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The End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815–2007

2010; University of Chicago Press; Volume: 6; Issue: 1 Linguagem: Inglês

10.1086/648696

2150-8372

Marc Flandreau, Juan Flores Zendejas, Norbert Gaillard, Sebastián Nieto‐Parra,

Banking stability, regulation, efficiency

Previous articleNext article FreeThe End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815–2007Marc Flandreau, Juan H. Flores, Norbert Gaillard, and Sebastián Nieto‐ParraMarc FlandreauGraduate Institute of International and Development Studies, Geneva, and CEPR Search for more articles by this author , Juan H. FloresUniversity of Geneva Search for more articles by this author , Norbert GaillardSciences Po, Paris Search for more articles by this author , and Sebastián Nieto‐ParraOECD Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinkedInRedditEmailPrint SectionsMoreWow. I hadn't thought of it through a historical perspective. (John Grisham, The Partner [1997])In the past 20 years, dedicated research efforts have helped us expand our knowledge of how the international financial system operates. Because the emergence of global finance is really a reemergence, much of this research has been devoted to understanding previous regimes and experiences in relation to modern ones. Although matters are hardly settled and controversy is vibrant, there is at least now a body of literature to which we can turn. We know much more about the record of international debt than we did 30 years ago. In particular, we have acquired knowledge on how previous bondholders have fared (Eichengreen and Portes 1986; Lindert and Morton 1989); the incidence of collective action institutions on recovery rates (Eichengreen and Portes 1989); debt crises and the volatility of bond prices (Bordo et al. 2001; Mauro, Sussman, and Yafeh 2006); contagion in the long run;1 and the factors that affect a country's reputation (Flandreau 2003; Tomz 2007).2 We have also acquired knowledge on the historical determinants of sovereign bond prices in secondary markets3 and on the historical effects of exchange rate regimes on credibility (or lack thereof).4 Finally, we have acquired statistical knowledge on the long‐run evolution of government debt.5One area has been relatively underresearched: the microeconomics of foreign currency sovereign debt issuance. Macroeconomists recognize that the workings of primary international capital markets are important because these markets provide countries with access to external funding.6 Yet the nuts and bolts of their operation are usually neglected, save the occasional outburst of interest in a special feature of possible relevance to policy. A prominent example is earlier research on the causes and consequences of the "original sin" phenomenon.7 The relevance of some more arcane aspects of debt issuance has also been acknowledged; we have in mind studies on the effect of certain covenants (e.g., collective action clauses) on bond prices.8This paper is the first to take up the issue of the operation of primary markets over the long run. We identify an intriguing result. Using new data on several episodes of foreign currency sovereign debt issues in leading capital markets and then arranging the output by underwriter, we find that defaults are today randomly distributed across underwriters. But they were not randomly distributed in the past, and this is what we call the default puzzle.Resolving the default puzzle requires that we discuss insights from banking theory. Our interpretation hinges on the effects of "brand" or "charter" value on intermediaries' risk taking. In the past era (by which we mean the long‐run period that began in the early nineteenth century and ended with the interwar crisis), underwriters provided valuable certification services. They tried to secure prestige by convincing investors that their name was associated with safer products. They did this not for the sake of honesty, altruism, or self‐esteem but rather because doing so entailed benefits. Today is different: underwriters have shed their role as certifiers and have outsourced it to rating agencies. The resulting reduction in liability risk also means that more competitive banks are prepared to issue riskier securities. We suggest that this new situation has given birth to a market for lemons, a market that did not exist in the past. We conclude that the next sovereign debt tsunami will crash on a foreign currency debt market that is by design more accident prone than its predecessors. Whether we will have adequate tools to handle the disaster remains to be seen.In support of these claims we marshal a large amount of new data. In contrast to many important and ambitious previous works, we draw not only on published sources but on archives as well, and we have also performed interviews. This reliance on primary evidence (archives and interviews) is essential given the sometimes secretive nature of the business under study. As a result, this paper is the first to deal with the operation of primary markets for foreign government debt over such a long time span. With the help of this new evidence, we are able to test our central argument through a number of its implications. Among our findings, we report a change in the degree of concentration in the underwriting business (highly concentrated in the past, much less so now), in the underwriting services provided (encompassing in the past, much more limited now), on the fees collected (large and increasing with risks in the past, small and unresponsive to bond spreads now), on the quality standards applied by