Citation
Effects of capital regulation and information asymmetries on bank lending

Material Information

Title:
Effects of capital regulation and information asymmetries on bank lending
Creator:
Marcus, David Frederic, 1968-
Publication Date:
Language:
English
Physical Description:
v, 87 leaves : ; 29 cm.

Subjects

Subjects / Keywords:
Assets ( jstor )
Bank capital ( jstor )
Capital markets ( jstor )
Capital requirements ( jstor )
Capital surplus ( jstor )
Fixed assets ( jstor )
Growth capital ( jstor )
Holding companies ( jstor )
Investment banking ( jstor )
Subsidiary companies ( jstor )
Dissertations, Academic -- Finance, Insurance, and Real Estate -- UF
Finance, Insurance, and Real Estate thesis, Ph. D
Genre:
non-fiction ( marcgt )

Notes

Thesis:
Thesis (Ph. D.)--University of Florida, 1996.
Bibliography:
Includes bibliographical references (leaves 84-86).
General Note:
Typescript.
General Note:
Vita.
Statement of Responsibility:
by David Frederic Marcus.

Record Information

Source Institution:
University of Florida
Holding Location:
University of Florida
Rights Management:
Copyright [name of dissertation author]. Permission granted to the University of Florida to digitize, archive and distribute this item for non-profit research and educational purposes. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder.
Resource Identifier:
023821059 ( ALEPH )
35771954 ( OCLC )

Downloads

This item has the following downloads:

effectsofcapital00marc ( .pdf )

AA00018866_00001.pdf

effectsofcapital00marc_0074.txt

effectsofcapital00marc_0062.txt

effectsofcapital00marc_0078.txt

effectsofcapital00marc_0066.txt

effectsofcapital00marc_0067.txt

effectsofcapital00marc_0090.txt

effectsofcapital00marc_0093.txt

effectsofcapital00marc_0086.txt

effectsofcapital00marc_0084.txt

effectsofcapital00marc_0079.txt

effectsofcapital00marc_0018.txt

effectsofcapital00marc_0003.txt

effectsofcapital00marc_0015.txt

effectsofcapital00marc_0010.txt

effectsofcapital00marc_0088.txt

effectsofcapital00marc_0091.txt

effectsofcapital00marc_0065.txt

effectsofcapital00marc_pdf.txt

effectsofcapital00marc_0032.txt

effectsofcapital00marc_0047.txt

effectsofcapital00marc_0026.txt

effectsofcapital00marc_0007.txt

effectsofcapital00marc_0080.txt

effectsofcapital00marc_0024.txt

effectsofcapital00marc_0027.txt

effectsofcapital00marc_0042.txt

effectsofcapital00marc_0075.txt

effectsofcapital00marc_0076.txt

effectsofcapital00marc_0004.txt

effectsofcapital00marc_0072.txt

effectsofcapital00marc_0082.txt

effectsofcapital00marc_0030.txt

effectsofcapital00marc_0087.txt

effectsofcapital00marc_0031.txt

effectsofcapital00marc_0035.txt

effectsofcapital00marc_0005.txt

effectsofcapital00marc_0002.txt

effectsofcapital00marc_0029.txt

effectsofcapital00marc_0036.txt

effectsofcapital00marc_0021.txt

effectsofcapital00marc_0019.txt

E9E8LU2HK_VN2QW5_xml.txt

effectsofcapital00marc_0039.txt

effectsofcapital00marc_0049.txt

effectsofcapital00marc_0061.txt

effectsofcapital00marc_0011.txt

effectsofcapital00marc_0060.txt

AA00018866_00001_pdf.txt

effectsofcapital00marc_0023.txt

effectsofcapital00marc_0059.txt

effectsofcapital00marc_0070.txt

effectsofcapital00marc_0025.txt

effectsofcapital00marc_0009.txt

effectsofcapital00marc_0028.txt

effectsofcapital00marc_0077.txt

effectsofcapital00marc_0017.txt

effectsofcapital00marc_0089.txt

effectsofcapital00marc_0041.txt

effectsofcapital00marc_0068.txt

effectsofcapital00marc_0045.txt

effectsofcapital00marc_0016.txt

effectsofcapital00marc_0034.txt

effectsofcapital00marc_0013.txt

effectsofcapital00marc_0008.txt

effectsofcapital00marc_0092.txt

effectsofcapital00marc_0056.txt

effectsofcapital00marc_0058.txt

effectsofcapital00marc_0000.txt

effectsofcapital00marc_0037.txt

effectsofcapital00marc_0051.txt

effectsofcapital00marc_0073.txt

effectsofcapital00marc_0052.txt

effectsofcapital00marc_0057.txt

effectsofcapital00marc_0012.txt

effectsofcapital00marc_0085.txt

effectsofcapital00marc_0063.txt

effectsofcapital00marc_0038.txt

effectsofcapital00marc_0050.txt

effectsofcapital00marc_0064.txt

effectsofcapital00marc_0048.txt

effectsofcapital00marc_0001.txt

effectsofcapital00marc_0083.txt

effectsofcapital00marc_0069.txt

effectsofcapital00marc_0071.txt

effectsofcapital00marc_0033.txt

effectsofcapital00marc_0046.txt

effectsofcapital00marc_0053.txt

effectsofcapital00marc_0044.txt

effectsofcapital00marc_0055.txt

effectsofcapital00marc_0022.txt

effectsofcapital00marc_0054.txt

effectsofcapital00marc_0040.txt

effectsofcapital00marc_0020.txt

effectsofcapital00marc_0081.txt

effectsofcapital00marc_0043.txt

effectsofcapital00marc_0014.txt

effectsofcapital00marc_0006.txt


Full Text









EFFECTS OF CAPITAL REGULATION AND INFORMATION
ASYMMETRIES ON BANK LENDING













By

DAVID FREDERIC MARCUS


A DISSERTATION PRESENTED TO THE GRADUATE
SCHOOL OF THE UNIVERSITY OF FLORIDA IN PARTIAL
FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY

UNIVERSITY OF FLORIDA

1996





UNIVERSITY OF FL.C?.IlA IJBRARES













ACKNOWLEDGMENTS



I owe special thanks to Professors Chris James, Joel Houston, Mike Ryngaert, and Mark

Flannery for their excellent guidance and many patient discussions. I have also benefited

greatly from conversations with Professors Jon Hamilton, Carolyn Takeda, Charles

Hadlock, and Jon Garfinkel. Most of all, I owe an enormous debt to my family, and

especially my wife Deborah, for their dedication to helping me realize my goal.














TABLE OF CONTENTS


ACKNOWLEDGMENTS -------------------------------------

ABSTRACT---------------------------

CHAPTERS


1

2


INTRODUCTION-------------------------------

BACKGROUND DISCUSSION -------------

Literature on Capital Regulation and Bank Growth-----------
Internal Additions to Capital and Bank Holding Companies------


3 DATA ---------------------

4 BANK HOLDING COMPANY ANALYSIS--------------

5 BANK SUBSIDIARY ANALYSIS---------------------

6 EXTERNAL CAPITAL ISSUANCE------------

7 SUMMARY AND CONCLUSIONS -....------------------

APPENDIX ESTIMATION OF RISK-WEIGHTED ASSETS------------

REFERENCES ---------------------------

BIOGRAPHICAL SKETCH- ------ ----------------------------------


pag&

ii

iv



1

8

8
15

22

27

44

57

78

80

84

87













Abstract of Dissertation Presented to the Graduate School of the University of Florida in
Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy

EFFECTS OF CAPITAL REGULATION AND INFORMATION ASYMMETRIES ON
BANK LENDING

By

David Frederic Marcus

August 1996

Chairman: Christopher M. James
Major Department: Finance, Insurance, and Real Estate

This paper provides evidence that asymmetric information problems increase the

costs of external finance for banking firms. Specifically, I find a positive and significant

relation between bank loan growth and internally generated additions to capital.

Consistent with the hypothesis that capital requirements limit bank financing choices, this

cash flow sensitivity of investment is positively related to the extent that capital

requirements are binding. I also find that the formulation of the capital ratio itself is

important in determining bank loan growth. Specifically, with regulators enforcing

leverage-based capital standards, banks can rely on a buffer stock of securities to fund

investment in a liquidity crisis. However, the use of risk-based standards substantially

reduces the effectiveness of securities as financial slack. My results also suggest that bank

holding companies establish internal capital markets to allocate scarce capital among their

subsidiaries in response to costly external finance. I find that investment by bank







subsidiaries is more sensitive to the cash flows and capitalization of its holding company

than its own cash flows and capitalization. Finally, I find that the severity of information

asymmetries affects both the likelihood of an external capital issuance and the expected

costs of issuance. I find a negative relation between the cash flow sensitivity of investment

and the probability that banks issue external capital. I also find that firms that anticipate

larger external finance costs exhibit significantly higher cash flow sensitivities of

investment.













CHAPTER 1
INTRODUCTION

Over the last fifteen years, banks operating in the United States have faced

increasingly stringent capital requirements. Concurrently, the growth rate of bank lending

has been sharply declining. Recent empirical work has questioned whether the more rigid

capital standards induced the slowdown in loan growth.' These studies rely on the critical

assumption that banks face information asymmetries which create a wedge between

internal and external financing costs. This results in capital market frictions that tie loan

growth to internally generated funds.2 Previously, scholars believed that the federal safety

net covering deposits removed financial firms from this problem. However, capital

requirements restrict the amount of (insured) debt funds that banks can utilize. As a

result, banks may benefit from holding capital greater than regulatory requirements

(surplus capital) as financial slack. This suggests that banks with more surplus capital

should invest more, and their investment should be less constrained by internally generated

funds than banks with less surplus capital. Moreover, increases in capital requirements

can prompt a decline in lending as banks replenish their surplus capital to its (new) optimal

level.



1 For an excellent review see Berger and Udell (1994) and Sharpe (1995).

2 See Fazzari, Hubbard, and Petersen (1988); Hoshi, Kashyap, and Scharfstein
(1991), and Bernanke, Gertler, and Gilchrist (1994).

1








2
A second effect of capital regulation is that the formulation of regulatory capital

ratios affects bank liquidity stocks. During the 1980s, regulators relied on leverage-based

requirements, mandating minimum capital levels per total assets. Under leverage-based

requirements, banks facing a funding shortage can support new loans through the

liquidation of other assets, namely securities, without changing required capital levels. In

this vein, security holdings may substitute for surplus capital by decreasing the dependency

on internally generated funds. However, beginning in 1990 regulators adopted risk-based

standards which require minimum capital per risk-weighted assets. Risk-weighted assets

are determined by assigning a weight based on credit risk to every bank asset. Since

securities receive a lower risk weight than loans, asset substitution could substantially

influence capital adequacy. In particular, an increase in loans increases the amount of

required bank capital even if securities are liquidated. Therefore, a change from leverage

to risk based standards may affect loan growth by reducing the role of securities as

liquidity and effectively increasing banks' desired surplus capital.

Given the existence of capital market frictions which tie investment to earnings, the

magnitude of the effect of internally generated funds may proxy for the size of the wedge

in financing costs. As a result, banks that are more constrained by internally generated

funds may be more concerned about facing a funding shortage. This suggests that these

banks may have a larger incentive to hedge their risks and therefore may rely more heavily

on derivatives and other off-balance sheet assets. Moreover, these banks may be less

likely to issue external capital and may anticipate larger costs when bringing capital issues

to the market (either in the form of underwriter fees or abnormal stock returns).








3

Most recent studies on capital regulation and loan growth focus on the adoption of

risk-based requirements and the simultaneous "credit crunch" of the early 1990s (in which

banks allegedly decreased lending in response to the new capital standards). In general,

these studies document a positive correlation between loan growth and capitalization.

Nonetheless, whether the decline in growth results from more stringent capital

requirements is not obvious. In particular, the observed relationship between loan growth

and capitalization may arise from either capital market imperfections or simply because

earnings and capitalization proxy for the profitability of lending opportunities.

An additional problem with prior studies of the relationship between capital

regulation and loan growth is that most concentrate on individual bank data. However,

the majority of banks are subsidiaries of multiple bank holding companies. If holding

companies manage capital on a consolidated basis, one would expect at best a weak link

between investment and earnings at the subsidiary level. Moreover, regulators have

recently attempted to require holding companies to inject capital into undercapitalized

subsidiaries.3 This 'source of strength' doctrine mandates that bank holding companies

must downstream capital to its subsidiary banks if they fail capital standards, as long as

this act does not cause the holding company itself to fail capital requirements. Thus, it

follows that the primary determinant of loan growth should be the capitalization and

earnings of the holding company and not the subsidiary bank.

In this paper I investigate the relationship between loan growth and internally

generated funds for a sample of 289 publicly traded bank holding companies from 1982-


3 See Keeton (1990), Fallon (1991), and Wall and Petersen (1995)










1994. Following the approach of Fazzari, Hubbard, and Petersen (1988), I assume that

capital market imperfections create a wedge between internal and external financing costs.

As a result, banks prefer to grow with internally generated funds. To control for growth

opportunities I include a measure ofTobin's Q and the bank's previous loan growth as

explanatory variables. I test the hypothesis that capital requirements increase banks' costs

of finance, and therefore I expect a negative relation between the overall sensitivity to

internally generated funds and surplus capital. In addition, I test the hypothesis that the

formulation of capital standards affects the role of securities holdings as liquidity. In

particular, I expect a negative relation between the sensitivity to internally generated funds

and securities holdings to exist while regulators impose leverage-based standards, but not

risk-based standards. I also examine the relation between the overall sensitivity to

internally generated funds and the amount of off-balance sheet assets utilized to test how

the severity of capital market imperfections affects banks' incentives to hedge risks.

To further test the existence of capital market frictions, I follow an approach

similar to Lamont (1993) and examine the relation between loan growth of individual bank

subsidiaries of multiple bank holding companies and the subsidiary's own earnings, as well

as the earnings of other subsidiaries within the same holding company.4 A finding that

subsidiary banks are more constrained by the earnings of the rest of the holding company

than its own earnings is consistent with the operation of an internal capital market. Since

holding company wide earnings may proxy for investment opportunities at the subsidiary


4 Lamont (1993) examines investment of firms with subsidiaries in both oil and
non-oil related business. His results suggest that investment of non-oil related subsidiaries
is positively related to the cash flows of the oil subsidiaries.









bank, I include both loan growth at other subsidiaries and the earnings of all non-bank

subsidiaries within the holding company as explanatory variables. As an additional test I

examine how the severity of information asymmetries at the holding company level affect

subsidiary bank dependence on both its own and holding company earnings.

An additional test on the effects of capital market frictions is to examine the

relation between the severity of information asymmetries and external capital issuances.

Following Bayless and Chaplinsky (1991, 1996), I develop a model which predicts

security issuance based on firm and market characteristics. Assuming the overall

sensitivity to internally generated funds proxies for the severity of capital market frictions,

banks that are more constrained by internally generated funds are expected to be less likely

to issue external capital. To control for a potential causality problem, I test this relation

using a lagged value of the sensitivity to internally generated funds. Because capital

deficient banks are likely to be the most constrained by internally generated funds and the

most in need of an external capital issuance, I include a dummy variable for whether banks

maintain minimum capital ratios as an explanatory variable.

Continuing along these lines, the costs associated with bringing an external capital

issue to the market should be related to the degree of information asymmetries. Following

Calomiris and Himmelberg (1995), I estimate underwriting fees associated with security

issuance after controlling for selectivity bias and examine the relation between these fees

and the sensitivity to internally generated funds. In addition, I predict the abnormal stock

returns associated with the announcement of a security issuance. A finding of a positive

relation between these costs of external finance and the sensitivity to internally generated










funds provides additional support for the hypothesis that the reliance on internal funds

proxies for the severity of capital market frictions.

Overall, I find a strong positive correlation between bank holding company loan

growth and internally generated additions to capital after controlling for differences in

growth opportunities. Consistent with the hypothesis that capital requirements increase

banks' financing costs, I find that the sensitivity of loan growth to earnings is significantly

greater among banks that are close to or below the minimum capital requirement. In

addition, I find that securities holdings provide banks with significant financial slack by

decreasing the dependency on internally generated funds. Moreover, after the

implementation of risk-based standards in 1990, loan growth is unrelated to securities

holdings, suggesting that the type of capital requirement enforced can have a significant

impact on loan growth. Also, consistent with the hypothesis that the severity of

information asymmetries influences the incentives to hedge, I find that banks that are more

constrained by internally generated funds hold more off-balance sheet assets.

In tests of the relation between loan growth and earnings at the subsidiary level, I

find that subsidiary loan growth is positively related to both its own earnings and the

earnings of other bank subsidiaries within the holding company. However, the sensitivity

of loan growth to the earnings of other subsidiaries is significantly greater than the

subsidiary's own earnings. Moreover, subsidiary loan growth is unrelated to its own

capitalization, but positively related to the holding company's capitalization. I also find

that subsidiary loan growth is negatively related to loan growth at other subsidiaries within

the holding company. This is consistent with the operation of an internal capital market in










which the overall investment capacity of the holding company is constrained. In addition,

I find that subsidiary loan growth is positively related to the earnings of non-bank

subsidiaries within the holding company. Furthermore, I find that as holding companies

become more constrained by internally generated funds, subsidiaries grow slower and

become more dependent on holding company earnings.

Finally, I examine the relation between the severity of information asymmetries, the

decision to issue external capital, and costs associated with an external capital issuance. I

find that the severity of information asymmetries affects banks' decisions to issue external

capital. In particular, my results document a negative relation between the overall

sensitivity to internally generated funds and the probability that the firm chooses to issue.

In tests of the relation between issuance costs and information asymmetries, I find that

banks that anticipate higher costs of security issuance are more constrained by internally

generated funds. Specifically, I find that the sensitivity to internally generated funds is

significantly higher for banks which expect high underwriting fees for issuing external

funds or large negative abnormal stock returns following the announcement of a security

issuance.

The remainder of the paper is organized in six chapters. Chapter 2 provides a

background discussion on the effects of capital requirements on bank investment activity.

Chapter 3 describes the data and empirical methodology. Chapter 4 documents empirical

tests for the holding company sample, while Chapter 5 documents the subsidiary bank

sample. Chapter 6 presents the external capital issuance analysis, and Chapter 7

summarizes and concludes.













CHAPTER 2
BACKGROUND DISCUSSION

Literature on Capital Regulation and Bank Growth


Bank capital regulation has changed substantially over the past fifteen years.

Before 1981, regulators relied solely on discretion when evaluating a bank's capital

adequacy. To eliminate potential bias in the examination process, regulators adopted a

minimum leverage-based capital ratio in 1981.1 A problem with leverage-based standards

is that the riskiness of bank assets is not considered when determining the minimum capital

level. Accordingly, banks had incentives to alter the riskiness of their asset portfolios. In

response, regulators created risk-based standards, which were implemented beginning in

1990.2 These new guidelines assign risk weights to all bank assets, including off-balance

sheet assets, based on credit risk.3 For example, commercial and industrial loans receive

100% risk weight, while cash and Treasury securities receive a risk weight of zero.

Some recent theoretical models have attempted to link capital regulation and bank

growth. Using an options-pricing model, Furlong and Keeley (1989) investigate how


Regulations required that banks maintain a minimum total capital ratio of 5.5%.
In 1985, regulators increased the standard to 6%.

2 Regulators imposed a minimum risk-based ratio of 7.25% beginning in 1990, and
8% beginning in 1992.
3 See Bank Holding Company Supervision Manual, section 4060, for a complete
description of risk-based capital standards.










increases in requirements affect bank risk taking behavior. Public opinion held that banks

would respond to increased requirements by increasing asset risk to offset the cost of

holding more capital. Contrary to this prediction, Furlong and Keeley show that banks

actually decrease asset risk following an increase in requirements. Although this is

excellent news for the FDIC, it has less to say about how bank growth responds, if at all,

to changes in capital requirements.

Passmore and Sharpe (1994) analyze how economic shocks and regulatory shifts

affect a profit maximizing bank. One prediction of their model is that increased capital

requirements cause a slowdown in loan growth by raising the marginal cost of funds. In

addition, they provide evidence that the resultant decline in bank lending may be most

pronounced at highly capitalized banks. This occurs because banks hold capital as a buffer

against regulatory intervention and funding shortages. One reason why banks may choose

high capital ratios is that they face high costs of capital shortages. Therefore, these firms

may react more to an increase in required capital ratios. This finding is at odds with the

popular notion that banks which are close to minimum standards would be the most

affected by an increase in capital requirements.4 This work allows for the possibility that

well capitalized institutions may be affected by increases in capital standards. In

particular, I test the hypothesis that banks rely on surplus capital (amount above

regulatory requirements) as a buffer stock against funding shortages.



4 Berger and Udell (1994) note that the commercial and industrial lending decline
in the early 1990s was not concentrated in banks with low risk-based capital ratios. In
turn, they cite this as evidence that risk-based standards were unlikely to have caused the
credit crunch.







10

Thakor (1995) develops an asymmetric information model in which banks perform

two key lending functions: pre-lending screening and post-lending monitoring. One result

of his model is that an increase in capital requirements elevates the endogenously

determined probability of a borrower being credit rationed by the entire banking system,

thereby reducing aggregate lending. This is consistent with Passmore and Sharpe and

suggests that the recent increase in capital standards may have significantly contributed to

the simultaneous decline in loan growth.

Because securities receive a lower risk-weight than loans, a change from leverage

to risk-based standards can have a significant impact on bank behavior. First, securities

require little or no capital backing, which increases their attractive relative to loans.

Consequently, banks may have gained incentive to shift assets out of loans and into

securities. Second, the role of securities as liquidity may have been diminished. With

regulators enforcing leverage-based requirements, banks could rely on a buffer stock of

securities to fund growth during a liquidity crisis. However, with risk-based standards

capital ratios decline following this type of asset substitution. Therefore, banks may have

experienced a drain on liquidity following this change in regulatory regimes. These

problems led recent empirical studies to investigate whether the regime shift induced the

"credit crunch" of the early 1990s. To date, the literature offers mixed predictions.

Peek and Rosengren (1995) and Hancock and Wilcox (1993) examine how loan

growth differs for banks based on whether they pass or fail capital requirements. Peek and

Rosengren (1995) study growth of New England banks which underwent formal

regulatory enforcement actions between 1989 and 1993. After controlling for size, time,










and region, they find that banks under formal action grow at a significantly slower pace.

In addition, they find that these banks were growing at a faster pace than other banks in

the quarters leading up to the enforcement actions. Thus, their evidence is consistent with

regulatory intervention significantly decreasing loan growth. This suggests that if the

change to risk-based standards caused an increase in regulatory intervention, then this

change may have contributed to the credit crunch.

However, the authors provide no proof of an increase in the number of banks with

enforcement actions based on the change to risk-based standards. In fact, the large

number of institutions under formal action may reflect the regional economic difficulties

during their sample period and not changes in capital regulations. Also, they do not

include a control period to compare the relationship between enforcement actions and

growth. Although this does not take away from their insight that in the 1990s regulatory

intervention has substantial effects (for New England banks), it does limit their ability to

test whether the change to risk-based standards had any impact on loan growth.

Hancock and Wilcox (1993) study the cross-sectional determinants of bank loan

and security growth during 1990 and 1991 based on whether banks experienced a "capital

shortfall" during their sample period. Capital shortfall is defined as the difference between

the actual 1990 year end capital and the regulatory minimum based on the 1990 beginning

of year total assets and a 5% capital requirement.5 In short, their findings reveal that a

capital shortfall has a large negative cross-sectional effect on loan growth in 1990.


5 The authors reasoned that banks could largely anticipate the amount of capital
that would be on the books at year end, and that this is the figure that should influence
growth.










A potential problem with this study is the authors' treatment of capital shortfall.

They assume that a 5% minimum leverage-based standard (introduced in 1981) remains in

effect through 1991. However, capital standards have been increased twice since 1981.6

Hence, the authors significantly understate the number of banks experiencing a capital

shortfall, and actually focus on only the most capital deficient banks. Therefore,

ascertaining exactly how a capital shortfall affects growth is difficult given the formulation

of these tests.

Due to the possible incentive banks may have gained to shift assets out of loans

and into securities, Haubrich and Wachtel (1993) explore how risk-based standards may

influence asset portfolio choice. The authors sort banks according to risk-based ratios and

analyze subsequent changes in portfolio mix. Their results suggest that banks in lower

capital groups tend to shift toward assets with lower risk weights, and in particular away

from commercial loans and into Treasury securities. They interpret this as evidence that

risk-based standards may have partially caused the credit crunch.

Since the authors fail to provide a benchmark period for comparing bank behavior,

however, it is possible that any changes in portfolio mix observed is simply optimal

rebalancing without regard to capital requirements. Likewise, the authors do not control

for bank size, growth opportunities, loan loss provisions, or previous growth, all of which

may significantly impact asset portfolio shifts.

6 It could be argued that the change to risk-based standards did not constitute an
increase in requirements since some banks would actually find their required capital
declining due to the new standards. However, for the majority of banks, and especially the
larger banks, the change to risk-based standards can be considered an increase in
requirements.










Given the existence of capital market imperfections, loan growth may be directly

related to capitalization. In this vein, Bernanke and Lown (1991) and Berger and Udell

(1994) investigate a direct link between capitalization and growth. Bemrnanke and Lown

(1991) examine growth as a function of beginning of period capital ratios. In their

interpretation, coefficients on capitalization serve to identify short run effects over a

period during which capital might be reasonably treated as exogenous. Relying on

aggregate state level data, their findings suggest that loan growth is positively related to

capitalization. A potential problem with this study is the utilization of state level data.

This analysis is likely to drop potentially important information specific to individual

banks.

Probably the most cited study in this area, Berger and Udell (1994) use a long

panel of observations to investigate asset growth's relationship with capitalization. In

particular, they examine differences in asset expansion during the credit crunch (early

1990s) relative to earlier years, especially with regard to capitalization. They find that

loan growth during the credit crunch does not appear to be consistently more sensitive to

capitalization than it was in the 1980s. In addition, they find that the decline in lending

was not concentrated in banks with low capital ratios. The authors interpret these findings

as evidence that risk-based standards were unlikely to have been the culprit behind the

contraction in lending during the early 1990s.

A basic problem in interpreting these results is that no change in coefficient

estimates does not necessarily imply no impact from increased regulatory standards.

Specifically, if all banks respond in a similar fashion to the change in regulations, then








14
coefficient estimates may not change at all. Therefore, the finding that loan growth is not

more affected by capitalization during the 1990s is not proof that the change to risk-based

standards had no effect. Moreover, the finding of a decline in lending at banks with high

capital ratios does not imply that the change in capital standards had no effect. Recall that

Passmore and Sharpe (1994) find that reductions in lending may be more severe at banks

with high capital ratios.

In this study, I test for the effects of capital regulation on loan growth in two ways.

First, consistent with prior studies I expect a positive relation between capital and growth.

More specifically, I hypothesize that banks consider the cushion between their capital and

required capital as a type of financial slack. Thus, an external shock which depletes this

slack could induce a slowdown in growth. Second, I test for the effects of the change to

risk-based standards through the relation between securities holdings and growth. In

particular, I expect securities to be positively related to growth in the 1980s, but unrelated

to growth in the 1990s, since risk-based standards may diminish the effectiveness of

securities as a buffer stock.

To improve upon previous studies, I provide evidence of an increase in the number

of capital deficient banks following the change to risk-based standards. I employ a long

panel of observations to observe bank behavior over time. Moreover, I use a number of

control variables to alleviate problems associated with bank growth opportunities and size.

Finally, I calculate surplus capital, which is in the same spirit as Hancock and Wilcox's

capital shortfall. However, my measure requires banks to comply with capital

requirements exactly as defined by regulations.









Internal Additions to Capital and Bank Holding Companies


It is widely accepted that banks play an important role in mitigating information

problems. Given this role, assuming that at least some bank assets will be difficult for

outsiders to value seems logical. Even so, access to federally insured deposits and the

absence of capital requirements may insulate banks from any adverse selection problems in

raising external funds. However, limited deposit insurance combined with capital

requirements suggest that banks must raise at least some funds in markets in which

asymmetric information may create a wedge between internal and external financing

costs.7 This implies that the more constrained banks are by capital requirements, the more

sensitive their growth might be to internally generated additions to capital (earnings

available to augment regulatory capital).'

A number of studies (some cited above) examine the empirical relation between

bank growth and capitalization, and in particular investigate the sensitivity of growth to

capital shocks. However, except work by Baer and McElravey (1993), studies do not

explicitly examine the sensitivity of loan growth to internal additions to capital. Since an

underlying assumption for capital shocks to adversely affect loan growth is capital market

friction which creates a wedge between internal and external finance costs, loan growth is

expected to be positively related to internal additions to capital.



7 See Myers and Majluf(1984), and Fazzari, Hubbard, and Petersen (1988).

8 Due to the way in which capital requirements are calculated, internal additions to
capital differs slightly from internally generated cash flows for non-financial firms.
Chapter 3 discusses the differences in detail.








16
Baer and McElravey (1993) investigate the relation between growth and internally

generated capital, and specifically address the issue of whether banks manage their assets

as if external finance is costly. Moreover, they examine how changes in capital

requirements might influence growth. Their results indicate that banks manage assets as if

there are significant costs with issuing new equity, or in other words, internally generated

capital strongly influences growth. They also find that growth explained by regulatory

capital increased dramatically following the introduction of specific minimum capital

standards in 1981. This suggests that banks view capital requirements as important, and

that increases in standards may have significant negative effects on growth.

A problem with their methodology is that the authors do not explicitly include

market or bank level economic control variables, such as Tobin's Q, previous growth, or

loan loss provisions. In addition their measure of internally generated capital is after

deductions for dividend payments and loan loss provisions. Since these are both

endogenous choice variables management has in its control, the inclusion of these items in

regressions may lead to misleading results. The authors also do not mention liquidity,

specifically securities holdings, playing a role in their investment model. This is surprising

since similar studies for non-financial firms generally recognize firm liquidity as an

important determinant of growth. Although it is conceivable that the availability of

insured deposit financing obviates the need to worry about liquidity, the existence of

capital requirements limits the amount of deposit financing allowable. As a result, liquidity

should be an important contributor to investment.








17

Most prior studies on bank growth and capitalization rely on bank subsidiary data.

However, if asymmetric information problems create capital market frictions, for most of

banks these frictions will occur at the holding company level. This is because usually the

parent company and not the subsidiary accesses the capital market. By definition, a bank

holding company is any organization which owns or controls at least 25 percent of any

class of voting stock of a commercial bank.9 Since the 1970s, bank holding companies

have dominated bank ownership, holding more than 90 percent of all commercial bank

assets in the United States in 1993. While the formulation of holding companies allows

banks to circumvent branching restrictions and other regulations imposed on individual

banks, the operation of a holding company also provides a mechanism for consolidating

the management and funding operations of individual subsidiary banks.

In the absence of regulations restricting bank holding companies from managing

capital on a consolidated basis, loan growth would be sensitive to the internally generated

capital of the entire holding company. Moreover, subsidiary bank loan growth would be

related primarily to the capitalization and earnings of the holding company, and not its

own capitalization and earnings. However, some restrictions on inter-company transfers

may potentially weaken the relation between subsidiary growth and holding company

earnings. For example, if holding companies are restricted in their ability to upstream

capital from subsidiaries, then each subsidiary's loan growth should partially depend on its

own earnings.


9 The 1970 Amendments to the Bank Holding Company Act of 1956 provide a
definition of a bank holding company and establishes limits on the activities in which
holding companies may engage.










One restriction, in particular, is the requirement that all subsidiaries plus the

holding company must individually maintain minimum capital ratios. This "building block"

approach implies that failure of any subsidiary to meet capital standards will impede the

holding company's ability to manage capital on a consolidated basis.10 A second

restriction is the Federal Reserve policy of viewing the holding company as a "source of

strength" to individual subsidiaries. This creates an obligation for the holding company to

downstream capital to inadequately capitalized subsidiaries. As a result, holding

companies may not be able to allocate capital to subsidiaries with positive NPV projects.

Finally, sections 23A and 23B of the Federal Reserve Act place restrictions on inter-

company transfers. Specifically, dividends, fees, and intercompany asset sales are

restricted to transfers of less than 10 percent of the bank's capital." Again, these

restrictions limit the ability of the holding company to allocate capital on a consolidated

basis.

I analyze the effects of capital market imperfections on the sensitivity of bank

investment, at both the holding company and subsidiary level, to internally generated

additions to capital. I assume that loan growth (net of loan losses) is the banking

equivalent of investment by non-financial firms.12 Given the existence of capital market



0 See the Bank Holding Company Supervision Manual, sections 2010 and 4060.2.

n See section 2020.1 of the Bank Holding Company Supervision Manual.

12 Bank investment in real assets is less than 3 percent of total assets. Arguably,
investment should consider securities. However, one motive for bank investment in
securities is liquidity. I control for securities holdings as a form of bank liquidity when
analyzing loan growth.










imperfections which create a wedge between internal and external finance, one would

expect a positive relation between holding company loan growth and internally generated

funds. Moreover, since capital requirements limit a bank's ability to substitute deposits for

equity, I expect the sensitivity of loan growth to internally generated funds (investment-

cashflow sensitivity) to be greatest for firms where the capital requirement is most binding.

I also examine how the nature of enforced capital requirements affects bank

investment-cashflow sensitivities. In particular, with regulators mandating leverage-based

capital standards, securities holdings may substitute for surplus capital as financial slack.

This is because banks can fund growth through the liquidation of securities without

changing required capital levels. Therefore, I expect the investment-cashflow sensitivities

to be decreasing the in amount of securities (relative to assets) that banks hold on their

balance sheets during the 1980s. However, beginning with the introduction of risk-based

standards in 1990, securities holdings may no longer be as efficient at providing financial

slack, and as a result I expect the investment-cashflow sensitivities to be unrelated to

securities holdings in the 1990s.

A common criticism of studies of the cash flow sensitivity of investment is that

current cash flow may be correlated with the profitability of investment opportunities. As

a result, even without capital market imperfections, investment may be positively related

to cash flows. I address this issue by including in the analysis the bank's market to book

value of assets as a measure ofTobin's Q. In addition, I include the bank's previous

growth as a second proxy for growth opportunities. I expect a positive relation between

loan growth and both the market to book ratio and lagged loan growth.








20

An additional check on the existence of capital market frictions is to examine the

operation of the internal capital market within a holding company. Specifically, if a

positive correlation between cash flows and loan demand drives the relation between cash

flows and loan growth, then subsidiary loan growth should be positively related to

subsidiary cash flows. Moreover, holding company cash flows (net of the subsidiary's

cash flows) will be related to loan growth at the subsidiary level only to the extent that

they proxy for local demand characteristics. It is likely that holding company cash flows

are a poorer proxy for local demand then subsidiary cash flows. Thus, in the absence of

capital market imperfections, they would be expected to be less important than the

subsidiary's own cash flows. Hence, a finding of holding company cash flows being more

important than subsidiary cash flows would be consistent with the hypothesis of costly

external capital.

