SOME EVIDENCE THAT BANKS USE INTERNAL CAPITAL MARKETS TO LOWER CAPITAL COSTS

Journal of Applied Corporate Finance S U M M E R 1 9 9 8 V O L U M E 1 1 . 2

Some Evidence that Banks Use Internal Capital Markets to Lower Capital Costs by Joel Houston and Christopher James, University of Florida

70JOURNAL OF APPLIED CORPORATE FINANCE

SOME EVIDENCE THATBANKS USE INTERNALCAPITAL MARKETS TOLOWER CAPITAL COSTS

by Joel Houston andChristopher James,University of Florida

70BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

anks, like all firms, enhance shareholdervalue whenever they invest in projectsthat provide shareholders with returnsthat exceed the cost of capital. Firms

policy, and organizational structure. In the articlethat immediately precedes ours, Ken Froot andJeremy Stein discuss the implications for banks’capital budgeting.1 Froot and Stein’s analysis sug-gests that, even when evaluating potential projectsthat use only internal equity, banks should incorpo-rate an additional risk premium into their estimate ofthe cost of equity capital—one that reflects the factthat the project imposes additional (unsystematic)risks on the bank’s available internal cash flow,which in turn increases the likelihood that the bankwill have to raise external capital in the future.Likewise, in a recent Journal of Finance article, KenFroot, David Scharfstein, and Jeremy Stein suggestthat the wedge between the cost of internal andexternal equity capital provides a motivation forcorporate hedging.2 Their argument is that firmshedge their cash flows to ensure that they havesufficient internal funds to fund all of their profitableinvestment opportunities.

Moreover, this assumption that banks find ex-ternal equity especially expensive is also central tothe debate over the extent of regulators’ contributionto the so-called “credit crunch” of the early 1990s inthe U.S.—and over the causes of the ongoing debtcrisis in Japan. In both cases, banks are said by someto have decreased their lending primarily in re-sponse to a decrease in their regulatory capital, andnot to a decline in profitable opportunities to lend.

Each of these arguments, then, is based on theassumption that banks find it especially costly toraise external equity capital. In this paper, wesummarize the evidence from some of our recentresearch that was designed to test this assumption.Stated in brief, our findings are as follows:

1. K. Froot and J. Stein, “A New Approach to Capital Budgeting for FinancialInstitutions,” Journal of Applied Corporate Finance Vol. 11 No. 2 (Summer 1998).

2. K. Froot, D. Scharfstein, and J. Stein, “Risk Management: CoordinatingCorporate Investment and Financing Policies,” Journal of Finance 48 (1993).

generate capital either internally by accumulatingundistributed profits or externally by issuing newcommon stock. It is widely recognized that eventhough internal equity may be readily available, it isnot costless. Rather, the cost of internal equity is anopportunity cost that reflects the returns sharehold-ers would have expected to receive had they in-vested their money in other firms with the same risk.

Arguably, the cost of external equity exceedsthe cost of internal capital. Not only must the firmprovide shareholders with their required return,but they must also pay the transaction costs tounderwrite the issue and the costs associated withissuing stock when the firm may be “undervalued”by the market. These transaction costs are fre-quently high, particularly for firms with assets thatare hard to value.

All of this suggests that there may be a signifi-cant “wedge” between the cost of internal andexternal capital. To the extent external capital ismore costly, bank managers have incentives tomanage their internal cash flow so as to minimizetheir need to raise external equity. Indeed, theexistence of this wedge can explain why most U.S.banks appear to conduct their Treasury and riskmanagement activities in ways that ensure thatinternally generated capital is sufficient to supportnew loan and asset growth.

In this article, we argue that external financingcosts in banking have important implications forbank lending, risk management, bank regulatory

B

VOLUME 11 NUMBER 2 SUMMER 199871

For large publicly traded bank holding companies,growth rates in lending are closely tied to the banks’internal cash flow and regulatory capital position.Specifically, bank lending tends to decrease after adecline in earnings and/or regulatory capital.

For the subsidiaries of bank holding companies,what matters most is the capital position and earn-ings of the holding companies and not of thesubsidiaries themselves.

The lending activity of banks affiliated with mul-tiple bank holding companies appears to be lesssensitive to their own earnings and capital than thelending of unaffiliated banks.

