Information quality and IPO underpricing: The role of underwriter pricing and allocation powers

In response to concerns over the use of book-building as the dominant price-setting mechanisms in IPOs, regulatory bodies in the emerging markets have implemented policies to restrict discretion exercised by underwriters. This study examines the regulatory policy effect on IPO underpricing, based on theories which explain information asymmetries among participants in the IPO process as the determinant of underpricing. Using the Korean IPO market with varying underwriter price-setting and allocation powers, I test for changes in the process by which information quality affects the initial return of IPOs when IPO reforms are withdrawn. The results suggest that when regulations limit underwriters' pricing and allocation powers, information is not impounded in the pricing of IPOs efficiently, but the inefficiency disappears when underwriters gain control over pricing and allotment of shares. Specifically, I find that IPOs are underpriced more for firms that produce poor quality accounting information, in accordance with asymmetric information theories, only when allocation powers are in the hands of underwriters. The results offer policy implications on regulating the IPO market in regard to the market price discovery process.