Furthermore, a finding of subsidiary loan growth being positively related to the

cash flows of non-bank subsidiaries within the holding company can be interpreted as

strong evidence that external finance is costly and holding companies operate and internal

capital market. Indeed, it seems unlikely that in absence of costly external finance,

subsidiary bank loan growth would be at all related to non-bank cash flows of the holding

company since arguably these non-bank cash flows are less likely to proxy for local loan

demand.

As a final test on the existence of capital market frictions, I examine the

information asymmetry surrounding external capital issuances. If the magnitude of the

investment-cashflow sensitivity proxies for the severity of capital market frictions that









banks face, banks with a large investment-cashflow sensitivity are expected to be less

willing to issue external capital. I develop a logit model which predicts banks' decision to

issue external capital based on firm and market characteristics. A finding of a negative

relation between the probability of issuance and the investment-cashflow sensitivity

provides evidence that the investment-cashflow sensitivity proxies for the severity of

information asymmetries.

The severity of information asymmetries may also be related to the expected costs

of bringing an external capital issue to the market. To test this hypothesis, I estimate the

relation between investment-cashflow sensitivities and costs associated with security

issuance. Following Calomiris and Himmelberg (1995), I estimate anticipated

underwriting fees based on firm characteristics, after controlling for selectivity bias. In a

likewise fashion, I estimate expected abnormal stock returns associated with the

announcement of a security issuance. A finding that banks that anticipate larger

underwriting fees or more negative abnormal stock returns have higher investment-

cashflow sensitivities would provide additional support for the hypothesis that expected

external finance costs affect banks' dependence on internally generated funds.













CHAPTER 3
DATA

I collect bank holding company data from the Federal Reserve Y-9 tapes from

1982-1994 (annual observations). Banks included in the sample are required to have a

minimum of two years of data, a non-negative book value of equity, and an available

market value of common equity. All stock price data come from the CRSP and NASD

master tapes. The final holding company sample contains 289 banks and 2229

observations.

Subsidiary bank data are collected from the Federal Reserve Reports of Income

and Condition (Call Reports). Call report data is only available from 1985-1989.

Subsidiary banks are required to have at least two year-end observations and be part of a

multiple bank holding company. I restrict the sample to multi-bank holding companies

because I am interested in examining whether holding companies act as an internal capital

market. In addition, the subsidiaries must be part of a holding company included in the

holding company sample described above. The subsidiary bank sample contains 2339

different bank subsidiaries of 215 holding companies yielding 7023 observations.

Studies of investment spending for nonfinancial firms consider investment to be a

function of internally generated funds after controlling for firm growth opportunities (see

for example Fazzari, et. al. (1988)). Typically, investment is considered changes in

property, plant, and equipment, deflated by the firm's capital stock at the beginning of the










period. Capital stock is usually proxied by property, plant, and equipment. In addition,

the existing literature generally deflates internally generated funds by the capital stock. I

consider bank investment to be the change in loans outstanding, and the capital stock to be

the beginning of period loans outstanding. Therefore, investment (loan growth) is defined

as the percentage change in loans outstanding.

The appropriate measure of internally generated funds for banking firms differs

slightly from the measure used in studies of nonfinancial firms. Specifically, studies of

nonfinancial firms generally measure internally generated cash flows as net income before

extraordinary items plus depreciation. However, banks may not be as constrained by cash

flow as nonfinancial firms because of the availability of insured deposit financing.

Nevertheless, they are constrained by the amount of debt financing they can utilize.

Regulations mandate capital requirements which limit banks' ability to borrow, and thus

banks should be concerned with the amount of regulatory capital that they generate. I

measure internally generated funds as net income before extraordinary items plus

depreciation and additions to loan loss provisions (since loan loss provisions are a non-

cash expense and are included in regulatory capital), and I scale this measure by the

beginning of period loan balance.' To control for differences in investment opportunities,

I use the holding company's market to book ratio ( a proxy for Tobin's Q) at the end of

the prior year and the bank's previous period loan growth. Furthermore, I include the log

of assets as a control for economies of scale.


SResults are similar if I do not include additions to loan losses as part of internally
generated funds. The results are also similar if I deduct dividend payments from internally
generated funds. See Chapter 4 for more detail.








24

To determine the effect of capitalization on loan growth, I estimate surplus capital

for all banks, both holding companies and subsidiaries. Surplus capital is defined as the

bank's beginning of year capital ratio minus the end of year required ratio.2 I choose the

end of year required ratio because this requirement is always at least as strict as the

current requirement. This assumes that banks have perfect foresight regarding short term

capital requirements, earnings and growth. Tests rely on the total or Tier II capital ratio.3

The Tier II ratio is chosen because regulations currently allow banks to pass the Tier I

ratio and yet fail the Tier II ratio, but not the reverse. Specifically, the secondary portion

of Tier II capital (loan losses and subordinated debt) is restricted to be no greater than the

primary portion of capital. In addition, current regulations require 4 percent Tier I and 8

percent Tier II capital ratios. Hence it is obvious that banks which pass the Tier II

requirement must by definition have passed the Tier I requirement.

Surplus capital provides an indication of financial slack, i.e., the cushion banks

have in their capital ratios (similar to the cash and liquid assets measure used in studies of

nonfinancial firms). I also include a dummy variable, BIND, which equals one if capital

surplus is non-positive, and zero otherwise. This variable indicates whether a bank failed

to meet the minimum capital requirement in any given year.



2 Data for risk-based capital ratios are not available. Therefore, I rely on a
methodology presented by Takeda (1994) to estimate risk-based ratios. See Appendix for
a description of this methodology.
3 Tier II capital is defined as total equity plus subordinated notes plus the
allowance for loan losses all scaled by assets (either total or risk-weighted). Total equity
includes both common and preferred equity. Tests were also performed using the primary
or Tier I ratio (simply total equity over assets), with similar results.









Required capital ratios have varied over time. From 1981-1989, regulators

enforced leverage-based capital ratios which they define as total equity plus subordinated

notes plus the allowance for loan losses, all divided by total assets. Required ratios were

5.5 percent from 1981-1984 and 6 percent from 1985-1989. In the 1990s, risk-based

capital ratios became enforced, with the only change in the calculation of the capital ratio

being the substitution of risk-weighted assets for total assets.4 Required ratios were 7.25

percent from 1990-1991, and 8 percent from 1992-1994.

In addition, I study announcements of all external security offerings which

augment regulatory capital (except for initial public offerings) by bank holding companies

that were publicly traded in the United States from 1982-1994. These offerings consist of

common stock, preferred stock, or subordinated notes. The initial sample of issuances

was collected from the Investment Dealer's Digest (IDD). I searched Dow Jones News

Retrieval for the announcement of these issuances and used these dates as the initial

announcement date. If no mention of the offering was found on Dow Jones News

Retrieval, I used the registration date listed in the IDD. The final sample contains 461

security offerings by 157 different bank holding companies.

To calculate abnormal returns following the announcement of a security offering, I

use the standard event study methodology (see Asquith and Mullins (1986)). All stock

return data are collected from either the CRSP or NASD data tapes. Abnormal returns for

security i on event date t are defined as:




4 See Appendix for estimation of risk-weighted assets.










AR = R,, (a,+Pfn,)


where R1t and Rnm, are the rate of return on security i and the return on the CRSP equally

weighted index on event day t respectively. The coefficients a and P3 are ordinary least

squares estimates of the intercept and slope of the market model regression. The

estimation period used for the market model comes from the period t= -100 through t= -

20 (where t=0 equals the event day).

The average abnormal return for a portfolio of N securities is:


AAR E AR1
N
AARt_ AR,t
N i=1



The test statistic, Z, for AAR, is based on the standardized abnormal return SAR, 5, has a

unit-normal distribution, and is calculated as:

N
Z--E SAR,, I N
i=1




5 Where SAR. = AR,, /Si,,


[S2S[1+I+ (R Mt--R)2 1/2
80 80
E (R.k-R)2
k=l

and Si is the residual standardized error from the market model regression, Rl the return
on the market portfolio for the kth day of the estimation period, and Rl the average return
of the market portfolio for the estimation period.













CHAPTER 4
BANK HOLDING COMPANY ANALYSIS

Table 1 provides descriptive statistics for the bank holding company sample. The

holding companies in my sample are relatively large, with median assets of over $2.6

billion during the entire sample period. As expected, loans make up the majority of bank

assets, with more than 62 percent of aggregate bank assets allocated to loans for the full

sample. In addition, securities holdings make up a large portion of bank assets,

comprising more than 14 percent of aggregate bank assets. For the full sample, the

median bank holding company's Tier II capital ratios exceeded the regulatory minimum by

approximately two percentage points. Furthermore, only about 6 percent of banks failed

to meet minimum capital standards.

Loan growth at the holding company level averaged about 6 percent a year.

Internal additions to capital for the average and median bank was approximately 1.5

percent of loans per year. Given capital requirements less than 8 percent, internal

additions to capital appear, on average, to be sufficient to support the observed asset and

loan growth.

One purpose of this paper is to examine possible effects of changes in capital

regulation on loan growth. From 1982-1994, capital regulation can be classified into three

regimes. The first, from 1982-1984, marks the introduction of minimum leverage-based

capital standards. Coincidentally, this period also corresponds with the announcement of











Table 1
Descriptive statistics (means, with medians in parentheses) for 289 publicly traded bank
holding companies.'


variable full sample 1982-1984 1985-1989 1990-1994

Total Assets (millions) 10,300 7,911 9,260 12,700
______________ (2,621) (2,074) (2,545) (3,619)

Loan Growth b 0.062 0.109 0.078 0.020 *
_______(0.076) (0.121) (0.090) (0.029) *

Internal Additions to 0.014 0.017 0.014 0.013
Capital/ Loans.,' (0.016) (0.017) (0.016) (0.016)

Market /Book Assetsd 1.005 0.986 1.010 1.010
(0.999) (0.985) (1.004) (1.003)
Book Capital in Excess 0.024 0.019 0.020 0.031 *
of Requirement / Assets (0.020) (0.016) (0.018) (0.028) *

Percentage with Capital 5.65% 8.12% 3.83%* 6.41%*
less than requirement.

Aggregate Industry 62.28% 60.14% 64.42% 61.25%
Loans / Assets

Aggregate Industry 14.62% 11.29% 13.12% 16.87%
Securities / Assets

Number of Observations 2229 431 940 858


a. Data are from the Federal Reserve Y-9 tape.
b. Loan growth equals change in total loans outstanding divided by loans outstanding at time t- 1.
c. Internal additions to capital equals net income plus changes in loan loss provisions (up to regulatory
maximum).
d. Market to book value of assets equals (Total Assets Book Equity + Market Equity) / Total Assets. Market
Equity equals the market value of common equity from CRSP. The ratio is calculated at year end for the prior
year.
e. Book capital in excess of requirement equals the bank's book capital for regulatory minimum Tier II capital
ratio. Tier II capital equals common stock, preferred stock, plus eligible subordinated debt and loan loss
reserves. For the period 1982-1984 the requirement is 5.5% of total assets. For 1985-1989 the requirement is
6%. Beginning in 1990, the requirement is based on risk-weighted assets. For 1990-1991, the minimum is
7.25% of risk-weighted assets, while from 1992-1994 the minimum is 8%.
* mean or median significantly different from previous time period at better than the 5% level.









the 'too big to fail' policy in which certain banks were deemed too important to be

allowed to fail.1 O'Hara and Shaw (1990) document that following this announcement,

large banks experienced an increase in stock price, which they attribute to be due to the

expanded conjectural guarantees. The second regime lasts from 1985-1989, when

regulators increased the minimum capital requirement from 5.5 to 6 percent. In addition,

regulators attempted to remove the expanded conjectural guarantees implied by the 'too

big to fail' policy. Finally, the third regime starts in 1990 and begins the era of risk-based

capital standards.

Table 1 provides the descriptive statistics by the three regulatory regimes. Notice

that with each regime, loan growth has declined (both average and median). If bank

growth opportunities have also declined, this could explain the decrease in loan growth.

Market to book ratios (a proxy for Tobin's Q) have increased since the early 1980s,

indicating that overall growth opportunities have improved. However, a potential

explanation for why overall growth opportunities improved while loan growth suffered is

that off-balance sheet growth drives the increase in market to book ratios.

A second possibility for why loan growth has suffered could be a simultaneous

decline in bank internal additions to capital. While it's true that internal additions to

capital declined since the first regime, the amount of the decline hardly matches the

substantial pace of the decline in lending.



This policy implies that regulators will attempt to bail out any large institution
which is insolvent. Furthermore, since the FDIC effectively insured all bank debt (not just
small deposits) in the Continental Illinois case, management of large banks may have
reasonably assumed that the federal safety net had been expanded.








30

Changes in capital regulation could induce a slowdown in lending if banks become

inclined to increase surplus capital. First, if penalties from being undercapitalize increase,

then banks will desire a larger buffer from regulatory intervention. Second, if risk-based

capital standards reduce the effectiveness of securities as financial slack, banks will require

more surplus capital as compensation for their lost liquidity. While average and median

surplus capital do not appear to be any different in the first or second regimes, since 1990

banks have increased surplus capital by more than one percentage point. The number of

capital deficient banks increased from just less than 4 percent in the mid 1980s to more

than 6 percent in the 1990s. Moreover, from 1990 to 1992, almost 10 percent of banks

failed capital standards (not reported).

If risk-based standards increase the attractiveness of securities relative to loans,

banks may increase the proportion of securities in their portfolio. Consistent with this

hypothesis, securities holdings increased from about 13 to almost 17 percent of aggregate

bank assets, while loans fell from 64 to 61 percent of aggregate assets following the

introduction of risk-based standards in 1990. Thus the change to risk-based capital may

have caused many banks to fail capital standards, induced banks to desire a larger surplus

capital, and given banks incentives to shift assets out of loans and into securities, all of

which may have contributed to the concurrent decline in loan growth.

If capital market imperfections create a wedge between internal and external

finance costs for banks, then inadequately capitalized banks may be more likely to pass up

profitable new lending opportunities than adequately capitalized banks. To test this

hypothesis, I examine whether loan growth is related to capitalization for the banks in my








31
sample. However, loan growth and capitalization may be correlated for other reasons. In

particular, loan losses are likely to be correlated with loan demand, causing a positive

correlation between loan growth and capitalization. Therefore, I also examine the relation

between internal additions to capital and bank capitalization.

Table 2 presents the results of this analysis. The top portion of the table analyzes

differences in holding company loan growth in three different capitalization categories:

failure to meet capital requirements, capital in excess of requirements by 2 percentage

points or less, and capital in excess of requirements by greater than 2 percentage points.

Loan growth at inadequately capitalized banks was significantly less than loan growth at

either of the other two categories. In addition, there is no difference between loan growth

at either of the two adequately capitalized categories. Moreover, as shown in the bottom

portion of the table, the amount of internal capital generation increases significantly with

capitalization, suggesting that performance strongly influences capital adequacy.

That loan growth is correlated with capitalization is consistent with capital

requirements and costly external finance constraining loan growth. However, as

mentioned above the finding that internal additions to capital is correlated with

capitalization may drive this result. Since loan losses and poor performance are likely to be

correlated with weak loan demand, the positive relation between loan growth and

capitalization may reflect demand as opposed to supply characteristics. To address these

concerns, I examine the relation between loan growth and internal additions to capital.

In Table 3, I present the results of a fixed-effects regression relating loan growth

to internal additions to capital, the market to book value of assets, previous loan growth,











Table 2
Differences in loan growth and internal additions to capital based upon whether minimum
capital requirements are binding for a sample of 289 bank holding companies from 1982-
1994.


Loan Growth

Mean Median
1. Capital less than or equal to regulatory -0.032% -0.034
minimum, N=126

2. Capital greater than regulatory minimum 0.066 0.083
by 2% or less, N=968

3. Capital greater than regulatory minimum 0.069 0.077
by more than 2%, N=1143

Test statistic of difference between 1 and 2. t=7.64 z=7.75

Test statistic of difference between 1 and 3. t=7.97 z=8.01

Test statistic of difference between 2 and 3. t=0.72 z=0.08

Internal Additions to Capital

Mean Median
1. Capital less than or equal to regulatory 0.002 0.005
minimum, N= 107

2. Capital greater than regulatory minimum 0.015 0.013
by 2% or less, N=908

3. Capital greater than regulatory minimum 0.017 0.019
by more than 2%, N=931

Test statistic of difference between 1 and 2. t=7.23 z=8.95

Test statistic of difference between 1 and 3. t=9.83 z=l 1.10

Test statistic of difference between 2 and 3. t=6.92 z=10.28











Table 3
Fixed effects regressions relating loan growth to internal additions to capital, capital
requirements, and firm financial characteristics. The sample consists of 289 bank holding
companies from 1982-1994 (standard errors in parentheses).


Dependent Variable = (Loans, Loanst., ) / Loans,.,

Coefficient (1) (2)

Additions to Capital /Loans,.,a 4.771 ** 3.906 **
(0.269) (0.198)
Surplus Capital / Assetst_,b 0.824 **
(0.155)
Bind' -0.061 **
(0.009)
Surplus Capital *Additions to -27.80 **
Capital / Loanst., (4.471)

Bind Additions to Capital / Loans,., 1.006 *
~_______________~_____ ~(0.512)
Securities / Assets,., 0.138** 0.133 **
~____~____________(0.039) (0.039)

Market / Book Assets,., 0.270** 0.260**
__(0.049) (0.049)

log (Assets,.,) -0.063 ** -0.064 **
_________________ (0.005) (0.005)

Lag loan growth 0.078 ** 0.078 **
_________________ (0.009) (0.009)

R2 0.383 0.385

N (categories) 1987(289) 1987(289)

F statistic, Bank dummies 2.278 ** 2.571 **

a. Additions to capital equals net income plus changes in loan loss provisions (up to regulatory maximum).
b. Surplus capital equals actual capital less capital required to meet minimum regulatory standards.
c. Bind=l if surplus capital is less than or equal to zero, =0 otherwise.
*, ** denote significance at the 5% and 1% levels respectively.










bank size, asset composition, and two variables designed to measure the extent to which

the bank faces binding capital requirements. These two variables are surplus capital,

defined as the difference between bank capital ratios and the required ratio, and a dummy

variable that takes on the value of one if surplus capital is non-positive and zero otherwise.

Furthermore, I interact these two variables with internal additions to capital to investigate

whether the cashflow sensitivity of loan growth varies depending on whether the holding

company faces a binding capital constraint. I assume that the lower the surplus capital, the

greater the likelihood that capital requirements are binding. These are the banks that are

most likely to constrain loan growth because of high external finance costs.

As shown in Table 3, loan growth is positively related to internal additions to

capital even after controlling for differences in growth opportunities with the market to

book ratio and previous loan growth. This is consistent with external finance being costly

relative to internal finance. In addition, loan growth is positively related to surplus capital,

and is significantly lower for holding companies which fail to meet capital requirements.

Furthermore, the sensitivity of loan growth to internal additions to capital decreases as

surplus capital increases. Notice a similar result that the sensitivity is significantly higher

for capital deficient banks. These results are consistent with the hypothesis that the loan

growth of capital constrained banks is significantly more sensitive to internally generated

funds than it is for banks that maintain adequate capital. This also suggests that increases

in capital standards may influence loan growth by diminishing surplus capital for all banks.

Following an increase in capital standards the percentage change in the predicted

sensitivity of loan growth to internal additions to capital will be largest for banks that had










the largest surplus capital (lowest sensitivity) before the change. This is consistent with

Passmore and Sharpe's hypothesis that the decline in lending may be most severe at well

capitalized institutions.

Since banks may be able to fund loan growth by selling securities holdings, the

sensitivity of loan growth to internal additions to capital may also be negatively related to

securities holdings.2 On the other hand, securities may only provide this type of financial

slack to banks that are not constrained by capital requirements. That is, capital

constrained banks need to increase capital, and therefore selling securities to fund growth

may not be an option. To investigate these possibilities, Table 4 presents regression

results relating loan growth to the same measures used in Table 3, plus six additional

interaction variables. These interaction variables are designed to explain the role of

securities as financial slack. In particular, I expect that the sensitivity of loan growth to

internal additions to capital to be decreasing in the amount of securities holdings, and this

relationship to be less important for banks which fail to maintain minimum capital ratios.

Like the results presented in Table 3, Table 4 provides evidence that banks view

external finance as more expensive than internal finance as indicated by the positive

coefficient on internal additions to capital. Moreover, these results support the claim that

surplus capital is positively related to loan growth, and negatively related to the sensitivity

of loan growth to internal additions to capital. In three of the four regressions presented,

the coefficient on the interaction between internal additions to capital and securities is

2 Even with risk-based standards, this may be true since banks can sell securities
with a non-zero risk weight or that have a capital gain to fund loan growth without
penalizing capital ratios.











Table 4
Fixed effects regressions relating loan growth to internal additions to capital, capital
requirements, and firm financial characteristics. The sample consists of 289 bank holding
companies from 1982-1994 (standard errors in parentheses).


Dependent Variable = (Loans, Loans,. ) / Loans,.,
coefficient (1) (2) (3) (4)
Additions to Capital / Loans,,a 4.737** 4.446** 4.763** 4.623**
(0.316) (0.345) (0.419) (0.351)
Surplus Capital / Assets,1b 0.678 ** 0.661 *
(0.153) (0.298)
Bind -0.061 ** -0.012
(0.009) (0.019)
Surplus Capital *Additions to -18.89 ** -19.47 *
Capital /Loans,., (4.417) (8.964)
Bind Additions to Capital / 0.916 -0.388
Loans,, (0.514) (1.172)
Securities/Assets,., 0.206** 0.182** 0.204** 0.212**
(0.044) (0.046) (0.059) (0.475)
Securities Additions to -2.763* -2.619** -2.876 -3.441**
Capital / Loans,., (1.288) (1.375) (1.906) (1.401)
Surplus Capital Securities / 0.077
Assets,-, (1.329)
Bind Securities / Assets,., -0.318 **
______________________________ (0.110)
Surplus Capital Securities 1.749
Additions to Capital / Loans,., (34.88)
Bind Securities Additions 8.313
to Capital / Loans%., (6.750)
Market/Book Assets,., 0.287** 0.256** 0.287** 0.260**
________________ (0.049) (0.049) (0.049) (0.049)
log (Assets,.) -0.066** -0.064** -0.066** -0.065**
________________ (0.005) (0.005) (0.005) (0.005)
Lag loan growth 0.080 ** 0.077 ** 0.080 ** 0.076 **
________________ (0.009) (0.009) (0.009) (0.009)
R 20.373 0.386 0.373 0.389
N (categories) 1992(289) 1987(289) 1992(289) 1987(289)
F statistic, Bank dummies 2.304** 2.489** 2.301** 2.502 **

a. Additions to capital equals net income plus changes in loan loss provisions (up to regulatory maximum).
b. Surplus capital equals actual capital less capital required to meet minimum regulatory standards.
c. Bind=l if surplus capital is less than or equal to zero, =0 otherwise.
*, ** denote significance at the 5% and 1% levels respectively.










negative and significantly different from zero at the one percent level. This is consistent

with the hypothesis that securities holdings serve as a buffer stock against funding

shortages. The negative coefficient on the interaction between BIND and securities

indicates that the role of securities as financial slack is less important for capital deficient

banks. In particular, the estimated coefficient on securities holdings for capital deficient

banks (by combining the two coefficients) is not significantly different from zero. These

results suggest that both surplus capital and securities holdings serve as liquidity by

decreasing banks' dependency on internally generated additions to capital.

This paper is interested in examining the effect of changes in capital regulations on

loan growth, specifically with regard to risk-based capital standards. Specifically, with

regulators enforcing risk-based standards, the role of securities as financial slack may be

significantly diminished. To investigate further, Table 5 presents results of fixed-effects

regression models of loan growth to the same measures used in Table 3, while allowing

coefficients on key explanatory variables to change with each regulatory regime. This will

enable me to investigate if changes in regulation altered the determinants of the loan

growth equation.

Surprisingly, results indicate that in the first regime (1982-1984), capital surplus

did not influence loan growth. This is consistent with banks believing that capital

requirements were not stringently enforced. A possible explanation for this is the

expanded conjectural guarantees implied by 'too big to fail.' In regimes two (1985-1989)

and three (1990-1994), surplus capital is positively related to loan growth and negatively

related to the sensitivity of loan growth to internal additions to capital. On the other hand,











Table 5
Fixed effects regressions relating loan growth to internal additions to capital, capital
requirements, and firm financial characteristics. The sample consists of 289 bank holding
companies from 1982-1994 (standard errors in parentheses).

Dependent Variable = (Loanst Loans,1 ) /Loanst.,
coefficient (1) (2)
Additions to Capital / Loans,, 5.348 ** (0.351) 4.783 ** (0.346)
Surplus Capital /Assetst., time 0.238 (0.549)
Surplus Capital / Assets,, time 1.987 ** (0.290)
Surplus Capital / Assets,. time 0.767 ** (0.179)
bind time 1 0.026 (0.028)
bind time -0.055** (0.015)
bind time -0.084** (0.014)
Surplus Capital timel Additions to Capital/Loans -4.385 (28.87)
Surplus Capital time Additions to Capital/Loans -61.31** (13.10)
Surplus Capital time Additions to Capital/Loans -28.16 ** (5.028)
bind time Additions to Capital -0.974 (2.009)
bind time Additions to Capital 0.513 (0.782)
bind time Additions to Capital -0.149 (0.740)
Securities / Assetst., time 0.553 ** (0.875) 0.449 ** (0.079)
Securities / Assetst., time 0.187** (0.053) 0.256** (0.050)
Securities / Assets,.,1 time 0.013 (0.049) 0.036 (0.048)
Securities* time *Additionsto Capital/Loans -11.30** (4.196) -8.119** (3.235)
Securities time Additions to Capital/Loans -7.718** (1.808) -3.275** (1.620)
Securities time Additions to Capital/Loans 2.360 (0.048) -0.038 (1.451)
Market /Book Assets,, 0.231 ** (0.048) 0.223** (0.049)
log (Assets.1) -0.024** (0.007) -0.024** (0.007)
Lag loan growth 0.058** (0.010) 0.058** (0.010)
R2 ______________________________0.439 0.431
N (categories) 1990(289) 1990(289)
F statistic, Bank dummies 2.022** 2.152**

*, ** denote significance at the 5% and 1% levels respectively.









securities holdings appear to be significant contributors of financial slack up until the

1990s. Specifically, the regime three coefficients on securities holdings (and the

interaction variables) are not significantly different from zero. Moreover, these

coefficients are significantly different from previous period coefficients suggesting a real

change in the value added of securities holdings. This suggests that the change to risk-

based standards significantly altered the role of securities as liquidity. As a result, this

change in regulatory regimes may have induced a slowdown in bank growth.

The results presented in Tables 3-5 indicate a negative relation between surplus

capital and the sensitivity of loan growth to internal additions to capital. In addition, the

results demonstrate that securities holdings are also negatively related to this sensitivity, at

least before the introduction of risk-based capital standards. However, whether a firm's

overall investment-cashflow sensitivity is negatively related to surplus capital, after

controlling for the effect of securities remains a question. Table 6 presents results of the

predicted sensitivity of loan growth to internal additions to capital from regression (1) in

Table 5.3 To estimate this overall sensitivity, I simply calculate the total effect of internal

additions to capital by multiplying the coefficient estimates on the interaction terms by the

appropriate variables, and adding these products to the coefficient of additions to capital.

This allows the estimate of the investment-cashflow sensitivity to vary by bank and year.

Notice that the mean and median investment-cashflow sensitivity is largest for banks that

fail to meet minimum capital standards (significantly different from the sensitivity for the



3 Results are similar if the investment-cashflow sensitivities are estimated from
regressions in Table 4.











Table 6
Characteristics of predicted investment-cashflow sensitivity


Variable=Predicted Investment-Cashflow Sensitivity estimated from coefficients on Additions to Capital
and interaction terms from regression (1), Table 5.

Descriptive Statistics, by Capitalization mean median

full sample, N=2229 3.706 3.774

1. Capital less than or equal to regulatory minimum, N=126 4.534 4.559

2. Capital greater than regulatory minimum by 2% or less, N=960 4.003 4.019

3. Capital greater than regulatory minimum by more than 2%, N= 143 3.365 3.469

Test statistic of difference between 1 and 2. t=19.94 z=15.44

Test statistic of difference between 1 and 3. t=-39.37 z=18.20

Test statistic of difference between 2 and 3. t=36.66 z=32.05


Table 7
Fixed effects regressions relating the predicted investment-cashflow sensitivity to off-
balance sheet assets and other firm financial characteristics. Off-balance sheet assets data
are available beginning in 1991. The sample consists of 230 bank holding companies from
1991-1994 (standard errors in parentheses).

Dependent Variable=Predicted Investment-Cashlflow Sensitivity estimated from coefficients on Additions to
Capital and interaction terms from regression (1), Table 5.

Variable (1) (2)

Constant 3.261 ** 8.795 **
(0.052) (1.325)
Off Balance Sheet Assetst./ Assets,.- 0.875** 0.661**
(0.227) (0.207)
Bind 0.548 **
_____________________________ (0.059)
Log (Assetst..) -0.364 **
(0.087)
R20.097 0.220
N 651 651
F statistic, Bank dummies 13.93** 13.62**


*, ** denote significance at the 5% and 1% levels respectively.









full sample, and from adequately capitalized banks at better that the one percent level).

Moreover, the sensitivity decreases in groups based on capitalization. Therefore, even

after controlling for the effect of securities, the investment-cashflow sensitivities are

negatively related to surplus capital.

This overall investment-cashflow sensitivity may proxy for the severity of capital

market frictions. If a larger sensitivity indicates more severe information asymmetries,

banks with higher investment-cashflow sensitivities may face higher costs of external

finance. As a result these banks may have increased incentives to hedge the risks inherent

in their asset portfolios. This implies that the amount of off-balance sheet assets as a

proportion of total assets may be positively related to the investment-cashflow sensitivity.

Table 7 presents fixed-effects regression results relating the investment-cashflow

sensitivity to off-balance sheet assets. Because of reporting requirements, complete off-

balance sheet data are only available beginning in 1991. Results indicate that banks with

larger investment-cashflow sensitivities use more off-balance sheet assets, presumably to

hedge against funding shortages. These results also provide evidence that larger banks are

less constrained by internally generated funds. All together, these results support the

hypothesis that the investment-cashflow sensitivity proxies for the severity of information

asymmetries.

As a check on the robustness of the results presented above, I perform a series of

tests intended to examine the stability of the coefficient estimates. Results for these tests

are not reported, however, tables are available upon request. To control for the possibility

that results are being driven by merger and acquisition activity, I perform all above tests








42

scaling observations by year end data. Results are qualitatively similar. I also perform the

regressions limiting bank loan growth to be less than 25 percent. In addition, I choose

other various limits for loan growth, none of which make a substantial impact on the

results. As a control for possible bias due to firms not surviving the sample period, I

estimate the basic regressions presented in Table 3 for the 97 banks which survive the

entire period. Results are consistent with previous results.

One possible difference for the relation between investment and cash flow for

banking firms relative to nonfinancial firms is that a large portion of the cash flow from a

new investment may be received up front. In particular, new loan originations usually

generate immediate fee income for banks, unlike investment for industrial firms which may

take years after the initial investment before income is realized. To investigate this further,

I examine the degree of autocorrelation in additions to capital. I find that there is a strong

one period correlation of more than 50 percent. Additionally, the second and third lagged

observations are correlated at more than 10 percent, although the partial correlation

coefficient is very small after the first period. Moreover, the results of an ARMA model

using four lagged observations are consistent with a strong one period correlation, with

subsequent periods significantly related, although to a much smaller extent.

A possible interpretation of these results is that the positive relation between loan

growth and internal additions to capital is not due to firms investing when they generate

income, rather they generate income when they invest. To address this concern, I estimate

the basic regressions replacing additions to capital with a lagged observation of additions

to capital. Results are consistent with previous results.








43
Furthermore, the formulation of internal additions to capital assumes that all bank

income which augments capital is available to fund loan growth. This implies that banks

may alter dividend policy to meet investment needs. However, it is possible that banks

find dividend cuts prohibitively expensive, and therefore do not vary dividend policy. In

addition, the inclusion of loan losses may bias estimates if firms manipulate these

provisions to their advantage. Therefore, I repeat the basic regression using three

variations of internal additions to capital. Variation one is simply the original definition

minus dividend payments. Variation two is defined as net income minus dividends (no

treatment for loan loss provisions). Finally, variation three is simply net income. Results

are qualitatively similar.

Loan growth may measure investment with error. Specifically, banks can invest in

loan commitments, which generate fee income and now require capital backing. Thus, I

estimate the regressions replacing loan growth with growth in loans and loan

commitments. Because of reporting requirements, growth in loan commitments is only

available beginning in 1990. Results from a heteroskedastic consistent model (I choose not

to use fixed-effects due to the small number of observations per firm) conform with

previously reported results, and support the hypothesis that external finance is costly and

that the sensitivity of investment to internal additions to capital is negatively related to

surplus capital. Moreover, securities holdings are not related to growth in this particular

model. This provides additional support that with risk-based capital standards, the role of

securities as financial slack has been diminished (since data is only available for these tests

in the 1990s).













CHAPTER 5
BANK SUBSIDIARY ANALYSIS

The above results are consistent with capital regulation significantly affecting bank

loan growth. Moreover, these results lend credence to the argument that banks find it

more costly to raise capital externally than through internal funds. To further examine this

issue, this chapter analyzes bank subsidiary loan growth as it relates to holding company

and subsidiary characteristics. Table 8 documents the descriptive statistics for bank

subsidiaries in my sample. Loan growth averaged about 9.5 percent a year, while internal

additions to capital averaged around 1.5 percent of total loans. Furthermore, the median

subsidiary and holding company's Tier II capital ratio exceeded the regulatory minimum

by slightly less than 2 percentage points.

The bottom section of Table 8 describes differences in subsidiary loan growth

based on capitalization of both holding companies and subsidiaries. The median loan

growth of subsidiaries whose holding company was inadequately capitalized was just over

1 percent. However, median growth of subsidiaries whose holding company was

adequately capitalized was significantly greater, at over 7.5 percent. In addition, there

appears to be no difference in subsidiary loan growth based on whether the subsidiary

itself maintains adequate capital ratios. These results are consistent with bank holding

companies operating capital on a consolidated basis.











