Do Bank Internal Capital Markets Promote Lending? (PDF Download ...

Journal of Banking & Finance 22 (1998) 899±918

Do bank internal capital markets promote lending? Joel F. Houston *, Christopher James Graduate School of Business, University of Florida, Gainesville, FL 32611-2017, USA

Abstract We analyze the relation between organization structure and bank lending. Loan growth among banks that are aliated with a multi-bank holding company is shown to be less sensitive to the bank's cash ¯ow, capital position and liquidity relative to unaliated banks. Our results, coupled with the recent ®ndings of Houston et al. (Houston, J.F., James, C., Marcus, D., Journal of Financial Economics 46 (1997) 135± 164.), suggest that bank holding companies establish internal capital markets in an attempt to allocate capital among their various subsidiaries. We also ®nd that aliated banks are more responsive to local market conditions than their unaliated counterparts. This ®nding suggests that despite the concerns raised regarding bank consolidation ± aliated banks are willing to lend in local markets as long as the opportunities are there. Ó 1998 Elsevier Science B.V. All rights reserved. JEL classi®cation: G21; G32 Keywords: Bank lending; Organization structure

1. Introduction Does the size and organizational structure of a bank aect its ability or willingness to lend? Moreover, do these factors aect the types of loans that banks make? These questions are important given the dramatic changes that *

Corresponding author. Tel.: (+1) 904 392 0153; fax: (+1) 904 392 0301.

0378-4266/98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved. PII S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 0 0 9 - 0

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J.F. Houston, C. James / Journal of Banking & Finance 22 (1998) 899±918

have occurred within the US banking industry over the past 10±15 years. 1 In particular, the widespread consolidation of the industry has produced at least three important changes which may aect bank lending. First, consolidation has created larger banks and larger banks historically have engaged in dierent types of lending than small banks. Second, banks aliated with bank holding companies control a larger percentage of overall bank assets. Third, consolidation has further enabled banks to raise funds in one region and lend money in another, thereby widening the separation between a bank's funding and lending operations. On balance, these changes are likely to have both positive and negative eects on the lending process. Larger, more diversi®ed banks may ®nd it easier to raise external capital. Furthermore, by establishing an internal capital market within a bank holding company, larger diversi®ed banks can more eciently allocate funds within the organization and avoid or mitigate external ®nancing costs. Such transfers of capital across regions may be dicult and costly if the bank is not aliated with a bank holding company. At the same time, consolidation has raised a number of concerns. For example, Boyd and Graham (1996) suggest that consolidation has failed to improve eciency but it has increased concentration (which may be anticompetitive), and has increased the number of very large banks which creates additional concerns for bank regulators. Others are concerned that consolidation has made banks less responsive to local conditions. Keeton (1996), for example, ®nds in a study of Midwest banks in the Tenth Federal Reserve district, that banks controlled by out-of-state holding companies are somewhat less likely to provide funds to local businesses and farmers. Finally, given that smaller banks tend to proportionally lend more money to small businesses, there are concerns that consolidation may adversely impact small business lending. Related to these issues, in a recent paper Houston et al. (1997) ®nd that even large bank holding companies face external ®nancing constraints which tie their lending to the internally generated cash and securities that they have available. 2 More importantly, they ®nd that subsidiary loan growth is more closely tied to the cash ¯ow and capital position of its holding company than it is to the bank's own cash ¯ow and capital position. This evidence suggests that multiple bank holding companies establish internal capital markets to allocate 1 Boyd and Graham (1996), Houston and James (1996), and Berger et al. (1995) each provide an analysis of the recent changes in the banking industry. 2 Recently there have been a number of papers examining the relation between investment and internally generated funds. See for example, Fazzari et al. (1988). The underlying assumption employed in these studies is that capital market frictions create a wedge between the cost of internal and external ®nancing that is manifest in a sensitivity of investment (loan growth) to internally generated funds (bank earnings).


