This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
We have seen that originally underwriting consisted in the distribution of the risk among several different merchants.
This remains a characteristic feature of present-day financial underwriting. It is true that the term is frequently applied to an agreement between a corporation and a single banking house, under which the banking house agrees to take over a block of securities at a given price. A transaction of this type may better be called a sale - or, at any rate, a contract of sale - rather than an underwriting. However, an arrangement of this kind, in which only one banking house is involved, is practically unknown except to cover issues of small size. A foreign government loan of as much as $6,000,000 was recently "swallowed" - to use the bankers' own term - by a single banking house; but ordinarily only issues of less than $2,000,000 to $3,000,000 are taken up by an individual house.
Usually, however, the original agreement is made between the corporation and a single banking house, and the banking house afterwards distributes proportions of the risk and profits among other banking houses. All these houses, working together, thus form themselves into the underwriting syndicate. Most of the larger banks and financial houses in the chief centres make it their practice to work in harmony with each other. The organization of the syndicate and the terms of the syndicate agreement will be taken up a little later.
There are two reasons which make it preferable for a banking house to join a considerable number of syndicates rather than to put through a smaller number of transactions in which it assumes for itself all of the risk and all of the profits. The first and obvious reason is in order to minimize risk. A false step in a syndicate - even though the syndicate should fail ultimately - would not prove ruinous; whereas the failure of a good-sized issue in which only one house was concerned might not only tie up enough capital to wreck the house, but might also wreck its reputation, which is an asset of even greater importance. The second motive for preferring syndicate participation is that it enables the bond and brokerage houses to offer to their customers a well-diversified list of securities. The general retail security merchant should be prepared to deliver to a customer any kind of security the customer may fancy, just as the department store is ready to sell anything from pins to locomotives.