Table 8
Descriptive statistics of subsidiaries of 215 publicly traded multiple bank holding
companies from 1985-1989'


variable mean median

Subsidiary Total Assets (millions) 250 99

Internal Additions to Capital / Loans, 0.018 0.018

Internal Additions to Capital / LoansH.W 0.014 0.016

Internal Additions to Capital /LoansNo..ac 0.004 0.004

Securities / Assets 0.219 0.205

Lead Bank Assets / Holding Company Assets 0.354 0.244

(Book Capital in Excess of Requirement / Assets), 0.024 0.018

(Book Capital in Excess of Requirement / Assets)H 0.019 0.017

Subsidiary Bank Loan Growth 0.096 0.075

Subsidiary Bank Loan Growth if holding company 0.028 0.012
capital is less than regulatory minimum, N=240

Subsidiary Bank Loan Growth if holding company 0.098 0.076
capital is greater than regulatory minimum, N=7037

Test Statistic of Difference in Subsidiary Loan Growth t=5.34 z=5.48
based on holding company capitalization

Subsidiary Bank Loan Growth if its capital is less than 0.095 0.073
regulatory minimum, N=275

Subsidiary Bank Loan Growth if its capital greater 0.111 0.108
than regulatory minimum, N=7002

Test Statistic of Difference in Subsidiary Loan Growth t=0.84 z=l.6
based on its own capitalization

a. Data are from the Federal Reserve Reports of Income and Condition (Call Reports).
b. Internal Additions to Capital H-Net equals holding company additions to capital less the bank's additions to
capital divided by holding company loans less loans of the subsidiary bank.
c. Internal Additions to Capital non-bank equals holding company additions to capital net of the aggregate
additions to capital of all bank subsidiaries divided by holding company loans less loans of the subsidiary bank.








46

As described in the previous chapter, loan growth may be related to capitalization

for reasons other than costly external finance. In particular, this relationship may arise due

to bank performance or loan losses. Recall that results presented are consistent with bank

holding companies operating as if external capital is more expensive than internally

generated capital. To further examine this issue, I look at the relationship between loan

growth at individual bank subsidiaries and internal additions to capital at both subsidiary

and holding company levels. To the extent that either subsidiary or holding company

additions to capital are positively related to loan growth (after controlling for the

profitability of the holding company's lending opportunities), this provides additional

evidence that bank holding companies are liquidity constrained.

Additionally, examining this relationship may alleviate concerns that the observed

correlation between internally generated capital and loan growth at the holding company

level arises because internally generated capital proxies for the profitability of lending

opportunities not captured by Tobin's Q. Indeed, a finding that subsidiary loan growth is

related to internally generated capital at the holding company's other subsidiaries and in

particular its non-bank subsidiaries would weaken the validity of this argument. In this

regard, my tests are similar to Lamont (1993) who studied how a subsidiary's cash flows

affected investment by an unrelated subsidiary within the same firm.

Furthermore, in light of the evidence suggesting that bank holding companies are

liquidity constrained, an interesting issue is how holding companies allocate capital among

their subsidiaries. Stein (1995), following Williamson (1975), argues that capital market

imperfections may give firms incentives to establish internal capital markets to allocate









resources more efficiently. Moreover, he speculates that firms with a narrow focus and

hard to value assets may have greater incentives to create internal capital markets. A

finding that subsidiary loan growth is more strongly related to holding company additions

to capital than their own additions to capital would be consistent with bank holding

companies operating internal capital markets and that banks are liquidity constrained.

Table 9 presents regression results relating subsidiary loan growth to the same

measures use to explain holding company loan growth in Table 3. One difference in this

table is the inclusion of separate measures for the cash flows produced by the subsidiary

bank and the rest of the holding company. I also use separate measures indicating

capitalization of the subsidiary and the holding company. Regressions are performed

using a between-effects regression which pools the observations for each subsidiary, using

mean values of all variables. This controls for the autocorrelation in the residuals across

the various years for each bank. I choose between-effects rather than fixed-effects due to

the relatively short time period in which I have data (1985-1989). The sample contains

over 2000 subsidiaries with at most 5 years of data per bank. Tests were also performed

with OLS estimates (not reported) with qualitatively similar results.

Results are presented for the full sample, the sample of banks whose assets

represent less than 15 percent of their holding company's assets (bottom three size

quartiles), and the sample of lead banks in each holding company (the largest subsidiary

within the holding company). For the full sample and the small bank sample, loan growth

at subsidiary banks is positively related to the holding company's market to book ratio (a

proxy for loan opportunities). In addition, loan growth is positively related to the











Table 9
Between effects regressions relating subsidiary loan growth to internal additions to capital,
capital requirements, and subsidiary and bank holding company financial characteristics.
The sample consists of 2339 subsidiaries of 215 multiple bank holding companies from
1985-1989 (standard errors in parentheses)

Dependent Variable = (Loans, Loans,. ) / Loans,.

Overall Sample Small Bank Lead Bank
Coefficient (1) (2) (1) (2) (1) (2)
(IACH-IACQ/(Loan,-LoanB)* 1.69** 1.65** 1.94** 1.90** 0.05 0.03
__________(0.184) (0.182) (0.219) (0.218) (0.270) (0.260)
IAC / Loan, 0.29** 0.25** 0.26** 0.23** 1.86** 1.99**
__________(0.071) (0.069) (0.074) (0.071) (0.531) (0.509)
(Surplus Capital /Assets), -0.16 -0.35 0.58
(0.294) ______ (0.33) (0.774)
(Surplus Capital / Assets), -0.16 -0.17 1.25**
(0.108) (0.11) (0.430)
Bindcb -0.18** -0.18** -0.18**
___________ _____ (0.025) ______ (0.026) (0.064)
Binds 0.03 0.03 -0.16*
________________ (0.019) (0.020) (0.082)
Market / Book8 0.50** 0.47** 0.52** 0.48** 0.30 0.27
______ ___(0.077) (0.077) (0.091) (0.091) (0.181) (0.178)
(Securities / Assets), 0.03 0.02 0.02 0.01 0.09 -0.02
______ ___(0.03) (0.03) (0.03) (0.027) (0.101) (0.093)

R20.097 0.116 0.096 0.114 0.125 0.139
N (Categories) 6999 6999 6328 6328 762 762
_________(2339) (2339) (2162) (2162) (278) (278)


a. IACi = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind, = 1 if bank capital ratio is less than or equal to the regulatory minimum.
*, ** denote significance at the 5% and 1% levels, respectively








49

subsidiary's own internal additions to capital. However, loan growth is also significantly

related to the additions to capital produced by all other firms within the holding company

(measured by IACH IACB). For these samples the coefficient estimates on other

subsidiaries' cash flow are nearly eight times that of the coefficient estimate on the bank's

own cash flow. Furthermore, although it does not seem as if there is a strong link between

surplus capital and loan growth, evidence suggests that subsidiaries are less likely to lend

if their holding company (and not the subsidiary itself) is inadequately capitalized.

Results for the lead bank sample differ substantially from the other samples.

Specifically, the lead bank's own additions to capital are much more strongly correlated

with loan growth than the holding company's additions to capital. Moreover, loan growth

appears to be positively related to capitalization at the lead bank as indicated by the

positive coefficient on surplus capital and negative coefficient on BIND for the lead bank.

These results should not be surprising, given that the lead bank generates the majority of

the loans, cash flows, and capital at the disposal of the holding company. In particular, the

correlation between the cash flows of subsidiaries and the cash flows of the entire holding

company is only 0.10 for the full sample, yet 0.62 for the lead bank sample.

To further investigate the relation between capitalization and loan growth, Table

10 presents regressions for the full sample and the small bank sample relating loan growth

to additions to capital and three measures for capital adequacy. Each measure is a dummy

variable indicating whether the bank (holding company, subsidiary, or both) fails capital

standards. Results are consistent with those presented in Table 9, and suggest that the

capitalization of the holding company and not the subsidiary bank constrains loan growth.










Table 10
Between effects regressions relating subsidiary loan growth to internal additions to capital,
capital requirements, and subsidiary and holding company financial characteristics. The
sample consists of 2339 subsidiaries of 215 multiple bank holding companies from 1985-
1989 (standard errors in parentheses).

Dependent Variable = (Loans; Loans,., ) /Loans,.,

Overall Sample Small Bank
Coefficient (1) (2) (3) (1) (2) (3)
(IACH-IACB)/(LoanH-LoanB)' 1.69** 1.63** 1.71** 1.94** 1.87** 1.95**
(0.182) (0.181) (0.184) (0.217) (0.216) (0.220)
IACB /Loan, 0.29** 0.26** 0.26** 0.24** 0.23** 0.24**
(0.069) (0.069) (0.069) (0.071) (0.071) (0.072)
BindH=l and BindB=lb -0.70** -0.77**
(0.115) (0.125)
BindH -0.18** -0.18**
(0.025) (0.026)
Bind, 0.03 0.03
(0.019) (0.020)
Market / BookH 0.50** 0.47** 0.50** 0.52** 0.49** 0.52**
__________(0.077) (0.077) (0.078) (0.090) (0.090) (0.091)
(Securities / Assets)B 0.02 0.01 0.03 0.003 0.001 0.02
(0.025) (0.025) (0.026) (0.027) (0.027) (0.027)

R 0.11 0.12 0.10 0.11 0.12 0.09
N (Categories) 7023 7023 7023 6328 6328 6328
_________________ (2339) (2339) (2339) (2162) (2162) (2162)


a. IAC1 = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind, = 1 if bank capital ratio is less than or equal to the regulatory minimum.
*, ** denote significance at the 5% and 1% levels, respectively









The results presented in Tables 9 and 10 provide support for the hypothesis that

bank holding companies find external finance more costly than internally generated

finance, and in response they establish an internal capital market. This interpretation

follows from the observation that subsidiary loan growth is strongly related to holding

company additions to capital. A competing explanation is that holding company cash

flows proxy for investment opportunities at the subsidiary bank that are not captured by

the holding company's market to book ratio or in the subsidiary's own additions to capital.

To address this concern, I include loan growth at other subsidiaries, and cash flows of

non-bank subsidiaries within the same holding company as explanatory variables.

Table 11 documents results including the loan growth of the rest of the holding

company as an additional variable to explain subsidiary loan growth. I still find that loan

growth is positively related to additions to capital at both the holding company and

subsidiary levels, and that the holding company effect remains considerably larger.

Likewise, I still find that binding capital requirements matter at the holding company level,

but not the subsidiary level. Surprisingly, the estimated coefficient on the holding

company's loan growth is negatively related to subsidiary growth. Conceiving why a

negative coefficient except in the context of an internal capital market in which holding

companies allocate capital across competing uses is difficult. Overall, these results

strongly affirm the conclusion that bank holding companies establish internal capital

markets to allocate capital on a consolidated basis.'


1 The negative coefficient on other subsidiaries' growth is somewhat sensitive to
sample and specification. If I exclude banks from Texas and Oklahoma (arguably the most
constrained banks), the coefficient is positive, though not significantly different from zero.











Table 11
Between effects regressions relating subsidiary loan growth to internal additions to capital,
loan growth in related subsidiaries, capital requirements, and subsidiary and holding
company financial characteristics. The sample consists of 2339 subsidiaries of 215
multiple bank holding companies from 1985-1989 (standard errors in parentheses).


Dependent Variable = (Loans, Loans,, ) / Loans._,

Coefficient Overall Sample Small Bank Lead Banks
Subsidiaries
(IACH-IACB)/(LoanH-LoanB)' 2.37** 2.46** 0.85
(0.296) (0.335) (0.520)
IACa / LoanB 0.33** 0.32** 2.07**
(0.069) (0.071) (0.544)
BindHb -0.19** -0.019** -0.19**
_____________________ (0.026) (0.028) (0.068)
Bind, 0.03 0.03 -0.16*
(0.020) (0.021) (0.086)
Loan GrowthHc -0.05* -0.06* -0.04
(0.026) (0.029) (0.036)
Market /BookH 0.52** 0.059** 0.34
(0.082) (0.097) (0.192)
(Securities / Assets)B -0.03 -0.04 -0.04
____________________ (0.027) (0.029) (0.099)

R' 1 0.12 0.12 0.15
N (Categories) 6999 (2339) 6328(2162) 762 (278)

a. IACi = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind = 1 if bank capital ratio is less than or equal to the regulatory minimum.
c. Loan GrowthH equals loan growth of other subsidiaries in the holding company divided by their beginning of
period loans outstanding.
*, ** denote significance at the 5% and 1% levels, respectively








53
Table 12 presents results from the second robustness check, in which I replace the

holding company's additions to capital with non-bank subsidiary's additions to capital.

The results indicate that bank loan growth is positively related to the non-bank cash flows

of the holding company, which provides further evidence that external capital is costly and

banks operate internal capital markets. Moreover, the magnitude of this effect is similar to

the magnitude of the holding company cash flows. Arguably, concluding that these results

are spurious is harder, since it is less likely that non-bank subsidiary cash flows are

positively related to lending opportunities of bank subsidiaries. In this regard, these tests

provide the closest parallel to the experiment provided by Lamont (1993).

As an additional test of the operation of an internal capital market, I examine the

relation between the overall investment-cashflow sensitivity of the holding company and

the subsidiary's dependence on both the holding company's and its own cash flows. The

investment-cashflow sensitivity may estimate the magnitude of information asymmetries,

although it is measured with error since it is an approximation using regression coefficients

(see Table 6). To alleviate an errors in variables bias, I use the investment-cashflow

sensitivity lagged one period as an instrumental variable.

The severity of information asymmetries should be directly related to the growth of

individual banks. Therefore, I expect subsidiary loan growth to be negatively related to

the investment-cashflow sensitivity of the holding company. A finding that the importance

of holding company cash flows is positively related to the holding company's investment-

cashflow sensitivity would provide further evidence of the operation of an internal capital

market. This indicates that the severity of the constraint faced by the holding company











Table 12
Between effects regressions relating subsidiary loan growth to internal additions to capital,
capital requirements, and subsidiary and holding company financial characteristics. The
sample consists of 2339 subsidiaries of 215 multiple bank holding companies from 1985-
1989 (standard errors in parentheses).

Dependent Variable = (Loanst Loans., ) / Loans,._
Coefficient Overall Sample Small Banks Lead Bank
(Non-Bank IAC)/(Loan,-LoanB)* 0.56** 1.28** 0.09
(0.173) (0.279) (0.203)
IACB / LoanB 0.33** 0.28** 1.98**
(0.069) (0.072) (0.506)
Bind Hb -0.19** -0.19** -0.18**
(0.025) (0.026) (0.064)
Bind, 0.01 0.02 -0.16*
_________________ (0.019) (0.020) (0.082)
Market / BookH 0.66** 0.69** 0.28
___________________ (0.075) (0.087) (0.177)
(Securities / Assets), 0.05* 0.05 -0.02
___________________ (0.026) (0.027) (0.093)
R2 0.09 0.09 0.14
N (Categories) 6999 (2339) 6328 (2162) 762 (278)


a. IAC, = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind, = 1 if bank capital ratio is less than or equal to the regulatory minimum.
*, ** denote significance at the 5% and 1% levels, respectively









directly influences the subsidiary's dependence on holding company earnings. Table 13

presents between effects regressions including the holding company's investment-cashflow

sensitivity and two interaction variables designed to test the relation between this

sensitivity and subsidiary reliance on both its own and holding company cashflows. These

variables are the interactions between holding company investment-cashflow sensitivity (as

estimated from equation (1) Table 5) and the two cash flow measures used above.2

At first glance, results in Table 13 might appear to be confusing. In particular, the

negative and significant coefficient on the holding company's cash flows for both the

overall sample and the lead banks may initially cause some concern. However, consider

that this variable appears twice in the regression, the second time interacted with the

holding company's investment-cashflow sensitivity. This sensitivity averages just under 4

(recall from Table 6), and for the majority of banks lies in a range from 3 to 5. After

combining these two estimates, it becomes clear that the total effect of holding company

cash flows will be positive for virtually all banks. Moreover, the positive coefficient on

the interaction term indicates that the severity of the holding company's constraint directly

affects the subsidiary's dependence on holding company earnings. Specifically, as holding

companies become more cash flow constrained, subsidiaries become more reliant on

holding company earnings. Likewise, the negative and significant coefficient on the

holding company's sensitivity (for the overall sample and small banks) indicates that as

holding company's become more constrained, their subsidiaries invest less. These results

provide additional evidence that holding companies operate internal capital markets.


2 Results are similar if the sensitivities are estimated from regressions in Table 4.











Table 13
Between effects regressions relating subsidiary loan growth to internal additions to capital,
estimated investment-cashflow sensitivity, capital requirements, and subsidiary and holding
company financial characteristics. The sample consists of 2339 subsidiaries of 215
multiple bank holding companies from 1985-1989 (standard errors in parentheses).

Dependent Variable = (Loans, Loans,. ) / Loans,.1,

Coefficient Overall Sample Small Banks Lead Bank
(IACH-IACB)/(LoanH-LoanB)' -1.984 ** -0.837 -10.60 *
(2.052) (2.571) (4.276)
IACB / LoanB 0.616 0.169 11.87*
(1.328) (1.513) (6.56)
BindHb -0.145** -0.159** -0.193**
__________________ (0.022) (0.023) (0.069)
Bind, 0.026 0.031 0.177*
(0.017) (0.019) (0.087)
Market / BookH 0.344** 0.468** 0.221
(0.068) (0.089) (0.197)
(Securities / Assets), 0.032 0.007 -0.063
____________(0.026) (0.029) (0.115)
Holding Company Investment- -0.038 ** -0.033 0.002
Cashflow Sensitivity ,., (0.023) (0.013) (0.044)

(IACH-IACB)/(LoanH-LoanB)d 1.059 0.742 2.997 *
Holding Company Investment- (0.532) (0.658) (1.214)
Cashflow Sensitivity,-
IAC / Loan Holding Company -0.103 0.012 -2.448
Investment-Cashflow (0.332) (0.378) (1.652)
Sensitivity-

R' 0.155 0.136 0.169
N (Categories) 6785 (2305) 6186 (2143) 751 (274)

a. IAC1 = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind4 = 1 if bank capital ratio is less than or equal to the regulatory minimum.
c. Loan GrowthH equals loan growth of other subsidiaries in the holding company divided by their beginning of
period loans outstanding.
d. Holding Company Investment-Cashflow Sensitivity is estimated from coefficients on internal additions to
capital and interaction variables from regression (1) in Table 5. To alleviate errors-in variables bias, I use the
lag investment-cashflow sensitivity as an instrumental variable.
*, ** denote significance at the 5% and 1% levels, respectively













CHAPTER 6
EXTERNAL CAPITAL ISSUANCE

The above analysis is consistent with the hypothesis that capital market frictions tie

investment to earnings for banks. To further study this issue, this chapter examines the

severity of information asymmetries surrounding external capital issuances. Specifically, if

the magnitude of the investment-cashflow sensitivity proxies for the severity of

information asymmetries, then ceteris paribus the likelihood that banks issue external

capital should be negatively related to this sensitivity. In addition, this sensitivity may

also be related to the expected costs associated with a security issuance. Banks that face

larger information asymmetries may expect higher underwriting fees and more negative

abnormal stock returns associated with an external capital issuance than banks that face

smaller information asymmetries.

Table 14 describes a summary of 461 security issuances by 157 different bank

holding companies from 1982-1994. The timing of security issuances suggests that

increases in capital standards may have induced banks to raise external funds in order to

replenish surplus capital. Notice that the most active issuance years (1985-1987, and

1991-1993) follow increases in capital standards.

Table 14 also documents the average abnormal returns for the security issuances in

my sample. I find that the average abnormal return following the announcement of a

common stock issuance is just less than -1%. Moreover, capital deficient banks











Table 14
Summary of bank holding company security issuances from 1982-1994


year common stock preferred stock subordinated total
notes
1982 1 10 4 15

1983 4 19 4 27

1984 9 8 17 34

1985 19 6 26 51

1986 28 4 16 48

1987 7 8 35 50

1988 1 4 9 14

1989 4 6 15 25

1990 2 4 4 10

1991 16 16 18 50

1992 22 18 36 76

1993 9 6 25 40

1994 0 5 16 31

total 122 114 225 461

Mean Offer Size (millions) 95,451 123,128 135,393 124,810

Mean (Offer Size/Assets) 1.0% 0.6% 1.1% 0.9%

Mean Underwriter Fees 4.2% 2.8% 1.4% 2.7%

Mean Abnormal Return -1.32% 0.15% -0.19% -0.42%
full sample (z=-5.6, N=105) (z--0.3, N=98) (z=-0.7, N=158) (z=-3.5, N=361)

Mean Abnormal Return -1.49% -0.02% -0.16% -0.48%
if bind=0 (z=-6.4, N=85) (z-0.1, N=74) (z--0.5,N=144) (z=-3.5, N=303)

Mean Abnormal Return 0.37% 0.05% -0.05% -0.12%
if bind=l1 (z=0.1, N=20) (z=0.7, N=24) (z=-0.7, N=14) (z=-0.8. N=58)

Test Statistic of Difference
in Mean Abnormal z=1.50 z=0.39 z=1.15 z=0.86
Returns, by bind I


Security issuances collected from the Investment Dealers Digest.
Announcement dates collected from Dow Jones News Retrieval










experience approximately zero abnormal return, while adequately capitalized banks lose

approximately 1.5% in value. This is consistent with Cornett and Tehranian (1994), and

provides evidence that the market anticipates external equity issues by inadequately

capitalized banks. Also consistent with previous studies, I find that preferred stock and

subordinated note issues do not invoke significant abnormal returns. This may occur

because these securities are less informationally intensive than common stock, so an

issuance of these securities may not elicit as severe of a lemon's problem.1

A bank's decision of whether to issue is likely to be related to the information

asymmetries it faces. Therefore, I develop a logit model which predicts the choice to issue

based on firm and market characteristics. Following Bayless and Chaplinsky (1991)

certain factors can be identified which are likely to influence the decision to issue. It can

be shown that an increase in the firm's stock price increases the share of returns to an

investment project retained by old stockholders and reduces the loss of existing firm value

to new stockholders. Thus, I include the ratio of the last three months' average stock

price to the prior thirty-six months' average. In addition, prior studies find that the

aggregate market conditions at the time of issuance have a significant influence on offer

choice. Essentially, firms are more likely to issue equity following strong equity market

performance. To control for market conditions, I include the ratio of the three-month

average market price (CRSP equal weighted index) to the thirty-six month average. The

variable Risk, the standard deviation of the firm's common stock returns, controls for

stock volatility.


See Mikkelson and Partch (1986)








60
In previous chapters, I argue that capital requirements affect bank decision making

by placing a binding constraint on the utilization of debt funds. This suggests that banks

which are capital deficient may be more likely to issue external funds. To control for this

possibility, I include a dummy variable for whether banks fail capital requirements, Bind,

as an explanatory variable. A second implication of this paper is that securities holdings

may provide banks with significant financial slack, especially if regulators enforce

leverage-based capital standards. In particular, firms with sufficient resources allocated to

securities holdings can fund growth through the liquidation of these holdings. As a result,

firms with a large buffer stock of securities may be less likely to issue external funds.

Thus, I include the ratio of securities to assets as an explanatory variable.

In the Myers and Majluf (1984) model, an increase in financial slack increases the

costs of adverse selection. Therefore, and increase in slack reduces the likelihood of an

equity offering. As an additional proxy for slack, I include a variable called free cash flow

(see Bayless and Chaplinsky (1996)). Free cash flow is designed to measure the flow of

funds constraint which motivates firms to issue securities when positive new present value

projects cannot be financed internally. Free cash flow is defined as current net income

less dividends and loan growth (investment). Banks are expected to be more likely to

issue when they have less free cash flow, hence I expect a negative coefficient.

This paper maintains that banks are concerned with the amount of regulatory

capital that they generate internally. Presumably, banks would fund all growth through

internally generated additions to capital if possible. However, that a bank chooses to issue

external funds does not necessarily mean that it requires a capital injection from a








61

regulatory point of view. It could be that sufficient profitable lending opportunities exist

that the bank could not take advantage of without raising external capital. Either way, the

amount of capital generated internally is likely to be an important factor in the decision to

issue external funds. To capture this relationship, I include the additions to capital,

lagged one observation, as an explanatory variable. This variable indicates the amount of

regulatory capital generated in the previous year. A negative coefficient on additions to

capital indicates that banks are more likely to issue if they have not been generating

sufficient capital internally. On the other hand, a positive coefficient indicates that banks

are more likely to issue when they have profitable growth opportunities.

Optimal capital structure theory maintains that firms have target debt ratios.

Because the costs of debt exceed the benefits for debt ratios above the target, firms are

predicted to be more likely to issue the further the firm's current debt ratio is above the

target ratio. Banks' optimal capital structure is likely to depend on the current capital

requirements. Indeed, the previous chapters provide evidence that surplus capital is an

important determinant of bank growth. I approximate each bank's optimal capital

structure as its average surplus capital over the entire sample period (1982-1994).2 The

deviation from the optimal, designated Target, is then calculated as the difference between

this average and the bank's current period surplus capital. A positive value for Target

indicates that the bank has less surplus capital than optimal. Since all security issues in my

sample augment regulatory capital, I expect a positive coefficient on Target.

2 This definition may not be completely accurate, since the optimal surplus capital
may change as capital standards change. As a separate test, I calculate Target over each
regime. Results are similar.








62

In a recent study, Bayless and Chaplinsky (1996) find that firms are more likely to

issue equity in a 'hot' issue market. Drawing on this research, I identify hot issuance

markets, and create an appropriate dummy variable (Hot) to include as an explanatory

variable. To identify hot markets, I use aggregate equity issue volume data from the

Federal Reserve System's Annual Statistical Digest. I classify the periods using scaled

issue volume, which is monthly issue volume divided by the month end value of

outstanding equity from the CRSP and NASD tapes.3 I rank three-month moving

averages of equity issue volume into quartiles. Hot markets are identified as at least three

contiguous months where equity volume exceeds the upper quartile.

The main purpose of this analysis is to examine the relation between information

asymmetries and the likelihood of issuance. If the predicted investment-cashflow

sensitivity proxies for the severity of capital market frictions, it should be negatively

related to the probability of issuance. The investment-cashflow sensitivity is estimated

using regression (1) from Table 5.4 Specifically, the coefficients on additions to capital

and the interaction variables are combined to predict the sensitivity for each bank in every

year (see Table 6).

Two potential problems arise when including this sensitivity as an explanatory

variable. First, since it is estimated using regression coefficients, it is measured with error.

To alleviate this problem, I instrument for this sensitivity using a lagged observation.


3 Like Bayless and Chaplinsky (1996), results are not sensitive to the use of scaled
volume. If I classify based on nominal dollar or real dollar volume, results are similar.

4 Results are similar if the investment-cashflow sensitivities are estimated from
regressions in Table 4.










Second, there may be a causality problem. Banks that issue securities may be less cash

flow constrained not because of information costs but because they raised external capital.

However, it is less likely that banks that issue were also less constrained by cash flow in

the previous year because of the decision to raise funds. Again this can be alleviated by

using the investment-cashflow sensitivity lagged one year.

Table 15 presents descriptive statistics based on whether the bank issues in a given

year, and if so which type of security it issues. Recall from Table 7 that the investment-

cashflow sensitivities are negatively related to bank size. This is consistent with large

banks facing less severe information asymmetries than small banks. Thus it should not be

surprising that banks which issue are significantly larger than banks which do not issue.

The average size for non-issuers is just over six billion, while stock issuers average over

twenty billion. Also, issuers are increasing loans faster and generating more internal

capital (except for preferred stock issuers) than non-issuers. However, issuers also have

significantly less free cash flow. These results are consistent with firms issuing when they

need funds to implement positive net present value projects.

This chapter is interested in examining the relation between the investment-

cashflow sensitivities and the likelihood of security issuance. One implication of capital

market frictions is that firms with more severe information asymmetries will be less likely

to issue external funds. Perhaps surprisingly, non-issuers have significantly lower

investment-cashflow sensitivities than issuers. However, this is likely influenced by the

fact that issuers have significantly less financial slack as measured by surplus capital and

securities holdings, and are more likely to be inadequately capitalized. To further address











Table 15
Descriptive statistics (means, with medians in parentheses) for 289 bank holding
companies classified by type of security issuance.'


Variable no issuance common stock preferred stock subordinated
issuance issuance note issuance
Total Assets (millions) 6,533 20,100 51,300* 38,600 *
(2,276) (5,597) (32,300)* (22,800)*
Loan Growth' 0.061 0.191* 0.087 0.152*
(0.076) (0.151) (0.055) (0.116)*
Internal Additions to 0.014 0.019* 0.015 0.019*
Capital/Loans.,t (0.017) (0.019)* (0.014) (0018)

Market /Book Assetsd 1.005 1.004 0.991 1.006
(0.999) (0.996) (0.989)* (1.000)
Book Capital in Excess 0.025 0.017 0.017* 0.023
of Requirement /Assetse (0.021) (0.014)* (0.010)* (0.017) *

Securities / Assets 0.215 0.193* 0.134* 0.165 *
(0.208) (0.195) (0.119)* (0.159)*
Risk' 0.023 0.022 0.023 0.019
(0.018) (0.017 (0.018) (0.016)
Predicted Investment- 3.688 3.915* 4.072 3.903*
Cashflow Sensitivity., (3.758) (3.915)* (4.174)* (4.006)*

Free Cash Flow/Loans ih -0.055 -0.185* -0.082* -0.144*
(-0.066) (-0.145)* (-0.048) (-0.110)*
Percentage with Capital 4.55% 9.02%* 21.9%* 9.78%*
less than requirement.

Number of Observations 1954 122 114 225

a. Data are from the Federal Reserve Y-9 tape.
b. Loan growth equals change in total loans outstanding divided by loans outstanding at time t- 1.
c. Internal additions to capital equals net income plus changes in loan loss provisions (up to regulatory
maximum).
d. Market to book value of assets equals (Total Assets Book Equity + Market Equity) / Total Assets. Market
Equity equals the market value of common equity from CRSP. The ratio is calculated at year end for the prior
year.
e. Book capital in excess of requirement equals the bank's book capital for regulatory minimum Tier II capital
ratio. Tier II capital equals common stock, preferred stock, plus eligible subordinated debt and loan loss
reserves. For the period 1982-1984 the requirement is 5.5% of total assets. For 1985-1989 the requirement is
6%. Beginning in 1990, the requirement is based on risk-weighted assets. For 1990-1991, the minimum is
7.25% of risk-weighted assets, while from 1992-1994 the minimum is 8%.
f Risk equals the standard deviation of the firm's daily stock return, after adjusting for bid-ask bounce.
g. Investment-Cashflow Sensitivity is estimated using coefficients on internal additions to capital and
interaction variables from regression (1) in Table 5.
h. Free Cash Flow is net income less dividends and loan growth.
* denotes significantly different from the no investment sample at better than the 5% level.








65

this issue, I estimate probit regression models of security choice while controlling for the

investment-cashflow sensitivity, surplus capital, and securities holdings.5

The sample contains a pooled time-series cross section of data. As a result,

observations may not be independent, especially for the common stock issuance model. In

particular, if a bank issues common stock in any given year, it is likely to not issue again in

the next year. In fact, for only twenty out of one hundred and twenty-two issues did a

bank issue common stock in consecutive years. Likewise, forty-two out of one hundred

and fourteen preferred stock, and sixty-eight out of two hundred and twenty-five

subordinated note issues occurred from a bank in consecutive years. To address this

problem, I include a dummy variable indicating whether the bank issued in the previous

year. Specifically, I create four dummy variables (any security, common stock, preferred

stock, and subordinated note) to include in the appropriate regressions, and expect the

coefficients to be negative.

Table 16 presents the results from probit models which estimate the decision to

issue based on the aforementioned firm and market characteristics. Because the

investment-cashflow sensitivity is related to capitalization and securities holdings, I

estimate the regressions both with and without this variable. Regardless of security type,



5 Results are similar using logit regressions.

6 As a separate test, I estimate the probit models for each year independently. In
these regressions, the coefficient estimates were relatively stable for the any issuance,
preferred stock, and subordinated note models. However, for the common stock model,
coefficients were not as stable. Moreover, in all models, coefficient estimates were not as
significant as those presented in Table 15, perhaps due to the use of many fewer
observations.






Table 16
Probit regressions relating a security issuance to firm financial characteristics. Year dummy variables included (results not reported).
The sample consists of 289 bank holding companies from 1982-1994 (standard errors in parentheses).

Dependent Variable=ISS =l if issuance, =0 otherwise______
coefficient ISSany ISSmy ISS, ISS, ISS, ISSP ISS. ISS.
Investment-Cashflow Sensitivityt.,b -0.5 (0.1) -0.6 (0.2) -0.9 (0.2) -0.1 (0.2)
Issued Last Year =1 ifyes, 0 ifno. -0.4 (0.1)* -0.4 (0,1)* -0.5 (0.2)* -0.5 (0.2)* -0.7 (0.2)* -0.6 (0.2)* -0.5 (0.1)* -0.5 (0.1)*
Bind 0.5 (0.2) 0.6 (0.2) 0.5 (0.2) 0.7 (0.2) 0.5 (0.2) 0.6 (0.2) 0.3 (0.2) 0.3 (0.2)
Prices 1.0 (0.5)* 1.1 (0.5)* 0.9 (0.6) 1.1 (0.6)* 1.2 (0.7) 1.4 (0.7)* 0.4 (0.9) 0.4 (0.8)
Marketd 16 (3.8)* 17 (3.8)* 14 (4.9)* 15 (5.0)* 14 (5.9)* 17 (6.3)* 10 (4.8) 10 (4.8)*
Risk' 1.4 (3.7) 1.3 (3.8) 11 (9.2) 12 (9.8) 1.3 (4.3) 1.3 (4.6) 0.9 (4.4) 0.9 (4.4)
Risk2 -3.4 (9.2) -3.3 (10) -59 (68) -70 (76) -3.1 (6.6) -3.0 (7.7) -2.4 (5.6) -2.4 (5.6)
log (Total Assets1,) 0.4 (0.03)* 0.4 (0.04)* 0.2 (0.04)* 0.3 (0.04)* 0.4 (0.05)* 0.5 (0.1)* 0.5 (0.1)* 0.5 (0.1)*
Hot Issuance Market 0.04 (0.1) 0.03 (0.1) -0.04 (0.1) -0.04(0.1) 0.04 (0.1) 0.04 (0.1) 0.03 (0.1) 0.03 (0.1)
Free Cash Flow / Loans,1 -1.3 (0.5)* -0.7 (0.5) -0.3 (0.6)* -0.7 (0.6) -1.2 (0.6)* -0.7 (0.6) -1.2 (0.6)* -1.2 (0.6)*
Lag (Additions to Capital/ Loans,.,) 6.9 (3.5)* 4.4 (3.6) 8.5 (4.0)* 5.9 (4.1) -4.3 (4.5) -4.3 (4.6) 5.9 (4.6) 5.8 (4.8)
Target' 2.2 (2.8) 1.3 (2.8) -1.3 (3.2) -1.4 (3.1) -5.8 (3.4) -5.8 (3.4) 2.5 (3.4) 2.4 (3.4)
Securities/Assets,; -1.2 (0.5)* -1.5 (0.6)* -0.9 (0.5)* -0.7 (0.7) -1.3 (0.6)* -1.3 (0.6)* -0.3 (0.7) -0.3 (0.9)
N (Pseudo R squared) 1879 (0.22) 1879 (0.23) 1879 (0.09) 1879(0.11) 1879 (0.27) 1879 (0.30) 1879 (0.29) 1879(0.30)

a. ISS, equals a dummy variable for security issuance in a given year (any=any security, c=common stock, p=preferred stock, sn=subordinated notes).
b. Investment-Cashflow Sensitivity is estimated using coefficients on internal additions to capital and interaction variables from regression (1) in Table 5.
c. Price=3 month average stock price / 36 month average price
d. Market=3 month average value of CRSP value-weighted index / 36 month average
e. Risk= standard deviation of daily stock return
f Target = the bank's average surplus capital over the entire sample period minus it's actual surplus capital.
*denote significance at the 5% level.









inclusion of the investment-cashflow sensitivity increases the pseudo R squared of the

model (and log likelihood ratio). Moreover, in three of four models after controlling for

capitalization and securities holdings, I find a negative and significant relation between the

choice of issuance and the investment-cashflow sensitivity. This provides evidence that

investment-cashflow sensitivities proxy for the severity of information asymmetries.

