Capital market frictions and the role of internal capital markets in banking

The extent to which banking firms face external financing costs when funding new loans has important implications for the role of banks in the corporate capital acquisition process, for the effectiveness of monetary policy and for the impact of capital requirements. We investigate this issue by examining the cash-flow sensitivity of loan growth at bank holding companies, and by examining the extent to which holding companies establish an internal capital market to allocate capital among their various subsidiaries. Overall, we find that loan growth at subsidiary banks is more sensitive to the holding company's cash flow and capital position than to the bank's own cash flow and capital. Moreover, we find that bank loan growth is negatively correlated with loan growth among the other subsidiaries within the holding company. Overall, this evidence suggests that bank holding companies establish internal capital markets to allocate scarce capital among their various subsidiaries.