market leaders (high in the past, low now), on the cooperation between underwriters and borrowers (strong in the past, limited today), and finally on the quality outlook of the products brought to the market (the past did not have a large market for products below the investment grade threshold, the present does).The balance of the paper is organized as follows. Section I presents the data, the default puzzle, and a sketch of the argument; the rest of the sections provide various tests of our theory. Section II discusses measures of market concentration. Section III provides evidence on underwriting patterns and fees levied. Section IV discusses the relation between underwriters' brand value and risk taking. Section V provides evidence on the link between underwriting and contagion, and Section VI explores the link between banker turnover and reputation. Section VII shows that the modern period has been characterized by the emergence of riskier debt, and Section VIII discusses the reasons for the regime change in the modern era. We end with conclusions in Section IX.I. The Default PuzzleA. Background and DataIn the nineteenth century, lending to foreign governments occurred through the agency of originating houses located in the leading financial markets of the time. Because these houses had subsidiaries or partners in various cities, the diffuse nature of origination was a characteristic feature of the business. London was the leader in that it was home to a large number of underwriters and issues, but Paris emerged as a serious competitor in the late nineteenth century.9 During the interwar period, the center of the world financial system shifted partly to New York, and government securities followed.10 After an extended period of suspension—coinciding with the period between the interwar bonded debt collapse and the banking debt debacle of the early 1980s—the loan origination market has been reinvented along lines that seem to be broadly similar.11 This prospering modern market relies on international securities originated and distributed by investment banks. The emerging markets crises of the 1990s and their boom during the period 2002–7 have been its latest vicissitudes. An open question at the time we are writing is the resilience of foreign country debt in the wake of the subprime crisis, global recession, and high credit default swap (CDS) premia.In this paper we examine foreign government debt issued in leading financial centers in the past 200 years. Our database comprises issues of foreign governments' debts since the beginning of the nineteenth century. We look at the markets in London (1818–1914), Paris (1882–1914), and New York (1920–30). We also look at the foreign government debt of "emerging" and "transition" countries that has been placed abroad during the present era (i.e., 1993–2007). Our data are not a series of samples but rather, as far as possible, the documented population of issues.12 The historical material is constructed from listings of securities issued in the relevant markets and checked against lists found in bank archives and periodicals. The modern material includes the population of issues that form the background for the league tables published by Bloomberg.13One issue that arises is the comparability of emerging and transition governments over time. Previous research has generally brushed this issue aside, considering nineteenth‐century borrowers such as Denmark, Sweden, or Canada to be suitable counterparts to modern emerging countries.14 Such an assumption may well be questioned (Accominotti et al. 2010). Because colonies were actually subsovereign entities, they have been excluded from this study. We focus on sovereign borrowing by emerging and transition countries now and on sovereign borrowing in foreign currency then. On the other hand, strict comparability would likely have required us to add countries that are more well behaved to the modern data set.Our logic is market based, not fundamentals based (the latter would be quite impossible to implement). In other words, we compare markets with each other. First of all, to the extent that producers of league tables and market participants describe the debt of emerging and transition countries as forming a market, it is natural to try to match it against historical counterparts. Previous periods did not recognize such differences and looked at the foreign currency government bond markets as a whole; in fact, those markets did contain predominantly the securities of countries without a large domestic market. Second, we noted a fair amount of continuity in the identity of the countries involved in various episodes (Russia in the nineteenth century and today is an example that comes to mind). Finally, we strongly believe that our basic findings would be robust to the inclusion in the modern group of safer borrowers, because our key point is about transformations in the high‐risk group, not in the low‐risk group.The chronology that we identify does capture the six successive waves of sovereign debt issues that have taken place since the 1820s. Historians have shown that the first five waves were terminated in more or less abrupt ways: those in the early nineteenth century (1818–29), the mid‐nineteenth century (1845–76), the 1880s (1877–95), the pre–World War I period (sometimes inappropriately called the "first era of globalization"), the 1920s (1920–30), and finally the modern era (1993–2007). Three of these waves (the 1820s, the mid‐nineteenth century, and the interwar period) were terminated by massive failures, so they will receive more detailed attention. In the rest of the paper these