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

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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.

Keywords: E51; G21; G32; bank regulation; internal capital markets; loan sales; multibank holding companies

Document Type: Research Article

DOI: http://dx.doi.org/10.1111/j.1538-4616.2010.00311.x

Affiliations: 1: Dmytro Holod is an Assistant Professor of Finance in the College of Business, SUNY—Stony Brook (  )., Email: Dmytro.Holod@sunysb.edu 2: Joe Peek is the Gatton Endowed Chair in International Banking and Financial Economics in the Finance Area, Gatton College of Business and Economics, University of Kentucky (  )., Email: joe.peek@uky.edu

Publication date: August 1, 2010

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