Capital Constraints, Asymmetric Information, and Internal Capital Markets in Banking: New Evidence

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Capital Constraints, Asymmetric Information, and
Internal Capital Markets in Banking New
Evidence

• Dmytro Holod
• SUNYStony Brook
• and
• Joe Peek
• University of Kentucky
• FDIC/JFSR 6th Annual Bank Research Conference

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Why Internal Capital Markets?

• Asymmetric information
• ? External finance costly
• Internal capital markets
• ? Mitigate the asymmetric information problem
  ? Alleviate financial constraints faced by the
  affiliates

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Alternative View

• May reduce investment efficiency
• Conflicts between
• Division managers and CEO
• CEO and shareholders

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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 segments investment with
  conglomerates cash flow or that of other
  segments

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Criticisms

• Provides only indirect evidence
• Such correlations are not valid indicators of
  financing constraintsKaplan/Zingales
• Correlation may be due to measurement error in
  average Tobins QPoterba
• Correlation may be driven by market
  powerCooper/Ejarque
• Correlation disappears with use of
  measurement-consistent GMM estimatorsErickson/Whi
  ted

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Banking Sector Studies

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

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Our Approach

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

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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

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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

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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

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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

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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 banks) K/A
  compared to net loan sales of a stand-alone bank

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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

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Specifications

• For banks affiliated with MBHCs
• Yit (Capital Transfers, Net Loan Sales)

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Expected Effects
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Specifications

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

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Data

• Individual bank call reports
• Annual data for capital transactions
• Small banks do not report quarterly
• Sample period 1987-2004
• Quarterly data for net loan sales
• Sample period 1987Q2-1993Q4
• Only time banks reported loan sales

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Sample

• FDIC-insured commercial banks
• Omit from sample
• Credit card banks
• Banks with loans-to-assets lt 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 variables mean
  value

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Preliminary EvidenceTable 1. Capital
transfers and net loan sales of bank subsidiaries
with differing capital ratiosBanks affiliated
with an MBHC Mean Values measured as a percent
of assets
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Preliminary EvidenceTable 5. Loan sales and
loan purchases of banks with differing capital
ratios, categorized by bank type Mean Values
measured as a percent of assets
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Estimation Results Table 6. Determinants of
capital transfers
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Estimation Results Table 7. Determinants of
net loan sales
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Estimation ResultsTable 8. Comparing net
loan sales of affiliated and stand-alone
banksBanks with assets lt 5 billion 1983 dollars
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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?

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Estimation ResultsTable 9. Determinants of net
loan sales by MBHCs MBHCs with assets lt 5
billion 1983 dollars
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Estimation ResultsTable 8. Comparing net loan
sales of affiliated and stand-alone
banksNon-publicly traded banks with assets lt 5
billion 1983 dollars
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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