Financial Flexibility and the Cost of External Finance for U.S. Bank Holding Companies

Article excerpt

BANKS RAISE FUNDS FROM segmented markets. While investors determine the risk premium in pricing uninsured claims, regulators play an important role in setting the risk premium on insured claims by assessing deposit insurance premia, and imposing other regulatory requirements. This simple difference has been used to explain a number of observed regularities including bank risk taking, regulator behavior, and investor responses to bank news. And yet, little empirical work has explored banks' choices of how much funding to raise from each source, or the determinants of that choice. While logic argues that individual banks will trade off the relative benefits and costs of raising funds from these two sources, quantification of these factors, especially the costs, may be problematic.

To understand some of the issues that must be addressed when quantifying the costs of accessing segmented markets, consider the following example. Assume two capital markets price a particular bank's securities differently. As the relative rates charged by the two markets change, the bank will obviously find it advantageous to increase its reliance on the now relatively cheaper market. The degree to which a bank can exploit changes in relative rates depends on its costs of accessing the two markets. The cheaper the bank's access costs, the better it can take advantage of pricing discrepancies.

Yet access to segmented markets will impact the bank in ways beyond simple arbitrage. Consider a bank that relies heavily on internal funds for investment. With perfect capital markets, shortfalls in internal funds can be offset with equivalent increases in external funds. However, if capital market imperfections exist such that the marginal cost of external funds increases in the quantity raised, then the bank may forgo lending when faced with internal fund shortfalls. We argue that access to segmented capital markets results in a marginal (deadweight) cost of access (totaled across all markets) that is less sensitive to quantity, making costs of internal fund shortfalls more similar in magnitude to the benefits of equivalent sized windfalls. Thus, the impact of variability in internal funds on firm value will be lower for banks with access to segmented markets. This latter benefit to segmented market access has important implications for the interaction between investment and financing decisions.

To ensure that we recognize both of the above-described benefits to accessing segmented markets, we begin our analysis with a theoretical model that explicitly admits the possibility of raising external capital from two segmented markets. We assume an increasing marginal cost of raising funds in either market, and illustrate how these access costs and relative prices in the two markets combine to affect a bank's capital raising activities. We show that higher access costs attenuate a bank's incentive to switch funding sources when the markets' relative prices change (i.e. the bank with high access costs will alter its funding mix to a lesser degree than the bank with low access costs).

Second, we show that a bank with access to two markets faces a deadweight cost of external finance function that is less convex than an otherwise identical bank's with access to only one market. Moreover, the lower the access cost convexity of either market, the lower the bank's total external finance cost convexity. Lower convexity of the deadweight cost of external finance translates into reduced concavity in the bank's profits with respect to internal funds (i.e., the firm will be more insulated from shocks to internal funds). Finally, our model presents a corollary to this latter result. Specifically, we model the bank's decision to carry costly liquid assets--financial slack. If there is uncertainty regarding next period's rate charged by the capital markets, the bank invests in liquid assets as a buffer against the uncertainty. The model shows that the bank with less convex access costs carries less slack. …