Third-party certification in new issues of corporate tax-exempt bonds: standby letter of credit and bond rating interaction

Financial Management (Financial Management Association), Spring, 1996 by Roger D. Stover

The question of third-party certification arises whenever the possibility of asymmetric information exists between corporate insiders and the investing public. This issue is particularly relevant when the security is being offered by a relatively unknown entity. Thus, a logical focus of previous research has been on initial public offerings of equity securities. Examples of such third parties include investment bankers (Beatty and Ritter, 1986, Carter and Manaster, 1990, and Johnson and Miller, 1988), auditors (DeAngelo, 1981, Michaely and Shaw, 1995, and Titman and Trueman, 1986), and venture capitalists (Megginson and Weiss, 1991). However, the role of commercial banks has also been discussed in the context of certification. Both Diamond (1991) and Fama (1985) suggest that bank loan decisions certify borrower quality and signal such information to the investment community.

This paper extends the concept of the commercial bank as a certifying agent to the bank issuance of standby letters of credit. Both James and Wier (1990) and Slovin and Young (1990) find that the existence of both bank debt and unused lines of credit reduces the expected underpricing of initial public offerings of equity. James and Wier argue that the main benefit is signaling information about the dispersion of the firm's market value. The focus in this paper is on credit-enhanced, corporate tax-exempt debt because of the documented evidence of inadequate financial information provided to investors by municipalities (Robbins, Apostolou, and Stawser, 1985). The lack of information, coupled with the uniquely local characteristics of this form of financing, suggests the opportunity for asymmetric information and, therefore, a potential need for third-party certification. However, in contrast to earlier studies, this research examines the bank's role in the context of an additional certifying agent - rating agencies. While Wakeman (1981) noted the importance of new debt issues being rated because of the greater certainty and assurance of credit quality for investors, Merton and Bodie (1992) concluded that there are reasons to believe such ratings have limited reliability. This study tests the robustness of the interaction between these two certifying agents, the bank issuing the letter of credit and the rating agency.

Consistent with the certification hypothesis (e.g., Booth and Smith, 1986), the empirical results of the structural equation model suggest that the quality of the bank issuing the standby letter of credit is apparent in the initial pricing of the letter of credit-backed debt. Employing a latent variable that measures both the credit quality and reputational concepts as evidenced in previous initial public offering research, the principal effect of varying bank quality on bond pricing is reflected indirectly through the reaction of the rating agencies. Therefore, as Megginson and Weiss (1991) found in terms of the role of the venture capitalist in initial equity offerings, the certification provided by the rating agency, albeit secondary to the bank's role, is a complement to the bank certifying function. The results also provide insight into the relative magnitude of this dual certification in the context of other management options to reduce the cost of its debt.

Section I summarizes the applicable research focusing on third-party certification with particular emphasis on bank lending and bond rating decisions along with the testable implication for the role of the standby letters of credit in the corporate tax-exempt debt market. Section II presents the empirical model and sample for this study. The results are shown in Section III with the conclusion in Section IV.

I. Literature Review and Testable Implication

This section reviews the relevant literature and develops the proposition that the initial pricing of the debt instrument is sensitive to the credit quality of the bank that issues the letter of credit.

A. Third-party Certification

Third-party certification has been an issue in the research of initial public offerings of common stock. The underlying premise is that corporate insiders have an incentive to withhold potentially damaging information from future investors so as to be able to sell the shares at a higher price. This tendency to withhold information is particularly strong for those firms that have little intention of returning to the capital markets. However, investors recognize such a strategy and tend to offer a lower price unless credible information is available to assure them that the initial offering price accurately reflects both public and private information.

The role of commercial banks as certifying agents in the debt market has been developed on the premise that the lending decision represents a signal of creditworthiness to outside investors. The principal focus is on the effectiveness of banks in their relationships with lesser-known, smaller firms. Fama (1985) concludes that short-term loans are particularly attractive to organizations without outside equity because of the role of that signal in reducing the information costs of other outside contracts. Diamond (1989) comments on the timing of reputation growth on the part of commercial borrowers. Considerable empirical evidence (e.g., Hull and Moellenberndt, 1994) provides support for the bank debt signaling role. There is also an implicit assumption that credit ratings, per se, also have a certifying influence in the debt markets. Hsueh and Kidwell (1988), Thompson and Vaz (1990), and Wakeman (1981) comment on the role of rating agencies in relaying their best estimate of the credit quality of the issuer. Liu and Thakor (1984) lend credence to this view in their examination of municipal bond offerings. They concluded that ratings yield information independent of other influences. However, Merton and Bodie (1992) question the reliability of such ratings.