periods will be referred to either in terms of the time spans just described or in shorthand as (respectively) "early nineteenth," "mid‐nineteenth," "1880s," "pre–World War I," "interwar," and "now."B. The PuzzleDefaulting countries are usually studied from the point of view of their characteristics or fundamentals, and accordingly an exciting literature has sought to relate default probabilities to countries' performance.15 Previous authors identified defaulting patterns and coined the expression "serial defaulters" to designate recidivists (Reinhart and Rogoff 2004). Here we suggest taking a different look. We bring a new dimension to the study and suggest examining defaults on the basis of underwriter identity. The importance of common lenders has been recognized in previous studies of contagion, which emphasized commonality of lending centers as a possible propagation mechanism. We bring the topic to a finer level and explore the relation between borrowers and underwriters.16 Our first question is to ask whether defaults across underwriters can be described as being generated from a random draw or whether, instead, underwriters do (or did) specialize in certain kinds of securities.17For this purpose we compare the distribution of defaults per underwriter during the modern era and earlier periods. A formal criterion that is chi‐square based is Cramér's V statistic (Kendall and Stuart 1979). We computed this statistic for three selected episodes of major sovereign debt distress (the 1820s, 1870s, and 1920s) as well as for today;18 the output is presented in figure 1. We see that formerly there was a clustering of defaults about certain intermediaries (in the past, defaults were not random) but that this is no longer true today (defaults are now randomly distributed).19 This intriguing result means that the identity of underwriters once provided information on the likelihood of future defaults but no longer does so. This is the default puzzle.Fig. 1. Cramér's V: are defaults randomly distributed across underwriters? Source: Authors' computations. View Large Image Download PowerPointC. Suggested ResolutionCan we make sense of this puzzle? The argument we put forward builds on theoretical insights from banking and finance theory but also extends ideas first articulated in Flandreau and Flores (2009). The argument has parallels to the classic paper by Diamond (1989) on the importance of repeat play in sustaining credibility. Because repeat play alone cannot sustain sovereign debt, Flandreau and Flores additionally incorporate underwriters' monopoly power. The intuition is related to that in the paper by Chemmanur and Fulghieri (1994), who develop a relevant model in which the financial intermediary's reputation for veracity mitigates the moral hazard problem in information production. Prestigious underwriters who might be tempted to overprice securities in order to generate short‐term gains do not actually do so because it would damage their reputation. Carter, Dark, and Singh (1998) show that, over the long run, issues managed by prestigious houses outperform those managed by ordinary ones. Also, Beatty and Ritter (1986) show that underwriters whose offerings underperform lose market share. Market share is the endogenous solution to precommitment and credibility problems. As a result, natural monopoly emerges as a separating equilibrium in which quality, commitment, and performance are related to one another.To see how these insights provide a way to think about the default puzzle, compare two regimes in which there are both informed agents (intermediaries) and uninformed agents (investors). In the first regime, which we argue coincides with earlier times, informed underwriters combine liquidity provision (they help with the issue of bonds) and signaling services. In contrast, the functions of providing liquidity and signaling quality are separated in the second regime, where underwriters concentrate on issuing as many bonds as they can. Certification has been delegated to rating agencies that provide advice to investors.We can readily see why the behavior of intermediaries will differ in the two regimes. The first regime provides an opportunity for certain underwriting banks to invest in prestige. Securing a reputation as a serious underwriter can become a source of rents because higher‐quality securities have a broader market, and this fact can be used to attract the best borrowers and retain an initial monopoly position. We thus expect that such a regime will exhibit monopoly power, strong relationships between top underwriters and issuers, cherry‐picking by the best underwriters, and a tendency for lower‐grade securities to have difficulty finding a market. The reason is that the market for speculative bonds is operated by those underwriters with the least ability to certify (the lemons problem).In the second regime, certification from other than underwriters does reduce potential informational rents for underwriters. If everyone knows the "true worth" of a security, then the marginal benefit of additional signals declines. Hence we expect financial intermediaries to compete more aggressively and underwriters to make more indiscriminate choices when picking securities. The portfolio of securities that hits the ground is thus of lower average quality than under the first regime. In sum, if certification has been outsourced, then underwriters escape liability risks. Investors are now advised of the risks and are encouraged to diversify it away. The result is the emergence of a "market for lemons."II. Market PowerOur view that earlier regimes rested on underwriter‐based