Consistent with the hypothesis that capital requirements impose binding

constraints, I find that the probability of issuing external funds is greater for banks that fail

capital requirements. Specifically, for the any security, common stock, and preferred

stock models, coefficient estimates on Bind, are positive and significant after controlling

for the investment-cashflow sensitivity. Moreover, the negative coefficients on securities

indicate that banks with more securities holdings are less likely to raise external capital.

This provides further evidence that banks rely on buffer stocks of capital and securities to

fund growth during a liquidity crisis.

The coefficient estimates on the dummy variable for issuance in the previous year

are negative and statistically significant for all four issuance models. This supports the

notion that banks are unlikely to issue external capital securities in consecutive years.

Also, the negative coefficients on free cash flow indicate that banks are more likely to

issue capital when they need funds to support growth.

As a second test of the relation between information costs and external capital

issuances, I examine the relation between investment-cashflow sensitivities and banks'

anticipated costs of security issuance. Following Calomiris and Himmelberg (1995), I

estimate expected underwriting costs based on firm characteristics and sort firms into high










and low cost categories. Using these categories, I determine whether high cost firms

display greater investment-cashflow sensitivities than low cost firms. Calomiris and

Himmelberg identify certain characteristics which are important in determining

underwriting fees. I use similar bank characteristics to estimate the fee model.

In Calomiris and Himmelberg, financial working capital, leverage, and sales are the

most important characteristics. I estimate financial working capital as securities holdings,

and control for leverage with capitalization. Translating sales to a banking firm

characteristic, I choose internally generated additions to capital. I pick additions to capital

over income because capital requirements cause banks to be concerned with the amount of

regulatory capital that they generate. I also include free cash flow to capture the flow of

funds constraint that motivates banks to issue. In addition, I include size, the deviation

from optimal capital structure (Target), and the volatility of stock returns (Risk).7

As in Calomiris and Himmelberg, this is not intended to be a structural model. The

process of experimentation that yields the model was an search for a model that

maximized adjusted R squared. Because of this problem, I choose not to focus on

individual coefficient estimates, rather I am more concerned with the accuracy of

predictions based on this model (the correlation between actual fees and predicted fees for

common stock issuances is more than 0.8). Moreover, I will sort firms into categories

based on this prediction so as not to rely on the prediction itself, but only a dummy

variable which indicates whether the prediction is over or under the median prediction.



7 I experiment with a number of alternative specifications, but report only the one
which yielded the largest adjusted R squared.








69

Table 17 presents results from a heteroskedastic consistent regression relating the

underwriting fees to firm characteristics. The most important firm characteristics in

determining fees are size and the amount of internal capital generation. Also, the adjusted

R squared for these models are similar to those from Calomiris and Himmelberg.

Because I am interested in using information about issuers to estimate the external

financing costs of non-issuers, I correct for potential selectivity bias before applying the

model to construct expected underwriting costs for issuers and non-issuers. That is, the

decision to issue is not random, and that decision is likely to be correlated with some or all

of the regressors in the underwriting fee model. To correct for this problem, I use a two-

step Heckman procedure in which the decision to issue is modeled as a probit model. The

probability of issuing derived from this probit enters as an explanatory variable in the

underwriting fee model. Since a probit model has been specified in Table 16, I rely on this

model for the Heckman procedure. Because my goal is to use predictors from the

Heckman procedure to explain differences in investment-cashflow sensitivities, I use the

probit model without the investment-cashflow sensitivity as an explanatory variable.

The results from the underwriting fee model and the probit model after correcting

for selectivity bias are presented in Table 18. The coefficients from the underwriting fee

model are used to construct predicted values of the cost of issuing each type of security

for all firms. I then create a dummy variable (High Fees) which equals one if the predicted

fees are above the median predicted fees, or zero otherwise for each security type. This

dummy variable is employed to estimate the relation between expected issue costs and the

sensitivity to internally generated funds.











Table 17
Heteroskedastic consistent regressions relating total underwriting expense to firm
characteristics. Year dummy variables included (results not reported). The sample
consists of 289 bank holding companies from 1982-1994 (standard errors in parentheses).

Dependent Variable= percentage fees associated with:
Variable Common Stock Preferred Stock Subordinated Notes

Bind" -0.001 0.002 -0.001
(0.002) (0.002) (0.003)
Log (Total Assets,.1) -0.007 ** -0.006 ** -0.006 **
(0.001) (0.001) (0.002)
Free Cash Flow / Loans,. b -0.001 0.002 -0.005
(0.005) (0.003) (0.014)

Lag (Additions to Capital/ -0.147 -0.189 -0.389 *
Loans,.,) (0.084) (0.085) (0.177)

Securities / Assetst., 0.025 -0.016 0.001
(0.013) (0.018) (0.024)

Target -0.085 -0.069 0.092
(0.076) (0.042) (0.095)
Riskd 0.748 ** 0.426 ** 0.432
(0.247) (0.152) (0.523)
Risk2 -4.635 ** -2.075 -3.697
(1.777) (0.763) (8.207)
N (Adjusted R2) 109 (0.661) 95 (0.419) 116 (0.417)

a. Bind =1 if surplus capital is less than or equal to zero, =--0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank's average surplus capital over the entire sample period minus it's actual surplus capital.
d. Risk=- standard deviation of daily stock return
*, ** denote significance at the 5% and 1% levels, respectively











Table 18
Regression models relating underwriting fees to firm characteristics, correcting for selectivity bias
using Heckman's two step procedure. (standard errors in parentheses)


common stock preferred stock subordinated notes
Variable Probit Model % fee Probit Model % fee Probit Model % fee
_____________ (1 =issuer) (1 =issuer) (1=issuer)

Binda 0.03 0.01 -0.06 0.002 0.28 0.002
______(0.067) (0.01) (0.143) (0.003) (0.138) (0.003)

Log (Total Assets,.,) 0.11 ** -0.01 ** 0.33 ** -0.01 ** 0.79 ** -0.01 **
_____________ (0.018) (0.001) (0.021) (0.001) (0.022) (0.001)

Free CashFlow/ -2.08** -0.002 -1.19** 0.002 -1.21 ** -0.01
Loans,.,' (0.117) (0.005) (0.114) (0.008) (0.116) (0.006)

Lag (Additions to 9.63** -0.17 -5.27** -0.19 37.2** -0.28
Capital /Loans,.) (2.062) (0.106) (2.167) (0.109) (2.148) (0.176)

Securities I/Assets,.- -9.14 ** 0.02 -2.50 ** -0.01 -10.8 ** -0.03
(0.332) (0.017) (0.319) (0.024) (0.336) (0.024)
Target' 54.3 ** -0.08 11.7 ** -0.08 21.2 ** 0.19
(2.126) (0.083) (1.945) (0.122) (2.084) (0.113)
Risk" -3.22 0.87 ** -8.73 ** 0.42 -0.71 0.20
(1.415) (0.271) (2.062) (0.25) (1.475) (0.504)
3 month avg Stock 5.68** 6.25** 15.1**
Price / 36 month avg (0.289) (0.287) (0.797)

3 month avg Market -35.3 ** 0.71 -22.9 **
Price / 36 mo avg (1.979) (2.089) (2.072)

Hot 0.28 ** 0.25 ** -0.59 **
_____________ (0.055) (0.059) (0.057)
Issued in the Previous -0.42 ** -0.35 ** 0.01
Year =1 if yes, 0 if no. (0.103) (0.112) (0.095)

Inverse Mills Ratio 0.003** -0.002 0.01**
from Probit' ________ (0.0002) ________ (0.0135) (0.002)

a. Bind =1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank's average surplus capital over the entire sample period minus it's actual surplus capital.
d. Risk= standard deviation of daily stock return
e. Inverse Mills Ratio = the probability of issuance derived from the Probit model
*, ** denote significance at the 5% and 1% levels, respectively










Table 19 presents fixed-effects regressions of loan growth identical to the model from

Table 3 with one important difference. I include the interaction of the variable High Fees with

additions to capital. The three categories of regressions indicate the security type for which the

underwriting fees are predicted. Because of a potential simultaneity bias induced by estimating

fees and then using the estimation as an explanatory variable, I instrument for this variable with a

lagged observation of High Fees. This interaction term is designed to test the hypothesis that

firms which anticipate larger external finance costs are more constrained by internally generated

funds. Regardless of security type, banks which anticipate higher than median underwriting fees

are more sensitive to internally generated funds.8 In other words, expected external finance costs

affect a bank's reliance on internally generated funds. This finding provides evidence that the

magnitude of the investment-cashflow sensitivity proxies for the size of the wedge between

internal and external financing costs.

Continuing along these lines, the expected abnormal returns following the announcement

of a security issuance may proxy for expected costs of issuance, and therefore may be related to

the investment-cashflow sensitivities. Using the same specifications from the underwriting fees

model, I estimate the abnormal stock returns based on firm characteristics using weighted least

squares, weighing each observation by the standard error from a market model regression. Table

20 presents results that indicate that abnormal returns are difficult to predict with observable

characteristics, as the adjusted R squared from these models is much lower than from the

underwriting fee models. However, this problem should simply introduce more noise in the


8 In additional tests, I divided firms into quartiles based on expected financing
costs. In these tests I find a significant difference between the highest and lowest quartile.
I also find a significant difference between the top two quartiles.











Table 19
Fixed effects regressions relating loan growth to internal additions to capital, expected
underwriting fees, and firm financial characteristics. The sample consists of 289 bank
holding companies from 1982-1994 (standard errors in parentheses).


Dependent Variable = (Loans, Loanst. ) / Loans,.,

Variable common stock preferred stock subord. notes

Additions to Capital/ 4.67 ** 3.59** 4.66 ** 3.76** 4.45 ** 3.65**
Loanst., (0.231) (0.188) (0.234) (0.201) (0.242) (0.202)

High Fees,., Additions to 0.38 0.39 0.34 0.39 0.82 ** 0.93 **
Capital /Loansta (0.186) (0.184) (0.179) (0.177) (0.165) (0.216)

Surplus Capital /Assetst., 0.93 ** 0.91 ** 0.82 **
(0.162) (0.164) (0.165)
Surplus Capital *Additions -30.7 ** -30.4 ** -26.6 **
to Capital /Loans., (4.588) (4.615) (4.761)

Bindb -0.05 -0.05 ** -0.05 **
______________ (0.009) (0.009) (0.009)
Bind Additions to Capital 0.46 0.99* 0.71
/ Loans,., (0.459) (0.512) (0.514)

Securities / Assets,., 0.13** 0.15** 0.13** 0.13** 0.13** 0.13**
______________ (0.039) (0.039) (0.040) (0.040) (0.040) (0.039)
Market/Book Assets,, 0.26 ** 0.27 ** 0.27 ** 0.26 ** 0.25 ** 0.24 **
_______________ (0.048) (0.049) (0.048) (0.049) (0.048) (0.048)
log (Assets,.,) -0.07 ** -0.07 ** -0.07 ** -0.07 ** -0.07 ** -0.07 **
_______________ (0.005) (0.005) (0.006) (0.005) (0.005) (0.005)
Lag loan growth 0.07 ** 0.07 ** 0.07 ** 0.07 ** 0.05 ** 0.04 **
(0.010) (0.010) (0.010) (0.010) (0.011) (0.012)
R2 0.379 0.377 0.379 0.375 0.383 0.379
N (categories) 1986 1986 1986 1986 1986 1986
_______________ (289) (289) (289) (289) (289) (289)
F statistic, Bank dummies 2.33 ** 2.62 ** 2.33 ** 2.60 ** 2.37 ** 2.65 **

a. High Fees =1 if the firms predicted fees from the Underwriting Fees model in Table 18 (corrected for
selectivity bias) are greater than the median predicted fees, =0 otherwise.
b. Bind=l if surplus capital<=0, 0 otherwise.
*, ** denote significance at the 5% and 1% levels, respectively











Table 20
Weighted least squares regressions relating abnormal stock returns following the
announcement of a security issuance to firm characteristics. Observations are weighted
by the standard errors from a market model regression. Year dummy variables included
(results not reported). The sample consists of 289 bank holding companies from 1982-
1994 (standard errors in parentheses).

Dependent Variable= abnormal stock returns associated with:
Variable Common Stock Preferred Stock Subordinated Notes

Bind" 0.03 ** -0.01 -0.01
(0.012) (0.011) (0.001)
Log (Total Assets,.,) 0.001 0.004 0.002
(0.002) (0.004) (0.002)
Free Cash Flow / Loanst.,b -0.03 0.03 0.02
(0.023) (0.013) (0.011)
Lag (Additions to Capital / -0.31 -0.17 0.32
Loans,.1) (0.457) (0.366) (0.233)
Securities /Assets,, -0.01 0.02 0.01
(0.065) (0.077) (0.031)
Target -0.08 -0.17 0.08
(0.377) (0.366) (0.193)
Risk' -0.76 0.06 -1.15
(0.802) (0.637) (0.872)
Risk2 6.18 1.06 12.9
(5.972) (3.121) (12.07)
N (Adjusted R2) 107(0.166) 90(0.339) 155(0.158)

a. Bind =1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank's average surplus capital over the entire sample period minus it's actual surplus capital.
d. Risk=- standard deviation of daily stock return


*, ** denote significance at the 5% and 1% levels, respectively










estimates and bias against finding any relation between expected costs and investment-

cashflow sensitivities.

Table 21 presents results from the probit and abnormal return models using the

Heckman procedure correcting for selectivity bias. As before, the coefficients from the

abnormal return model are used to construct predicted values of the cost of issuing each

type of security for all firms. I then create a dummy variable (Large Abnormal Returns)

which equals one if the predicted abnormal returns are more negative than the median

predicted returns, or zero otherwise for each security type. This dummy variable is

employed to estimate the relation between expected costs and the sensitivity to internally

generated funds.

Table 22 presents results from a fixed effects regression model of loan growth,

including the interaction between Large Abnormal Returns and additions to capital.

Again, because of a potential simultaneity bias resulting from estimating costs, I

instrument for this variable with a lagged observation of Large Abnormal Returns. As in

the underwriting fee models, regardless of security type, banks that expect abnormal

returns more negative than the median expected abnormal return are significantly more

constrained by internally generated additions to capital. This suggests that expected

abnormal stock returns influence the dependence on internally generated additions to

capital, and that banks that anticipate larger external finance costs are more constrained by

additions to capital than banks that anticipate smaller costs. Overall, these results provide

evidence that investment-cashflow sensitivities proxy for the severity of information

asymmetries.











Table 21
Regression models relating abnormal stock returns to firm characteristics, correcting for
selectivity bias using Heckman's two step procedure. (standard errors in parentheses).


common stock preferred stock subordinated notes

Variable Probit Model Abnormal Probit Model Abnormal Probit Model Abnormal
(1 =issuer) Return (1 =issuer) Return (l=issuer) Return

Bind' 0.46 ** 0.02 0.05 -0.01 0.40 ** -0.01
(0.064) (0.008) (0.145) (0.010) (0.140) (0.003)

Log (Total Assetst1) 0.04 0.002 0.40 ** 0.01 0.04 0.002 *
(0.019) (0.003) (0.021) (0.004) (0.019) (0.001)

Free Cash Flow/ 0.23 -0.03 -1.31 ** 0.03 0.15 0.02 **
Loanst.,b (0.119) (0.019) (0.116) (0.023) (0.123) (0.006)

Lag (Additions to -17.5 ** -0.02 -8.72 ** -0.17 4.69 0.25 *
Capital /Loans.t) (2.089) (0.440) (2.273) (0.358) (2.117) (0.129)
Securities/Assets,., -5.73 ** 0.001 -3.44 ** -0.01 -1.85 ** 0.03 *
(0.316) (0.072) (0.345) (0.070) (0.305) (0.013)

Targetc 18.7 ** -0.25 19.8 ** -0.02 6.53 ** 0.04
(1.858) (0.362) (2.169) (0.373) (1.862) (0.109)
Riskd -27.31 ** -0.48 -5.23 ** 0.86 -13.1 ** -1.48 *
(2.112) (0.884) (2.026) (0.819) (2.121) (0.628)
3 month avg Stock 3.82 ** 7.60 ** -5.48 **
Price / 36 month avg (0.531) (0.288) (0.703)

3 month avg Market 30.8** 18.6** 15.0**
Price /36 mo avg (2.057) (2.267) (2.075)

Hot 0.13* -0.32** -0.12*
_____________ (0.057) (0.061) (0.058)

Issued in the Previous -0.41 ** -0.37 ** -0.33 **
Year =1 if yes, 0 if no. (0.102) (0.118) (0.077)

Inverse Mills Ratio 0.01 0.02 -0.02**
from Probitr ______ (0.018) ______(0.012) (0.001)

a. Bind =1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank's average surplus capital over the entire sample period minus it's actual surplus capital.
d. Risk=-- standard deviation of daily stock return
e. Inverse Mills Ratio = the probability of issuance derived from the Probit model
*, ** denote significance at the 5% and 1% levels, respectively











Table 22
Fixed effects regressions relating loan growth to internal additions to capital, expected
abnormal stock returns, and firm financial characteristics. The sample consists of 289
bank holding companies from 1982-1994 (standard errors in parentheses).


Dependent Variable = (Loanst Loans,.1 ) / Loans,.,

Variable common stock preferred stock subord. notes

Additions to Capital / Loans,, 4.52** 3.77** 4.51** 3.66** 4.68** 3.76**
(0.242) (0.207) (0.233) (0.204) (0.227) (0.199)
Large Abnormal Returns,, 0.32 0.37 0.85 ** 0.84 ** 0.72 ** 0.76 **
Additions to Capital / Loans,.," (0.177) (0.178) (0.210) (0.209) (0.189) (0.189)

Surplus Capital/Assets,., 0.80 ** 0.87 ** 0.95 **
________________ (0.163) ______ (0.155) (0.159)
Surplus Capital *Additions to -26.5 ** -27.7 ** -30.9 **
Capital /Loans.1 (4.722) (4.458) (4.551)

Bindb -0.05** -0.06** -0.06**
______ (0.009) (0.009) (0.009)
Bind Additions to Capital / 0.21 1.02 0.97 *
Loans,., (0.533) ______ (0.511) (0.501)

Securities / Assets,., 0.12** 0.12** 0.13** 0.13** 0.11** 0.11**
(0.039) (0.039) (0.039) (0.038) (0.040) (0.040)
Market/Book Assets,., 0.26 ** 0.25 ** 0.26 ** 0.24 ** 0.24 ** 0.22 **
(0.047) (0.048) (0.049) (0.049) (0.049) (0.049)
log (Assets,.,) -0.07 ** -0.07 ** -0.06 ** -0.07 ** -0.07 ** -0.07 **
________________ (0.005) (0.005) (0.005) (0.005) (0.005) (0.005)
Lag loan growth 0.07 ** 0.07 ** 0.08 ** 0.08 ** 0.06 ** 0.06 **
________(0.009) (0.009) (0.009) (0.009) (0.010) (0.010)
S0.355 0.351 0.385 0.384 0.383 0.379
N (categories) 1968 1968 1968 1968 1968 1968
________________ (289) (289) (289) (289) (289) (289)
F statistic, Bank dummies 2.35 ** 2.62 ** 2.34 ** 2.63** 2.36 ** 2.63 **

a. Large Abnormal Returns =1 if the firms predicted abnormal stock returns from the Abnormal Stock Returns
model in Table 21 (corrected for selectivity bias) are more negative than the median predicted abnormal return,
=0 otherwise.
b. Bind=l if surplus capital<=0, 0 otherwise.

*, ** denote significance at the 5% and 1% levels, respectively













CHAPTER 7
SUMMARY AND CONCLUSIONS

Overall, my results suggest that asymmetric information problems increase the

costs of external finance for banking firms. In particular, I find a positive and significant

relation between bank loan growth and internally generated additions to capital.

Moreover, consistent with the hypothesis that capital requirements limit bank financing

alternatives, this cashflow sensitivity of investment is positively related to the extent that

capital requirements are binding. This relationship implies that increases in capital

standards, which increase the likelihood that capital requirements are binding, could

induce a slowdown in loan growth.

I also find that the formulation of the capital ratio itself is important in determining

bank loan growth. Specifically, with regulators enforcing leverage-based capital

standards, banks can rely on a buffer stock of securities to fund investment in a liquidity

crisis. This results in a negative relation between the cashflow sensitivity of investment

and securities holdings. However, the use of risk-based standards substantially reduces

the effectiveness of securities as financial slack. As a result, the change from leverage-

based to risk-based standards may have caused banks to desire more surplus capital, and

therefore may have had a negative impact on loan growth.

My results also suggest that bank holding companies allocate capital in a way

consistent with the operation of an internal capital market by holding companies that find









equity expensive to raise externally. Specifically, I find that investment by bank

subsidiaries is more sensitive to the cash flows and capitalization of its holding company

than its own cash flows and capitalization. I also find that subsidiary investment is

significantly related to the non-bank earnings of its holding company. These results are

consistent with the hypothesis of costly external finance, and suggest that empirical studies

of the effects of changes in capital requirements should be considered on the holding

company level and not the individual bank level.

Finally, I find that the severity of information asymmetries affects both the

likelihood and the costs of an external capital issuance. In particular, I find a negative

relation between the cash flow sensitivity of investment and the probability that banks

issue external capital. I also find that firms which anticipate underwriting fees larger than

the median expected fee for an external capital issuance exhibit significantly higher cash

flow sensitivities of investment. Moreover, banks expecting abnormal stock returns more

negative than the median expected abnormal return following the announcement of an

external capital issue are significantly more constrained by internally generated funds.

These results provide evidence that investment-cashflow sensitivities proxy for the severity

of capital market imperfections.













APPENDIX
ESTIMATION OF RISK-WEIGHTED ASSETS


A data set with complete risk-weighted assets data is available to me for 98 bank

holding companies on December 31, 1995.1 These data disaggregate total risk-weighted

assets into three major categories: balance sheet assets, loan commitments, and

derivatives. Table 23 presents descriptive statistics. The sample contains both very large

and small banks, as total assets range from a low of $105 million to Citicorp's $216

billion. In addition, risk-weighted assets range from $51 million to $230 billion. By far,

balance sheet assets contribute the most to risk-weighted assets. For many banks, mostly

small ones, off-balance sheet assets hardly add to risk-weighted assets at all. Therefore,

for the most accurate approximation of total risk-weighted assets, I estimate each major

component separately. That is, I decompose risk-weighted assets into its three broad

categories. A regression for each component is specified, and parameter estimates

obtained. The regressions are specified as follows:

RWBS = aILOANS + a2SECS
RWLC = PJISLC + p2LC + P2LOC
RWD = YIFEXPURCH +y2FEXPOPT +Y3FEXWOPT +Y4FEXSWP+Y5FUTURES
+Y6WOPT + y7POPT + y8SWAPS




1 Data set supplied by Carolyn Takeda. Before December 1991, the breakdown of
risk-weighted assets into its components is not available.

80











Table 23
Descriptive Statistics of 98 bank holding companies at year-end 1991. Data were
collected from the Federal Reserve Y-9 Data Tapes. This sample consists of banks for
which complete risk-based capital data was available.*


Variable Mean Median Min Max


Total Assets (millions) 17,474 5,317 105 216,920


Risk-Weighted Assets (millions) 14,700 3,787 51 238,000


Risk-Weighted Assets, from on- 9,738 2,229 18 165,000
balance sheet items (millions)

Risk-Weighted Assets, from loan 2,435 216 20 54,800
commitments (millions)

Risk-Weighted Assets, from derivative 424 0 0 108,000
assets (millions)

Loans / TA 0.6008 0.6358 0.1266 0.8057


Securities / TA 0.2399 0.2233 0.0348 0.6152


(Loans Loans,-,) / Loans.-, 0.0054 -0.0044 -0.3558 0.3206


Internal Additions to Capital / Loanst., 0.0096 0.0120 -0.0213 0.0219


Market /Book Assets 1.0182 1.0149 0.9554 1.2055


Book Capital in Excess of Requirement 0.0228 0.0226 -0.0072 0.2046
/ Assets

* Special thanks to Carolyn Takeda for use of this data set.










RWBS = risk-weighted assets attributable to the balance sheet
LOANS = loans outstanding
SECS = securities held
RWLC = risk-weighted assets attributable to loan commitments
SLC = stand-by letters of credit
LC = loan commitments
LOC = lines of credit
RWD = risk-weighted assets attributable to derivative assets
FEXPURCH = foreign exchange purchase commitments
FEXPOPT = foreign exchange purchase options
FEXWOPT = foreign exchange written options
FEXSWP = foreign exchange swaps
FUTURES = futures and forwards
WOPT = written options
POPT = purchase options
SWAPS = non-foreign exchange swaps.

Actual risk-based capital data are used as the dependent variables, and broad

classifications of on and off-balance sheet components are used as the independent

variables. Coefficient estimates from these equations are then used to approximate the

risk-weights assigned to each component for purposes of computing total risk-weighted

assets. Consequently, this procedure approximates risk-based capital ratios for all banks

from 1990 to present.2

Table 24 presents the regression results. As expected, the coefficient on loans is

very significant and close to unity. Moreover, the results estimate the risk-weight on

stand-by letters of credit to be approximately one.3 The next largest risk-weight comes

from securities, at 0.34. No variable has a coefficient significantly greater than one, which

is consistent with risk-based capital standards.


2 Reporting requirements from 1990 to present ensure sufficient off-balance sheet
data to estimate risk-weighted assets for the majority of firms in the sample.

3 Coefficient not significantly different from one.











Table 24
Least squares estimation of risk-weighted assets (RWA). Data were collected from the
Federal Reserve Y-9 Data Tapes. A sample of 98 firms contains complete RWA data for
year-end 1991. These observations are used to estimate components of RWA. RWA is
decomposed into three categories, balance sheet assets, off-balance sheet loan
commitments, and derivative sheet assets. Regressions use the actual amount of RWA
attributable to a category as the dependent variable. Broad classes of asset items are used
as independent variables. Regressions are performed using White's correction for
heteroskedasticity. Standard errors are in parenthesis.

Variable RWA: Balance RWA: Loan RWA: Derivative
Sheet Assets Commitments Assets
Loans *** 1.0197
(0.0403)
Securities 0.3393
____~_________ (0.2396)
Stand-by Letters of *** 1.3174
Credit (0.3134)

Loan Commitments *** 0.1483
______~_________~___(0.0424)
Lines of Credit -0.5543
_____________ ~ (1.5209)
Foreign Exchange (FEX) *** 0.0069
Purchase Comm. (0.0008)

Foreign Exchange *** 0.3266
Purchase Options (0.0528)

Foreign Exchange *** -0.2819
Written Options (0.0482)

Foreign Exchange Swaps *** 0.0435
~____~_______~_____ ____~______(0.0012)
Futures and Forwards *** -0.0069
~____~__________ ______________ (0.0006)
Written Options (non -0.0039
FEX) _____ ___ (0.0075)

Purchase Options (non *** 0.0201
FEX) ______________ ______________ (0.0058)

SWAPS (non FEX) *** 0.0134
____________~ ~ (0.0001)
N 98 98 98
Adjusted R Squared 0.9940 0.9793 0.9999

*, **, *** denote significant at the 10%, 5%, and 1% levels respectively.













REFERENCES


Asquith, Paul and D. Mullins (1986). "Equity Issues and Offering Dilutions," Journal of
Financial Economics 15, 61-89.

Baer, Herbert L. and John N. McElravey (1993). "Capital Shocks and Bank Growth,
1973-1991," Federal Reserve Bank of Chicago Economics Perspectives 17, 2-21.

Bayless Mark, and Susan Chaplinsky (1991). "Expectations of Security Type and the
Information Content of Debt and Equity Offers," Journal of Financial
Intermediation 1,195-214.

______ (1996). "Is There a 'Window of Opportunity' for Seasoned Equity
Issuance?" Journal of Finance 51, 253-278.

Berger, Alan N. and Gregory F. Udell (1994). "Did Risk-Based Capital Allocate Bank
Credit and Cause a 'Credit Crunch' in the U.S.?" Journal ofMoney, Credit, and
Banking 26, 585-634.

Bernanke, Ben S., M Gertler and S. Gilchrist (1994). "The Financial Accelerator and the
Flight to Quality," National Bureau of Economic Research Working Paper.

Bernanke, Ben S. and Cara S. Lown (1991). "The Credit Crunch," Brookings Papers on
Economic Activity 2, 205-248.

Calomiris, Charles, and Charles Himmelberg (1995). "Investment Banking Costs as a
Measure of the Cost of Access to External Finance," National Bureau of
Economic Research Working Paper.

Comett, Marcia M. and Hassan Tehranian (1994). "An Examination of Voluntary Versus
Involuntary Security Issuances by Commercial Banks," Journal of Financial
Economics 35, 99-122.

Fallon, Kieran (1991). "Source of Strength or Source of Weakness? A Critique of the
'Source of Strength' Doctrine in Banking Reform," New York University Law
Review 66, 1344-1403.










Fazzari, Steven M., R. Glenn Hubbard and Bruce C. Petersen (1988), "Financing
Constraints and Corporate Investment," Brookings Papers on Economic Activity
1, 141-195.

Federal Reserve Board of Governors (1996). Bank Holding Company Supervision
Manual, Federal Reserve, Washington D.C.

Furlong, Frederick T. and Michael C. Keeley (1989). "Capital Regulation and Bank Risk-
Taking: A Note," Journal of Banking and Finance 13, 883-892.

Hancock, D and J. Wilcox (1993). "Has There Been a 'Capital Crunch' in Banking? The
Effects on Bank Lending of Real Estate Market Conditions and Bank Capital
Shortfalls," Journal of Housing Economics 3, 31-50.

Haubrich, Joseph G. and Paul Wachtel, (1993). "Capital Requirements and Shifts in
Commercial Bank Portfolios," Federal Reserve Bank of Cleveland Economic
Review 29, 2-15.

Hoshi, T., A. Kashyap and D. Scharfstein (1991). "Corporate Structure, Liquidity, and
Investment," Quarterly Journal of Economics 106, 33-59.

Keeton, William (1990). "Bank Holding Companies, Cross-Bank Guarantees, and Source
of Strength," Federal Reserve Bank of Kansas City Economic Review 75, 54-67.

Lamont, Owen (1993). "Cashflow and Investment: Evidence From Internal Capital
Markets," Massachusetts Institute of Technology Working Paper.

Mikkelson, Wayne H. and Megan Partch (1986). "Valuation Effects Of Security
Offerings and the Issuance Process," Journal of Financial Economics 15, 31-60.

Myers, Stewart C. and Nicholas S. Majluf(1984). "Corporate Financing and Investment
Decisions when Firms Have Information that Investors Do Not Have," Journal of
Financial Economics 13, 187-221.

O'Hara, Maureen, and Wayne Shaw (1990). "Deposit Insurance and Wealth Effects: The
Value of Being Too Big to Fail,"' Journal of Finance 45, 1587-1600.

Passmore, Wayne and Steven A. Sharpe, (1994). "Optimal Bank Portfolios and the Credit
Crunch," Finance and Economic Discussion Series 94-19, Federal Reserve Board.

Peek, Joe and Eric S. Rosengren (1995), "Bank Regulation and the Credit Crunch,"
Journal of Banking and Finance 19, 679-693.










Sharpe, Steven A. (1995). "Bank Capitalization, Regulation, and the Credit Crunch: A
Critical Review of the Research Findings," Federal Reserve Board of Governors
Working Paper.

Stein, Jeremy C. (1995). "Internal Capital Markets and the Competition for Corporate
Resources," National Bureau of Economic Research Working Paper.

Takeda, Carolyn T. (1994). "Economic Determinants of Contingent Commitment
Activity and the Effect of Risk-Based Capital," University of Florida Working
Paper.

Thakor, Anjan V (1996). "Capital Requirements, Monetary Policy, and Aggregate Bank
Lending: Theory and Empirical Evidence," Journal of Finance 51, 279-324.

Wall, Larry and D. Peterson (1995). "Bank Holding Company Capital Targets in the
Early 1990s: The Regulators Versus the Markets," Journal of Banking and
Finance 19, 563-575.

Williamson, Oliver E. (1975). Markets and Hierarchies: Analysis and Antitrust
Implications, Collier Macmillan Publishers, Inc., New York.













BIOGRAPHICAL SKETCH

David Frederic Marcus was born the third child of Jeffery Neal and Ellen Janet

Marcus on September 4, 1968, in Eau Claire, Wisconsin. He attended the University of

Colorado at Boulder from 1986-1990. David graduated Magna Cum Laude with a

Bachelor of Science. Following graduation, David worked for two years before enrolling

at the University of Florida as a doctoral student.







I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy.


"topheZa m es, chairman
SunBan Crofessor of Finance,
Insurance, and Real Estate

I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy. /


Dr. oel F. Houston
Associate Professor of Finance
Insurance, and Real Estate


I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy.


Dr. Michael D. Ryngaert
Associate Professor of Finance
Insurance, and Real Estate

I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy. /


Sr. Jonathan H. Hamilton
Associate Professor of Economics

This dissertation was submitted to the Graduate Faculty of the Department of Finance,
Insurance, and Real Estate in the College of Business Administration and to the Graduate School
and was accepted as partial fulfillment of the requirements for the degree of Doctor of
Philosophy.


