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

Authors


  • We would like to thank the editor for her detailed comments, as well as two anonymous referees for their suggestions. In addition, we would like to thank participants in seminars at the Federal Reserve Banks of Boston and Kansas City, Baruch College, the European Central Bank, the 1st Singapore International Conference on Finance, the 6th Annual FDIC Bank Research Conference, and the 2006 Financial Intermediation Research Society Conference on Banking, Corporate Finance, and Intermediation for their comments.

Abstract

A growing literature investigates the role of internal capital markets in mitigating financial constraints faced by the subsidiaries of a conglomerate. Most studies have relied on indirect tests based on correlations between the cash flows and the investment of the subsidiaries. In contrast, we avoid the widespread criticisms of such specifications by providing direct tests that focus on the mechanisms through which internal reallocations of funds occur. We find that internal capital markets are used by multibank holding companies to mitigate capital constraints faced by individual bank subsidiaries. In addition, we show that internal capital management within a multibank holding company involves not only the movement of capital to those subsidiaries with a relatively greater need for capital but also the movement of assets (loans) from less well capitalized to better capitalized subsidiaries by means of loan sales and purchases among the subsidiaries. Furthermore, net loan sales are used to allow efficiency-enhancing specialization among bank subsidiaries, insofar as those subsidiaries with the best loan origination opportunities are able to focus on loan originations even if they do not have sufficient capital to hold the loans. Our evidence is consistent with banks affiliated with holding companies more actively participating in loan sales and purchases because, by using their internal secondary loan market, they are able to avoid the “lemons” problem faced by stand-alone banks.

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