Thus, our results suggest that bank holdingcompanies manage their earnings on a consolidatedbasis in a way that significantly reduces each subsidiary’sdependence on its own capital and earnings position.We view these findings as evidence that externalfinancing costs induce bank holding companies toestablish internal capital markets for the purpose ofallocating scarce capital across their various subsid-iaries. By “internal capital market” we mean a capitalbudgeting process within the holding company inwhich all the lending and investment opportunitiesof the various subsidiaries are ranked according totheir risk-adjusted returns. Then the available inter-nal capital is allocated to the highest-ranked oppor-tunities until the returns fall below the cost of capitalor the capital is exhausted, whichever comes first.

One benefit of an internal capital market is thatit creates a diversified source of internally generatedfunds that can reduce need to raise capital externally.Consistent with benefits of diversification, we findthat banks affiliated with multiple bank holdingcompanies face smaller external financing con-straints and are more responsive to local lendingopportunities than their unaffiliated counterparts.We also find that following an acquisition, previ-ously unaffiliated banks increase their lending inlocal markets. This finding suggests that, contrary tothe concerns of critics of bank consolidation, geo-graphic consolidation may enable banks to be moreresponsive to their local lending opportunities.

FINANCING AND REGULATORYCONSTRAINTS ON BANKS

It is widely accepted that commercial banks andother private lenders play an important role inproducing information about potential borrowersand in monitoring borrower performance after a loanis made. Indeed, many firms choose to borrowprivately rather than issuing public securities be-cause banks and other private lenders have acomparative advantage in mitigating informationproblems and other capital market frictions thatmake external financing costly.3 This informationrole for banks suggests that a large portion of bankassets may be difficult for outside investors to value.And this difficulty, in turn, may create informationproblems for banks themselves when they have toraise external funds.

Despite these concerns, one might expect banksto be well-positioned to raise capital, particularlysince a large part of their assets are funded withfederally insured deposits. Arguably, insured de-positors are less concerned about the value of thebank asset portfolios, since the value of their claimis protected; and this in turn reduces the cost to thebank of raising additional funds through demanddeposits. At the same time, capital requirementstogether with limited access to insured deposits—perhaps arising from regulatory taxes, local depositmarket conditions or Federal Reserve policy—implythat at least a portion of a bank’s financing must beraised in markets in which information problemspotentially create a wedge between the cost ofinternal and external financing.4 And, to the extentthat capital requirements restrict the flexibility ofbank financing, external financing costs can makebank loan and asset growth particularly sensitive tointernally generated additions to capital.

If capital market frictions create a wedge be-tween internal and external financing, these frictionswill occur at the holding company level, since it istypically the parent company that accesses thecapital market. The Bank Holding Company Acts

3. There is a large (and growing) literature on the role of banks in the corporatecapital acquisition process. See, for example, D. W. Diamond, “Financial Interme-diation and Delegated Monitoring,” Review of Economic Studies 51 (1984); D. W.Diamond, “Monitoring and Reputation: The Choice between Bank Loans andDirectly Placed Debt,” Journal of Political Economy 99 (1991); D. W. Diamond,“Seniority and Maturity of Debt Contracts,” Journal of Financial Economics 33(1993); and R.G. Rajan, “Insiders and Outsiders: The Choice between Informed andArm’s Length Debt,” Journal of Finance 47 (1992). For empirical studies thatprovide evidence consistent with banks playing an important role in mitigating

information problems in financial markets, see C.M. James, “Some Evidence on theUniqueness of Bank Loans,” Journal of Financial Economics 19 (1987); M. Petersenand R.G. Rajan, “The Benefits of Firm-Creditor Relationships: Evidence from SmallBusiness Data,” Journal of Finance 49 (1994); and J.F. Houston and C.M. James,“Bank Information Monopolies and the Mix of Private and Public Debt Claims,”Journal of Finance 51 (1996a).

4. See S.C. Myers and N.S. Majluf, “Corporate Financing and InvestmentDecisions When Firms Have Information That Investors Do Not Have,” Journal ofFinancial Economics (1984).


authorize the Federal Reserve to regulate bankholding companies. As part of the regulatory pro-cess, holding companies are subject to the sameminimum capital requirements that are imposed oninsured commercial banks. For example, if indi-vidual banks are subject to a minimum capital-to-total-asset ratio of 5%, the holding company issubject to the same requirement based on its consoli-dated assets.