Dean, Graduate School


August, 1996

















LD
1780
199_q









UNIVERSITY OF FLORIDA
11111I 11 1 111111 i 11111111 I III I 1111111111
3 1262 08555 0852




Full Text

PAGE 1

())(&76 2) &$3,7$/ 5(*8/$7,21 $1' ,1)250$7,21 $6<00(75,(6 21 %$1. /(1',1* %\ '$9,' )5('(5,& 0$5&86 $ ',66(57$7,21 35(6(17(' 72 7+( *5$'8$7( 6&+22/ 2) 7+( 81,9(56,7< 2) )/25,'$ ,1 3$57,$/ )8/),//0(17 2) 7+( 5(48,5(0(176 )25 7+( '(*5(( 2) '2&725 2) 3+,/2623+< 81,9(56,7< 2) )/25,'$ 81,9(56,7< 2) )/25,'$ /,%5$5,(6

PAGE 2

$&.12:/('*0(176 RZH VSHFLDO WKDQNV WR 3URIHVVRUV &KULV -DPHV -RHO +RXVWRQ 0LNH 5\QJDHUW DQG 0DUN )ODQQHU\ IRU WKHLU H[FHOOHQW JXLGDQFH DQG PDQ\ SDWLHQW GLVFXVVLRQV KDYH DOVR EHQHILWHG JUHDWO\ IURP FRQYHUVDWLRQV ZLWK 3URIHVVRUV -RQ +DPLOWRQ &DURO\Q 7DNHGD &KDUOHV +DGORFN DQG -RQ *DUILQNHO 0RVW RI DOO RZH DQ HQRUPRXV GHEW WR P\ IDPLO\ DQG HVSHFLDOO\ P\ ZLIH 'HERUDK IRU WKHLU GHGLFDWLRQ WR KHOSLQJ PH UHDOL]H P\ JRDO

PAGE 3

7$%/( 2) &217(176 SDJH $&.12:/('*0(176 LL $%675$&7 LY &+$37(56 ,1752'8&7,21 %$&.*5281' ',6&866,21 /LWHUDWXUH RQ &DSLWDO 5HJXODWLRQ DQG %DQN *URZWK ,QWHUQDO $GGLWLRQV WR &DSLWDO DQG %DQN +ROGLQJ &RPSDQLHV '$7$ %$1. +2/',1* &203$1< $1$/<6,6 %$1. 68%6,',$5< $1$/<6,6 (;7(51$/ &$3,7$/ ,668$1&( 6800$5< $1' &21&/86,216 $33(1',; (67,0$7,21 2) 5,6.:(,*+7(' $66(76 5()(5(1&(6 %,2*5$3+,&$/ 6.(7&+ LQ

PAGE 4

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

PAGE 5

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

PAGE 6

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f GHEW IXQGV WKDW EDQNV FDQ XWLOL]H $V D UHVXOW EDQNV PD\ EHQHILW IURP KROGLQJ FDSLWDO JUHDWHU WKDQ UHJXODWRU\ UHTXLUHPHQWV VXUSOXV FDSLWDOf DV ILQDQFLDO VODFN 7KLV VXJJHVWV WKDW EDQNV ZLWK PRUH VXUSOXV FDSLWDO VKRXOG LQYHVW PRUH DQG WKHLU LQYHVWPHQW VKRXOG EH OHVV FRQVWUDLQHG E\ LQWHUQDOO\ JHQHUDWHG IXQGV WKDQ EDQNV ZLWK OHVV VXUSOXV FDSLWDO 0RUHRYHU LQFUHDVHV LQ FDSLWDO UHTXLUHPHQWV FDQ SURPSW D GHFOLQH LQ OHQGLQJ DV EDQNV UHSOHQLVK WKHLU VXUSOXV FDSLWDO WR LWV QHZf RSWLPDO OHYHO )RU DQ H[FHOOHQW UHYLHZ VHH %HUJHU DQG 8GHOO f DQG 6KDUSH f 6HH )D]]DUL +XEEDUG DQG 3HWHUVHQ f +RVKL .DVK\DS DQG 6FKDUIVWHLQ f DQG %HPDQNH *HUWOHU DQG *LOFKULVW f

PAGE 7

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f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f

PAGE 8

0RVW UHFHQW VWXGLHV RQ FDSLWDO UHJXODWLRQ DQG ORDQ JURZWK IRFXV RQ WKH DGRSWLRQ RI ULVNEDVHG UHTXLUHPHQWV DQG WKH VLPXOWDQHRXV fFUHGLW FUXQFKf RI WKH HDUO\ V LQ ZKLFK EDQNV DOOHJHGO\ GHFUHDVHG OHQGLQJ LQ UHVSRQVH WR WKH QHZ FDSLWDO VWDQGDUGVf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fVRXUFH RI VWUHQJWKf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f )DOORQ f DQG :DOO DQG 3HWHUVHQ f

PAGE 9

)ROORZLQJ WKH DSSURDFK RI )D]]DUL +XEEDUG DQG 3HWHUVHQ f DVVXPH WKDW FDSLWDO PDUNHW LPSHUIHFWLRQV FUHDWH D ZHGJH EHWZHHQ LQWHUQDO DQG H[WHUQDO ILQDQFLQJ FRVWV $V D UHVXOW EDQNV SUHIHU WR JURZ ZLWK LQWHUQDOO\ JHQHUDWHG IXQGV 7R FRQWURO IRU JURZWK RSSRUWXQLWLHV LQFOXGH D PHDVXUH RI 7RELQfV 4 DQG WKH EDQNfV SUHYLRXV ORDQ JURZWK DV H[SODQDWRU\ YDULDEOHV WHVW WKH K\SRWKHVLV WKDW FDSLWDO UHTXLUHPHQWV LQFUHDVH EDQNVf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f LQFHQWLYHV WR KHGJH ULVNV 7R IXUWKHU WHVW WKH H[LVWHQFH RI FDSLWDO PDUNHW IULFWLRQV IROORZ DQ DSSURDFK VLPLODU WR /DPRQW f DQG H[DPLQH WKH UHODWLRQ EHWZHHQ ORDQ JURZWK RI LQGLYLGXDO EDQN VXEVLGLDULHV RI PXOWLSOH EDQN KROGLQJ FRPSDQLHV DQG WKH VXEVLGLDU\fV RZQ HDUQLQJV DV ZHOO DV WKH HDUQLQJV RI RWKHU VXEVLGLDULHV ZLWKLQ WKH VDPH KROGLQJ FRPSDQ\ $ ILQGLQJ WKDW VXEVLGLDU\ EDQNV DUH PRUH FRQVWUDLQHG E\ WKH HDUQLQJV RI WKH UHVW RI WKH KROGLQJ FRPSDQ\ WKDQ LWV RZQ HDUQLQJV LV FRQVLVWHQW ZLWK WKH RSHUDWLRQ RI DQ LQWHUQDO FDSLWDO PDUNHW 6LQFH KROGLQJ FRPSDQ\ ZLGH HDUQLQJV PD\ SUR[\ IRU LQYHVWPHQW RSSRUWXQLWLHV DW WKH VXEVLGLDU\ /DPRQW f H[DPLQHV LQYHVWPHQW RI ILUPV ZLWK VXEVLGLDULHV LQ ERWK RLO DQG QRQRLO UHODWHG EXVLQHVV +LV UHVXOWV VXJJHVW WKDW LQYHVWPHQW RI QRQRLO UHODWHG VXEVLGLDULHV LV SRVLWLYHO\ UHODWHG WR WKH FDVK IORZV RI WKH RLO VXEVLGLDULHV

PAGE 10

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f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f HVWLPDWH XQGHUZULWLQJ IHHV DVVRFLDWHG ZLWK VHFXULW\ LVVXDQFH DIWHU FRQWUROOLQJ IRU VHOHFWLYLW\ ELDV DQG H[DPLQH WKH UHODWLRQ EHWZHHQ WKHVH IHHV DQG WKH VHQVLWLYLW\ WR LQWHUQDOO\ JHQHUDWHG IXQGV ,Q DGGLWLRQ SUHGLFW WKH DEQRUPDO VWRFN UHWXUQV DVVRFLDWHG ZLWK WKH DQQRXQFHPHQW RI D VHFXULW\ LVVXDQFH $ ILQGLQJ RI D SRVLWLYH UHODWLRQ EHWZHHQ WKHVH FRVWV RI H[WHUQDO ILQDQFH DQG WKH VHQVLWLYLW\ WR LQWHUQDOO\ JHQHUDWHG

PAGE 11

IXQGV SURYLGHV DGGLWLRQDO VXSSRUW IRU WKH K\SRWKHVLV WKDW WKH UHOLDQFH RQ LQWHUQDO IXQGV SUR[LHV IRU WKH VHYHULW\ RI FDSLWDO PDUNHW IULFWLRQV 2YHUDOO ILQG D VWURQJ SRVLWLYH FRUUHODWLRQ EHWZHHQ EDQN KROGLQJ FRPSDQ\ ORDQ JURZWK DQG LQWHUQDOO\ JHQHUDWHG DGGLWLRQV WR FDSLWDO DIWHU FRQWUROOLQJ IRU GLIIHUHQFHV LQ JURZWK RSSRUWXQLWLHV &RQVLVWHQW ZLWK WKH K\SRWKHVLV WKDW FDSLWDO UHTXLUHPHQWV LQFUHDVH EDQNVf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fV RZQ HDUQLQJV 0RUHRYHU VXEVLGLDU\ ORDQ JURZWK LV XQUHODWHG WR LWV RZQ FDSLWDOL]DWLRQ EXW SRVLWLYHO\ UHODWHG WR WKH KROGLQJ FRPSDQ\fV FDSLWDOL]DWLRQ DOVR ILQG WKDW VXEVLGLDU\ ORDQ JURZWK LV QHJDWLYHO\ UHODWHG WR ORDQ JURZWK DW RWKHU VXEVLGLDULHV ZLWKLQ WKH KROGLQJ FRPSDQ\ 7KLV LV FRQVLVWHQW ZLWK WKH RSHUDWLRQ RI DQ LQWHUQDO FDSLWDO PDUNHW LQ

PAGE 12

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f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

PAGE 13

&+$37(5 %$&.*5281' ',6&866,21 /LWHUDWXUH RQ &DSLWDO 5HJXODWLRQ DQG %DQN *URZWK %DQN FDSLWDO UHJXODWLRQ KDV FKDQJHG VXEVWDQWLDOO\ RYHU WKH SDVW ILIWHHQ \HDUV %HIRUH UHJXODWRUV UHOLHG VROHO\ RQ GLVFUHWLRQ ZKHQ HYDOXDWLQJ D EDQNfV FDSLWDO DGHTXDF\ 7R HOLPLQDWH SRWHQWLDO ELDV LQ WKH H[DPLQDWLRQ SURFHVV UHJXODWRUV DGRSWHG D PLQLPXP OHYHUDJHEDVHG FDSLWDO UDWLR LQ n $ SUREOHP ZLWK OHYHUDJHEDVHG VWDQGDUGV LV WKDW WKH ULVNLQHVV RI EDQN DVVHWV LV QRW FRQVLGHUHG ZKHQ GHWHUPLQLQJ WKH PLQLPXP FDSLWDO OHYHO $FFRUGLQJO\ EDQNV KDG LQFHQWLYHV WR DOWHU WKH ULVNLQHVV RI WKHLU DVVHW SRUWIROLRV ,Q UHVSRQVH UHJXODWRUV FUHDWHG ULVNEDVHG VWDQGDUGV ZKLFK ZHUH LPSOHPHQWHG EHJLQQLQJ LQ 7KHVH QHZ JXLGHOLQHV DVVLJQ ULVN ZHLJKWV WR DOO EDQN DVVHWV LQFOXGLQJ RIIEDODQFH VKHHW DVVHWV EDVHG RQ FUHGLW ULVN )RU H[DPSOH FRPPHUFLDO DQG LQGXVWULDO ORDQV UHFHLYH b ULVN ZHLJKW ZKLOH FDVK DQG 7UHDVXU\ VHFXULWLHV UHFHLYH D ULVN ZHLJKW RI ]HUR 6RPH UHFHQW WKHRUHWLFDO PRGHOV KDYH DWWHPSWHG WR OLQN FDSLWDO UHJXODWLRQ DQG EDQN JURZWK 8VLQJ DQ RSWLRQVSULFLQJ PRGHO )XUORQJ DQG .HHOH\ f LQYHVWLJDWH KRZ 5HJXODWLRQV UHTXLUHG WKDW EDQNV PDLQWDLQ D PLQLPXP WRWDO FDSLWDO UDWLR RI b ,Q UHJXODWRUV LQFUHDVHG WKH VWDQGDUG WR b 5HJXODWRUV LPSRVHG D PLQLPXP ULVNEDVHG UDWLR RI b EHJLQQLQJ LQ DQG b EHJLQQLQJ LQ 6HH %DQN +ROGLQJ &RPSDQ\ 6XSHUYLVLRQ 0DQXDO VHFWLRQ IRU D FRPSOHWH GHVFULSWLRQ RI ULVNEDVHG FDSLWDO VWDQGDUGV

PAGE 14

LQFUHDVHV LQ UHTXLUHPHQWV DIIHFW EDQN ULVN WDNLQJ EHKDYLRU 3XEOLF RSLQLRQ KHOG WKDW EDQNV ZRXOG UHVSRQG WR LQFUHDVHG UHTXLUHPHQWV E\ LQFUHDVLQJ DVVHW ULVN WR RIIVHW WKH FRVW RI KROGLQJ PRUH FDSLWDO &RQWUDU\ WR WKLV SUHGLFWLRQ )XUORQJ DQG .HHOH\ VKRZ WKDW EDQNV DFWXDOO\ GHFUHDVH DVVHW ULVN IROORZLQJ DQ LQFUHDVH LQ UHTXLUHPHQWV $OWKRXJK WKLV LV H[FHOOHQW QHZV IRU WKH )',& LW KDV OHVV WR VD\ DERXW KRZ EDQN JURZWK UHVSRQGV LI DW DOO WR FKDQJHV LQ FDSLWDO UHTXLUHPHQWV 3DVVPRUH DQG 6KDUSH f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f DV D EXIIHU VWRFN DJDLQVW IXQGLQJ VKRUWDJHV %HUJHU DQG 8GHOO f QRWH WKDW WKH FRPPHUFLDO DQG LQGXVWULDO OHQGLQJ GHFOLQH LQ WKH HDUO\ V ZDV QRW FRQFHQWUDWHG LQ EDQNV ZLWK ORZ ULVNEDVHG FDSLWDO UDWLRV ,Q WXUQ WKH\ FLWH WKLV DV HYLGHQFH WKDW ULVNEDVHG VWDQGDUGV ZHUH XQOLNHO\ WR KDYH FDXVHG WKH FUHGLW FUXQFK

PAGE 15

7KDNRU f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fFUHGLW FUXQFKf RI WKH HDUO\ V 7R GDWH WKH OLWHUDWXUH RIIHUV PL[HG SUHGLFWLRQV 3HHN DQG 5RVHQJUHQ f DQG +DQFRFN DQG :LOFR[ f H[DPLQH KRZ ORDQ JURZWK GLIIHUV IRU EDQNV EDVHG RQ ZKHWKHU WKH\ SDVV RU IDLO FDSLWDO UHTXLUHPHQWV 3HHN DQG 5RVHQJUHQ f VWXG\ JURZWK RI 1HZ (QJODQG EDQNV ZKLFK XQGHUZHQW IRUPDO UHJXODWRU\ HQIRUFHPHQW DFWLRQV EHWZHHQ DQG $IWHU FRQWUROOLQJ IRU VL]H WLPH

PAGE 16

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f LW GRHV OLPLW WKHLU DELOLW\ WR WHVW ZKHWKHU WKH FKDQJH WR ULVNEDVHG VWDQGDUGV KDG DQ\ LPSDFW RQ ORDQ JURZWK +DQFRFN DQG :LOFR[ f VWXG\ WKH FURVVVHFWLRQDO GHWHUPLQDQWV RI EDQN ORDQ DQG VHFXULW\ JURZWK GXULQJ DQG EDVHG RQ ZKHWKHU EDQNV H[SHULHQFHG D fFDSLWDO VKRUWIDOOf GXULQJ WKHLU VDPSOH SHULRG &DSLWDO VKRUWIDOO LV GHILQHG DV WKH GLIIHUHQFH EHWZHHQ WKH DFWXDO \HDU HQG FDSLWDO DQG WKH UHJXODWRU\ PLQLPXP EDVHG RQ WKH EHJLQQLQJ RI \HDU WRWDO DVVHWV DQG D b FDSLWDO UHTXLUHPHQW ,Q VKRUW WKHLU ILQGLQJV UHYHDO WKDW D FDSLWDO VKRUWIDOO KDV D ODUJH QHJDWLYH FURVVVHFWLRQDO HIIHFW RQ ORDQ JURZWK LQ 7KH DXWKRUV UHDVRQHG WKDW EDQNV FRXOG ODUJHO\ DQWLFLSDWH WKH DPRXQW RI FDSLWDO WKDW ZRXOG EH RQ WKH ERRNV DW \HDU HQG DQG WKDW WKLV LV WKH ILJXUH WKDW VKRXOG LQIOXHQFH JURZWK

PAGE 17

$ SRWHQWLDO SUREOHP ZLWK WKLV VWXG\ LV WKH DXWKRUVf WUHDWPHQW RI FDSLWDO VKRUWIDOO 7KH\ DVVXPH WKDW D b PLQLPXP OHYHUDJHEDVHG VWDQGDUG LQWURGXFHG LQ f UHPDLQV LQ HIIHFW WKURXJK +RZHYHU FDSLWDO VWDQGDUGV KDYH EHHQ LQFUHDVHG WZLFH VLQFH +HQFH WKH DXWKRUV VLJQLILFDQWO\ XQGHUVWDWH WKH QXPEHU RI EDQNV H[SHULHQFLQJ D FDSLWDO VKRUWIDOO DQG DFWXDOO\ IRFXV RQ RQO\ WKH PRVW FDSLWDO GHILFLHQW EDQNV 7KHUHIRUH DVFHUWDLQLQJ H[DFWO\ KRZ D FDSLWDO VKRUWIDOO DIIHFWV JURZWK LV GLIILFXOW JLYHQ WKH IRUPXODWLRQ RI WKHVH WHVWV 'XH WR WKH SRVVLEOH LQFHQWLYH EDQNV PD\ KDYH JDLQHG WR VKLIW DVVHWV RXW RI ORDQV DQG LQWR VHFXULWLHV +DXEULFK DQG :DFKWHO f H[SORUH KRZ ULVNEDVHG VWDQGDUGV PD\ LQIOXHQFH DVVHW SRUWIROLR FKRLFH 7KH DXWKRUV VRUW EDQNV DFFRUGLQJ WR ULVNEDVHG UDWLRV DQG DQDO\]H VXEVHTXHQW FKDQJHV LQ SRUWIROLR PL[ 7KHLU UHVXOWV VXJJHVW WKDW EDQNV LQ ORZHU FDSLWDO JURXSV WHQG WR VKLIW WRZDUG DVVHWV ZLWK ORZHU ULVN ZHLJKWV DQG LQ SDUWLFXODU DZD\ IURP FRPPHUFLDO ORDQV DQG LQWR 7UHDVXU\ VHFXULWLHV 7KH\ LQWHUSUHW WKLV DV HYLGHQFH WKDW ULVNEDVHG VWDQGDUGV PD\ KDYH SDUWLDOO\ FDXVHG WKH FUHGLW FUXQFK 6LQFH WKH DXWKRUV IDLO WR SURYLGH D EHQFKPDUN SHULRG IRU FRPSDULQJ EDQN EHKDYLRU KRZHYHU LW LV SRVVLEOH WKDW DQ\ FKDQJHV LQ SRUWIROLR PL[ REVHUYHG LV VLPSO\ RSWLPDO UHEDODQFLQJ ZLWKRXW UHJDUG WR FDSLWDO UHTXLUHPHQWV /LNHZLVH WKH DXWKRUV GR QRW FRQWURO IRU EDQN VL]H JURZWK RSSRUWXQLWLHV ORDQ ORVV SURYLVLRQV RU SUHYLRXV JURZWK DOO RI ZKLFK PD\ VLJQLILFDQWO\ LPSDFW DVVHW SRUWIROLR VKLIWV ,W FRXOG EH DUJXHG WKDW WKH FKDQJH WR ULVNEDVHG VWDQGDUGV GLG QRW FRQVWLWXWH DQ LQFUHDVH LQ UHTXLUHPHQWV VLQFH VRPH EDQNV ZRXOG DFWXDOO\ ILQG WKHLU UHTXLUHG FDSLWDO GHFOLQLQJ GXH WR WKH QHZ VWDQGDUGV +RZHYHU IRU WKH PDMRULW\ RI EDQNV DQG HVSHFLDOO\ WKH ODUJHU EDQNV WKH FKDQJH WR ULVNEDVHG VWDQGDUGV FDQ EH FRQVLGHUHG DQ LQFUHDVH LQ UHTXLUHPHQWV

PAGE 18

*LYHQ WKH H[LVWHQFH RI FDSLWDO PDUNHW LPSHUIHFWLRQV ORDQ JURZWK PD\ EH GLUHFWO\ UHODWHG WR FDSLWDOL]DWLRQ ,Q WKLV YHLQ %HUQDQNH DQG /RZQ f DQG %HUJHU DQG 8GHOO f LQYHVWLJDWH D GLUHFW OLQN EHWZHHQ FDSLWDOL]DWLRQ DQG JURZWK %HUQDQNH DQG /RZQ f H[DPLQH JURZWK DV D IXQFWLRQ RI EHJLQQLQJ RI SHULRG FDSLWDO UDWLRV ,Q WKHLU LQWHUSUHWDWLRQ FRHIILFLHQWV RQ FDSLWDOL]DWLRQ VHUYH WR LGHQWLI\ VKRUW UXQ HIIHFWV RYHU D SHULRG GXULQJ ZKLFK FDSLWDO PLJKW EH UHDVRQDEO\ WUHDWHG DV H[RJHQRXV 5HO\LQJ RQ DJJUHJDWH VWDWH OHYHO GDWD WKHLU ILQGLQJV VXJJHVW WKDW ORDQ JURZWK LV SRVLWLYHO\ UHODWHG WR FDSLWDOL]DWLRQ $ SRWHQWLDO SUREOHP ZLWK WKLV VWXG\ LV WKH XWLOL]DWLRQ RI VWDWH OHYHO GDWD 7KLV DQDO\VLV LV OLNHO\ WR GURS SRWHQWLDOO\ LPSRUWDQW LQIRUPDWLRQ VSHFLILF WR LQGLYLGXDO EDQNV 3UREDEO\ WKH PRVW FLWHG VWXG\ LQ WKLV DUHD %HUJHU DQG 8GHOO f XVH D ORQJ SDQHO RI REVHUYDWLRQV WR LQYHVWLJDWH DVVHW JURZWKfV UHODWLRQVKLS ZLWK FDSLWDOL]DWLRQ ,Q SDUWLFXODU WKH\ H[DPLQH GLIIHUHQFHV LQ DVVHW H[SDQVLRQ GXULQJ WKH FUHGLW FUXQFK HDUO\ Vf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

PAGE 19

FRHIILFLHQW HVWLPDWHV PD\ QRW FKDQJH DW DOO 7KHUHIRUH WKH ILQGLQJ WKDW ORDQ JURZWK LV QRW PRUH DIIHFWHG E\ FDSLWDOL]DWLRQ GXULQJ WKH V LV QRW SURRI WKDW WKH FKDQJH WR ULVNEDVHG VWDQGDUGV KDG QR HIIHFW 0RUHRYHU WKH ILQGLQJ RI D GHFOLQH LQ OHQGLQJ DW EDQNV ZLWK KLJK FDSLWDO UDWLRV GRHV QRW LPSO\ WKDW WKH FKDQJH LQ FDSLWDO VWDQGDUGV KDG QR HIIHFW 5HFDOO WKDW 3DVVPRUH DQG 6KDUSH f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fV FDSLWDO VKRUWIDOO +RZHYHU P\ PHDVXUH UHTXLUHV EDQNV WR FRPSO\ ZLWK FDSLWDO UHTXLUHPHQWV H[DFWO\ DV GHILQHG E\ UHJXODWLRQV

PAGE 20

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f $ QXPEHU RI VWXGLHV VRPH FLWHG DERYHf H[DPLQH WKH HPSLULFDO UHODWLRQ EHWZHHQ EDQN JURZWK DQG FDSLWDOL]DWLRQ DQG LQ SDUWLFXODU LQYHVWLJDWH WKH VHQVLWLYLW\ RI JURZWK WR FDSLWDO VKRFNV +RZHYHU H[FHSW ZRUN E\ %DHU DQG 0F(OUDYH\ f VWXGLHV GR QRW H[SOLFLWO\ H[DPLQH WKH VHQVLWLYLW\ RI ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO 6LQFH DQ XQGHUO\LQJ DVVXPSWLRQ IRU FDSLWDO VKRFNV WR DGYHUVHO\ DIIHFW ORDQ JURZWK LV FDSLWDO PDUNHW IULFWLRQ ZKLFK FUHDWHV D ZHGJH EHWZHHQ LQWHUQDO DQG H[WHUQDO ILQDQFH FRVWV ORDQ JURZWK LV H[SHFWHG WR EH SRVLWLYHO\ UHODWHG WR LQWHUQDO DGGLWLRQV WR FDSLWDO 6HH 0\HUV DQG 0DMOXI f DQG )D]]DUL +XEEDUG DQG 3HWHUVHQ f 'XH WR WKH ZD\ LQ ZKLFK FDSLWDO UHTXLUHPHQWV DUH FDOFXODWHG LQWHUQDO DGGLWLRQV WR FDSLWDO GLIIHUV VOLJKWO\ IURP LQWHUQDOO\ JHQHUDWHG FDVK IORZV IRU QRQIPDQFLDO ILUPV &KDSWHU GLVFXVVHV WKH GLIIHUHQFHV LQ GHWDLO

PAGE 21

%DHU DQG 0F(OUDYH\ f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fV 4 SUHYLRXV JURZWK RU ORDQ ORVV SURYLVLRQV ,Q DGGLWLRQ WKHLU PHDVXUH RI LQWHUQDOO\ JHQHUDWHG FDSLWDO LV DIWHU GHGXFWLRQV IRU GLYLGHQG SD\PHQWV DQG ORDQ ORVV SURYLVLRQV 6LQFH WKHVH DUH ERWK HQGRJHQRXV FKRLFH YDULDEOHV PDQDJHPHQW KDV LQ LWV FRQWURO WKH LQFOXVLRQ RI WKHVH LWHPV LQ UHJUHVVLRQV PD\ OHDG WR PLVOHDGLQJ UHVXOWV 7KH DXWKRUV DOVR GR QRW PHQWLRQ OLTXLGLW\ VSHFLILFDOO\ VHFXULWLHV KROGLQJV SOD\LQJ D UROH LQ WKHLU LQYHVWPHQW PRGHO 7KLV LV VXUSULVLQJ VLQFH VLPLODU VWXGLHV IRU QRQILQDQFLDO ILUPV JHQHUDOO\ UHFRJQL]H ILUP OLTXLGLW\ DV DQ LPSRUWDQW GHWHUPLQDQW RI JURZWK $OWKRXJK LW LV FRQFHLYDEOH WKDW WKH DYDLODELOLW\ RI LQVXUHG GHSRVLW ILQDQFLQJ REYLDWHV WKH QHHG WR ZRUU\ DERXW OLTXLGLW\ WKH H[LVWHQFH RI FDSLWDO UHTXLUHPHQWV OLPLWV WKH DPRXQW RI GHSRVLW ILQDQFLQJ DOORZDEOH $V D UHVXOW OLTXLGLW\ VKRXOG EH DQ LPSRUWDQW FRQWULEXWRU WR LQYHVWPHQW

PAGE 22

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fV ORDQ JURZWK VKRXOG SDUWLDOO\ GHSHQG RQ LWV RZQ HDUQLQJV 7KH $PHQGPHQWV WR WKH %DQN +ROGLQJ &RPSDQ\ $FW RI SURYLGH D GHILQLWLRQ RI D EDQN KROGLQJ FRPSDQ\ DQG HVWDEOLVKHV OLPLWV RQ WKH DFWLYLWLHV LQ ZKLFK KROGLQJ FRPSDQLHV PD\ HQJDJH

PAGE 23

2QH UHVWULFWLRQ LQ SDUWLFXODU LV WKH UHTXLUHPHQW WKDW DOO VXEVLGLDULHV SOXV WKH KROGLQJ FRPSDQ\ PXVW LQGLYLGXDOO\ PDLQWDLQ PLQLPXP FDSLWDO UDWLRV 7KLV fEXLOGLQJ EORFNf DSSURDFK LPSOLHV WKDW IDLOXUH RI DQ\ VXEVLGLDU\ WR PHHW FDSLWDO VWDQGDUGV ZLOO LPSHGH WKH KROGLQJ FRPSDQ\fV DELOLW\ WR PDQDJH FDSLWDO RQ D FRQVROLGDWHG EDVLV $ VHFRQG UHVWULFWLRQ LV WKH )HGHUDO 5HVHUYH SROLF\ RI YLHZLQJ WKH KROGLQJ FRPSDQ\ DV D fVRXUFH RI VWUHQJWKf WR LQGLYLGXDO VXEVLGLDULHV 7KLV FUHDWHV DQ REOLJDWLRQ IRU WKH KROGLQJ FRPSDQ\ WR GRZQVWUHDP FDSLWDO WR LQDGHTXDWHO\ FDSLWDOL]HG VXEVLGLDULHV $V D UHVXOW KROGLQJ FRPSDQLHV PD\ QRW EH DEOH WR DOORFDWH FDSLWDO WR VXEVLGLDULHV ZLWK SRVLWLYH 139 SURMHFWV )LQDOO\ VHFWLRQV $ DQG % RI WKH )HGHUDO 5HVHUYH $FW SODFH UHVWULFWLRQV RQ LQWHUn FRPSDQ\ WUDQVIHUV 6SHFLILFDOO\ GLYLGHQGV IHHV DQG LQWHUFRPSDQ\ DVVHW VDOHV DUH UHVWULFWHG WR WUDQVIHUV RI OHVV WKDQ SHUFHQW RI WKH EDQNfV FDSLWDO $JDLQ WKHVH UHVWULFWLRQV OLPLW WKH DELOLW\ RI WKH KROGLQJ FRPSDQ\ WR DOORFDWH FDSLWDO RQ D FRQVROLGDWHG EDVLV DQDO\]H WKH HIIHFWV RI FDSLWDO PDUNHW LPSHUIHFWLRQV RQ WKH VHQVLWLYLW\ RI EDQN LQYHVWPHQW DW ERWK WKH KROGLQJ FRPSDQ\ DQG VXEVLGLDU\ OHYHO WR LQWHUQDOO\ JHQHUDWHG DGGLWLRQV WR FDSLWDO DVVXPH WKDW ORDQ JURZWK QHW RI ORDQ ORVVHVf LV WKH EDQNLQJ HTXLYDOHQW RI LQYHVWPHQW E\ QRQILQDQFLDO ILUPV *LYHQ WKH H[LVWHQFH RI FDSLWDO PDUNHW 6HH WKH %DQN +ROGLQJ &RPSDQ\ 6XSHUYLVLRQ 0DQXDO VHFWLRQV DQG 6HH VHFWLRQ RI WKH %DQN +ROGLQJ &RPSDQ\ 6XSHUYLVLRQ 0DQXDO %DQN LQYHVWPHQW LQ UHDO DVVHWV LV OHVV WKDQ SHUFHQW RI WRWDO DVVHWV $UJXDEO\ LQYHVWPHQW VKRXOG FRQVLGHU VHFXULWLHV +RZHYHU RQH PRWLYH IRU EDQN LQYHVWPHQW LQ VHFXULWLHV LV OLTXLGLW\ FRQWURO IRU VHFXULWLHV KROGLQJV DV D IRUP RI EDQN OLTXLGLW\ ZKHQ DQDO\]LQJ ORDQ JURZWK

PAGE 24

LPSHUIHFWLRQV ZKLFK FUHDWH D ZHGJH EHWZHHQ LQWHUQDO DQG H[WHUQDO ILQDQFH RQH ZRXOG H[SHFW D SRVLWLYH UHODWLRQ EHWZHHQ KROGLQJ FRPSDQ\ ORDQ JURZWK DQG LQWHUQDOO\ JHQHUDWHG IXQGV 0RUHRYHU VLQFH FDSLWDO UHTXLUHPHQWV OLPLW D EDQNfV DELOLW\ WR VXEVWLWXWH GHSRVLWV IRU HTXLW\ H[SHFW WKH VHQVLWLYLW\ RI ORDQ JURZWK WR LQWHUQDOO\ JHQHUDWHG IXQGV LQYHVWPHQW FDVKIORZ VHQVLWLYLW\f WR EH JUHDWHVW IRU ILUPV ZKHUH WKH FDSLWDO UHTXLUHPHQW LV PRVW ELQGLQJ DOVR H[DPLQH KRZ WKH QDWXUH RI HQIRUFHG FDSLWDO UHTXLUHPHQWV DIIHFWV EDQN LQYHVWPHQWFDVKIORZ VHQVLWLYLWLHV ,Q SDUWLFXODU ZLWK UHJXODWRUV PDQGDWLQJ OHYHUDJHEDVHG FDSLWDO VWDQGDUGV VHFXULWLHV KROGLQJV PD\ VXEVWLWXWH IRU VXUSOXV FDSLWDO DV ILQDQFLDO VODFN 7KLV LV EHFDXVH EDQNV FDQ IXQG JURZWK WKURXJK WKH OLTXLGDWLRQ RI VHFXULWLHV ZLWKRXW FKDQJLQJ UHTXLUHG FDSLWDO OHYHOV 7KHUHIRUH H[SHFW WKH LQYHVWPHQWFDVKIORZ VHQVLWLYLWLHV WR EH GHFUHDVLQJ WKH LQ DPRXQW RI VHFXULWLHV UHODWLYH WR DVVHWVf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fV PDUNHW WR ERRN YDOXH RI DVVHWV DV D PHDVXUH RI 7RELQfV 4 ,Q DGGLWLRQ LQFOXGH WKH EDQNfV SUHYLRXV JURZWK DV D VHFRQG SUR[\ IRU JURZWK RSSRUWXQLWLHV H[SHFW D SRVLWLYH UHODWLRQ EHWZHHQ ORDQ JURZWK DQG ERWK WKH PDUNHW WR ERRN UDWLR DQG ODJJHG ORDQ JURZWK

PAGE 25

$Q DGGLWLRQDO FKHFN RQ WKH H[LVWHQFH RI FDSLWDO PDUNHW IULFWLRQV LV WR H[DPLQH WKH RSHUDWLRQ RI WKH LQWHUQDO FDSLWDO PDUNHW ZLWKLQ D KROGLQJ FRPSDQ\ 6SHFLILFDOO\ LI D SRVLWLYH FRUUHODWLRQ EHWZHHQ FDVK IORZV DQG ORDQ GHPDQG GULYHV WKH UHODWLRQ EHWZHHQ FDVK IORZV DQG ORDQ JURZWK WKHQ VXEVLGLDU\ ORDQ JURZWK VKRXOG EH SRVLWLYHO\ UHODWHG WR VXEVLGLDU\ FDVK IORZV 0RUHRYHU KROGLQJ FRPSDQ\ FDVK IORZV QHW RI WKH VXEVLGLDU\fV FDVK IORZVf ZLOO EH UHODWHG WR ORDQ JURZWK DW WKH VXEVLGLDU\ OHYHO RQO\ WR WKH H[WHQW WKDW WKH\ SUR[\ IRU ORFDO GHPDQG FKDUDFWHULVWLFV ,W LV OLNHO\ WKDW KROGLQJ FRPSDQ\ FDVK IORZV DUH D SRRUHU SUR[\ IRU ORFDO GHPDQG WKHQ VXEVLGLDU\ FDVK IORZV 7KXV LQ WKH DEVHQFH RI FDSLWDO PDUNHW LPSHUIHFWLRQV WKH\ ZRXOG EH H[SHFWHG WR EH OHVV LPSRUWDQW WKDQ WKH VXEVLGLDU\f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