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scarce capital within the organization. In some sense, these results provide support to both the proponents and opponents of bank consolidation. The establishment of internal capital markets may enhance eciency by eectively transferring capital to subsidiaries with the most promising opportunities. At the same time, these transfers lend support to those who argue that large bank holding companies are less responsive to local markets. In this paper we more directly analyze the connection between organization structure and bank lending by contrasting the lending behavior of banks that are aliated with a multiple bank holding company to the lending behavior of unaliated banks (i.e., banks that are not part of a multi-bank holding company). We ®nd strong evidence that unaliated banks are more cash ¯ow constrained ± their loan growth is more highly correlated with internal cash ¯ow, and more in¯uenced by the bank's capital position and liquid assets. These results are consistent with those banks facing higher external ®nancing costs and suggest that there may be important ®nancial eciencies arising from bank consolidation. Again, however, there remains the concern that aliated banks may be less responsive to local market conditions. To investigate this issue, we also consider overall state loan growth as a proxy for local market demand. Interestingly, we ®nd that loan growth among aliated banks is signi®cantly more sensitive to local market conditions than it is for unaliated banks. In this respect, our results suggest that aliated banks are potentially even more responsive to the various local markets that they serve. Despite these conclusions, our results need to be interpreted with a great deal of caution. First, while aliated banks are more responsive to the local market demand, this in turn implies that they are less willing to provide credit when the local market is weak ± particularly if the holding company has better prospects elsewhere. While this may lead to a more ecient allocation of capital, it does suggest that aliated banks are less willing to prop up businesses in a troubled region. If this is the case, policy makers should recognize that the organizational structure of the banking industry may aect the lending process over the business cycle. At the same time, while our results suggest that aliated banks are less liquidity constrained, our results do not distinguish among the dierent types of bank lending. It may be the case that consolidation has increased the amount of large commercial lending, yet decreased the amount of small business lending. Perhaps osetting this concern are recent studies by Peek and Rosengen (1995, 1998) and Berger et al. (1998) which suggest that mergers have not had a strong negative eect on small business lending. Finally, while our results suggest that the operation of an internal capital market lessens the external ®nancing constraints, we provide no direct evidence that internal capital markets improve the overall eciency with which capital is allocated. Speci®cally, while internal capital markets may serve to reduce

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liquidity constraints, agency problems within a conglomerate enterprise may lead to a suboptimal allocation of capital. For example, Scharfstein and Stein (1997) argue that rent seeking activities by divisional managers can result in stronger divisions subsidizing weaker ones within a conglomerate organization. The rest of the paper proceeds as follows. Section 2 provides some background information regarding internal capital markets in banking and the connection between mergers, organizational structure and bank lending. Section 3 outlines the data and methodology that we have used in the study. The empirical results are presented in Section 4. Section 5 concludes. 2. Background 2.1. Issues regarding bank consolidation Recently, a number of papers have documented the widespread consolidation of the banking industry. These papers have also considered the many implications resulting from consolidation. Berger et al. (1995) point out that the number of chartered banks has fallen sharply in recent years. While there were more than 14,000 banks in 1986, this number has fallen to just over 10,000 in recent years. Moreover, larger banks today hold an increasing percentage of total bank assets. In 1979, banks with less than $100 million in assets held nearly 14% of the industry's assets ± by 1994, that number had fallen to 7%. By contrast, the largest banks, with assets exceeding $100 billion now control roughly 20% of the industry's assets ± in 1979 this percentage was less than 10%. 3 Whether consolidation has improved the industry's overall eciency remains an open question. Berger et al. (1995) suggest that geographical and product deregulation have probably enhanced overall competition and the market for corporate control. Likewise, Berger (1997) concludes that recent mergers have improved pro®tability. He suggests that some of the improvement has taken place because of the replacement or reforming of inecient management. At the same time, Berger attributes some of the improvement to increased diversi®cation (resulting largely from product and geographical deregulation) which has enabled some banks to shift their portfolios away from safer securities towards lending which tends to be more pro®table. However, Houston and Ryngaert (1994) looking at the stock market's response to large bank mergers suggest that the typical merger has failed to improve overall shareholder wealth, but that the more successful mergers have tended to be those that provide the greatest opportunity for cost-cutting. Boyd 3

These numbers are reported in Berger et al. (1995).


