under a negotiated contract in which the investment banker is