PAGE 26

EDQNV IDFH EDQNV ZLWK D ODUJH LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ DUH H[SHFWHG WR EH OHVV ZLOOLQJ WR LVVXH H[WHUQDO FDSLWDO GHYHORS D ORJLW PRGHO ZKLFK SUHGLFWV EDQNVf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f HVWLPDWH DQWLFLSDWHG XQGHUZULWLQJ IHHV EDVHG RQ ILUP FKDUDFWHULVWLFV DIWHU FRQWUROOLQJ IRU VHOHFWLYLW\ ELDV ,Q D OLNHZLVH IDVKLRQ HVWLPDWH H[SHFWHG DEQRUPDO VWRFN UHWXUQV DVVRFLDWHG ZLWK WKH DQQRXQFHPHQW RI D VHFXULW\ LVVXDQFH $ ILQGLQJ WKDW EDQNV WKDW DQWLFLSDWH ODUJHU XQGHUZULWLQJ IHHV RU PRUH QHJDWLYH DEQRUPDO VWRFN UHWXUQV KDYH KLJKHU LQYHVWPHQW FDVKIORZ VHQVLWLYLWLHV ZRXOG SURYLGH DGGLWLRQDO VXSSRUW IRU WKH K\SRWKHVLV WKDW H[SHFWHG H[WHUQDO ILQDQFH FRVWV DIIHFW EDQNVf GHSHQGHQFH RQ LQWHUQDOO\ JHQHUDWHG IXQGV

PAGE 27

&+$37(5 '$7$ FROOHFW EDQN KROGLQJ FRPSDQ\ GDWD IURP WKH )HGHUDO 5HVHUYH < WDSHV IURP DQQXDO REVHUYDWLRQVf %DQNV LQFOXGHG LQ WKH VDPSOH DUH UHTXLUHG WR KDYH D PLQLPXP RI WZR \HDUV RI GDWD D QRQQHJDWLYH ERRN YDOXH RI HTXLW\ DQG DQ DYDLODEOH PDUNHW YDOXH RI FRPPRQ HTXLW\ $OO VWRFN SULFH GDWD FRPH IURP WKH &563 DQG 1$6' PDVWHU WDSHV 7KH ILQDO KROGLQJ FRPSDQ\ VDPSOH FRQWDLQV EDQNV DQG REVHUYDWLRQV 6XEVLGLDU\ EDQN GDWD DUH FROOHFWHG IURP WKH )HGHUDO 5HVHUYH 5HSRUWV RI ,QFRPH DQG &RQGLWLRQ &DOO 5HSRUWVf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ff 7\SLFDOO\ LQYHVWPHQW LV FRQVLGHUHG FKDQJHV LQ SURSHUW\ SODQW DQG HTXLSPHQW GHIODWHG E\ WKH ILUPfV FDSLWDO VWRFN DW WKH EHJLQQLQJ RI WKH

PAGE 28

SHULRG &DSLWDO VWRFN LV XVXDOO\ SUR[LHG E\ SURSHUW\ SODQW DQG HTXLSPHQW ,Q DGGLWLRQ WKH H[LVWLQJ OLWHUDWXUH JHQHUDOO\ GHIODWHV LQWHUQDOO\ JHQHUDWHG IXQGV E\ WKH FDSLWDO VWRFN FRQVLGHU EDQN LQYHVWPHQW WR EH WKH FKDQJH LQ ORDQV RXWVWDQGLQJ DQG WKH FDSLWDO VWRFN WR EH WKH EHJLQQLQJ RI SHULRG ORDQV RXWVWDQGLQJ 7KHUHIRUH LQYHVWPHQW ORDQ JURZWKf LV GHILQHG DV WKH SHUFHQWDJH FKDQJH LQ ORDQV RXWVWDQGLQJ 7KH DSSURSULDWH PHDVXUH RI LQWHUQDOO\ JHQHUDWHG IXQGV IRU EDQNLQJ ILUPV GLIIHUV VOLJKWO\ IURP WKH PHDVXUH XVHG LQ VWXGLHV RI QRQIPDQFLDO ILUPV 6SHFLILFDOO\ VWXGLHV RI QRQILQDQFLDO ILUPV JHQHUDOO\ PHDVXUH LQWHUQDOO\ JHQHUDWHG FDVK IORZV DV QHW LQFRPH EHIRUH H[WUDRUGLQDU\ LWHPV SOXV GHSUHFLDWLRQ +RZHYHU EDQNV PD\ QRW EH DV FRQVWUDLQHG E\ FDVK IORZ DV QRQILQDQFLDO ILUPV EHFDXVH RI WKH DYDLODELOLW\ RI LQVXUHG GHSRVLW ILQDQFLQJ 1HYHUWKHOHVV WKH\ DUH FRQVWUDLQHG E\ WKH DPRXQW RI GHEW ILQDQFLQJ WKH\ FDQ XWLOL]H 5HJXODWLRQV PDQGDWH FDSLWDO UHTXLUHPHQWV ZKLFK OLPLW EDQNVf DELOLW\ WR ERUURZ DQG WKXV EDQNV VKRXOG EH FRQFHUQHG ZLWK WKH DPRXQW RI UHJXODWRU\ FDSLWDO WKDW WKH\ JHQHUDWH PHDVXUH LQWHUQDOO\ JHQHUDWHG IXQGV DV QHW LQFRPH EHIRUH H[WUDRUGLQDU\ LWHPV SOXV GHSUHFLDWLRQ DQG DGGLWLRQV WR ORDQ ORVV SURYLVLRQV VLQFH ORDQ ORVV SURYLVLRQV DUH D QRQn FDVK H[SHQVH DQG DUH LQFOXGHG LQ UHJXODWRU\ FDSLWDOf DQG VFDOH WKLV PHDVXUH E\ WKH EHJLQQLQJ RI SHULRG ORDQ EDODQFH 7R FRQWURO IRU GLIIHUHQFHV LQ LQYHVWPHQW RSSRUWXQLWLHV XVH WKH KROGLQJ FRPSDQ\fV PDUNHW WR ERRN UDWLR D SUR[\ IRU 7RELQfV 4f DW WKH HQG RI WKH SULRU \HDU DQG WKH EDQNfV SUHYLRXV SHULRG ORDQ JURZWK )XUWKHUPRUH LQFOXGH WKH ORJ RI DVVHWV DV D FRQWURO IRU HFRQRPLHV RI VFDOH 5HVXOWV DUH VLPLODU LI GR QRW LQFOXGH DGGLWLRQV WR ORDQ ORVVHV DV SDUW RI LQWHUQDOO\ JHQHUDWHG IXQGV 7KH UHVXOWV DUH DOVR VLPLODU LI GHGXFW GLYLGHQG SD\PHQWV IURP LQWHUQDOO\ JHQHUDWHG IXQGV 6HH &KDSWHU IRU PRUH GHWDLO

PAGE 29

7R GHWHUPLQH WKH HIIHFW RI FDSLWDOL]DWLRQ RQ ORDQ JURZWK HVWLPDWH VXUSOXV FDSLWDO IRU DOO EDQNV ERWK KROGLQJ FRPSDQLHV DQG VXEVLGLDULHV 6XUSOXV FDSLWDO LV GHILQHG DV WKH EDQNf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f LV UHVWULFWHG WR EH QR JUHDWHU WKDQ WKH SULPDU\ SRUWLRQ RI FDSLWDO ,Q DGGLWLRQ FXUUHQW UHJXODWLRQV UHTXLUH SHUFHQW 7LHU DQG SHUFHQW 7LHU ,, FDSLWDO UDWLRV +HQFH LW LV REYLRXV WKDW EDQNV ZKLFK SDVV WKH 7LHU ,, UHTXLUHPHQW PXVW E\ GHILQLWLRQ KDYH SDVVHG WKH 7LHU UHTXLUHPHQW 6XUSOXV FDSLWDO SURYLGHV DQ LQGLFDWLRQ RI ILQDQFLDO VODFN L H WKH FXVKLRQ EDQNV KDYH LQ WKHLU FDSLWDO UDWLRV VLPLODU WR WKH FDVK DQG OLTXLG DVVHWV PHDVXUH XVHG LQ VWXGLHV RI QRQILQDQFLDO ILUPVf DOVR LQFOXGH D GXPP\ YDULDEOH %,1' ZKLFK HTXDOV RQH LI FDSLWDO VXUSOXV LV QRQSRVLWLYH DQG ]HUR RWKHUZLVH 7KLV YDULDEOH LQGLFDWHV ZKHWKHU D EDQN IDLOHG WR PHHW WKH PLQLPXP FDSLWDO UHTXLUHPHQW LQ DQ\ JLYHQ \HDU 'DWD IRU ULVNEDVHG FDSLWDO UDWLRV DUH QRW DYDLODEOH 7KHUHIRUH UHO\ RQ D PHWKRGRORJ\ SUHVHQWHG E\ 7DNHGD f WR HVWLPDWH ULVNEDVHG UDWLRV 6HH $SSHQGL[ IRU D GHVFULSWLRQ RI WKLV PHWKRGRORJ\ 7LHU ,, FDSLWDO LV GHILQHG DV WRWDO HTXLW\ SOXV VXERUGLQDWHG QRWHV SOXV WKH DOORZDQFH IRU ORDQ ORVVHV DOO VFDOHG E\ DVVHWV HLWKHU WRWDO RU ULVNZHLJKWHGf 7RWDO HTXLW\ LQFOXGHV ERWK FRPPRQ DQG SUHIHUUHG HTXLW\ 7HVWV ZHUH DOVR SHUIRUPHG XVLQJ WKH SULPDU\ RU 7LHU UDWLR VLPSO\ WRWDO HTXLW\ RYHU DVVHWVf ZLWK VLPLODU UHVXOWV

PAGE 30

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f E\ EDQN KROGLQJ FRPSDQLHV WKDW ZHUH SXEOLFO\ WUDGHG LQ WKH 8QLWHG 6WDWHV IURP 7KHVH RIIHULQJV FRQVLVW RI FRPPRQ VWRFN SUHIHUUHG VWRFN RU VXERUGLQDWHG QRWHV 7KH LQLWLDO VDPSOH RI LVVXDQFHV ZDV FROOHFWHG IURP WKH ,QYHVWPHQW 'HDOHUfV 'LJHVW ,''f VHDUFKHG 'RZ -RQHV 1HZV 5HWULHYDO IRU WKH DQQRXQFHPHQW RI WKHVH LVVXDQFHV DQG XVHG WKHVH GDWHV DV WKH LQLWLDO DQQRXQFHPHQW GDWH ,I QR PHQWLRQ RI WKH RIIHULQJ ZDV IRXQG RQ 'RZ -RQHV 1HZV 5HWULHYDO XVHG WKH UHJLVWUDWLRQ GDWH OLVWHG LQ WKH ,'' 7KH ILQDO VDPSOH FRQWDLQV VHFXULW\ RIIHULQJV E\ GLIIHUHQW EDQN KROGLQJ FRPSDQLHV 7R FDOFXODWH DEQRUPDO UHWXUQV IROORZLQJ WKH DQQRXQFHPHQW RI D VHFXULW\ RIIHULQJ XVH WKH VWDQGDUG HYHQW VWXG\ PHWKRGRORJ\ VHH $VTXLWK DQG 0XOOLQV ff $OO VWRFN UHWXUQ GDWD DUH FROOHFWHG IURP HLWKHU WKH &563 RU 1$6' GDWD WDSHV $EQRUPDO UHWXUQV IRU VHFXULW\ RQ HYHQW GDWH W DUH GHILQHG DV 6HH $SSHQGL[ IRU HVWLPDWLRQ RI ULVNZHLJKWHG DVVHWV

PAGE 31

$5LW 5LW FW 5Pf ZKHUH 5L DQG 5PW DUH WKH UDWH RI UHWXUQ RQ VHFXULW\ L DQG WKH UHWXUQ RQ WKH &563 HTXDOO\ ZHLJKWHG LQGH[ RQ HYHQW GD\ W UHVSHFWLYHO\ 7KH FRHIILFLHQWV D DQG 3 DUH RUGLQDU\ OHDVW VTXDUHV HVWLPDWHV RI WKH LQWHUFHSW DQG VORSH RI WKH PDUNHW PRGHO UHJUHVVLRQ 7KH HVWLPDWLRQ SHULRG XVHG IRU WKH PDUNHW PRGHO FRPHV IURP WKH SHULRG W WKURXJK W ZKHUH W HTXDOV WKH HYHQW GD\f 7KH DYHUDJH DEQRUPDO UHWXUQ IRU D SRUWIROLR RI 1 VHFXULWLHV LV 1 $$5 7 $5 7KH WHVW VWDWLVWLF =f IRU $$5 LV EDVHG RQ WKH VWDQGDUGL]HG DEQRUPDO UHWXUQ 6$5c KDV D XQLWQRUPDO GLVWULEXWLRQ DQG LV FDOFXODWHG DV = e 6$58 L :KHUH 6$5r $5 6LW L 5 5 f V >Y>L B/BXPf§f§f§@@n J ( N DQG 6c LV WKH UHVLGXDO VWDQGDUGL]HG HUURU IURP WKH PDUNHW PRGHO UHJUHVVLRQ 5PIF WKH UHWXUQ RQ WKH PDUNHW SRUWIROLR IRU WKH 0L GD\ RI WKH HVWLPDWLRQ SHULRG DQG 5P WKH DYHUDJH UHWXUQ RI WKH PDUNHW SRUWIROLR IRU WKH HVWLPDWLRQ SHULRG

PAGE 32

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f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

PAGE 33

7DEOH 'HVFULSWLYH VWDWLVWLFV PHDQV ZLWK PHGLDQV LQ SDUHQWKHVHVf IRU SXEOLFO\ WUDGHG EDQN KROGLQJ FRPSDQLHV YDULDEOH OXOO VDPSOH 7RWDO $VVHWV PLOOLRQVf f f f f /RDQ *URZWKE f f r f r r f r ,QWHUQDO $GGLWLRQV WR &DSLWDO /RDQVn f f r f r f 0DUNHW %RRN $VVHWVn f f r f r f %RRN &DSLWDO LQ ([FHVV RI 5HTXLUHPHQW $VVHWVH f f f r f r 3HUFHQWDJH ZLWK &DSLWDO OHVV WKDQ UHTXLUHPHQW b b b r b r $JJUHJDWH ,QGXVWU\ /RDQV $VVHWV b b b b $JJUHJDWH ,QGXVWU\ 6HFXULWLHV $VVHWV b b b b 1XPEHU RI 2EVHUYDWLRQV D 'DWD DUH IURP WKH )HGHUDO 5HVHUYH < WDSH E /RDQ JURZWK HTXDOV FKDQJH LQ WRWDO ORDQV RXWVWDQGLQJ GLYLGHG E\ ORDQV RXWVWDQGLQJ DW WLPH W F ,QWHUQDO DGGLWLRQV WR FDSLWDO HTXDOV QHW LQFRPH SOXV FKDQJHV LQ ORDQ ORVV SURYLVLRQV XS WR UHJXODWRU\ PD[LPXPf G 0DUNHW WR ERRN YDOXH RI DVVHWV HTXDOV 7RWDO $VVHWV %RRN (TXLW\ 0DUNHW (TXLW\f 7RWDO $VVHWV 0DUNHW (TXLW\ HTXDOV WKH PDUNHW YDOXH RI FRPPRQ HTXLW\ IURP &563 7KH UDWLR LV FDOFXODWHG DW \HDU HQG IRU WKH SULRU \HDU H %RRN FDSLWDO LQ H[FHVV RI UHTXLUHPHQW HTXDOV WKH EDQNfV ERRN FDSLWDO IRU UHJXODWRU\ PLQLPXP 7LHU ,, FDSLWDO UDWLR 7LHU ,, FDSLWDO HTXDOV FRPPRQ VWRFN SUHIHUUHG VWRFN SOXV HOLJLEOH VXERUGLQDWHG GHEW DQG ORDQ ORVV UHVHUYHV )RU WKH SHULRG WKH UHTXLUHPHQW LV b RI WRWDO DVVHWV )RU WKH UHTXLUHPHQW LV b %HJLQQLQJ LQ WKH UHTXLUHPHQW LV EDVHG RQ ULVNZHLJKWHG DVVHWV )RU WKH PLQLPXP LV b RI ULVNZHLJKWHG DVVHWV ZKLOH IURP WKH PLQLPXP LV b r PHDQ RU PHGLDQ VLJQLILFDQWO\ GLIIHUHQW IURP SUHYLRXV WLPH SHULRG DW EHWWHU WKDQ WKH b OHYHO

PAGE 34

WKH fWRR ELJ WR IDLOf SROLF\ LQ ZKLFK FHUWDLQ EDQNV ZHUH GHHPHG WRR LPSRUWDQW WR EH DOORZHG WR IDLO 2f+DUD DQG 6KDZ f GRFXPHQW WKDW IROORZLQJ WKLV DQQRXQFHPHQW ODUJH EDQNV H[SHULHQFHG DQ LQFUHDVH LQ VWRFN SULFH ZKLFK WKH\ DWWULEXWH WR EH GXH WR WKH H[SDQGHG FRQMHFWXUDO JXDUDQWHHV 7KH VHFRQG UHJLPH ODVWV IURP ZKHQ UHJXODWRUV LQFUHDVHG WKH PLQLPXP FDSLWDO UHTXLUHPHQW IURP WR SHUFHQW ,Q DGGLWLRQ UHJXODWRUV DWWHPSWHG WR UHPRYH WKH H[SDQGHG FRQMHFWXUDO JXDUDQWHHV LPSOLHG E\ WKH fWRR ELJ WR IDLOf SROLF\ )LQDOO\ WKH WKLUG UHJLPH VWDUWV LQ DQG EHJLQV WKH HUD RI ULVNEDVHG FDSLWDO VWDQGDUGV 7DEOH SURYLGHV WKH GHVFULSWLYH VWDWLVWLFV E\ WKH WKUHH UHJXODWRU\ UHJLPHV 1RWLFH WKDW ZLWK HDFK UHJLPH ORDQ JURZWK KDV GHFOLQHG ERWK DYHUDJH DQG PHGLDQf ,I EDQN JURZWK RSSRUWXQLWLHV KDYH DOVR GHFOLQHG WKLV FRXOG H[SODLQ WKH GHFUHDVH LQ ORDQ JURZWK 0DUNHW WR ERRN UDWLRV D SUR[\ IRU 7RELQfV 4f KDYH LQFUHDVHG VLQFH WKH HDUO\ V LQGLFDWLQJ WKDW RYHUDOO JURZWK RSSRUWXQLWLHV KDYH LPSURYHG +RZHYHU D SRWHQWLDO H[SODQDWLRQ IRU ZK\ RYHUDOO JURZWK RSSRUWXQLWLHV LPSURYHG ZKLOH ORDQ JURZWK VXIIHUHG LV WKDW RIIEDODQFH VKHHW JURZWK GULYHV WKH LQFUHDVH LQ PDUNHW WR ERRN UDWLRV $ VHFRQG SRVVLELOLW\ IRU ZK\ ORDQ JURZWK KDV VXIIHUHG FRXOG EH D VLPXOWDQHRXV GHFOLQH LQ EDQN LQWHUQDO DGGLWLRQV WR FDSLWDO :KLOH LWfV WUXH WKDW LQWHUQDO DGGLWLRQV WR FDSLWDO GHFOLQHG VLQFH WKH ILUVW UHJLPH WKH DPRXQW RI WKH GHFOLQH KDUGO\ PDWFKHV WKH VXEVWDQWLDO SDFH RI WKH GHFOLQH LQ OHQGLQJ 7KLV SROLF\ LPSOLHV WKDW UHJXODWRUV ZLOO DWWHPSW WR EDLO RXW DQ\ ODUJH LQVWLWXWLRQ ZKLFK LV LQVROYHQW )XUWKHUPRUH VLQFH WKH )',& HIIHFWLYHO\ LQVXUHG DOO EDQN GHEW QRW MXVW VPDOO GHSRVLWVf LQ WKH &RQWLQHQWDO ,OOLQRLV FDVH PDQDJHPHQW RI ODUJH EDQNV PD\ KDYH UHDVRQDEO\ DVVXPHG WKDW WKH IHGHUDO VDIHW\ QHW KDG EHHQ H[SDQGHG

PAGE 35

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f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

PAGE 36

VDPSOH +RZHYHU ORDQ JURZWK DQG FDSLWDOL]DWLRQ PD\ EH FRUUHODWHG IRU RWKHU UHDVRQV ,Q SDUWLFXODU ORDQ ORVVHV DUH OLNHO\ WR EH FRUUHODWHG ZLWK ORDQ GHPDQG FDXVLQJ D SRVLWLYH FRUUHODWLRQ EHWZHHQ ORDQ JURZWK DQG FDSLWDOL]DWLRQ 7KHUHIRUH DOVR H[DPLQH WKH UHODWLRQ EHWZHHQ LQWHUQDO DGGLWLRQV WR FDSLWDO DQG EDQN FDSLWDOL]DWLRQ 7DEOH SUHVHQWV WKH UHVXOWV RI WKLV DQDO\VLV 7KH WRS SRUWLRQ RI WKH WDEOH DQDO\]HV GLIIHUHQFHV LQ KROGLQJ FRPSDQ\ ORDQ JURZWK LQ WKUHH GLIIHUHQW FDSLWDOL]DWLRQ FDWHJRULHV IDLOXUH WR PHHW FDSLWDO UHTXLUHPHQWV FDSLWDO LQ H[FHVV RI UHTXLUHPHQWV E\ SHUFHQWDJH SRLQWV RU OHVV DQG FDSLWDO LQ H[FHVV RI UHTXLUHPHQWV E\ JUHDWHU WKDQ SHUFHQWDJH SRLQWV /RDQ JURZWK DW LQDGHTXDWHO\ FDSLWDOL]HG EDQNV ZDV VLJQLILFDQWO\ OHVV WKDQ ORDQ JURZWK DW HLWKHU RI WKH RWKHU WZR FDWHJRULHV ,Q DGGLWLRQ WKHUH LV QR GLIIHUHQFH EHWZHHQ ORDQ JURZWK DW HLWKHU RI WKH WZR DGHTXDWHO\ FDSLWDOL]HG FDWHJRULHV 0RUHRYHU DV VKRZQ LQ WKH ERWWRP SRUWLRQ RI WKH WDEOH WKH DPRXQW RI LQWHUQDO FDSLWDO JHQHUDWLRQ LQFUHDVHV VLJQLILFDQWO\ ZLWK FDSLWDOL]DWLRQ VXJJHVWLQJ WKDW SHUIRUPDQFH VWURQJO\ LQIOXHQFHV FDSLWDO DGHTXDF\ 7KDW ORDQ JURZWK LV FRUUHODWHG ZLWK FDSLWDOL]DWLRQ LV FRQVLVWHQW ZLWK FDSLWDO UHTXLUHPHQWV DQG FRVWO\ H[WHUQDO ILQDQFH FRQVWUDLQLQJ ORDQ JURZWK +RZHYHU DV PHQWLRQHG DERYH WKH ILQGLQJ WKDW LQWHUQDO DGGLWLRQV WR FDSLWDO LV FRUUHODWHG ZLWK FDSLWDOL]DWLRQ PD\ GULYH WKLV UHVXOW 6LQFH ORDQ ORVVHV DQG SRRU SHUIRUPDQFH DUH OLNHO\ WR EH FRUUHODWHG ZLWK ZHDN ORDQ GHPDQG WKH SRVLWLYH UHODWLRQ EHWZHHQ ORDQ JURZWK DQG FDSLWDOL]DWLRQ PD\ UHIOHFW GHPDQG DV RSSRVHG WR VXSSO\ FKDUDFWHULVWLFV 7R DGGUHVV WKHVH FRQFHUQV H[DPLQH WKH UHODWLRQ EHWZHHQ ORDQ JURZWK DQG LQWHUQDO DGGLWLRQV WR FDSLWDO ,Q 7DEOH SUHVHQW WKH UHVXOWV RI D IL[HGHIIHFWV UHJUHVVLRQ UHODWLQJ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO WKH PDUNHW WR ERRN YDOXH RI DVVHWV SUHYLRXV ORDQ JURZWK

PAGE 37

7DEOH 'LIIHUHQFHV LQ ORDQ JURZWK DQG LQWHUQDO DGGLWLRQV WR FDSLWDO EDVHG XSRQ ZKHWKHU PLQLPXP FDSLWDO UHTXLUHPHQWV DUH ELQGLQJ IRU D VDPSOH RI EDQN KROGLQJ FRPSDQLHV IURP /RDQ *URZWK 0HDQ 0HGLDQ &DSLWDO OHVV WKDQ RU HTXDO WR UHJXODWRU\ PLQLPXP 1 b &DSLWDO JUHDWHU WKDQ UHJXODWRU\ PLQLPXP E\ b RU OHVV 1 &DSLWDO JUHDWHU WKDQ UHJXODWRU\ PLQLPXP E\ PRUH WKDQ b 1 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] ,QWHUQDO $GGLWLRQV WR &DSLWDO 0HDQ 0HGLDQ &DSLWDO OHVV WKDQ RU HTXDO WR UHJXODWRU\ PLQLPXP 1 &DSLWDO JUHDWHU WKDQ UHJXODWRU\ PLQLPXP E\ b RU OHVV 1 &DSLWDO JUHDWHU WKDQ UHJXODWRU\ PLQLPXP E\ PRUH WKDQ b 1 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] O 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ]

PAGE 38

7DEOH )L[HG HIIHFWV UHJUHVVLRQV UHODWLQJ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO FDSLWDO UHTXLUHPHQWV DQG ILUP ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQV f /RDQV &RHIILFLHQW f f $GGLWLRQV WR &DSLWDO /RDQVr rr rr f f 6XUSOXV &DSLWDO $VVHWVE rr f %LQG rr f 6XUSOXV &DSLWDO r $GGLWLRQV WR rr &DSLWDO /RDQV f %LQG r $GGLWLRQV WR &DSLWDO /RDQV r f 6HFXULWLHV $VVHWV rr rr f f 0DUNHW %RRN $VVHWV rr rr f f ORJ $VVHWVf rr rr f f /DJ ORDQ JURZWK rr rr f f 5 1 FDWHJRULHVf f f ) VWDWLVWLF %DQN GXPPLHV rr rr D $GGLWLRQV WR FDSLWDO HTXDOV QHW LQFRPH SOXV FKDQJHV LQ ORDQ ORVV SURYLVLRQV XS WR UHJXODWRU\ PD[LPXPf E 6XUSOXV FDSLWDO HTXDOV DFWXDO FDSLWDO OHVV FDSLWDO UHTXLUHG WR PHHW PLQLPXP UHJXODWRU\ VWDQGDUGV F %LQG O LI VXUSOXV FDSLWDO LV OHVV WKDQ RU HTXDO WR ]HUR RWKHUZLVH r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 39

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

PAGE 40

WKH ODUJHVW VXUSOXV FDSLWDO ORZHVW VHQVLWLYLW\f EHIRUH WKH FKDQJH 7KLV LV FRQVLVWHQW ZLWK 3DVVPRUH DQG 6KDUSHf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

PAGE 41

7DEOH )L[HG HIIHFWV UHJUHVVLRQV UHODWLQJ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO FDSLWDO UHTXLUHPHQWV DQG ILUP ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQVW /RDQV f /RDQV FRHIILFLHQW f f f f $GGLWLRQV WR &DSLWDO /RDQVD rr f rr f rr f rr f 6XUSOXV &DSLWDO $VVHWVE rr f r f %LQGF rr f f 6XUSOXV &DSLWDO r$GGLWLRQV WR &DSLWDO /RDQV rr f r f %LQG r $GGLWLRQV WR &DSLWDO /RDQV f f 6HFXULWLHV $VVHWV rr f rr f rr f rr f 6HFXULWLHV r $GGLWLRQV WR &DSLWDO /RDQV r f rr f f rr f 6XUSOXV &DSLWDO r 6HFXULWLHV $VVHWV f %LQG r 6HFXULWLHV $VVHWV rr f 6XUSOXV &DSLWDO r 6HFXULWLHV r $GGLWLRQV WR &DSLWDO /RDQV f %LQG r 6HFXULWLHV r $GGLWLRQV WR &DSLWDO /RDQV f 0DUNHW %RRN $VVHWV rr f rr f rr f rr f ORJ $VVHWVf rr f rr f rr f rr f /DJ ORDQ JURZWK rr f rr f rr f rr f 5 1 FDWHJRULHVf f f f f ) VWDWLVWLF %DQN GXPPLHV rr rr rr rr D $GGLWLRQV WR FDSLWDO HTXDOV QHW LQFRPH SOXV FKDQJHV LQ ORDQ ORVV SURYLVLRQV XS WR UHJXODWRU\ PD[LPXPf E 6XUSOXV FDSLWDO HTXDOV DFWXDO FDSLWDO OHVV FDSLWDO UHTXLUHG WR PHHW PLQLPXP UHJXODWRU\ VWDQGDUGV F %LQG LI VXUSOXV FDSLWDO LV OHVV WKDQ RU HTXDO WR ]HUR RWKHUZLVH r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 42

QHJDWLYH DQG VLJQLILFDQWO\ GLIIHUHQW IURP ]HUR DW WKH RQH SHUFHQW OHYHO 7KLV LV FRQVLVWHQW ZLWK WKH K\SRWKHVLV WKDW VHFXULWLHV KROGLQJV VHUYH DV D EXIIHU VWRFN DJDLQVW IXQGLQJ VKRUWDJHV 7KH QHJDWLYH FRHIILFLHQW RQ WKH LQWHUDFWLRQ EHWZHHQ %,1' DQG VHFXULWLHV LQGLFDWHV WKDW WKH UROH RI VHFXULWLHV DV ILQDQFLDO VODFN LV OHVV LPSRUWDQW IRU FDSLWDO GHILFLHQW EDQNV ,Q SDUWLFXODU WKH HVWLPDWHG FRHIILFLHQW RQ VHFXULWLHV KROGLQJV IRU FDSLWDO GHILFLHQW EDQNV E\ FRPELQLQJ WKH WZR FRHIILFLHQWVf LV QRW VLJQLILFDQWO\ GLIIHUHQW IURP ]HUR 7KHVH UHVXOWV VXJJHVW WKDW ERWK VXUSOXV FDSLWDO DQG VHFXULWLHV KROGLQJV VHUYH DV OLTXLGLW\ E\ GHFUHDVLQJ EDQNVf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f FDSLWDO VXUSOXV GLG QRW LQIOXHQFH ORDQ JURZWK 7KLV LV FRQVLVWHQW ZLWK EDQNV EHOLHYLQJ WKDW FDSLWDO UHTXLUHPHQWV ZHUH QRW VWULQJHQWO\ HQIRUFHG $ SRVVLEOH H[SODQDWLRQ IRU WKLV LV WKH H[SDQGHG FRQMHFWXUDO JXDUDQWHHV LPSOLHG E\ fWRR ELJ WR IDLOf ,Q UHJLPHV WZR f DQG WKUHH f VXUSOXV FDSLWDO LV SRVLWLYHO\ UHODWHG WR ORDQ JURZWK DQG QHJDWLYHO\ UHODWHG WR WKH VHQVLWLYLW\ RI ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO 2Q WKH RWKHU KDQG

PAGE 43

7DEOH )L[HG HIIHFWV UHJUHVVLRQV UHODWLQJ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO FDSLWDO UHTXLUHPHQWV DQG ILUP ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQV f /RDQV FRHIILFLHQW f f $GGLWLRQV WR &DSLWDO /RDQV rr f rr f 6XUSOXV &DSLWDO $VVHWV r WLPHO f 6XUSOXV &DSLWDO $VVHWV r WLPH rr f 6XUSOXV &DSLWDO $VVHWV r WLPH rr f ELQG r WLPHO f ELQG r WLPH rr f ELQG r WLPH rr f 6XUSOXV &DSLWDO r WLPHO r $GGLWLRQV WR &DSLWDO/RDQV f 6XUSOXV &DSLWDO r WLPH r $GGLWLRQV WR &DSLWDO/RDQV rr f 6XUSOXV &DSLWDO r WLPH r $GGLWLRQV WR &DSLWDO/RDQV rr f ELQG r WLPHO r $GGLWLRQV WR &DSLWDO f ELQG r WLPH r $GGLWLRQV WR &DSLWDO f ELQG r WLPH r $GGLWLRQV WR &DSLWDO f 6HFXULWLHV $VVHWV r WLPHO rr f rr f 6HFXULWLHV $VVHWV r WLPH rr f rr f 6HFXULWLHV $VVHWV r WLPH f f 6HFXULWLHV r WLPHO r $GGLWLRQV WR &DSLWDO/RDQV rr f rr f 6HFXULWLHV r WLPH r $GGLWLRQV WR &DSLWDO/RDQV rr f rr f 6HFXULWLHV r WLPH r $GGLWLRQV WR &DSLWDO/RDQV f f 0DUNHW %RRN $VVHWV rr f rr f ORJ $VVHWVf rr f rr f /DJ ORDQ JURZWK rr f rr f 5 1 FDWHJRULHVf f f ) VWDWLVWLF %DQN GXPPLHV rr rr r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 44

VHFXULWLHV KROGLQJV DSSHDU WR EH VLJQLILFDQW FRQWULEXWRUV RI ILQDQFLDO VODFN XS XQWLO WKH V 6SHFLILFDOO\ WKH UHJLPH WKUHH FRHIILFLHQWV RQ VHFXULWLHV KROGLQJV DQG WKH LQWHUDFWLRQ YDULDEOHVf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fV RYHUDOO LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ LV QHJDWLYHO\ UHODWHG WR VXUSOXV FDSLWDO DIWHU FRQWUROOLQJ IRU WKH HIIHFW RI VHFXULWLHV UHPDLQV D TXHVWLRQ 7DEOH SUHVHQWV UHVXOWV RI WKH SUHGLFWHG VHQVLWLYLW\ RI ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO IURP UHJUHVVLRQ f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

PAGE 45

7DEOH &KDUDFWHULVWLFV RI SUHGLFWHG LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ 9DULDEOH 3UHGLFWHG ,QYHVWPHQW&DVKIORZ 6HQVLWLYLW\ HVWLPDWHG IURP FRHIILFLHQWV RQ $GGLWLRQV WR &DSLWDO DQG LQWHUDFWLRQ WHUPV IURP UHJUHVVLRQ f 7DEOH 'HVFULSWLYH 6WDWLVWLFV E\ &DSLWDOL]DWLRQ PHDQ PHGLDQ IXOO VDPSOH 1 &DSLWDO OHVV WKDQ RU HTXDO WR UHJXODWRU\ PLQLPXP 1 &DSLWDO JUHDWHU WKDQ UHJXODWRU\ PLQLPXP E\ b RU OHVV 1 &DSLWDO JUHDWHU WKDQ UHJXODWRU\ PLQLPXP E\ PRUH WKDQ b 1 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W O ] 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] 7HVW VWDWLVWLF RI GLIIHUHQFH EHWZHHQ DQG W ] 7DEOH )L[HG HIIHFWV UHJUHVVLRQV UHODWLQJ WKH SUHGLFWHG LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ WR RII EDODQFH VKHHW DVVHWV DQG RWKHU ILUP ILQDQFLDO FKDUDFWHULVWLFV 2IIEDODQFH VKHHW DVVHWV GDWD DUH DYDLODEOH EHJLQQLQJ LQ 7KH VDPSOH FRQVLVWV RI EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH 3UHGLFWHG ,QYHVWPHQW&DVKIORZ 6HQVLWLYLW\ HVWLPDWHG IURP FRHIILFLHQWV RQ $GGLWLRQV WR &DSLWDO DQG LQWHUDFWLRQ WHUPV IURP UHJUHVVLRQ f 7DEOH 9DULDEOH f f &RQVWDQW rr rr f f 2II %DODQFH 6KHHW $VVHWV $VVHWV rr rr f f %LQG rr f /RJ $VVHWVf rr f 5 1 ) VWDWLVWLF %DQN GXPPLHV rr rr r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 46

