Capital Constraints, Asymmetric Information, and Internal Capital Markets in Banking: New Evidence Dmytro Holod SUNY—Stony Brook and Joe Peek University of Kentucky FDIC/JFSR 6 th Annual Bank Research Conference

Why Internal Capital Markets? Asymmetric information → External finance costly Internal capital markets → Mitigate the asymmetric information problem → Alleviate financial constraints faced by the affiliates

Alternative View May reduce investment efficiency –Conflicts between Division managers and CEO CEO and shareholders

Prior Research Primarily focuses on correlations of investment and cash flows Compares that for a segment of a conglomerate with –That for a stand-alone firm in same industry –Correlation of segment’s investment with conglomerate’s cash flow or that of other segments

Criticisms Provides only indirect evidence Such correlations are not valid indicators of financing constraints—Kaplan/Zingales Correlation may be due to measurement error in average Tobin’s Q—Poterba Correlation may be driven by market power— Cooper/Ejarque Correlation disappears with use of measurement-consistent GMM estimators— Erickson/Whited

Banking Sector Studies Focus mainly on loan growth-cash flow sensitivities of MBHC subsidiaries –Houston/James/Marcus (1997) –Houston/James (1998) –Campello (2002)

Our Approach Look at mechanisms through which internal capital markets operate Provide direct evidence on the operation of internal capital markets within MBHCs

Our Approach Recognize that banks do not need additional (physical or financial) capital to “produce” (originate) additional loans –Low capital banks can originate loans and then sell them to banks with excess capital Internal capital markets within MBHCs can work by either (or both) –Shifting capital among subsidiary banks –Shifting loans among subsidiary banks

Why Move Capital Among Bank Subsidiaries? Each individual bank must meet its regulatory K/A requirement –Move capital from high K/A banks to low K/A banks; and loans in opposite direction Differences in loan origination opportunities –Move capital from banks with weak loan origination opportunities to banks with stronger opportunities; and loans in opposite direction

Limitations on Loan Sales Asymmetric information problem in secondary loan market between buyers and sellers Lemons problem mitigated if loan sales transactions are between affiliates of same MBHC –Banks in MBHC should be more active in secondary loan market and their net loan sales should be more responsive to their K/A ratio compared to stand-alone banks

Hypotheses Capital Transfers –MBHCs move capital from better capitalized to less well capitalized subsidiaries in order to satisfy regulatory capital requirements –MBHCs move capital from bank subsidiaries with weaker loan growth opportunities to those with better opportunities

Hypotheses Net loan sales –MBHCs move loans from less well capitalized to better capitalized subsidiaries –MBHCs move loans from subsidiaries with better loan origination opportunities to those with poorer opportunities –Net loan sales of a bank affiliated with an MBHC should be more responsive to its (the bank’s) K/A compared to net loan sales of a stand-alone bank

Dependent Variables Capital Transfers Three components –(Minus) dividends paid to parent –Bank capital sale and acquisition –Other transactions with parent Positive value is associated with a transfer of capital to a bank from its parent Net Loan Sales = Loan Sales – Loan Purchases

Specifications For banks affiliated with MBHCs Y it = (Capital Transfers, Net Loan Sales)

Expected Effects Capital TransfersNet Loan Sales Capital Bank (-) Capital RestBHC (+) NPL Bank (+) NPL RestBHC (-) ROE Bank (+/-)?(+/-) ROE RestBHC (-/+)?(-/+) GSEmpl Bank (+) GSEmpl RestBHC (-)

Specifications Comparing stand-alone banks to banks affiliated with MBHCs Expect

Data Individual bank call reports Annual data for capital transactions –Small banks do not report quarterly –Sample period: Quarterly data for net loan sales –Sample period: 1987Q2-1993Q4 –Only time banks reported loan sales

Sample FDIC-insured commercial banks Omit from sample –Credit card banks –Banks with loans-to-assets < 5% –Foreign-owned banks –First 8 quarters of de novo banks –Merger quarter and subsequent quarter of adjustment to merger –Observations with extreme values: more than four standard deviations away from variable’s mean value

