Academic journal article Financial Management

Agency and Internal Capital Market Inefficiency: Evidence from Banking Organizations

Academic journal article Financial Management

Agency and Internal Capital Market Inefficiency: Evidence from Banking Organizations

Article excerpt

Using banking data, I provide evidence that agency problems are at the root of internal capital market inefficiency. I find that publicly traded bank holding companies (BHCs) are less efficient in their internal capital allocation than nonpublicly traded BHCs. This suggests that the divergence of interests between the chief executive officer and the shareholders is an important source of the internal capital misallocation. I also demonstrate that BHCs incorporating a tiered organizational structure are less efficient than nontiered BHCs, but only within a sample of BHCs that are publicly traded. These findings imply that a greater degree of rent-seeking activity by division managers contributes to internal capital market inefficiency only if the top manager is an agent. This is consistent with theoretical models that explain internal capital misallocations through the multiple layers of agency within an organization.

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The purpose of this study is to empirically investigate the sources of internal capital market inefficiencies. One of the main reasons for such inefficiencies, as suggested by the literature, is the rent-seeking activity of the division managers of a conglomerate (Stein, 1997; Rajah, Servaes, and Zingales, 2000; Scharfstein and Stein, 2000). However, for the division managers' rent-seeking activity to result in internal capital misallocation, it is important that the top manager, who makes decisions about the allocation of funds among subsidiaries, is also an agent whose interests may diverge from the owners' goal of firm value maximization (Scharfstein and Stein, 2000).

If these two layers of agency are at the root of internal capital market inefficiencies, one would expect the following. First, more internal capital market inefficiencies should be observed within publicly traded conglomerates. A chief executive officer (CEO) of a publicly traded company is an agent and is, therefore, more likely to have perverse incentives when compared to a CEO of a nonpublicly traded company. In addition, the misallocation of funds within a publicly traded conglomerate should be further exacerbated if the conglomerate has a tiered structure. The CEO, acting also as an agent, must deal with several layers of agency at the division levels.

In this study, I use banking data to compare the efficiency of internal fund allocation among subsidiaries of publicly traded bank holding companies (BHCs) with that of nonpublicly traded BHCs. Furthermore, I distinguish between tiered and nontiered BHCs. (1) The banking data provide a unique opportunity to test the two main predictions of this study. Unlike the data sets for the nonfinancial firms, banking data contain information for both publicly traded and nonpublicly traded banking organizations. This is because all types of banks have to file regulatory reports. As a result, it is possible to make the distinction between publicly traded and nonpublicly traded banking organizations. Furthermore, regulators require banking organizations to report on the level of the consolidated BHC and also on the individual bank subsidiary levels. This makes it possible to track the organizational hierarchy of each BHC and make the distinction between tiered and nontiered banking organizations.

I find that publicly traded BHCs are less efficient in their internal capital allocation when compared to nonpublicly traded BHCs. This inefficiency is further exacerbated if a publicly traded BHC is also tiered. However, tiered nonpublicly traded BHCs do not exhibit higher internal capital market inefficiency. They allocate funds more efficiently among their subsidiaries than nontiered nonpublicly traded BHCs. These results provide strong evidence in favor of Scharfstein and Stein's (2000) model that suggests the rent-seeking activity of the division managers may result in the misallocation of internal resources within a conglomerate if the CEO is an agent who is not necessarily acting in the best interests of their shareholders. …

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