IXOO VDPSOH DQG IURP DGHTXDWHO\ FDSLWDOL]HG EDQNV DW EHWWHU WKDW WKH RQH SHUFHQW OHYHOf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

PAGE 47

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

PAGE 48

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f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f FRQIRUP ZLWK SUHYLRXVO\ UHSRUWHG UHVXOWV DQG VXSSRUW WKH K\SRWKHVLV WKDW H[WHUQDO ILQDQFH LV FRVWO\ DQG WKDW WKH VHQVLWLYLW\ RI LQYHVWPHQW WR LQWHUQDO DGGLWLRQV WR FDSLWDO LV QHJDWLYHO\ UHODWHG WR VXUSOXV FDSLWDO 0RUHRYHU VHFXULWLHV KROGLQJV DUH QRW UHODWHG WR JURZWK LQ WKLV SDUWLFXODU PRGHO 7KLV SURYLGHV DGGLWLRQDO VXSSRUW WKDW ZLWK ULVNEDVHG FDSLWDO VWDQGDUGV WKH UROH RI VHFXULWLHV DV ILQDQFLDO VODFN KDV EHHQ GLPLQLVKHG VLQFH GDWD LV RQO\ DYDLODEOH IRU WKHVH WHVWV LQ WKH Vf

PAGE 49

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f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

PAGE 50

7DEOH 'HVFULSWLYH VWDWLVWLFV RI VXEVLGLDULHV RI SXEOLFO\ WUDGHG PXOWLSOH EDQN KROGLQJ FRPSDQLHV IURP D YDULDEOH PHDQ PHGLDQ 6XEVLGLDU\ 7RWDO $VVHWV PLOOLRQVf ,QWHUQDO $GGLWLRQV WR &DSLWDO /RDQV%DQN ,QWHUQDO $GGLWLRQV WR &DSLWDO /RDQV+QHWE ,QWHUQDO $GGLWLRQV WR &DSLWDO /RDQV1RQ %PNF 6HFXULWLHV $VVHWV /HDG %DQN $VVHWV +ROGLQJ &RPSDQ\ $VVHWV %RRN &DSLWDO LQ ([FHVV RI 5HTXLUHPHQW $VVHWVf%DQN %RRN &DSLWDO LQ ([FHVV RI 5HTXLUHPHQW $VVHWVf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f E ,QWHUQDO $GGLWLRQV WR &DSLWDO +1HW HTXDOV KROGLQJ FRPSDQ\ DGGLWLRQV WR FDSLWDO OHVV WKH EDQNfV DGGLWLRQV WR FDSLWDO GLYLGHG E\ KROGLQJ FRPSDQ\ ORDQV OHVV ORDQV RI WKH VXEVLGLDU\ EDQN F ,QWHUQDO $GGLWLRQV WR &DSLWDO QRQEDQN HTXDOV KROGLQJ FRPSDQ\ DGGLWLRQV WR FDSLWDO QHW RI WKH DJJUHJDWH DGGLWLRQV WR FDSLWDO RI DOO EDQN VXEVLGLDULHV GLYLGHG E\ KROGLQJ FRPSDQ\ ORDQV OHVV ORDQV RI WKH VXEVLGLDU\ EDQN

PAGE 51

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fV OHQGLQJ RSSRUWXQLWLHVf WKLV SURYLGHV DGGLWLRQDO HYLGHQFH WKDW EDQN KROGLQJ FRPSDQLHV DUH OLTXLGLW\ FRQVWUDLQHG $GGLWLRQDOO\ H[DPLQLQJ WKLV UHODWLRQVKLS PD\ DOOHYLDWH FRQFHUQV WKDW WKH REVHUYHG FRUUHODWLRQ EHWZHHQ LQWHUQDOO\ JHQHUDWHG FDSLWDO DQG ORDQ JURZWK DW WKH KROGLQJ FRPSDQ\ OHYHO DULVHV EHFDXVH LQWHUQDOO\ JHQHUDWHG FDSLWDO SUR[LHV IRU WKH SURILWDELOLW\ RI OHQGLQJ RSSRUWXQLWLHV QRW FDSWXUHG E\ 7RELQfV 4 ,QGHHG D ILQGLQJ WKDW VXEVLGLDU\ ORDQ JURZWK LV UHODWHG WR LQWHUQDOO\ JHQHUDWHG FDSLWDO DW WKH KROGLQJ FRPSDQ\fV RWKHU VXEVLGLDULHV DQG LQ SDUWLFXODU LWV QRQEDQN VXEVLGLDULHV ZRXOG ZHDNHQ WKH YDOLGLW\ RI WKLV DUJXPHQW ,Q WKLV UHJDUG P\ WHVWV DUH VLPLODU WR /DPRQW f ZKR VWXGLHG KRZ D VXEVLGLDU\fV FDVK IORZV DIIHFWHG LQYHVWPHQW E\ DQ XQUHODWHG VXEVLGLDU\ ZLWKLQ WKH VDPH ILUP )XUWKHUPRUH LQ OLJKW RI WKH HYLGHQFH VXJJHVWLQJ WKDW EDQN KROGLQJ FRPSDQLHV DUH OLTXLGLW\ FRQVWUDLQHG DQ LQWHUHVWLQJ LVVXH LV KRZ KROGLQJ FRPSDQLHV DOORFDWH FDSLWDO DPRQJ WKHLU VXEVLGLDULHV 6WHLQ f IROORZLQJ :LOOLDPVRQ f DUJXHV WKDW FDSLWDO PDUNHW LPSHUIHFWLRQV PD\ JLYH ILUPV LQFHQWLYHV WR HVWDEOLVK LQWHUQDO FDSLWDO PDUNHWV WR DOORFDWH

PAGE 52

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f 7KH VDPSOH FRQWDLQV RYHU VXEVLGLDULHV ZLWK DW PRVW \HDUV RI GDWD SHU EDQN 7HVWV ZHUH DOVR SHUIRUPHG ZLWK 2/6 HVWLPDWHV QRW UHSRUWHGf ZLWK TXDOLWDWLYHO\ VLPLODU UHVXOWV 5HVXOWV DUH SUHVHQWHG IRU WKH IXOO VDPSOH WKH VDPSOH RI EDQNV ZKRVH DVVHWV UHSUHVHQW OHVV WKDQ SHUFHQW RI WKHLU KROGLQJ FRPSDQ\fV DVVHWV ERWWRP WKUHH VL]H TXDUWLOHVf DQG WKH VDPSOH RI OHDG EDQNV LQ HDFK KROGLQJ FRPSDQ\ WKH ODUJHVW VXEVLGLDU\ ZLWKLQ WKH KROGLQJ FRPSDQ\f )RU WKH IXOO VDPSOH DQG WKH VPDOO EDQN VDPSOH ORDQ JURZWK DW VXEVLGLDU\ EDQNV LV SRVLWLYHO\ UHODWHG WR WKH KROGLQJ FRPSDQ\fV PDUNHW WR ERRN UDWLR D SUR[\ IRU ORDQ RSSRUWXQLWLHVf ,Q DGGLWLRQ ORDQ JURZWK LV SRVLWLYHO\ UHODWHG WR WKH

PAGE 53

7DEOH %HWZHHQ HIIHFWV UHJUHVVLRQV UHODWLQJ VXEVLGLDU\ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO FDSLWDO UHTXLUHPHQWV DQG VXEVLGLDU\ DQG EDQN KROGLQJ FRPSDQ\ ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI VXEVLGLDULHV RI PXOWLSOH EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQVf /RDQV &RHIILFLHQW 2YHUDOO 6DPSOH 6PDOO %DQN /HDG %DQN f f f f f f ,$&+,$&%f/RDQ+/RDQ%fr rr f rr f rr f rr f f f ,$&E /RDQ% rr f rr f rr f rr f rr f rr f 6XUSOXV &DSLWDO $VVHWVf f f f 6XUSOXV &DSLWDO $VVHWVf% f f rr f %LQGfE rr f rr f rr f %LQG% f f r f 0DUNHW %RRNf rr f rr f rr f rr f f f 6HFXULWLHV $VVHWVf% f f f f f f 5 1 &DWHJRULHVf f f f f f f D ,$& LQWHUQDO DGGLWLRQV WR FDSLWDO + IRU KROGLQJ FRPSDQ\ DQG % IRU VXEVLGLDU\f E %LQGM LI EDQN FDSLWDO UDWLR LV OHVV WKDQ RU HTXDO WR WKH UHJXODWRU\ PLQLPXP r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 54

VXEVLGLDU\fV RZQ LQWHUQDO DGGLWLRQV WR FDSLWDO +RZHYHU ORDQ JURZWK LV DOVR VLJQLILFDQWO\ UHODWHG WR WKH DGGLWLRQV WR FDSLWDO SURGXFHG E\ DOO RWKHU ILUPV ZLWKLQ WKH KROGLQJ FRPSDQ\ PHDVXUHG E\ ,$&+ ,$&%f )RU WKHVH VDPSOHV WKH FRHIILFLHQW HVWLPDWHV RQ RWKHU VXEVLGLDULHVf FDVK IORZ DUH QHDUO\ HLJKW WLPHV WKDW RI WKH FRHIILFLHQW HVWLPDWH RQ WKH EDQNfV RZQ FDVK IORZ )XUWKHUPRUH DOWKRXJK LW GRHV QRW VHHP DV LI WKHUH LV D VWURQJ OLQN EHWZHHQ VXUSOXV FDSLWDO DQG ORDQ JURZWK HYLGHQFH VXJJHVWV WKDW VXEVLGLDULHV DUH OHVV OLNHO\ WR OHQG LI WKHLU KROGLQJ FRPSDQ\ DQG QRW WKH VXEVLGLDU\ LWVHOIf LV LQDGHTXDWHO\ FDSLWDOL]HG 5HVXOWV IRU WKH OHDG EDQN VDPSOH GLIIHU VXEVWDQWLDOO\ IURP WKH RWKHU VDPSOHV 6SHFLILFDOO\ WKH OHDG EDQNfV RZQ DGGLWLRQV WR FDSLWDO DUH PXFK PRUH VWURQJO\ FRUUHODWHG ZLWK ORDQ JURZWK WKDQ WKH KROGLQJ FRPSDQ\f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f IDLOV FDSLWDO VWDQGDUGV 5HVXOWV DUH FRQVLVWHQW ZLWK WKRVH SUHVHQWHG LQ 7DEOH DQG VXJJHVW WKDW WKH FDSLWDOL]DWLRQ RI WKH KROGLQJ FRPSDQ\ DQG QRW WKH VXEVLGLDU\ EDQN FRQVWUDLQV ORDQ JURZWK

PAGE 55

7DEOH %HWZHHQ HIIHFWV UHJUHVVLRQV UHODWLQJ VXEVLGLDU\ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO FDSLWDO UHTXLUHPHQWV DQG VXEVLGLDU\ DQG KROGLQJ FRPSDQ\ ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI VXEVLGLDULHV RI PXOWLSOH EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQV f /RDQV &RHIILFLHQW 2YHUDOO 6DPSOH 6PDOO %DQN f f f f f f ,$&+,$&%f/RDQ+/RDQ%fD rr f rr f rr f rr f rr f rr f /$&E /RDQ% rr f rr f rr f rr f rr f rr f %LQG+ O DQG%LQG% OE rr f rr f %LQG+ rr f rr f %LQG% f f 0DUNHW %RRN+ rr f rr f rr f rr f rr f rr f 6HFXULWLHV $VVHWVf% f f f f f f 5 1 &DWHJRULHVf f f f f f f D $& LQWHUQDO DGGLWLRQV WR FDSLWDO + IRU KROGLQJ FRPSDQ\ DQG % IRU VXEVLGLDU\f E %LQG LI EDQN FDSLWDO UDWLR LV OHVV WKDQ RU HTXDO WR WKH UHJXODWRU\ PLQLPXP r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 56

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fV PDUNHW WR ERRN UDWLR RU LQ WKH VXEVLGLDU\f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fV ORDQ JURZWK LV QHJDWLYHO\ UHODWHG WR VXEVLGLDU\ JURZWK &RQFHLYLQJ ZK\ D QHJDWLYH FRHIILFLHQW H[FHSW LQ WKH FRQWH[W RI DQ LQWHUQDO FDSLWDO PDUNHW LQ ZKLFK KROGLQJ FRPSDQLHV DOORFDWH FDSLWDO DFURVV FRPSHWLQJ XVHV LV GLIILFXOW 2YHUDOO WKHVH UHVXOWV VWURQJO\ DIILUP WKH FRQFOXVLRQ WKDW EDQN KROGLQJ FRPSDQLHV HVWDEOLVK LQWHUQDO FDSLWDO PDUNHWV WR DOORFDWH FDSLWDO RQ D FRQVROLGDWHG EDVLV 7KH QHJDWLYH FRHIILFLHQW RQ RWKHU VXEVLGLDULHVf JURZWK LV VRPHZKDW VHQVLWLYH WR VDPSOH DQG VSHFLILFDWLRQ ,I H[FOXGH EDQNV IURP 7H[DV DQG 2NODKRPD DUJXDEO\ WKH PRVW FRQVWUDLQHG EDQNVf WKH FRHIILFLHQW LV SRVLWLYH WKRXJK QRW VLJQLILFDQWO\ GLIIHUHQW IURP ]HUR

PAGE 57

7DEOH %HWZHHQ HIIHFWV UHJUHVVLRQV UHODWLQJ VXEVLGLDU\ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO ORDQ JURZWK LQ UHODWHG VXEVLGLDULHV FDSLWDO UHTXLUHPHQWV DQG VXEVLGLDU\ DQG KROGLQJ FRPSDQ\ ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI VXEVLGLDULHV RI PXOWLSOH EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQVf /RDQV &RHIILFLHQW 2YHUDOO 6DPSOH 6PDOO %DQN 6XEVLGLDULHV /HDG %DQNV ,$&+,$&%f/RDQ+/RDQ%ff rr rr f f f ,$&E /RDQ% rr rr rr f f f %LQGfE rr rr rr f f f %LQG% r f f f /RDQ *URZWK+F r r f f f 0DUNHW %RRN+ rr rr f f f 6HFXULWLHV $VVHWVf% f f f 5 1 &DWHJRULHVf f f f D ,$& LQWHUQDO DGGLWLRQV WR FDSLWDO + IRU KROGLQJ FRPSDQ\ DQG % IRU VXEVLGLDU\f E %LQG LI EDQN FDSLWDO UDWLR LV OHVV WKDQ RU HTXDO WR WKH UHJXODWRU\ PLQLPXP F /RDQ *URZWK+ HTXDOV ORDQ JURZWK RI RWKHU VXEVLGLDULHV LQ WKH KROGLQJ FRPSDQ\ GLYLGHG E\ WKHLU EHJLQQLQJ RI SHULRG ORDQV RXWVWDQGLQJ r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 58

7DEOH SUHVHQWV UHVXOWV IURP WKH VHFRQG UREXVWQHVV FKHFN LQ ZKLFK UHSODFH WKH KROGLQJ FRPSDQ\fV DGGLWLRQV WR FDSLWDO ZLWK QRQEDQN VXEVLGLDU\f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f $V DQ DGGLWLRQDO WHVW RI WKH RSHUDWLRQ RI DQ LQWHUQDO FDSLWDO PDUNHW H[DPLQH WKH UHODWLRQ EHWZHHQ WKH RYHUDOO LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ RI WKH KROGLQJ FRPSDQ\ DQG WKH VXEVLGLDU\fV GHSHQGHQFH RQ ERWK WKH KROGLQJ FRPSDQ\fV DQG LWV RZQ FDVK IORZV 7KH LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ PD\ HVWLPDWH WKH PDJQLWXGH RI LQIRUPDWLRQ DV\PPHWULHV DOWKRXJK LW LV PHDVXUHG ZLWK HUURU VLQFH LW LV DQ DSSUR[LPDWLRQ XVLQJ UHJUHVVLRQ FRHIILFLHQWV VHH 7DEOH f 7R DOOHYLDWH DQ HUURUV LQ YDULDEOHV ELDV XVH WKH LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ ODJJHG RQH SHULRG DV DQ LQVWUXPHQWDO YDULDEOH 7KH VHYHULW\ RI LQIRUPDWLRQ DV\PPHWULHV VKRXOG EH GLUHFWO\ UHODWHG WR WKH JURZWK RI LQGLYLGXDO EDQNV 7KHUHIRUH H[SHFW VXEVLGLDU\ ORDQ JURZWK WR EH QHJDWLYHO\ UHODWHG WR WKH LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ RI WKH KROGLQJ FRPSDQ\ $ ILQGLQJ WKDW WKH LPSRUWDQFH RI KROGLQJ FRPSDQ\ FDVK IORZV LV SRVLWLYHO\ UHODWHG WR WKH KROGLQJ FRPSDQ\fV LQYHVWPHQW FDVKIORZ VHQVLWLYLW\ ZRXOG SURYLGH IXUWKHU HYLGHQFH RI WKH RSHUDWLRQ RI DQ LQWHUQDO FDSLWDO PDUNHW 7KLV LQGLFDWHV WKDW WKH VHYHULW\ RI WKH FRQVWUDLQW IDFHG E\ WKH KROGLQJ FRPSDQ\

PAGE 59

7DEOH %HWZHHQ HIIHFWV UHJUHVVLRQV UHODWLQJ VXEVLGLDU\ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO FDSLWDO UHTXLUHPHQWV DQG VXEVLGLDU\ DQG KROGLQJ FRPSDQ\ ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI VXEVLGLDULHV RI PXOWLSOH EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQVf /RDQV &RHIILFLHQW 2YHUDOO 6DPSOH 6PDOO %DQNV /HDG %DQN 1RQ%DQN ,$&f/RDQ+/RDQ%fD rr rr f f f ,$&E /RDQ% rr rr rr f f f %LQGfE rr rr rr f f f %LQG% r f f f 0DUNHW %RRNf rr rr f f f 6HFXULWLHV $VVHWVf% r f f f 5 1 &DWHJRULHVf f f f D ,$& LQWHUQDO DGGLWLRQV WR FDSLWDO + IRU KROGLQJ FRPSDQ\ DQG % IRU VXEVLGLDU\f E %LQG LI EDQN FDSLWDO UDWLR LV OHVV WKDQ RU HTXDO WR WKH UHJXODWRU\ PLQLPXP r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 60

GLUHFWO\ LQIOXHQFHV WKH VXEVLGLDU\fV GHSHQGHQFH RQ KROGLQJ FRPSDQ\ HDUQLQJV 7DEOH SUHVHQWV EHWZHHQ HIIHFWV UHJUHVVLRQV LQFOXGLQJ WKH KROGLQJ FRPSDQ\fV LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ DQG WZR LQWHUDFWLRQ YDULDEOHV GHVLJQHG WR WHVW WKH UHODWLRQ EHWZHHQ WKLV VHQVLWLYLW\ DQG VXEVLGLDU\ UHOLDQFH RQ ERWK LWV RZQ DQG KROGLQJ FRPSDQ\ FDVKIORZV 7KHVH YDULDEOHV DUH WKH LQWHUDFWLRQV EHWZHHQ KROGLQJ FRPSDQ\ LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ DV HVWLPDWHG IURP HTXDWLRQ f 7DEOH f DQG WKH WZR FDVK IORZ PHDVXUHV XVHG DERYH $W ILUVW JODQFH UHVXOWV LQ 7DEOH PLJKW DSSHDU WR EH FRQIXVLQJ ,Q SDUWLFXODU WKH QHJDWLYH DQG VLJQLILFDQW FRHIILFLHQW RQ WKH KROGLQJ FRPSDQ\fV FDVK IORZV IRU ERWK WKH RYHUDOO VDPSOH DQG WKH OHDG EDQNV PD\ LQLWLDOO\ FDXVH VRPH FRQFHUQ +RZHYHU FRQVLGHU WKDW WKLV YDULDEOH DSSHDUV WZLFH LQ WKH UHJUHVVLRQ WKH VHFRQG WLPH LQWHUDFWHG ZLWK WKH KROGLQJ FRPSDQ\fV LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ 7KLV VHQVLWLYLW\ DYHUDJHV MXVW XQGHU UHFDOO IURP 7DEOH f DQG IRU WKH PDMRULW\ RI EDQNV OLHV LQ D UDQJH IURP WR $IWHU FRPELQLQJ WKHVH WZR HVWLPDWHV LW EHFRPHV FOHDU WKDW WKH WRWDO HIIHFW RI KROGLQJ FRPSDQ\ FDVK IORZV ZLOO EH SRVLWLYH IRU YLUWXDOO\ DOO EDQNV 0RUHRYHU WKH SRVLWLYH FRHIILFLHQW RQ WKH LQWHUDFWLRQ WHUP LQGLFDWHV WKDW WKH VHYHULW\ RI WKH KROGLQJ FRPSDQ\fV FRQVWUDLQW GLUHFWO\ DIIHFWV WKH VXEVLGLDU\fV GHSHQGHQFH RQ KROGLQJ FRPSDQ\ HDUQLQJV 6SHFLILFDOO\ DV KROGLQJ FRPSDQLHV EHFRPH PRUH FDVK IORZ FRQVWUDLQHG VXEVLGLDULHV EHFRPH PRUH UHOLDQW RQ KROGLQJ FRPSDQ\ HDUQLQJV /LNHZLVH WKH QHJDWLYH DQG VLJQLILFDQW FRHIILFLHQW RQ WKH KROGLQJ FRPSDQ\fV VHQVLWLYLW\ IRU WKH RYHUDOO VDPSOH DQG VPDOO EDQNVf LQGLFDWHV WKDW DV KROGLQJ FRPSDQ\fV EHFRPH PRUH FRQVWUDLQHG WKHLU VXEVLGLDULHV LQYHVW OHVV 7KHVH UHVXOWV SURYLGH DGGLWLRQDO HYLGHQFH WKDW KROGLQJ FRPSDQLHV RSHUDWH LQWHUQDO FDSLWDO PDUNHWV 5HVXOWV DUH VLPLODU LI WKH VHQVLWLYLWLHV DUH HVWLPDWHG IURP UHJUHVVLRQV LQ 7DEOH

PAGE 61

7DEOH %HWZHHQ HIIHFWV UHJUHVVLRQV UHODWLQJ VXEVLGLDU\ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO HVWLPDWHG LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ FDSLWDO UHTXLUHPHQWV DQG VXEVLGLDU\ DQG KROGLQJ FRPSDQ\ ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI VXEVLGLDULHV RI PXOWLSOH EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQVf /RDQV &RHIILFLHQW 2YHUDOO 6DPSOH 6PDOO %DQNV /HDG %DQN ,$&+,$&%f/RDQ+/RDQ%ff rr r f f f ,$&% /RDQ% r f f f %LQG+E rr rr rr f f f %LQG% r f f f 0DUNHW %RRNf rr rr f f f 6HFXULWLHV $VVHWVf% f f f +ROGLQJ &RPSDQ\ ,QYHVWPHQW rr r &DVKIORZ 6HQVLWLYLW\ f f f ,$&+/$&%f/RDQ+/RDQ%fG r r r +ROGLQJ &RPSDQ\ ,QYHVWPHQW &DVKIORZ 6HQVLWLYLW\ f f f ,$&E /RDQ% r +ROGLQJ &RPSDQ\ ,QYHVWPHQW&DVKIORZ 6HQVLWLYLW\ f f f 5 1 &DWHJRULHVf f f f D ,$& LQWHUQDO DGGLWLRQV WR FDSLWDO + IRU KROGLQJ FRPSDQ\ DQG % IRU VXEVLGLDU\f E %LQG LI EDQN FDSLWDO UDWLR LV OHVV WKDQ RU HTXDO WR WKH UHJXODWRU\ PLQLPXP F /RDQ *URZWK HTXDOV ORDQ JURZWK RI RWKHU VXEVLGLDULHV LQ WKH KROGLQJ FRPSDQ\ GLYLGHG E\ WKHLU EHJLQQLQJ RI SHULRG ORDQV RXWVWDQGLQJ G +ROGLQJ &RPSDQ\ ,QYHVWPHQW&DVKIORZ 6HQVLWLYLW\ LV HVWLPDWHG IURP FRHIILFLHQWV RQ LQWHUQDO DGGLWLRQV WR FDSLWDO DQG LQWHUDFWLRQ YDULDEOHV IURP UHJUHVVLRQ f LQ 7DEOH 7R DOOHYLDWH HUURUVLQ YDULDEOHV ELDV XVH WKH ODJ LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ DV DQ LQVWUXPHQWDO YDULDEOH r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 62

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f IROORZ LQFUHDVHV LQ FDSLWDO VWDQGDUGV 7DEOH DOVR GRFXPHQWV WKH DYHUDJH DEQRUPDO UHWXUQV IRU WKH VHFXULW\ LVVXDQFHV LQ P\ VDPSOH ILQG WKDW WKH DYHUDJH DEQRUPDO UHWXUQ IROORZLQJ WKH DQQRXQFHPHQW RI D FRPPRQ VWRFN LVVXDQFH LV MXVW OHVV WKDQ b 0RUHRYHU FDSLWDO GHILFLHQW EDQNV

PAGE 63

7DEOH 6XPPDU\ RI EDQN KROGLQJ FRPSDQ\ VHFXULW\ LVVXDQFHV IURP \HDU FRPPRQ VWRFN SUHIHUUHG VWRFN VXERUGLQDWHG QRWHV WRWDO WRWDO 0HDQ 2IIHU 6L]H PLOOLRQVf 0HDQ 2IIHU 6L]H $VVHWVf b b b b 0HDQ 8QGHUZULWHU )HHV b b b b 0HDQ $EQRUPDO 5HWXUQ IXOO VDPSOH b ] 1 f b ] 1 f b ] 1 f b ] 1 f 0HDQ $EQRUPDO 5HWXUQ LI ELQG b ] 1 f b ] 1 f b ] 1 f b ] 1 f 0HDQ $EQRUPDO 5HWXUQ LI ELQG O b ] 1 f b ] 1 f b ] 1 f b ] 1 f 7HVW 6WDWLVWLF RI 'LIIHUHQFH LQ 0HDQ $EQRUPDO 5HWXUQV E\ ELQG ] ] ] ] 6HFXULW\ LVVXDQFHV FROOHFWHG IURP WKH ,QYHVWPHQW 'HDOHUV 'LJHVW $QQRXQFHPHQW GDWHV FROOHFWHG IURP 'RZ -RQHV 1HZV 5HWULHYDO

PAGE 64

H[SHULHQFH DSSUR[LPDWHO\ ]HUR DEQRUPDO UHWXUQ ZKLOH DGHTXDWHO\ FDSLWDOL]HG EDQNV ORVH DSSUR[LPDWHO\ b LQ YDOXH 7KLV LV FRQVLVWHQW ZLWK &RUQHWW DQG 7HKUDQLDQ f DQG SURYLGHV HYLGHQFH WKDW WKH PDUNHW DQWLFLSDWHV H[WHUQDO HTXLW\ LVVXHV E\ LQDGHTXDWHO\ FDSLWDOL]HG EDQNV $OVR FRQVLVWHQW ZLWK SUHYLRXV VWXGLHV ILQG WKDW SUHIHUUHG VWRFN DQG VXERUGLQDWHG QRWH LVVXHV GR QRW LQYRNH VLJQLILFDQW DEQRUPDO UHWXUQV 7KLV PD\ RFFXU EHFDXVH WKHVH VHFXULWLHV DUH OHVV LQIRUPDWLRQDOO\ LQWHQVLYH WKDQ FRPPRQ VWRFN VR DQ LVVXDQFH RI WKHVH VHFXULWLHV PD\ QRW HOLFLW DV VHYHUH RI D OHPRQfV SUREOHP $ EDQNfV GHFLVLRQ RI ZKHWKHU WR LVVXH LV OLNHO\ WR EH UHODWHG WR WKH LQIRUPDWLRQ DV\PPHWULHV LW IDFHV 7KHUHIRUH GHYHORS D ORJLW PRGHO ZKLFK SUHGLFWV WKH FKRLFH WR LVVXH EDVHG RQ ILUP DQG PDUNHW FKDUDFWHULVWLFV )ROORZLQJ %D\OHVV DQG &KDSOLQVN\ f FHUWDLQ IDFWRUV FDQ EH LGHQWLILHG ZKLFK DUH OLNHO\ WR LQIOXHQFH WKH GHFLVLRQ WR LVVXH ,W FDQ EH VKRZQ WKDW DQ LQFUHDVH LQ WKH ILUPfV VWRFN SULFH LQFUHDVHV WKH VKDUH RI UHWXUQV WR DQ LQYHVWPHQW SURMHFW UHWDLQHG E\ ROG VWRFNKROGHUV DQG UHGXFHV WKH ORVV RI H[LVWLQJ ILUP YDOXH WR QHZ VWRFNKROGHUV 7KXV LQFOXGH WKH UDWLR RI WKH ODVW WKUHH PRQWKVf DYHUDJH VWRFN SULFH WR WKH SULRU WKLUW\VL[ PRQWKVf DYHUDJH ,Q DGGLWLRQ SULRU VWXGLHV ILQG WKDW WKH DJJUHJDWH PDUNHW FRQGLWLRQV DW WKH WLPH RI LVVXDQFH KDYH D VLJQLILFDQW LQIOXHQFH RQ RIIHU FKRLFH (VVHQWLDOO\ ILUPV DUH PRUH OLNHO\ WR LVVXH HTXLW\ IROORZLQJ VWURQJ HTXLW\ PDUNHW SHUIRUPDQFH 7R FRQWURO IRU PDUNHW FRQGLWLRQV LQFOXGH WKH UDWLR RI WKH WKUHHPRQWK DYHUDJH PDUNHW SULFH &563 HTXDO ZHLJKWHG LQGH[f WR WKH WKLUW\VL[ PRQWK DYHUDJH 7KH YDULDEOH 5LVN WKH VWDQGDUG GHYLDWLRQ RI WKH ILUPfV FRPPRQ VWRFN UHWXUQV FRQWUROV IRU VWRFN YRODWLOLW\ 6HH 0LNNHOVRQ DQG 3DUWFK f

PAGE 65

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f PRGHO DQ LQFUHDVH LQ ILQDQFLDO VODFN LQFUHDVHV WKH FRVWV RI DGYHUVH VHOHFWLRQ 7KHUHIRUH DQG LQFUHDVH LQ VODFN UHGXFHV WKH OLNHOLKRRG RI DQ HTXLW\ RIIHULQJ $V DQ DGGLWLRQDO SUR[\ IRU VODFN LQFOXGH D YDULDEOH FDOOHG IUHH FDVK IORZ VHH %D\OHVV DQG &KDSOLQVN\ ff )UHH FDVK IORZ LV GHVLJQHG WR PHDVXUH WKH IORZ RI IXQGV FRQVWUDLQW ZKLFK PRWLYDWHV ILUPV WR LVVXH VHFXULWLHV ZKHQ SRVLWLYH QHZ SUHVHQW YDOXH SURMHFWV FDQQRW EH ILQDQFHG LQWHUQDOO\ )UHH FDVK IORZ LV GHILQHG DV FXUUHQW QHW LQFRPH OHVV GLYLGHQGV DQG ORDQ JURZWK LQYHVWPHQWf %DQNV DUH H[SHFWHG WR EH PRUH OLNHO\ WR LVVXH ZKHQ WKH\ KDYH OHVV IUHH FDVK IORZ KHQFH H[SHFW D QHJDWLYH FRHIILFLHQW 7KLV SDSHU PDLQWDLQV WKDW EDQNV DUH FRQFHUQHG ZLWK WKH DPRXQW RI UHJXODWRU\ FDSLWDO WKDW WKH\ JHQHUDWH LQWHUQDOO\ 3UHVXPDEO\ EDQNV ZRXOG IXQG DOO JURZWK WKURXJK LQWHUQDOO\ JHQHUDWHG DGGLWLRQV WR FDSLWDO LI SRVVLEOH +RZHYHU WKDW D EDQN FKRRVHV WR LVVXH H[WHUQDO IXQGV GRHV QRW QHFHVVDULO\ PHDQ WKDW LW UHTXLUHV D FDSLWDO LQMHFWLRQ IURP D

PAGE 66

UHJXODWRU\ SRLQW RI YLHZ ,W FRXOG EH WKDW VXIILFLHQW SURILWDEOH OHQGLQJ RSSRUWXQLWLHV H[LVW WKDW WKH EDQN FRXOG QRW WDNH DGYDQWDJH RI ZLWKRXW UDLVLQJ H[WHUQDO FDSLWDO (LWKHU ZD\ WKH DPRXQW RI FDSLWDO JHQHUDWHG LQWHUQDOO\ LV OLNHO\ WR EH DQ LPSRUWDQW IDFWRU LQ WKH GHFLVLRQ WR LVVXH H[WHUQDO IXQGV 7R FDSWXUH WKLV UHODWLRQVKLS LQFOXGH WKH DGGLWLRQV WR FDSLWDO ODJJHG RQH REVHUYDWLRQ DV DQ H[SODQDWRU\ YDULDEOH 7KLV YDULDEOH LQGLFDWHV WKH DPRXQW RI UHJXODWRU\ FDSLWDO JHQHUDWHG LQ WKH SUHYLRXV \HDU $ QHJDWLYH FRHIILFLHQW RQ DGGLWLRQV WR FDSLWDO LQGLFDWHV WKDW EDQNV DUH PRUH OLNHO\ WR LVVXH LI WKH\ KDYH QRW EHHQ JHQHUDWLQJ VXIILFLHQW FDSLWDO LQWHUQDOO\ 2Q WKH RWKHU KDQG D SRVLWLYH FRHIILFLHQW LQGLFDWHV WKDW EDQNV DUH PRUH OLNHO\ WR LVVXH ZKHQ WKH\ KDYH SURILWDEOH JURZWK RSSRUWXQLWLHV 2SWLPDO FDSLWDO VWUXFWXUH WKHRU\ PDLQWDLQV WKDW ILUPV KDYH WDUJHW GHEW UDWLRV %HFDXVH WKH FRVWV RI GHEW H[FHHG WKH EHQHILWV IRU GHEW UDWLRV DERYH WKH WDUJHW ILUPV DUH SUHGLFWHG WR EH PRUH OLNHO\ WR LVVXH WKH IXUWKHU WKH ILUPfV FXUUHQW GHEW UDWLR LV DERYH WKH WDUJHW UDWLR %DQNVf RSWLPDO FDSLWDO VWUXFWXUH LV OLNHO\ WR GHSHQG RQ WKH FXUUHQW FDSLWDO UHTXLUHPHQWV ,QGHHG WKH SUHYLRXV FKDSWHUV SURYLGH HYLGHQFH WKDW VXUSOXV FDSLWDO LV DQ LPSRUWDQW GHWHUPLQDQW RI EDQN JURZWK DSSUR[LPDWH HDFK EDQNfV RSWLPDO FDSLWDO VWUXFWXUH DV LWV DYHUDJH VXUSOXV FDSLWDO RYHU WKH HQWLUH VDPSOH SHULRG f 7KH GHYLDWLRQ IURP WKH RSWLPDO GHVLJQDWHG 7DUJHW LV WKHQ FDOFXODWHG DV WKH GLIIHUHQFH EHWZHHQ WKLV DYHUDJH DQG WKH EDQNfV FXUUHQW SHULRG VXUSOXV FDSLWDO $ SRVLWLYH YDOXH IRU 7DUJHW LQGLFDWHV WKDW WKH EDQN KDV OHVV VXUSOXV FDSLWDO WKDQ RSWLPDO 6LQFH DOO VHFXULW\ LVVXHV LQ P\ VDPSOH DXJPHQW UHJXODWRU\ FDSLWDO H[SHFW D SRVLWLYH FRHIILFLHQW RQ 7DUJHW 7KLV GHILQLWLRQ PD\ QRW EH FRPSOHWHO\ DFFXUDWH VLQFH WKH RSWLPDO VXUSOXV FDSLWDO PD\ FKDQJH DV FDSLWDO VWDQGDUGV FKDQJH $V D VHSDUDWH WHVW FDOFXODWH 7DUJHW RYHU HDFK UHJLPH 5HVXOWV DUH VLPLODU