certification implies that we ought to observe more market power in earlier periods. In table 1, we organize some hard evidence regarding the degree of competition that prevailed during successive episodes. Working with the sources described in appendix A, we constructed two statistical measures of market power. The first measure we discuss is the Herfindahl‐Hirschman (H‐H) index. Recall that an index value below 1,000 is associated with an unconcentrated market. Values between 1,000 and 1,800 characterize a moderately concentrated market, and values above 1,800 indicate that the market is highly concentrated. The second measure is the market share of the top three underwriters.Table 1. Characteristics of Primary MarketsPeriodNumber ofUnderwritersH‐H IndexMarket ShareTop Three (%)Names ofTop Three1818–25122,43273.4Rothschild B. A. Goldschmidt Thomas Wilson1845–76451,38255.3Rothschild Barings Imperial Ottoman Bank1877–95342,17665.5Rothschild Barings Hambros1895–1913: London331,19651.7Rothschild Hong Kong Bank Barings1895–1914: Paris141,74665.0Rothschild BPPB Banque Impériale Ottomane1920–30: New York202,86968.9JP Morgan National City Blair1993–2007: New York291,14548.0JP Morgan Citi Morgan Stanley1993–2007: London2687638.6JP Morgan UBS Deutsche Bank1993–2007: All4384239.4JP Morgan Citi Deutsche BankSource: See app. A.View Table Image: 1 | 2Table 1 shows that the H‐H index fluctuated over time but that the overall degree of concentration was typically higher during earlier periods. The highest degrees of concentration were in the mid‐nineteenth, interwar, and late nineteenth‐century Paris market (close to or above 1,800). There was also fairly high concentration (H‐H index of 1,667) in the early period (1820s). Concentration for the 1880s and pre–World War I period was more moderate (values of 1,200 and 1,270, respectively). The lowest degree of concentration is obtained for the modern period (New York and London), for which indices are slightly above or below 1,000 and have an aggregate concentration of only 842.After computing market shares for the top three underwriters, we find that they always controlled more than 50% of the market in historical time periods; the proportion is now below 50%. Peaks correspond to the early nineteenth century (London), late nineteenth century (Paris), and interwar period (New York), which are all above 65%. The low ebb is observed for New York and London today (48% and 38%, respectively). Again, market power is substantially lower today.Finally, figures 2a–2e rank underwriters' market shares in various episodes. Striking features are the decline over time of the leader's share and the reduced difference now between the leader and its immediate followers. In the 1820s, Rothschild had 40.8% of the amounts loaned in London and the next intermediary (B. A. Goldschmidt) had 23.6%. During the interwar period, JP Morgan held 50.8% of the New York market whereas the next best (National City) had 9.9%. JP Morgan still leads the New York market, but only with 20.8%, and the next best (Citi) is close behind with 15%. We conclude the market for underwriting foreign government debts was highly concentrated until the interwar period, but it has become much more competitive as of late.Fig. 2. Ranking of top 10 underwriters by market share (percentage): a, 1818–29; b, 1845–76; c, 1877–95; d, 1920–30; e, New York, 1993–2007. Sources: Authors' computations from own database; see appendix A.View Large Images : 1 | 2 | 3 | 4 | 5 | Download PowerPointIII. Good Girls Go to Heaven, Bad Girls Go EverywhereWe now examine two more predictions of our theory. First, if prestigious underwriters formerly worried about retaining market share but do not today, then we should observe that they used to cherry‐pick better securities and are much less discriminating today. Evidence of this is provided in figures 3a and 3b. The figures compare the ex ante quality of the portfolio of securities underwritten by the leading intermediary with the portfolio of the other firms. Here "quality" is measured in terms of the distribution of spreads (evidence from ratings, when they are available, provides similar results). A noticeable difference between figure 3a and figure 3b is that the interwar leader specialized in higher‐quality securities whereas the modern leader tends to issue securities of similar or lower quality than followers. Figure 4 provides evidence of the average yield brought out by the "best and the rest" in a number of time periods. The figure shows that, until the interwar period, the best always issued safer securities than the rest.Fig. 3. Spreads at issue: market leader versus the rest: a, New York, interwar period; b, New York, modern era. Sources: Authors' computations from own database; see appendix A.View Large Images : 1 | 2 | Download PowerPointFig. 