If bank holding companies are free to managetheir capital and liquidity on a consolidated basis,then capital market frictions would make loangrowth sensitive to internally generated capital ona consolidated basis. In this case, the loan growthof individual subsidiary banks would be primarilyrelated to the holding company’s capitalization andearnings.

However, several regulatory restrictions make itdifficult for holding companies to manage theircapital on a consolidated basis. Among these restric-tion is the Federal Reserve’s practice of following a“building block” approach when evaluating capitaladequacy. This practice requires individual subsid-iaries to be adequately capitalized as well as requir-ing adequate capitalization for holding companieson a consolidated basis.

A second and related impediment to consoli-dated capital management is the longstanding Fed-eral Reserve policy of viewing a bank holdingcompany as a “source of strength” to individual banksubsidiaries.5 The source of strength doctrine givesrise to a perceived obligation on the part of theholding company to downstream capital to inad-equately capitalized subsidiaries. The requirementto downstream funds implies that the holding com-pany may not always be able to allocate capital tothose subsidiaries with the most valuable (highestnet present value (NPV) investment opportunities.

In sum, even if banks have the economicincentive to make lending and other investmentdecisions on a consolidated basis, it is not clearwhether, or to what extent, existing regulations andregulatory oversight give them the power to do so.Ultimately, this remains an empirical issue. With thisin mind, let’s turn to some evidence on how banksactually behave in the face of such regulatoryconstraints.

MEASURING THE RELATIVE COST OFEXTERNAL FINANCING

In a series of recent studies, we have attemptedto analyze the effects of capital market frictions onthe sensitivity of bank investment to changes in cashflow at both the holding company and the subsidiarylevel. Our approach borrows heavily from otherstudies that have examined the correlation betweencash flow and investment among non-financialfirms.6 These studies start from the premise that, if afirm is not constrained in its ability to raise externalcapital, there should little correlation between itsinternally generated cash flow and investment. Bycontrast, a positive correlation between cash flowand investment suggests that the firm finds it morecostly to expand their assets once their internalcapital is exhausted.

In conducting our studies, we begin with theassumption that “lending” in banking is equivalentto “investment” by non-financial firms. This assump-tion implies that bank loan growth (net of loanlosses) is the best measure of a bank’s ongoinginvestment. Bank investment in real assets is gener-ally quite small; it typically amounts to less than 3%of total assets.

Some might argue that banks’ investments insecurities should also be viewed as part of theirinvestment activity. However, one important reasonthat banks invest in securities is to have enoughliquidity to ensure their ability to finance future loangrowth. Therefore, when developing our empiricalmodel for predicting loan growth, we include thesecurities holdings of the bank, along with the bank’sinternally generated funds, as explanatory variables.

We argue that, in the absence of externalconstraints, there should not be a significant corre-lation between bank lending and internal cash flowafter controlling for loan demand. By contrast, apositive significant correlation between lending andinternal cash flow indicates that banks find it costlyto raise external capital. Moreover, since capitalrequirements limit a bank’s ability to substitutedeposits for equity capital (or for other sources offunding that are subject to potential adverse selec-tion problems), we would expect the sensitivity ofloan growth to internally generated funds to be

5. This principle is reflected in Regulation Y12 CFR (Section 225.4(a)(1) whichstates: “A bank holding company shall serve as a source of financial and managerialstrength to its subsidiaries...”

6. See S.M. Fazzari, R.G. Hubbard, and B.C. Petersen, “Financing Constraintsand Corporate Investment,” Brookings Papers on Economic Activity 1, 1988.


greatest for firms where the capital requirement ismost likely to be binding.

A common criticism of studies that use cash flowsensitivity of investment to measure external financ-ing constraints is that current cash flow may becorrelated with the profitability of investment oppor-tunities. That is, for example, when banks’ operatingcash flows decline, their opportunities to makeprofitable new loans may also be reduced by thesame conditions that have caused the shortfall incash flow. To the extent this is so, banks’ decisionsto cut back on lending could be motivated not by theshortage of cash flow and capital, but by the declinein good lending opportunities. And so, even in theabsence of capital market frictions, investment andcash flows may be positively correlated.

