Regulatory imitation: a case of primary markets in India

Abstract

The broader question attempted to be answered by this body of research is whether imitation of regulations from more developed securities markets is efficient or otherwise. On one hand the regulations in the developed markets have a successfully proven track record and so it s not a blind leap by the regulators and on the other hand due to the unique exogenous factors the same regulations might be rendered improper. This body of research looks at one such instance wherein framework for book-building guidelines was created from such existing framework in developed markets. Context of this dissertation lies in the primary markets of equity shares in India. Shares can be priced through an increasingly popular mechanism of price discovery called the book-building. Book-building, a widely prevalent mechanism in markets more efficient than the Indian markets was introduced in India, with regulatory guidelines almost similar to the ones in those efficient markets with modifications related to the retail investors as Indian markets are uniquely characterized by the presence of retail investors. Securities and Exchange Board of India (SEBI), the market regulator which is a statutory body specifically operated within the regulatory mandate of protection of interest of investors probably weighing the impropriety of re-inventing the wheel visavis continuation of regulatory void, chose to introduce regulatory guidance heavily drawing upon the existing framework in efficient markets. According to this framework, Merchant Bankers (MBs), the intermediaries who sell shares of companies on behalf of companies to retail (and non-institutional) and institutional investors were allowed to allocate on a discretionary basis no. of shares to Qualified Institutional Buyers (QIBs) based on subjective factors apart from the objective factors of the size of their bid and the price point at which they bid without any micro level oversight by SEBI. It is widely researched phenomena that under such a framework MBs either act in the interest of companies and thereby extract the best price from QIBs or collude with the allocating under priced share to them, which they can later on flip upon listing and pocket what is called listing gains in India. Situation becomes slightly more peculiar in India where on one hand the QIBs were given discretionary allocation and thereby they put very high bids within a few minutes of opening of an issue (in a book which is in India very uniquely available on the websites of nationalized exchanges) leading the retail(and non-institutional) investors to bid highly as well. But, the retail investors get proportionate allocation. In a herd mentality, the retail (and non-institutional investors) get allocated very small proportion of their bids. They rush to the after-market (post-listing) and buy shares from sellers, which are the investors who got allocated shares in the offering. SEBI changed this situation based upon the cue from investors and market participants and thereby introduced proportionate allocations for QIBs as well. This body of work compares the two regimes mainly to understand the whether the earlier rule (which was a seeming regulatory imitation) was better than the situation currently on hand or the regulatory change made no difference at all. To understand these effects a sample of 25 offerings from the pre-regulation period and74 offerings from the post-regulation period were studied. Mainly their books (all applications bid by applicants for any offering) were looked into, which gives an indication of no. of shares applied for among other things. This was followed by looking into the number of shares allocated to QIBs and how many shares they flipped post allocation. So, the hypothesis being tested here are whether the average flipping has gone down post-regulation, has the average under pricing gone down post-regulation and whether the unmet demand has gone down. Yet another hypothesis is that herding should have gone down in case, the initial spike of demand no longer lures non-QIB investors into investing. The data does not show that the flipping, under pricing or unmet demand of QIB investors is significantly different than that of the period pre-regulation. This is a surprising result, owing to the fact that out of about 350 plus issues that hit the market since August 2003, about 100 issues have been analysed for the purpose of this dissertation. It is however seen that the spike of orders on the first day especially first hour or so has gone down drastically. The unmet demand has also gone down slightly, the flipping has gone down. Earlier the non-QIB investors seemed to start applying only after 3 pm during the day however in the post-regulation period, non-QIB investors have been active from the starting of the first day itself and in fact the applications go up during the middle of the day. The most important finding is statistical significance of regulation dummy. Its coefficient is not statistically significant, which brings us to a scenario wherein book-building process (rather intervention of MBs) per se added no value to the price discovery as well as fit in allocations and in such case, raises a serious public policy issue of role of MBs in the process of primary market operations. In short, the highest paid intermediary in the expensive process of raising money from the primary market i.e. the MB does not do the job he is supposed to thereby creates a huge inefficiency in the market, owing to the fact that he plays a major role in price discovery, valuation of securities, QIB participation which was all supposed to increase good governance in the market and he also affects financial well-being of a large number of retail investors who increasingly invest in the stock market, lest the whole process of capital formation which propels the economic engine of progress of any country.