Dr. Econ

Why do investment banks syndicate a new securities issue (and related questions)?

December 1999

Why do investment banks syndicate a new securities issue?

Investment banks play a key role in the issuance of new corporate and state and local government securities. However they also face considerable risks in doing so. Investment bankers typically provide one or more of the following services for the entity issuing new securities:

  • Advice on the timing, issue price, volume of securities offered, and other terms,
  • Purchase all or some of the securities from the issuer, and
  • Resell the securities to the public.

The latter two activities, called underwriting, generate fees for the investment bank. However, underwriting may involve substantial risks, especially the risk that the investment bank underwriting the securities may not be able to resell the securities at a profit. In cases where the investment bank must sell the securities at a price below what it paid to purchase them from the issuer, the investment bank will suffer a loss of its own capital.

Since there is considerable uncertainty about the success or failure of new securities offerings, investment banks typically share the potential risks (and rewards) by forming a syndicate of investment banks. The number of firms included in the syndicate may vary widely, depending on the size and the risks associated with the securities. Establishment of a syndicate thus limits the risk to any single investment bank from any single new issue by spreading the risk across a number of investment banks.

What is ERISA and what does it do? And, what are its implications for the financial markets?

The Employee Retirement Income Security Act of 1974 (ERISA) was designed by Congress to comprehensively regulate pension plans. ERISA is a complex piece of legislation that is administered by the Department of Labor and the Internal Revenue Service. It includes the following important provisions:

  • Sets funding standards for firm contributions that are sufficient to cover projected benefit payouts,
  • Establishes fiduciary standards (including the so-called “prudent man” rule of investing) for pension fund trustees, managers, and/or advisors,
  • Sets minimum vesting standards for plan participants’ rights to accumulated benefits,
  • Created the Pension Benefit Guarantee Corporation (PBGC), an insurance fund for vested benefits, and
  • Requires periodic reporting and public disclosure.

ERISA plays an important role in maintaining employee confidence in the safety of their pension plans. Maintaining confidence in pension plans is significant given the rapid expansion of pension plan holdings in the financial system. In 1998, pension funds (not including Federal employees) held over $6.7 trillion in assets, or over 28 percent of all financial intermediary assets. Pension funds are now the largest category of financial intermediary in the United States, with assets greater than either the banking industry ($5.6 trillion) or the mutual fund industry ($5.1 trillion).

Why are life insurance companies major buyers of bonds?

At yearend 1998, the life insurance industry, with $2.8 billion in assets, was a major holder of corporate bonds. The industry’s $1.1 trillion in corporate and foreign bonds in 1998 accounted for nearly 39 percent of life insurance industry assets.

Life insurance companies play an important role, both in the corporate bond market and the financial system. In 1998, they were the fourth largest category of financial intermediary, accounting for nearly 12 percent of U.S. financial intermediary assets.

Because life insurance companies enter into many long-term financial contracts (insurance products, annuities) with customers, they have relatively predictable long-term cash inflows that they can match to actuarially expected payouts. These predictable long-term contractual flows allow life insurance companies to invest a sizeable portion of their portfolio in correspondingly long-term financial assets, like corporate bonds.

In contrast to the life insurance industry, the property and casualty insurance industry typically has shorter-term contractual arrangements and experiences potentially larger and less predictable losses (natural disaster, for example). Thus, in 1998 the property and casualty insurance industry requires relatively more short-term financial assets in their portfolio. The property and casualty insurance industry held less than 18 percent of its assets in corporate and foreign bonds in 1998, less than half the percent held by the life insurance industry.

References

Fabozzi, Frank J., Franco Modigliani, and Michael G. Ferri. 1994. Foundations of Financial Markets and Institutions, Chapters 7, 9, and 14. Englewood Cliffs, NJ: Prentice Hall Inc.

Rose, Peter S. 1994. Money and Capital Markets, Chapter 6. Burr Ridge, Illinois: Irwin.

Saunders, Anthony. 1997. Financial Institutions Management, Chapters 2, 3, and 18. Boston, MA: Irwin/McGraw-Hill.

Source of financial data: Flow of Funds Accounts of the United States, Federal Reserve Statistical Release Z.1, Fourth Quarter 1998. <http://www.federalreserve.gov/releases/Z1/>