Our tests address this issue of causality in twoways. Our first approach is to control for differencesin growth opportunities. As a proxy for growthopportunities, we use the bank’s market-to-bookvalue of assets. An alternative, and perhaps, cleanerway of examining the importance of external financ-ing costs in banking is to examine the operation ofthe internal capital market within a bank holdingcompany. Specifically, if the positive relation be-tween loan growth and internally generated cashresults primarily from a positive correlation betweencash flows and loan demand, then there should bea positive correlation between subsidiary loan growthand subsidiary cash flow. Indeed, if changes in loandemand cause the positive correlation between loangrowth and cash flow, then holding company cashflow (net of the subsidiary’s earnings) will be relatedto loan growth at the subsidiary level only to theextent that holding company cash flow serves as aproxy for local demand conditions. Thus, the findingthat holding company cash flows are more importantthan subsidiary cash flows in determining subsidiar-ies’ loan growth can be interpreted as evidence ofcostly external financing.

Finally, if demand factors induce a positivecorrelation between subsidiary loan growth andholding company cash flows, we would generallyexpect loan growth in the various subsidiaries to bepositively correlated—that is, higher cash flowsthroughout the holding company coincide withgreater lending opportunities, which in turn lead to

greater lending for all the subsidiaries. If this expla-nation is correct, we should see a positive relationbetween subsidiary loan growth and loan growth atother subsidiaries within the holding company.

In fact, we find that this correlation is more oftennegative, suggesting that loan growth in one subsid-iary comes at the expense of loan growth elsewhere.We conclude that this result strongly suggests thatholding companies allocate scarce cash flow throughinternal capital markets.

IS BANK LENDING AFFECTED BY EXTERNALFINANCING COSTS?

In a paper we published recently with DavidMarcus in the Journal of Financial Economics,7 weexamined the sensitivity of loan growth to capitali-zation and internally generated cash flow for asample of 281 publicly traded bank holding compa-nies during the 1980s. This time period was chosenbecause it pre-dated risk based capital requirements,which allowed us to compare the lending activity ofbanks that did not meet minimum capital require-ments (during this period the regulatory minimumwas between 5 and 6%)8 with the activity of banksthat met the requirement. We chose publicly tradedbanks because we needed stock price information toconduct part of our analysis. In addition, these banksare the least likely to find it costly to raise new capital.Arguably, the results we find would be even strongerfor banks with non-traded equity.

One frequently cited implication of costly exter-nal financing is that banks that do not meet minimumcapital requirements are more likely to pass upprofitable new lending opportunities (since presum-ably these banks would have to raise capital exter-nally). While there are many other reasons whypoorly capitalized banks might grow more slowlythan well-capitalized institutions, it is interesting toexamine whether loan growth was related to capi-talization for the banks in our sample and, if so,whether it was the capitalization of the holdingcompany or bank that was more important.

A simple, albeit crude, way to address this issueis to examine differences in the mean and medianloan growth rates by whether or not the bank orholding company meets minimum capital require-

7. Joel Houston, Christopher James, and David Marcus, “Capital MarketFrictions and the Role of Internal Capital Markets in Banking,” Journal of FinancialEconomics Vol. 46 (1997).

8. We have extended our analysis into the 1990s and find results that are verysimilar to those reported in this article.

External financing costs can make bank loan and asset growth particularly sensitiveto internally generated additions to capital.


ments. As shown in Table 1, the average loan growthof inadequately capitalized banks was about a thirdof the loan growth of adequately capitalized banks.Notice also that the average loan growth of indi-vidual subsidiary banks was significantly higherwhen the holding company was adequately capital-ized. Finally, consistent with the idea that holdingcompanies manage their capital on a consolidatedbasis, what appears to affect loan growth at thesubsidiary level is whether the holding company isadequately capitalized and not whether the subsid-iary bank has adequate capital.

