Should Financial Institutions Own Equity? A Test of the 'German Bank Influence Model'

Abstract

This paper tests two competing hypotheses about the influence of financial institutions as large shareholders on the performance of their industrial portfolio firms: the superior monitoring hypothesis versus the rent extraction hypothesis. The methodology of this study exploits the abolishment of capital gains taxes on interfirm share holdings in Germany in two ways. First, the surprise announcement of the tax reform constitutes a natural experiment that allows analyzing the market responses to anticipated changes in firms' ownership structures cross-sectionally. Second, abnormal returns of portfolio firms around actual sales and acquisitions by financial institutions are analyzed in an event study. Altogether, there is virtually no evidence in favor of the superior monitoring hypothesis, which predicts a positive effect of having a financial institution as a shareholder on the performance of the portfolio firm. Moreover, I find only moderate support of the rent extraction hypothesis, which implies a negative relationship between firm performance and a shareholder belonging to the financial industry. Overall, the link between financial institutions as shareholders and firm performance is found to be markedly weak, if existent at all. This result helps to reconcile the highly heterogeneous findings of prior static studies.