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

This paper examines the functioning of internal capital markets within bank holding companies (BHCs) and its implications for the impact of monetary policy on banks. I find that as monetary policy is tightened, if a small bank operates jointly with a large bank (with easy access to noninsured deposits) within a BHC then the small bank’s loan growth becomes less sensitive to its own internally generated funds. In contrast, if a small bank is unaffiliated with a large BHC, its loan growth becomes significantly more dependent on its own cash flow in periods of tight money supply. I also examine the role of internal capital markets in the investment allocation process of financial conglomerates. I find evidence that within small (more constrained) BHCs the funding of loans becomes less sensitive to cash flow for the worse performing affiliates compared to the best affiliates as the Fed tightens. This finding agrees with the inefficient cross-subsidization (or “socialism”) argument of Scharfstein and Stein (2000), but not with Stein’s (1997) prediction of “winner-picking.” In contrast, internal capital markets may have a disciplinary role in large BHCs, as poorly-performing affiliates are not cushioned from Fed tightenings even though Fed policies do not constrain large banks’ access to external finance. These results are remarkable given the many obstacles imposed by bank regulators on the ability of BHCs to allocate capital among their affiliates. They also imply that internal capital markets in financial conglomerates work in ways that can offset the impact of monetary policy on bank credit supply. *Department of Finance, University of Illinois at Urbana-Champaign, 340 Commerce West Building, 1206 South Sixth Street. Champaign, IL 61820. E-mail: [email protected]. Phone: (217) 359-7339. I thank Charlie Calomiris, Charlie Kahn, George Pennacchi, and Mike Weisbach for their helpful comments and suggestions. All remaining errors are mine.