While these results suggest that bank capitalinfluences loan growth, there are a number ofreasons why loan growth might be related to bankcapital even if external financing were no moreexpensive than internal financing. For example, aprimary reason banks are inadequately capitalized isbecause of loan losses. Since loan losses are likely tobe greatest in regions with weak economic growthand loan demand, our finding that loan growth isrelated to capitalization by itself tells us little aboutthe importance of external financing constraints.Therefore, a better way to examine the effects ofexternal financing costs is to examine the relationbetween loan growth and earnings while controllingfor controlling for differences in lending opportuni-ties as well as other bank characteristics that mayeffect lending.

As described in our Journal of Financial Eco-nomics paper, we use multiple regression tech-niques to control for these other characteristics.Since our primary concern here is with the relation

between loan growth, cash flow, and bank capitali-zation, we report our estimates of the loan growththat results from each dollar of internally generatedcash flow among banks with varying levels ofsurplus capital. As shown in Figure 1, among bankswith no surplus capital (their capital levels just meetthe regulatory minimum), an additional dollar ofinternal cash leads, on average, to a $4.53 increasein loan volume. In contrast, for banks with surpluscapital equal to 10% of their assets, loans increase byjust about a dollar for each additional dollar inearnings. Since our regression controls for differ-ences in loan demand, these results confirm thatwhen surplus capital is low, bank lending is con-strained by the bank’s ability to add to its capitalthrough earnings. This result implies that banks findexternal equity financing expensive relative to inter-nally generated funds.

A more direct test of whether external financingcosts force banks to limit loan growth is to comparethe cash flow sensitivity of loan growth of banks thatface high underwriting fees for new securities issuesto the cash flow sensitivity of banks subject to lowunderwriter fees. If external financing costs makeloan growth more dependent on bank earnings (andcash flow), loan growth at high-fee banks should bemore sensitive to earnings than it is for low-feebanks.9 Defining high-fee banks as those with pre-dicted underwriter fees above the median in oursample, and low-fee banks as those with underwriterfees below the median, our study found that loangrowth was significantly more sensitive to cash flowfor high-fee than low-fee banks.

TABLE 1LOAN GROWTH ANDHOLDING COMPANYCAPITALIZATION

Holding Companies Loan Growth Subsidiary Banks Loan Growth

Mean Median Mean Median

Holding Company Capital less than Regulatory Minimum.041 .047 .053 .038

Holding Company with Capital greater than Regulatory Minimum.132 .107 .341 .080

Subsidiary Bank with Capital less than Regulatory Minimum.N/A .N/A .104 .080

Subsidiary Bank with Capital greater than Regulatory Minimum.N/A .N/A .100 .080

9. Since underwriter fees can vary over time we estimate the relation betweenunderwriter fees and firm characteristics (such as the size of the bank, the bank’sportfolio composition and measures of bank risk). We use these estimated

relationships to forecast what fees would be charged for banks that do not issuesecurities in a particular year. This estimation procedure is described in detail inour Journal of Financial Economics article.


DO BANKS ESTABLISH INTERNALCAPITAL MARKETS?

If external financing is especially costly, thereare likely to be benefits from establishing a stablesource of earnings either through risk managementpolicies or through geographical or product marketdiversification. Moreover a holding company facingexternal financing constraint can create value byestablishing an internal capital market to reallocatefunds across its various subsidiaries. This realloca-tion makes sense if cash flows from one subsidiarycan be transferred to another subsidiary where thereturns are higher.

As Jeremy Stein pointed out in his March 1997article in the Journal of Finance,10 internal capitalmarkets imply a type of “winners picking-loserssticking” allocation of scarce capital. That is, somesubsidiaries receive more funding than they wouldon a stand-alone basis (the winners) while othersubsidiaries receive less funding than they would ona stand-alone basis. Along a similar dimension, theRAROC-type capital budgeting model discussed inthe accompanying article by Froot and Stein alsoembodies this approach because it implies the costof capital of a particular project is dependent on firm-specific risk factors that in turn depend on the otherprojects the firm has undertaken.

The operation of an internal capital market atthe holding company level has several implications:

First, loan growth at any bank in a multiple bankholding company will depend primarily on the cashflows of the overall holding company and not on thebank’s own cash flows. For a small bank in a largemulti-bank holding company, the aggregate cash

flows of the other subsidiaries will be the primarydeterminant of loan growth.

Second, loan growth at any one bank in a multibankholding company can be negatively correlated withloan growth of other banks in the holding company.

