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

Joel Houston and Christopher James

Journal of Applied Corporate Finance, 1998, vol. 11, issue 2, 70-78

Abstract: To the extent raising external capital is especially costly for banks (as the preceding article suggests), bank managers have incentives to manage their internal cash flow in ways that minimize their need to raise external equity. One way to accomplish this is to establish bank holding companies that set up internal capital markets for the purpose of allocating scarce capital across their various subsidiaries. By “internal capital market” the authors mean a capital budgeting process in which all the lending and investment opportunities of the different subsidiaries are ranked according to their risk‐adjusted returns; and all internal capital available for investment is then allocated to the highestranked opportunities until either the capital is exhausted or returns fall below the cost of capital, whichever comes first. As evidence of the operation of internal capital markets in bank holding companies, the authors report the following set of findings from their own recent studies: ▪ For large publicly traded bank holding companies, growth rates in lending are closely tied to the banks' internal cash flow and regulatory capital position. ▪ For the subsidiaries of bank holding companies, what matters most is the capital position and earnings of the holding companies and not of the subsidiaries themselves. ▪ The lending activity of banks affiliated with multiple bank holding companies appears to be less dependent on their own earnings and capital than the lending of unaffiliated banks. The authors also report that, after being acquired, previously unaffiliated banks increase their lending in local markets. This finding suggests that, contrary to the concerns of critics of bank consolidation, geographic consolidation may make banks more responsive to local lending opportunities.

Date: 1998
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