4. Risk taking: average spreads in basis points for the best and the rest. Sources: Authors' computations from own database; see appendix A. View Large Image Download PowerPointThe other test we consider looks at ex post results. Suppose that serious underwriters make careful choices to protect market shares. We should expect problems (measured here by default events) to be concentrated within the lower end of the underwriter spectrum: less prestigious houses, which are also the ones with the smallest market shares.20 A convenient tool to capture this intuition is to construct Lorenz curves of underwriters' performance. Ranking intermediaries' market shares from the smallest (low prestige) to the largest (high prestige) and then plotting the cumulated share of underwriters' securities in default (as a percentage of the total amount in default) help explicate the risk taking of underwriters. To see this, we use $$( x_{k},\,d_{k}) $$ to define the pair formed by the amount underwritten by bank k ( $$x_{k}$$ ) and the defaulted amount previously underwritten by bank k ( $$d_{k}$$ ). Indices k are ordered by the amount of banks' underwriting: The cumulated market share $$X_{k}$$ for banks with smaller market shares than k is and the cumulated default share $$D_{k}$$ for banks with smaller market shares than k is Finally, the Lorenz curve of underwriters' performance is then defined by the pairs ( $$X_{k}$$ , $$D_{k}$$ ).Suppose that underwriters do not worry about what happens to the securities they have sold. Then default is random: the smallest underwriter with (say) 5% of the securities underwritten will have about 5% of the defaults; when combined with the next‐larger underwriter who has (say) 10% of the market, this will account for about 15% of the defaults, and so on. The resulting Lorenz curve should therefore be close to the 45° line. Now suppose that prestige does confer a larger market share but also requires placing only good securities (otherwise prestige will be lost). In this case, the smallest (least prestigious) underwriter with 5% of the securities underwritten will have much more than 5% of the defaults (say 20%). In contrast, the largest (most prestigious) underwriter with (say) 20% of the securities underwritten may have only 5% of the defaults. The resulting Lorenz curve should therefore be concave.To test for these possibilities, we consider four episodes (fig. 5). As before, the "past" is represented by the three most violent historical debt crises in history (1820s, 1844–75, and 1920–30). In comparing these episodes with the modern period, we find that the former are associated with strongly concave Lorenz curves. This contrasts with the modern period, in which the Lorenz curve essentially overlaps with the 45° line. This is consistent with our view that default was not randomly distributed in the past because underwriters formerly made careful choices.Fig. 5. Lorenz curves: three debt crises (1820s, 1840s–70s, 1920s) versus today. The straight line (diagonal) is the 45° line. Sources: Authors' database; see appendix A. View Large Image Download PowerPointIV. Fees and Risk TakingThat underwriters were more heavily involved in the past than they are today should imply that, other things being equal, they took on more risks and required substantially larger fees than is now the case. To show this, we first summarize qualitative evidence obtained from our study of many early underwriting contracts as well as interviews with modern market participants; we then provide new data on the long‐run evolution of underwriting fees.A. Underwriting Contracts, Past and PresentToday, a key aspect of any international bond issue is the "agreement" between the main underwriter and the government. This document specifies the particulars of the issue, such as the bond structure. One central aspect of the agreement is the "distribution system." In principle, distribution could take the form of either "best efforts" or "firm commitment"—two forms that are known in other segments of the capital market. Under best efforts, the intermediary pledges to help in the sale of bonds but does not bind itself to acquiring any if there are no other buyers. That is, a failed issue creates no liability. By contrast, in a "firm commitment" arrangement, the financial intermediary agrees to purchase all securities directly from the issuer for sale to the public and is liable for any unsold inventory. Interviews with market participants suggested that "best efforts" is the ruling pattern today.21In the past, the contract signed between governments and underwriters was also a central part of the process. We have examined many such contracts. As today, the main choice was using the underwriter either as merely distributor of the bond or rather also as full insurer of the issue's success. The former arrangement was known as "sale on commission" and the second as "firm taking." These are equivalent to the modern systems of best efforts and firm commitment: with sale on commission, underwriters received subscriptions for the purchase of bonds but took no liability in the result of the issue.22 With firm taking, the issue was understood to be purchased from the government and then resold to the public. Mixed arrangements involved partial commitment with a portion sold on commission.23The contracts that we examined indicate that firm taking became the dominant pattern over the nineteenth century, although there were periods and countries for which a greater proportion of sales on commission can be observed. It is fair to say that, by the end of the nineteenth century, full or quasi‐full underwriting had become the nearly absolute norm. However, there were still some exceptions. We found that Barings initially favored sales on commission. Testifying in 1875, one Barings employee drew a sharp contrast between issues for which they acted as genuine "contractors" (fully underwriting the issue) and issues for which they would be mere "agents" (only placing the loan in the market), adding that "most generally loans are issued by the firm [i.e., Barings] in London as agents for the Government" (Great Britain. House of Commons 1875, 1; our italics).24 This declaration is consistent with the actual Barings contracts that we could inspect. Yet over time, even Barings moved to full underwriting.The same pattern (i.e., predominance of the full underwriting contract) also prevailed during the interwar period. The Senate Committ