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and Graham (1996) also provide a less sanguine view of the recent consolidation of the banking industry. They ®nd that bank mergers have done little to improve eciency. One important exception is that eciencies have typically arisen when small banks have merged. Given that consolidation has increased concentration in local banking markets and the number of banks that regulators may now view as ``too big to fail'', Boyd and Graham conclude that the disadvantages of consolidation may outweigh the bene®ts. Past research has also explored the connection between mergers, ®rm size and the level and type of bank lending. Berger et al. (1995) ®nd that small banks tend to specialize in small business loans, whereas larger banks tend to lend more heavily to larger businesses. This correlation has led some to conclude that consolidation has and will continue to have a detrimental eect on small business lending. For example, Berger et al. estimate that there was a 34.8% real contraction in loans to borrowers with bank credit of less than $1 million during the ®rst half of the 1990s. Building on the idea that targets tend to gradually adopt the characteristics of their acquirers, Peek and Rosengen (1998) suggest that, at ®rst glance, this might lead one to conclude that mergers are likely to reduce small business lending ± since large banks tend to make fewer small business loans. However, they ®nd that in many, but not the majority of instances, acquiring ®rms hold a larger percentage of small business loans relative to the ®rms they acquire. Peek and Rosengren conclude that, ``... not all mergers will shrink small business lending, many will actually raise it''. In related work, Berger et al. (1998) explore the dynamic response of small business lending to consolidation. They make the important point that mergers may lead combined ®rms to hold a dierent proportion of small business loans than what would be obtained by simply taking a weighted average of the proportions held by the two banks prior to the merger. Just as importantly, they argue that other institutions in the market may step in to ®ll the vacuum if mergers induce other institutions to reduce the total amount of small business lending. 2.2. Consolidation and the creation of internal capital markets Consolidation within banking provides banking organizations the opportunity to diversify their operations geographically and across product lines. One potential advantage of this process is that it permits banks to establish internal capital markets for the allocation of scarce capital and the management of liquidity. As Stein (1997) points out, the creation of an internal capital market in which headquarters (e.g. the holding company) allocates capital across diverse projects can create value and limit the distortions arising from the costs of raising funds externally. The intuition is rather straightforward: while agency problems may limit the consolidated ®rm's ability to raise

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external capital, managers may have the right incentives to allocate capital properly within the ®rm since managers realize the private bene®ts of control rights from the projects they oversee. As a result, managers maximize ®rm value by ``winner picking'' ± i.e. they rank projects according to their relative value and allocate the available capital accordingly. Internal capital markets may be particularly bene®cial in banking. Stein speculates that the incentives to establish internal capital markets may be strongest among ®rms that are narrowly focused and whose assets are relatively hard to value. Relative to industrial ®rms, banking assets are relatively homogenous. Moreover, the fact that bank loans assets are typically viewed as ``informationally intensive'' suggests that outsiders may ®nd it dicult to discern the true value of a bank's assets. Finally, bank organizational structure has historically been determined by regulation (in the form of intra and interstate branching restrictions and restrictions on holding company aliation). The recent removal of these restrictions is likely to permit banks to move towards a more ecient (unconstrained) organizational form. In a recent paper Kashyap and Stein (1997) provide evidence that adverse selection problems associated with raising external funds are particularly important for small banks. Speci®cally, they ®nd that changes in monetary policy matter most for the lending of small banks with the least liquid balance sheets. They argue that this eect arises from the costs these banks face in substituting nonreservable deposits (primarily uninsured liabilities) and equity capital for insured reservable deposits. These results suggest that there may be signi®cant bene®ts associated with consolidating these banks into an internal capital market operated by a holding company. There is also some empirical evidence outside of banking that diversi®ed ®rms establish internal capital markets. For example, Lamont (1996) ®nds that among diversi®ed oil ®rms, investments in the oil industry are tied to the cash ¯ows of the nonoil related businesses. Shin and Stulz (1996) also ®nd evidence that among diversi®ed industrial ®rms, cash ¯ow in one division often has an eect on investment in other nonrelated subsidiaries. However, their study raises the possibility that these transfers are not designed to transfer capital eciently, but rather re¯ect a ``bureaucratic rigidity'' where capital allocation schemes are determined ineciently and are slow to adjust. Houston et al. (1997) examine the operation of internal capital markets within the banking industry by examining the cash ¯ow sensitivity of loan growth among subsidiaries of multiple bank lending companies. Their study builds on the literature which has investigated the correlation between investment and cash ¯ow (e.g. Fazzari et al., 1988). This literature argues that a positive correlation between cash ¯ow and investment (after controlling for the level of investment opportunities) indicates that ®rm investment depends on the availability of internal capital ± which in turn suggests that there are important frictions in the capital allocation process and that external capital is


