Internal Capital Markets in Financial Conglomerates: Evidence from Small Bank Responses to Monetary Policy

Abstract

This paper investigates internal capital markets in financial conglomerates by studying the responses of small banks to changes in monetary policy. I find that if a small bank operates on a stand-alone basis, then that bank's loan growth becomes significantly more dependent on its own cash flows as monetary policy is tightened. In contrast, if a small bank operates under a multi-bank holding company with another bank with easy access to nonreservable funds, then the small bank's loan growth does not become more sensitive to its own cash flows in periods of tight money. My evidence shows that internal capital markets in financial conglomerates relax the constraints faced by affiliates unable to raise funds via liabilities that bear credit risk. Further analysis indicates that internal capital markets have the potential of lessening the impact of Fed policies on bank lending activity. The paper also examines the role of internal capital markets in influencing the investment allocation process of conglomerates. In a sample of constrained (unconstrained) multi-bank holding companies, comparisons across bank affiliates of the same conglomerate show that the funding of new loans becomes less (more) sensitive to affiliate-level cash flows for the worst affiliates relative to the best affiliates following a tightening. My findings suggest that frictions between conglomerate headquarters and external capital markets are at the root of investment inefficiencies generated by internal capital markets.