Third, and finally, if the operation of a internalcapital market serves to loosen external financingconstraints, banks affiliated with a multiple bankholding company will be less constrained by down-turns in their own cash flow or earnings thanunaffiliated banks.

Figure 2 shows the relationship between loangrowth and both the holding company’s earningsand the subsidiary’s own earnings. (Holding com-pany earning are computed by taking overall hold-ing company earnings and subtracting the subsidiary’sown earnings.) As shown in the figure, subsidiaryloan growth is almost ten times more sensitive to theholding company’s earnings than its own earnings.This result strongly suggests the operation of aninternal capital market. Moreover, this result alsosuggests that the positive relation between loangrowth and earnings results from external financingconstraints and not a positive correlation betweenearnings and loan demand (since presumably thesubsidiaries’ own earnings would be more closelyrelated to local loan demand than the holdingcompany’s earnings).

A second implication of bank holding compa-nies operating an internal capital market is that loangrowth at one bank can be negatively correlated withloan growth at other banks within the holdingcompany. We find evidence of this type of winnerpicking. Specifically, after controlling for other fac-tors affecting lending (earnings, capitalization, and

FIGURE 1THE PREDICTED DOLLARCHANGE IN HOLDINGCOMPANY LENDINGRESULTING FROM ADOLLAR INCREASE INHOLDING COMPANY CASHFLOW

10. Jeremy Stein, “Internal Capital and the Competition for CorporateResources,” Journal of Finance 52 (1997).

What appears to affect loan growth at the subsidiary level is whether the holdingcompany is adequately capitalized and not whether the subsidiary bank has

adequate capital.


liquidity), we find that higher loan growth at othersubsidiaries of the holding company leads to lowerloan growth at a given bank within the holdingcompany.

A final, and perhaps more important, implica-tion of the operation of an internal capital market isthat affiliation with a multiple bank holding com-pany may reduce external financing constraints andincrease bank lending. We investigated this issue ina recent article published in the Journal of Bankingand Finance.11 In that study, we compared the cashflow sensitivity of loan growth for banks affiliatedwith multiple bank holding companies in our sample

to a similar measure estimated for a sample ofunaffiliated banks. Our sample of unaffiliated banksconsisted of all (4778) U.S. banks that were not partof a multi-bank holding company as of 1986.

Figure 3 shows the sensitivity of loan growth tocash flow for the unaffiliated and affiliated banksover the four-year period 1986-1989. Consistent withthe idea that affiliation reduces external financingconstraints, the loan growth of affiliated banks wassignificantly less sensitive to earnings than loangrowth at unaffiliated banks. More specifically, theresults shown in the top of Figure 3 suggest that, forevery dollar reduction in earnings, unaffiliated banks

FIGURE 2SUBSIDIARY LOANGROWTH PER DOLLAR OFHOLDING COMPANY ANDTHE SUBSIDIARIES OWNEARNINGS

*Evaluated at zero surplus capital.

FIGURE 3 SENSITIVITY OF LOAN GROWTH TO EARNINGS AND STATE LENDING OPPORTUNITIES:AFFILIATED VERSUS UNAFFILIATED BANK

*Evaluated at zero surplus capital.**Includes sensitivity to banks own and overall holding company earnings.

11. Joel Houston and Christopher James, “Do Internal Capital MmarketsPromote Lending?,” Journal of Banking and Finance forthcoming.


cut lending by $2.75, as compared to $1.75 foraffiliated banks.12

One often-cited concern with bank consolida-tion is that acquired banks that become part of amulti-bank holding company will lend less in theirlocal markets than they would have had they re-mained unaffiliated. Indeed, in 1995 Texas becamethe first state to opt out of the interstate branchingprovision of the Riegle-Neal Interstate Banking andBranching Act largely as a result of concerns thatconsolidation would result in a decline in lending tosmall business communities. This move was basedon the belief that small independent banks are morerelationship-oriented and that these relationshipsmake small banks more responsive to local creditneeds. Larger affiliated banks, the argument goes,have a comparative advantage in lending to largecorporate borrowers.13