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more costly than internal capital. Houston et al. (1997) ®nd bank holding companies are liquidity constrained, i.e. their lending is tied to cash ¯ow. Moreover, they also ®nd that lending among bank holding company subsidiaries is more closely tied to the holding company's cash ¯ow, liquidity, and capital position than the bank's own characteristics. A common criticism of studies that examine the relation between investment and cash ¯ows is that cash ¯ows may proxy for the pro®tability of investment opportunities and not supply factors arising from external ®nancing constraints. Houston et al. (1997) address this issue in several ways. First they examine the relation between loan growth, the subsidiary's own cash ¯ows, as well as the cash ¯ows of other subsidiaries within the holding company. Consistent with the existence of external ®nancing constraints, they ®nd that loan growth at the subsidiary is determined primarily by the holding company's cash ¯ows and capital, not by cash ¯ows at the subsidiary level. Second, Houston et al. separate liquidity eects from loan demand factors by examining the relation between loan growth at individual subsidiaries within the same holding company. They ®nd a negative relation between loan growth at the subsidiary level and overall loan growth of the holding company. This result is consistent with the existence of an internal capital market in which capital constrained banks allocate capital across competing uses. Finally, Houston et al. ®nd that the cash ¯ow sensitivity of loan growth is positively related to the cost of issuing public securities. In this paper, building upon the methodology of Houston et al., we compare the cash ¯ow sensitivity of bank lending among aliated and unaliated banks. This analysis provides us with a clearer test of the eects that changing organizational structure has on bank lending. In addition, we examine the eects of aliation on external ®nancing constraints by comparing the cash ¯ow sensitivity of loan growth before and after a bank is acquired. This approach provides us with further insights into whether internal capital markets within bank holding companies promote or discourage lending. Regulatory restrictions on consolidated capital management and capital transfers among unaliated banks in a bank holding company are likely to blur distinctions between aliated and unaliated banks. Speci®cally, the Federal Reserve practice of following a building block approach to capital adequacy (i.e. requiring every bank subsidiary to be adequately capitalized) as well as limits on up-streaming capital from subsidiaries to the holding company impair the ability of holding companies to manage capital on a consolidated basis. In addition, if unaliated banks are able to transfer capital through common ownership by groups of investors, then they may operate an internal capital markets outside the holding company structure.

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3. Data To compare the lending activity and external ®nancing constraints faced by aliated and unaliated banks we collected information on a sample of subsidiary banks of publicly traded multiple bank holding companies and from banks that are not aliated with a multiple bank holding company. The sample of subsidiary banks, which we refer to as the aliated sample consists of 1976 subsidiaries of 178 multi-bank holding companies. This sample is the one used in Houston et al. (1997). For this sample, we collected data for both the subsidiary banks and the holding company. We collected bank holding company data from the Federal Reserve Y-9 tapes from 1986 to 1989 (annual observations). Holding companies included in the sample are required to have a minimum of two years of data, a nonnegative book value of equity, and an available market value of common equity. All stock data come from the CRSP and NASD master tapes. We restrict our sample period to the 1980s because, after 1989, banks (subsidiaries and holding companies) became subject to riskbased capital requirements. Risk-based requirements represented a major regime change in regulatory behavior. Hence we choose to study a period for which the regulatory regime for bank capital is constant. 4 Balance sheet and income statement information for both aliated and unaliated banks are from the Federal Reserve Reports of Income and Condition (Call Reports). Call Report data is available to us beginning in 1985, so our sample spans 1986±1989. Aliated banks must have at least two yearend observations and be part of a multi-bank holding company to be included in the subsidiary sample. Unaliated banks are banks that are not part of a multiple bank holding company. All unaliated banks on the 1986 Call Report tapes with data available in 1985 and 1986 were included in our sample. These banks were then followed forward through 1989. If after 1986, the bank became part of a multibank holding company it was dropped from the unaliated bank sample. 5 The ®nal sample consists of 17,065 observations on 4778 unaliated banks. The samples of aliated and unaliated banks are geographically diverse, each containing banks in every state and the District of Columbia. However, unaliated banks are (proportionately) more heavily concentrated in states

4 We have extended our holding company sample tests through 1992, with no signi®cant dierence in results (not reported). One additional complication when extending the data through 1992 is that complete risk-weighted asset data are not available. In these instances, we rely on a technique developed by Takeda (1994) for the estimation of risk-based capital ratios. Regression analysis is used to approximate the risk weights associated with on- and o-balance sheet assets. For a complete discussion see Takeda (1994) or Marcus (1996). 5 Banks were identi®ed as members of a multi-bank holding company if their holding company bank number was associated with for more than one bank on the Call Report for a given year.


