The Role of Financial Intermediaries in Securities Issues: A Theoretical Analysis

We consider a model of securities issues where the quality of securities is private information to the issuer, and firms of higher quality are more reluctant to issue securities than low quality firms. We show that, when the issuer directly trades with investors, market breakdown may occur. This is caused by the issuer's attempts to signal his type through the offering price. Things change if we introduce a financial intermediary which: i) underwrites the issue, ii) influences the offering price.Underwriting creates a wedge between the interests of the intermediary and those of the issuer, which allows trade with investors to be restored. A by-product of this conflict of interest is that trade is characterized by underpricing. Another implication is that the intermediary may act as a reliable screening device when she possesses private information about the firm's quality. In general, our analysis suggests that collusion between the intermediary and the issuer hinders trade, whereas collusion between the intermediary and investors may promote it.