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

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 operative within multibank holding companies and that they are used to mitigate capital constraints faced by individual bank subsidiaries. Furthermore, 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 capitalized to more capitalized subsidiaries by means of loan sales and purchases among the subsidiaries. This internal secondary loan market allows banks in holding companies to avoid the lemons problem faced by stand-alone banks by making transactions with their affiliate banks. This second mechanism has been overlooked in the existing literature on the operation of internal capital markets within banking organizations. Ignoring this mechanism may seriously understate the volume of activity in the internal capital markets within banking organizations.