Preliminary Evidence Table 1. Capital transfers and net loan sales of bank subsidiaries with differing capital ratios Banks affiliated with an MBHC Mean Values measured as a percent of assets Annually, Capital-to-Assets Ratio <66-9>9 Number of observations3,16925,17514,323 Cap. trans. with HC Quarterly, 1987:Q2-1993:Q4 Number of observations10,49557,84121,979 Net Loan Sales

Preliminary Evidence Table 5. Loan sales and loan purchases of banks with differing capital ratios, categorized by bank type Mean Values measured as a percent of assets Capital-to-Assets Ratio <66-9>9 Stand-alone banks Number of observations17,521100,08790,824 Net Loan Sales Banks affiliated with an MBHC Number of observations10,49557,84121,979 Net Loan Sales

Estimation Results: Table 6. Determinants of capital transfers CapTrans it /Assets it-1 (CapitalRatio it-1 ) Bank ** (0.00) (CapitalRatio it-1 ) RestBHC ** (0.00) (LRAssets it-1 ) Bank ** (0.00) (LRAssets it-1 ) BHC (0.06) (NPL it-1 ) Bank ** (0.00) (NPL it-1 ) RestBHC * (0.02) (ROE it-1 ) Bank ** (0.00) (ROE it-1 ) RestBHC (0.31) (GSEmpl it-1 ) Bank ** (0.01) (GSEmpl it-1 ) RestBHC ** (0.00)

Estimation Results: Table 7. Determinants of net loan sales NetLoanSales it /Assets it-1 All banksBanks with assets < $5 billion (CapitalRatio it-1 ) Bank ** (0.00) ** (0.00) (CapitalRatio it-1 ) RestBHC ** (0.00) ** (0.00) (LRAssets it-1 ) Bank ** (0.00) (0.74) (LRAssets it-1 ) BHC (0.81) (0.91) (NPL it-1 ) Bank ** (0.00) * (0.03) (NPL it-1 ) RestBHC (0.28) (0.12) (ROE it-1 ) Bank * (0.03) ** (0.01) (ROE it-1 ) RestBHC (0.65) (0.81) (GSEmpl it-1 ) Bank (0.23) (0.69) (GSEmpl it-1 ) RestBHC (0.60) (0.78)

Estimation Results Table 8. Comparing net loan sales of affiliated and stand-alone banks Banks with assets < 5 billion 1983 dollars NetLoanSales it /Assets it-1 Banks affiliated with an MBHC Stand-alone banks Difference CapitalRatio it ** (0.00) ** (0.00) ** (0.00) LRAssets it (0.93) (0.17) (0.28) NPL it * (0.02) (0.10) (0.14) ROE it * (0.02) ** (0.00) (0.37) GSEmpl it (0.35) * (0.03) (0.07)

Estimation Results K/A effect on net loan sales for banks affiliated with an MBHC about three times as large as for stand-alone banks But can this be due to banks affiliated with an MBHC being better able to buy and sell loans in the external loan market, perhaps due to reputation effects of MBHC?

Estimation Results Table 9. Determinants of net loan sales by MBHCs MBHCs with assets < 5 billion 1983 dollars NetLoanSales it /Assets it-1 CapitalRatio it * (0.02) LRAssets it (0.28) NPL it (0.10) ROE it (0.08) (GSEmpl it-1 ) WeightedAv (0.44)

Estimation Results Table 8. Comparing net loan sales of affiliated and stand-alone banks Non-publicly traded banks with assets < 5 billion 1983 dollars NetLoanSales it /Assets it-1 Banks affiliated with an MBHC Stand-alone banksDifference CapitalRatio it ** (0.00) ** (0.00) * (0.03) LRAssets it (0.10) (0.29) * (0.02) NPL it (0.13) (0.07) (0.40) ROE it * (0.04) ** (0.00) (0.26) GSEmpl it (0.41) * (0.05) (0.16)

Conclusions We looked at the mechanisms through which internal capital markets operate We provided direct evidence that internal capital markets operated within MBHCs Operates through both capital transfers and net loan sales MBHCs respond to differences in capital positions of bank subsidiaries, differing needs for additional capital, and differing loan growth opportunities Internal secondary loan market lets bank subsidiaries avoid the lemons problem faced by stand-alone banks