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that were historically unit branching states (e.g. Kansas, Oklahoma and Illinois). Studies of investment spending for non®nancial ®rms consider investment to be a function of internally generated funds after controlling for ®rm growth opportunities (see for example Fazzari et al., 1988). Typically, investment is measured by changes in capital de¯ated by the ®rm's capital stock at the end of previous year. Capital stock is usually proxied by property, plant, and equipment. We consider bank investment to be changes in loans outstanding, and the capital stock to be the loans outstanding at the end of the previous year. Therefore, investment (loan growth) is de®ned as the percentage change in loans outstanding. The appropriate measure of internally generated funds for banking ®rms diers slightly from the measure used in studies of non®nancial ®rms. Specifically, studies of non®nancial ®rms generally measure internally generated cash ¯ows as net income before extraordinary items plus depreciation. However, banks may not be as constrained by cash ¯ow as non®nancial ®rms because of the availability of insured deposits. Nevertheless, they are constrained by the proportion of debt ®nancing they can utilize. Regulations mandate capital requirements which limit banks' ability to borrow, and thus banks should be concerned with the amount of regulatory capital that they generate. We measure internally generated funds as net income before extraordinary items plus depreciation and additions to loan loss provisions (since loan loss provisions are a noncash expense and are included in regulatory capital) and we scale this measure by the company's loan balance at the end of the previous year. 6 In examining the relation between investment and cash ¯ows it is important to control for dierences in the investment opportunities (loan demand) ®rms face. A standard control variable used in the literature is Tobin's q or the ratio of the market to book value of the ®rms assets. We cannot use a Tobin's q proxy as an explanatory variable for aliated banks and many unaliated banks because their common stock is not publicly traded. Instead, we control for dierences in investment opportunities in two ways. First, we use the average loan growth in the state computed for our sample of banks. Speci®cally, we average the loan growth (equally weighted) for all banks in our sample in a state in a given year. Second, we include the lagged value of asset growth. 7 To measure the extent to which a bank or bank holding company is capital

6

Our results are similar if we do not include additions to loan losses in our measure of internally generated funds. For a discussion of regulations pertaining to loan loss provisioning see Walter (1991). Our results are also similar if we deduct dividend payments from internally generated funds. 7 As discussed earlier, Houston et al. (1997) provide evidence that the correlation between loan growth and cash ¯ows arises primarily from supply factors.

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constrained, we calculate its surplus capital at the end of the previous year. Surplus capital is the bank's or holding company's Tier II capital ratio minus the ratio which was required by regulators in that given year. Required capital ratio was 6% from 1985 to 1989. As an alternative measure of the regulatory constraint, we also include a dummy variable, BIND, which equals 1 if surplus capital is nonpositive, and 0 otherwise. This variable indicates whether a bank failed to meet the minimum capital requirement at the end of the previous year. 4. Results 4.1. Summary statistics Table 1 summarizes the key characteristics of the aliated and unaliated banks in our sample. The mean unaliated bank has total assets of $83.87 million. The aliated banks are signi®cantly larger, with mean total assets of $276.84 million. The median asset size of the unaliated banks is also smaller ($37.30 million versus $107.35 million). Annual loan growth is also higher among the aliated banks (6.1% versus 4.3%). However, the unaliated banks have a higher proportion of internally generated capital available for lending. Internal additions to capital as a percentage of total loans average 1.8% for the mean unaliated bank as opposed to 1.6% for the average aliated bank. Likewise, the median unaliated bank has a higher proportion of internal capital relative to the median aliated bank (1.9% versus 1.7%). Table 1 also shows that unaliated banks tend to hold a higher proportion of liquid assets and have higher capital ratios. The median unaliated bank holds roughly 30% of its assets in liquid securities, and maintains a book capital ratio 3.1 percentage points above the regulatory minimum. By contrast, the median aliated bank has a securities to total asset ratio of 20.7%, and maintains a book capital ratio of 1.8 percentage points above the regulatory minimum. One interpretation of these numbers is that unaliated banks ®nd it relatively costlier to raise external capital, and they adjust by holding more securities and maintaining higher capital ratios. To better control for the eects of bank size, we also construct sub-samples which consist of the aliated and unaliated banks whose total assets are less than $100 million. Again, the overall results hold for the small bank subsamples. The small aliated banks are larger, have higher loan growth, hold a smaller proportion of securities and have less surplus capital relative to the small unaliated banks. Finally, the aliated banks typically operate in states with higher average loan growth. The mean and median state loan growth are 6.1% and 7.0%, respectively for the aliated banks, and 4.3% and 4.5%, respectively for the unaliated banks. The same pattern emerges for the small bank sub-samples. These numbers suggest that the higher loan growth among

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$140.41 $49.03 0.049 0.051 0.018 0.019 0.283 0.272 0.029 0.025 0.049 0.054

$37.30 0.044 0.019 0.294 0.031 0.045

17,065

$83.87 0.043 0.018 0.303 0.027 0.043

Median

Mean

Mean Median

Unaliated banks

Overall sample

5934

$276.84 $107.35 0.061 0.066 0.016 0.017 0.221 0.207 0.022 0.018 0.061 0.070

Mean Median

Aliated banks

2805

$53.70 $53.04 0.047 0.053 0.015 0.018 0.244 0.239 0.026 0.022 0.047 0.050

Mean Median

Small aliated banks (