While an economic analysis of these argu-ments is beyond the scope of this article, ouranalysis of lending patterns of affiliated and unaf-filiated banks can shed some light on this issue.First notice that affiliated banks face fewer externalfinancing constraints than unaffiliated banks, sug-gesting that unaffiliated banks’ lending is con-strained by the banks’ own earnings. Second, lend-ing at affiliated banks appears to be more respon-sive to local loan demand than it is for unaffiliatedbanks. Specifically, using the overall rate of loangrowth in the state in which a bank operates as ameasure of local lending opportunities, we findaffiliated banks are more responsive to local lend-ing opportunities than unaffiliated banks. Indeed,as summarized in the right-hand panel of Figure 3,our findings suggest that a 10% increase in stateloan growth (controlling for other factors) is associ-ated with a 8.4% increase in loan growth at affili-ated banks as opposed to only a 7% increase inloan at unaffiliated banks (a difference is statisti-cally significant at the 1% level).

Looking over time, a similar pattern emergeswhen we consider changes in the loan growth ofunaffiliated banks that were acquired and, hence,became affiliated. After the acquisition, the loangrowth of such newly affiliated banks became lesssensitive to cash flow and more sensitive to stateloan growth.

WHAT DOES IT ALL MEAN?

Does the size and organizational structure of abank affect its ability or willingness to lend? More-over, do these factors affect the types of loans thatbanks make? These questions are important given thedramatic changes that have occurred within the U.S.banking industry over the past ten to fifteen years.

Our study provides some answers to thesequestions. Specifically we find that bank loan growthis determined, in part, by the bank’s organizationalstructure. The loan growth of banks affiliated with amulti-bank holding company is typically less sensi-tive to the bank’s cash flow, liquidity, and capitalposition than the loan growth of unaffiliated banks.In addition, we find that the correlation between abank’s loan growth and average loan growth in thestate in which the bank operates is much higheramong the sample of affiliated banks.

Our finding that loan growth is correlated withcash flows suggests that banks find external capitalto be more expensive than internal capital, and thatbanks are typically “capital constrained” despitetheir access to insured deposits. Our results alsosuggest that affiliated banks are less constrained inthat their loan growth is less sensitive to cash flow,liquidity, and their capital ratio. Moreover, ourfinding that lending among affiliated bank is moreclosely related to overall state loan growth suggeststhat affiliated banks are perhaps more responsive tolocal market conditions, despite the current regula-tory concern about bank consolidation and thegrowing importance of banks affiliated with out-of-state holding companies.

We must stress, however, that our results bythemselves do not suggest that regulators should beunconcerned about consolidation. While our find-ings suggest that affiliated banks are more respon-sive than unaffiliated banks to local market condi-tions, this is clearly a doubled-edge sword. Affiliatedbanks may have greater size and deeper pockets(due to their internal capital markets), which wouldenable them to lend more money when a localmarket is strong. But the same logic suggests thatthey may be less willing to provide capital to localbusinesses when the local market is soft. In theseinstances, the internal capital market would ensure

12. In this study, unlike the one discussed above, we calculate the sensitivityof the loan growth of affiliated banks to the combined earnings of the holdingcompany and the subsidiary bank.

13. See P. Strahan and J. Weston, “Small Business Lending and BankConsolidation: Is There a Cause for Concern?,” Current Issues, Federal ReserveBank 2, no. 3., 1996.

The loan growth of banks affiliated with a multi-bank holding company is typicallyless sensitive to the bank’s cash flow, liquidity, and capital position than the loangrowth of unaffiliated banks. In addition, we find that affiliated banks are more

responsive to local lending opportunities than unaffiliated banks.


that capital is transferred to other regions thatprovide better investment opportunities.

It is also important to recognize that bankborrowers are not forced to establish relationshipswith affiliated banks. If they are sufficiently con-cerned about their ability to obtain capital in down

markets, they may choose to establish a relationshipwith an unaffiliated bank whose fortunes are moreclosely tied to the local economy. Such preferencescould explain why small unaffiliated banks oftencontinue to thrive despite the apparent benefits ofconsolidation.

JOEL HOUSTON

is Associate Professor of Finance at the University of Florida.

CHRISTOPHER JAMES

is the William H. Dial/SunBank Professor of Finance at theUniversity of Florida.

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SOME EVIDENCE THAT BANKS USE INTERNAL CAPITAL MARKETS TO LOWER CAPITAL COSTS