PAGE 67

,Q D UHFHQW VWXG\ %D\OHVV DQG &KDSOLQVN\ f ILQG WKDW ILUPV DUH PRUH OLNHO\ WR LVVXH HTXLW\ LQ D fKRWf LVVXH PDUNHW 'UDZLQJ RQ WKLV UHVHDUFK LGHQWLI\ KRW LVVXDQFH PDUNHWV DQG FUHDWH DQ DSSURSULDWH GXPP\ YDULDEOH +RWf WR LQFOXGH DV DQ H[SODQDWRU\ YDULDEOH 7R LGHQWLI\ KRW PDUNHWV XVH DJJUHJDWH HTXLW\ LVVXH YROXPH GDWD IURP WKH )HGHUDO 5HVHUYH 6\VWHPf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f IURP 7DEOH 6SHFLILFDOO\ WKH FRHIILFLHQWV RQ DGGLWLRQV WR FDSLWDO DQG WKH LQWHUDFWLRQ YDULDEOHV DUH FRPELQHG WR SUHGLFW WKH VHQVLWLYLW\ IRU HDFK EDQN LQ HYHU\ \HDU VHH 7DEOH f 7ZR SRWHQWLDO SUREOHPV DULVH ZKHQ LQFOXGLQJ WKLV VHQVLWLYLW\ DV DQ H[SODQDWRU\ YDULDEOH )LUVW VLQFH LW LV HVWLPDWHG XVLQJ UHJUHVVLRQ FRHIILFLHQWV LW LV PHDVXUHG ZLWK HUURU 7R DOOHYLDWH WKLV SUREOHP LQVWUXPHQW IRU WKLV VHQVLWLYLW\ XVLQJ D ODJJHG REVHUYDWLRQ /LNH %D\OHVV DQG &KDSOLQVN\ f UHVXOWV DUH QRW VHQVLWLYH WR WKH XVH RI VFDOHG YROXPH ,I FODVVLI\ EDVHG RQ QRPLQDO GROODU RU UHDO GROODU YROXPH UHVXOWV DUH VLPLODU 5HVXOWV DUH VLPLODU LI WKH LQYHVWPHQWFDVKIORZ VHQVLWLYLWLHV DUH HVWLPDWHG IURP UHJUHVVLRQV LQ 7DEOH

PAGE 68

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f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

PAGE 69

7DEOH 'HVFULSWLYH VWDWLVWLFV PHDQV ZLWK PHGLDQV LQ SDUHQWKHVHVf IRU EDQN KROGLQJ FRPSDQLHV FODVVLILHG E\ W\SH RI VHFXULW\ LVVXDQFH 9DULDEOH QR LVVXDQFH FRPPRQ VWRFN LVVXDQFH SUHIHUUHG VWRFN LVVXDQFH VXERUGLQDWHG QRWH LVVXDQFH 7RWDO $VVHWV PLOOLRQVf r r r f f r f r f r /RDQ *URZWKE r r f fr f fr ,QWHUQDO $GGLWLRQV WR r r &DSLWDO /RDQV f fr f f 0DUNHW %RRN $VVHWVnr r f f f r f %RRN &DSLWDO LQ ([FHVV r r RI 5HTXLUHPHQW $VVHWV H f fr f r f r 6HFXULWLHV $VVHWV r r r f f fr fr 5LVNI f f f 3UHGLFWHG ,QYHVWPHQW r r r &DVKIORZ 6HQVLWLYLW\p f fr fr f r )UHH &DVK )ORZ/RDQVK r r r f f r f f r 3HUFHQWDJH ZLWK &DSLWDO OHVV WKDQ UHTXLUHPHQW b b r b r b r 1XPEHU RI 2EVHUYDWLRQV D 'DWD DUH IURP WKH )HGHUDO 5HVHUYH < WDSH E /RDQ JURZWK HTXDOV FKDQJH LQ WRWDO ORDQV RXWVWDQGLQJ GLYLGHG E\ ORDQV RXWVWDQGLQJ DW WLPH W F ,QWHUQDO DGGLWLRQV WR FDSLWDO HTXDOV QHW LQFRPH SOXV FKDQJHV LQ ORDQ ORVV SURYLVLRQV XS WR UHJXODWRU\ PD[LPXPf G 0DUNHW WR ERRN YDOXH RI DVVHWV HTXDOV 7RWDO $VVHWV %RRN (TXLW\ 0DUNHW (TXLW\f 7RWDO $VVHWV 0DUNHW (TXLW\ HTXDOV WKH PDUNHW YDOXH RI FRPPRQ HTXLW\ IURP &563 7KH UDWLR LV FDOFXODWHG DW \HDU HQG IRU WKH SULRU \HDU H %RRN FDSLWDO LQ H[FHVV RI UHTXLUHPHQW HTXDOV WKH EDQNfV ERRN FDSLWDO IRU UHJXODWRU\ PLQLPXP 7LHU ,, FDSLWDO UDWLR 7LHU ,, FDSLWDO HTXDOV FRPPRQ VWRFN SUHIHUUHG VWRFN SOXV HOLJLEOH VXERUGLQDWHG GHEW DQG ORDQ ORVV UHVHUYHV )RUWKH SHULRG WKH UHTXLUHPHQW LV b RI WRWDO DVVHWV )RU WKH UHTXLUHPHQW LV b %HJLQQLQJ LQ WKH UHTXLUHPHQW LV EDVHG RQ ULVNZHLJKWHG DVVHWV )RU WKH PLQLPXP LV b RI ULVNZHLJKWHG DVVHWV ZKLOH IURP WKH PLQLPXP LV b I 5LVN HTXDOV WKH VWDQGDUG GHYLDWLRQ RI WKH ILUPfV GDLO\ VWRFN UHWXUQ DIWHU DGMXVWPJ IRU ELGDVN ERXQFH J ,QYHVWPHQW&DVKIORZ 6HQVLWLYLW\ LV HVWLPDWHG XVLQJ FRHIILFLHQWV RQ LQWHUQDO DGGLWLRQV WR FDSLWDO DQG LQWHUDFWLRQ YDULDEOHV IURP UHJUHVVLRQ f LQ 7DEOH K )UHH &DVK )ORZ LV QHW LQFRPH OHVV GLYLGHQGV DQG ORDQ JURZWK r GHQRWHV VLJQLILFDQWO\ GLIIHUHQW IURP WKH QR LQYHVWPHQW VDPSOH DW EHWWHU WKDQ WKH b OHYHO

PAGE 70

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f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

PAGE 71

7DEOH 3URELW UHJUHVVLRQV UHODWLQJ D VHFXULW\ LVVXDQFH WR ILUP ILQDQFLDO FKDUDFWHULVWLFV
PAGE 72

LQFOXVLRQ RI WKH LQYHVWPHQWFDVKIORZ VHQVLWLYLW\ LQFUHDVHV WKH SVHXGR 5 VTXDUHG RI WKH PRGHO DQG ORJ OLNHOLKRRG UDWLRf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f DQWLFLSDWHG FRVWV RI VHFXULW\ LVVXDQFH )ROORZLQJ &DORPLULV DQG +LPPHOEHUJ f HVWLPDWH H[SHFWHG XQGHUZULWLQJ FRVWV EDVHG RQ ILUP FKDUDFWHULVWLFV DQG VRUW ILUPV LQWR KLJK

PAGE 73

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f DQG WKH YRODWLOLW\ RI VWRFN UHWXUQV 5LVNf $V LQ &DORPLULV DQG +LPPHOEHUJ WKLV LV QRW LQWHQGHG WR EH D VWUXFWXUDO PRGHO 7KH SURFHVV RI H[SHULPHQWDWLRQ WKDW \LHOGV WKH PRGHO ZDV DQ VHDUFK IRU D PRGHO WKDW PD[LPL]HG DGMXVWHG 5 VTXDUHG %HFDXVH RI WKLV SUREOHP FKRRVH QRW WR IRFXV RQ LQGLYLGXDO FRHIILFLHQW HVWLPDWHV UDWKHU DP PRUH FRQFHUQHG ZLWK WKH DFFXUDF\ RI SUHGLFWLRQV EDVHG RQ WKLV PRGHO WKH FRUUHODWLRQ EHWZHHQ DFWXDO IHHV DQG SUHGLFWHG IHHV IRU FRPPRQ VWRFN LVVXDQFHV LV PRUH WKDQ f 0RUHRYHU ZLOO VRUW ILUPV LQWR FDWHJRULHV EDVHG RQ WKLV SUHGLFWLRQ VR DV QRW WR UHO\ RQ WKH SUHGLFWLRQ LWVHOI EXW RQO\ D GXPP\ YDULDEOH ZKLFK LQGLFDWHV ZKHWKHU WKH SUHGLFWLRQ LV RYHU RU XQGHU WKH PHGLDQ SUHGLFWLRQ H[SHULPHQW ZLWK D QXPEHU RI DOWHUQDWLYH VSHFLILFDWLRQV EXW UHSRUW RQO\ WKH RQH ZKLFK \LHOGHG WKH ODUJHVW DGMXVWHG 5 VTXDUHG

PAGE 74

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f ZKLFK HTXDOV RQH LI WKH SUHGLFWHG IHHV DUH DERYH WKH PHGLDQ SUHGLFWHG IHHV RU ]HUR RWKHUZLVH IRU HDFK VHFXULW\ W\SH 7KLV GXPP\ YDULDEOH LV HPSOR\HG WR HVWLPDWH WKH UHODWLRQ EHWZHHQ H[SHFWHG LVVXH FRVWV DQG WKH VHQVLWLYLW\ WR LQWHUQDOO\ JHQHUDWHG IXQGV

PAGE 75

7DEOH +HWHURVNHGDVWLF FRQVLVWHQW UHJUHVVLRQV UHODWLQJ WRWDO XQGHUZULWLQJ H[SHQVH WR ILUP FKDUDFWHULVWLFV
PAGE 76

7DEOH 5HJUHVVLRQ PRGHOV UHODWLQJ XQGHUZULWLQJ IHHV WR ILUP FKDUDFWHULVWLFV FRUUHFWLQJ IRU VHOHFWLYLW\ ELDV XVLQJ +HFNPDQfV WZR VWHS SURFHGXUH VWDQGDUG HUURUV LQ SDUHQWKHVHVf FRPPRQ VWRFN SUHIHUUHG VWRFN VXERUGLQDWHG QRWHV 9DULDEOH 3URELW 0RGHO O LVVXHUf b IHH 3URELW 0RGHO O LVVXHUf b IHH 3URELW 0RGHO O LVVXHUf b IHH %LQG f f f f r f f /RJ 7RWDO $VVHWVf rr f rr f rr f rr f rr f rr f )UHH &DVK )ORZ /RDQVE rr f f rr f f rr f f /DJ $GGLWLRQV WR &DSLWDO /RDQVf rr f f rr f f rr f f 6HFXULWLHV $VVHWV rr f f rr f f rr f f 7DUJHW rr f f rr f f rr f f 5LVNG r f rr f rr f r f f f PRQWK DYJ 6WRFN 3ULFH PRQWK DYJ rr f rr f rr f PRQWK DYJ 0DUNHW 3ULFH PR DYJ rr f f rr f +RW rr f rr f rr f ,VVXHG LQ WKH 3UHYLRXV
PAGE 77

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f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

PAGE 78

7DEOH )L[HG HIIHFWV UHJUHVVLRQV UHODWLQJ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO H[SHFWHG XQGHUZULWLQJ IHHV DQG ILUP ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQV f /RDQV 9DULDEOH FRPPRQ VWRFN SUHIHUUHG VWRFN VXERUG QRWHV $GGLWLRQV WR &DSLWDO /RDQV rr f rr f rr f rr f rr f rr f +LJK )HHV r $GGLWLRQV WR &DSLWDO /RDQV r f r f r f r f rr f rr f 6XUSOXV &DSLWDO $VVHWV rr f rr f rr f 6XUSOXV &DSLWDO r$GGLWLRQV WR &DSLWDO /RDQV rr f rr f rr f %LQG r f rr f rr f %LQG r $GGLWLRQV WR &DSLWDO /RDQV f r f f 6HFXULWLHV $VVHWV rr f rr f rr f rr f rr f rr f 0DUNHW %RRN $VVHWV rr f rr f rr f rr f rr f rr f ORJ $VVHWVf rr f rr f rr f rr f rr f rr f /DJ ORDQ JURZWK rr f rr f rr f rr f rr f rr f 5 1 FDWHJRULHVf f f f f f f ) VWDWLVWLF %DQN GXPPLHV rr rr rr rr rr rr D +LJK )HHV LI WKH ILUPV SUHGLFWHG IHHV IURP WKH 8QGHUZULWLQJ )HHV PRGHO LQ 7DEOH FRUUHFWHG IRU VHOHFWLYLW\ ELDVf DUH JUHDWHU WKDQ WKH PHGLDQ SUHGLFWHG IHHV RWKHUZLVH E %LQG O LI VXUSOXV FDSLWDO RWKHUZLVH r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 79

7DEOH :HLJKWHG OHDVW VTXDUHV UHJUHVVLRQV UHODWLQJ DEQRUPDO VWRFN UHWXUQV IROORZLQJ WKH DQQRXQFHPHQW RI D VHFXULW\ LVVXDQFH WR ILUP FKDUDFWHULVWLFV 2EVHUYDWLRQV DUH ZHLJKWHG E\ WKH VWDQGDUG HUURUV IURP D PDUNHW PRGHO UHJUHVVLRQ
PAGE 80

HVWLPDWHV DQG ELDV DJDLQVW ILQGLQJ DQ\ UHODWLRQ EHWZHHQ H[SHFWHG FRVWV DQG LQYHVWPHQW FDVKIORZ VHQVLWLYLWLHV 7DEOH SUHVHQWV UHVXOWV IURP WKH SURELW DQG DEQRUPDO UHWXUQ PRGHOV XVLQJ WKH +HFNPDQ SURFHGXUH FRUUHFWLQJ IRU VHOHFWLYLW\ ELDV $V EHIRUH WKH FRHIILFLHQWV IURP WKH DEQRUPDO UHWXUQ PRGHO DUH XVHG WR FRQVWUXFW SUHGLFWHG YDOXHV RI WKH FRVW RI LVVXLQJ HDFK W\SH RI VHFXULW\ IRU DOO ILUPV WKHQ FUHDWH D GXPP\ YDULDEOH /DUJH $EQRUPDO 5HWXUQVf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

PAGE 81

7DEOH 5HJUHVVLRQ PRGHOV UHODWLQJ DEQRUPDO VWRFN UHWXUQV WR ILUP FKDUDFWHULVWLFV FRUUHFWLQJ IRU VHOHFWLYLW\ ELDV XVLQJ +HFNPDQfV WZR VWHS SURFHGXUH VWDQGDUG HUURUV LQ SDUHQWKHVHVf FRPPRQ VWRFN SUHIHUUHG VWRFN VXERUGLQDWHG QRWHV 9DULDEOH 3URELW 0RGHO O LVVXHUf $EQRUPDO 5HWXUQ 3URELW 0RGHO O LVVXHUf $EQRUPDO 5HWXUQ 3URELW 0RGHO O LVVXHUf $EQRUPDO 5HWXUQ %LQG rr f r f f f rr f f /RJ 7RWDO $VVHWVf r f f rr f r f r f r f )UHH &DVK )ORZ /RDQVWE r f f rr f f f rr f /DJ $GGLWLRQV WR &DSLWDO /RDQVf rr f f rr f f r f r f 6HFXULWLHV $VVHWV rr f f rr f f rr f r f 7DUJHWn rr f f rr f f rr f f 5LVNG rr f f rr f f rr f r f PRQWK DYJ 6WRFN 3ULFH PRQWK DYJ rr f rr f rr f PRQWK DYJ 0DUNHW 3ULFH PR DYJ rr f rr f rr f +RW r f rr f r f ,VVXHG LQ WKH 3UHYLRXV
PAGE 82

7DEOH )L[HG HIIHFWV UHJUHVVLRQV UHODWLQJ ORDQ JURZWK WR LQWHUQDO DGGLWLRQV WR FDSLWDO H[SHFWHG DEQRUPDO VWRFN UHWXUQV DQG ILUP ILQDQFLDO FKDUDFWHULVWLFV 7KH VDPSOH FRQVLVWV RI EDQN KROGLQJ FRPSDQLHV IURP VWDQGDUG HUURUV LQ SDUHQWKHVHVf 'HSHQGHQW 9DULDEOH /RDQV /RDQVf /RDQV 9DULDEOH FRPPRQ VWRFN SUHIHUUHG VWRFN VXERUG QRWHV $GGLWLRQV WR &DSLWDO /RDQV rr f rr f rr f rr f rr f rr f /DUJH $EQRUPDO 5HWXUQV r $GGLWLRQV WR &DSLWDO /RDQV r f r f rr f rr f rr f rr f 6XUSOXV &DSLWDO $VVHWV rr f rr f rr f 6XUSOXV &DSLWDO r$GGLWLRQV WR &DSLWDO /RDQV rr f rr f rr f %LQGE rr f rr f rr f %LQG r $GGLWLRQV WR &DSLWDO /RDQV f r f r f 6HFXULWLHV $VVHWV rr f rr f rr f rr f rr f rr f 0DUNHW %RRN $VVHWV rr f rr f rr f rr f rr f rr f ORJ $VVHWVf rr f rr f rr f rr f rr f rr f /DJ ORDQ JURZWK rr f rr f rr f rr f rr f rr f 5 1 FDWHJRULHVf f f f f f f ) VWDWLVWLF %DQN GXPPLHV rr rr rr rr rr rr D /DUJH $EQRUPDO 5HWXUQV LI WKH ILUPV SUHGLFWHG DEQRUPDO VWRFN UHWXUQV IURP WKH $EQRUPDO 6WRFN 5HWXUQV PRGHO LQ 7DEOH FRUUHFWHG IRU VHOHFWLYLW\ ELDVf DUH PRUH QHJDWLYH WKDQ WKH PHGLDQ SUHGLFWHG DEQRUPDO UHWXUQ RWKHUZLVH E %LQG O LI VXUSOXV FDSLWDO RWKHUZLVH r rr GHQRWH VLJQLILFDQFH DW WKH b DQG b OHYHOV UHVSHFWLYHO\

PAGE 83

&+$37(5 6800$5< $1' &21&/86,216 2YHUDOO P\ UHVXOWV VXJJHVW WKDW DV\PPHWULF LQIRUPDWLRQ SUREOHPV LQFUHDVH WKH FRVWV RI H[WHUQDO ILQDQFH IRU EDQNLQJ ILUPV ,Q SDUWLFXODU ILQG D SRVLWLYH DQG VLJQLILFDQW UHODWLRQ EHWZHHQ EDQN ORDQ JURZWK DQG LQWHUQDOO\ JHQHUDWHG DGGLWLRQV WR FDSLWDO 0RUHRYHU FRQVLVWHQW ZLWK WKH K\SRWKHVLV WKDW FDSLWDO UHTXLUHPHQWV OLPLW EDQN ILQDQFLQJ DOWHUQDWLYHV WKLV FDVKIORZ VHQVLWLYLW\ RI LQYHVWPHQW LV SRVLWLYHO\ UHODWHG WR WKH H[WHQW WKDW FDSLWDO UHTXLUHPHQWV DUH ELQGLQJ 7KLV UHODWLRQVKLS LPSOLHV WKDW LQFUHDVHV LQ FDSLWDO VWDQGDUGV ZKLFK LQFUHDVH WKH OLNHOLKRRG WKDW FDSLWDO UHTXLUHPHQWV DUH ELQGLQJ FRXOG LQGXFH D VORZGRZQ LQ ORDQ JURZWK DOVR ILQG WKDW WKH IRUPXODWLRQ RI WKH FDSLWDO UDWLR LWVHOI LV LPSRUWDQW LQ GHWHUPLQLQJ EDQN ORDQ JURZWK 6SHFLILFDOO\ ZLWK UHJXODWRUV HQIRUFLQJ OHYHUDJHEDVHG FDSLWDO VWDQGDUGV EDQNV FDQ UHO\ RQ D EXIIHU VWRFN RI VHFXULWLHV WR IXQG LQYHVWPHQW LQ D OLTXLGLW\ FULVLV 7KLV UHVXOWV LQ D QHJDWLYH UHODWLRQ EHWZHHQ WKH FDVKIORZ VHQVLWLYLW\ RI LQYHVWPHQW DQG VHFXULWLHV KROGLQJV +RZHYHU WKH XVH RI ULVNEDVHG VWDQGDUGV VXEVWDQWLDOO\ UHGXFHV WKH HIIHFWLYHQHVV RI VHFXULWLHV DV ILQDQFLDO VODFN $V D UHVXOW WKH FKDQJH IURP OHYHUDJH EDVHG WR ULVNEDVHG VWDQGDUGV PD\ KDYH FDXVHG EDQNV WR GHVLUH PRUH VXUSOXV FDSLWDO DQG WKHUHIRUH PD\ KDYH KDG D QHJDWLYH LPSDFW RQ ORDQ JURZWK 0\ UHVXOWV DOVR VXJJHVW WKDW EDQN KROGLQJ FRPSDQLHV DOORFDWH FDSLWDO LQ D ZD\ FRQVLVWHQW ZLWK WKH RSHUDWLRQ RI DQ LQWHUQDO FDSLWDO PDUNHW E\ KROGLQJ FRPSDQLHV WKDW ILQG

PAGE 84

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

PAGE 85

$33(1',; (67,0$7,21 2) 5,6.:(,*+7(' $66(76 $ GDWD VHW ZLWK FRPSOHWH ULVNZHLJKWHG DVVHWV GDWD LV DYDLODEOH WR PH IRU EDQN KROGLQJ FRPSDQLHV RQ 'HFHPEHU n 7KHVH GDWD GLVDJJUHJDWH WRWDO ULVNZHLJKWHG DVVHWV LQWR WKUHH PDMRU FDWHJRULHV EDODQFH VKHHW DVVHWV ORDQ FRPPLWPHQWV DQG GHULYDWLYHV 7DEOH SUHVHQWV GHVFULSWLYH VWDWLVWLFV 7KH VDPSOH FRQWDLQV ERWK YHU\ ODUJH DQG VPDOO EDQNV DV WRWDO DVVHWV UDQJH IURP D ORZ RI 6, PLOOLRQ WR &LWLFRUSfV ELOOLRQ ,Q DGGLWLRQ ULVNZHLJKWHG DVVHWV UDQJH IURP PLOOLRQ WR ELOOLRQ %\ IDU EDODQFH VKHHW DVVHWV FRQWULEXWH WKH PRVW WR ULVNZHLJKWHG DVVHWV )RU PDQ\ EDQNV PRVWO\ VPDOO RQHV RIIEDODQFH VKHHW DVVHWV KDUGO\ DGG WR ULVNZHLJKWHG DVVHWV DW DOO 7KHUHIRUH IRU WKH PRVW DFFXUDWH DSSUR[LPDWLRQ RI WRWDO ULVNZHLJKWHG DVVHWV HVWLPDWH HDFK PDMRU FRPSRQHQW VHSDUDWHO\ 7KDW LV GHFRPSRVH ULVNZHLJKWHG DVVHWV LQWR LWV WKUHH EURDG FDWHJRULHV $ UHJUHVVLRQ IRU HDFK FRPSRQHQW LV VSHFLILHG DQG SDUDPHWHU HVWLPDWHV REWDLQHG 7KH UHJUHVVLRQV DUH VSHFLILHG DV IROORZV 5:%6 ;M/2$16 D6(&6 5:/& 3M6/& S/& 3/2& 5:'
PAGE 86

7DEOH 'HVFULSWLYH 6WDWLVWLFV RI EDQN KROGLQJ FRPSDQLHV DW \HDUHQG 'DWD ZHUH FROOHFWHG IURP WKH )HGHUDO 5HVHUYH < 'DWD 7DSHV 7KLV VDPSOH FRQVLVWV RI EDQNV IRU ZKLFK FRPSOHWH ULVNEDVHG FDSLWDO GDWD ZDV DYDLODEOH r 9DULDEOH 0HDQ 0HGLDQ 0LQ 0D[ 7RWDO $VVHWV PLOOLRQVf 5LVN:HLJKWHG $VVHWV PLOOLRQVf 5LVN:HLJKWHG $VVHWV IURP RQ EDODQFH VKHHW LWHPV PLOOLRQVf 5LVN:HLJKWHG $VVHWV IURP ORDQ FRPPLWPHQWV PLOOLRQVf 5LVN:HLJKWHG $VVHWV IURP GHULYDWLYH DVVHWV PLOOLRQVf /RDQV 7$ 6HFXULWLHV 7$ /RDQVW /RDQVf /RDQV ,QWHUQDO $GGLWLRQV WR &DSLWDO /RDQV 0DUNHW %RRN $VVHWV %RRN &DSLWDO LQ ([FHVV RI 5HTXLUHPHQW $VVHWV r 6SHFLDO WKDQNV WR &DURO\Q 7DNHGD IRU XVH RI WKLV GDWD VHW

PAGE 87

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

PAGE 88

7DEOH /HDVW VTXDUHV HVWLPDWLRQ RI ULVNZHLJKWHG DVVHWV 5:$f 'DWD ZHUH FROOHFWHG IURP WKH )HGHUDO 5HVHUYH < 'DWD 7DSHV $ VDPSOH RI ILUPV FRQWDLQV FRPSOHWH 5:$ GDWD IRU \HDUHQG 7KHVH REVHUYDWLRQV DUH XVHG WR HVWLPDWH FRPSRQHQWV RI 5:$ 5:$ LV GHFRPSRVHG LQWR WKUHH FDWHJRULHV EDODQFH VKHHW DVVHWV RIIEDODQFH VKHHW ORDQ FRPPLWPHQWV DQG GHULYDWLYH VKHHW DVVHWV 5HJUHVVLRQV XVH WKH DFWXDO DPRXQW RI 5:$ DWWULEXWDEOH WR D FDWHJRU\ DV WKH GHSHQGHQW YDULDEOH %URDG FODVVHV RI DVVHW LWHPV DUH XVHG DV LQGHSHQGHQW YDULDEOHV 5HJUHVVLRQV DUH SHUIRUPHG XVLQJ :KLWHnV FRUUHFWLRQ IRU KHWHURVNHGDVWLFLW\ 6WDQGDUG HUURUV DUH LQ SDUHQWKHVLV 9DULDEOH 5:$ %DODQFH 6KHHW $VVHWV 5:$ /RDQ &RPPLWPHQWV 5:$ 'HULYDWLYH $VVHWV /RDQV rrr f 6HFXULWLHV f 6WDQGE\ /HWWHUV RI &UHGLW rrr f /RDQ &RPPLWPHQWV rrr f /LQHV RI &UHGLW f )RUHLJQ ([FKDQJH )(;f 3XUFKDVH &RPP rrr f )RUHLJQ ([FKDQJH 3XUFKDVH 2SWLRQV rrr f )RUHLJQ ([FKDQJH :ULWWHQ 2SWLRQV rrr f )RUHLJQ ([FKDQJH 6ZDSV rrr f )XWXUHV DQG )RUZDUGV rrr f :ULWWHQ 2SWLRQV QRQ )(;f f 3XUFKDVH 2SWLRQV QRQ )(;f rrr f 6:$36 QRQ )(;f rrr f 1 $GMXVWHG 5 6TXDUHG r rr rrr GHQRWH VLJQLILFDQW DW WKH b b DQG b OHYHOV UHVSHFWLYHO\

PAGE 89

5()(5(1&(6 $VTXLWK 3DXO DQG 0XOOLQV f f(TXLW\ ,VVXHV DQG 2IIHULQJ 'LOXWLRQVf -RXUQDO RI )LQDQFLDO (FRQRPLFV %DHU +HUEHUW / DQG -RKQ 1 0F(OUDYH\ f f&DSLWDO 6KRFNV DQG %DQN *URZWK f )HGHUDO 5HVHUYH %DQN RI &KLFDJR (FRQRPLFV 3HUVSHFWLYHV %D\OHVV 0DUN DQG 6XVDQ &KDSOLQVN\ f f([SHFWDWLRQV RI 6HFXULW\ 7\SH DQG WKH ,QIRUPDWLRQ &RQWHQW RI 'HEW DQG (TXLW\ 2IIHUVf -RXUQDO RI )LQDQFLDO ,QWHUPHGLDWLRQ f f,V 7KHUH D f:LQGRZ RI 2SSRUWXQLW\f IRU 6HDVRQHG (TXLW\ ,VVXDQFH"f -RXUQDO RI )LQDQFH %HUJHU $ODQ 1 DQG *UHJRU\ ) 8GHOO f f'LG 5LVN%DVHG &DSLWDO $OORFDWH %DQN &UHGLW DQG &DXVH D n&UHGLW &UXQFKn LQ WKH 86"f -RXUQDO RI 0RQH\ &UHGLW DQG %DQNLQJ %HPDQNH %HQ 6 0 *HUWOHU DQG 6 *LOFKULVW f f7KH )LQDQFLDO $FFHOHUDWRU DQG WKH )OLJKW WR 4XDOLW\f 1DWLRQDO %XUHDX RI (FRQRPLF 5HVHDUFK :RUNLQJ 3DSHU %HUQDQNH %HQ 6 DQG &DUD 6 /RZQ f f7KH &UHGLW &UXQFKf %URRNLQJV 3DSHUV RQ (FRQRPLF $FWLYLW\ &DORPLULV &KDUOHV DQG &KDUOHV +LPPHOEHUJ f f,QYHVWPHQW %DQNLQJ &RVWV DV D 0HDVXUH RI WKH &RVW RI $FFHVV WR ([WHUQDO )LQDQFHf 1DWLRQDO %XUHDX RI (FRQRPLF 5HVHDUFK :RUNLQJ 3DSHU &RUQHWW 0DUFLD 0 DQG +DVVDQ 7HKUDQLDQ f f$Q ([DPLQDWLRQ RI 9ROXQWDU\ 9HUVXV ,QYROXQWDU\ 6HFXULW\ ,VVXDQFHV E\ &RPPHUFLDO %DQNVf -RXUQDO RI )LQDQFLDO (FRQRPLFV )DOORQ .LHUDQ f f6RXUFH RI 6WUHQJWK RU 6RXUFH RI :HDNQHVV" $ &ULWLTXH RI WKH f6RXUFH RI 6WUHQJWKf 'RFWULQH LQ %DQNLQJ 5HIRUPf 1HZ
PAGE 90

)D]]DUL 6WHYHQ 0 5 *OHQQ +XEEDUG DQG %UXFH & 3HWHUVHQ f f)LQDQFLQJ &RQVWUDLQWV DQG &RUSRUDWH ,QYHVWPHQWf %URRNLQJV 3DSHUV RQ (FRQRPLF $FWLYLW\ )HGHUDO 5HVHUYH %RDUG RI *RYHUQRUV f %DQN +ROGLQJ &RPSDQ\ 6XSHUYLVLRQ 0DQXDO )HGHUDO 5HVHUYH :DVKLQJWRQ & )XUORQJ )UHGHULFN 7 DQG 0LFKDHO & .HHOH\ f f&DSLWDO 5HJXODWLRQ DQG %DQN 5LVN 7DNLQJ $ 1RWHf -RXUQDO RI %DQNLQJ DQG )LQDQFH +DQFRFN DQG :LOFR[ f f+DV 7KHUH %HHQ D f&DSLWDO &UXQFKf LQ %DQNLQJ" 7KH (IIHFWV RQ %DQN /HQGLQJ RI 5HDO (VWDWH 0DUNHW &RQGLWLRQV DQG %DQN &DSLWDO 6KRUWIDOOVf -RXUQDO RI +RXVLQJ (FRQRPLFV +DXEULFK -RVHSK DQG 3DXO :DFKWHO f f&DSLWDO 5HTXLUHPHQWV DQG 6KLIWV LQ &RPPHUFLDO %DQN 3RUWIROLRVf )HGHUDO 5HVHUYH %DQN RI &OHYHODQG (FRQRPLF 5HYLHZ +RVKL 7 $ .DVK\DS DQG 6FKDUIVWHLQ f f&RUSRUDWH 6WUXFWXUH /LTXLGLW\ DQG ,QYHVWPHQWf 4XDUWHUO\ -RXUQDO RI (FRQRPLFV .HHWRQ :LOOLDP f f%DQN +ROGLQJ &RPSDQLHV &URVV%DQN *XDUDQWHHV DQG 6RXUFH RI 6WUHQJWKf )HGHUDO 5HVHUYH %DQN RI .DQVDV &LW\ (FRQRPLF 5HYLHZ /DPRQW 2ZHQ f f&DVKIORZ DQG ,QYHVWPHQW (YLGHQFH )URP ,QWHUQDO &DSLWDO 0DUNHWVf 0DVVDFKXVHWWV ,QVWLWXWH RI 7HFKQRORJ\ :RUNLQJ 3DSHU 0LNNHOVRQ :D\QH + DQG 0HJDQ 3DUWFK f f9DOXDWLRQ (IIHFWV 2I 6HFXULW\ 2IIHULQJV DQG WKH ,VVXDQFH 3URFHVVf -RXUQDO RI )LQDQFLDO (FRQRPLFV 0\HUV 6WHZDUW & DQG 1LFKRODV 6 0DMOXI f f&RUSRUDWH )LQDQFLQJ DQG ,QYHVWPHQW 'HFLVLRQV ZKHQ )LUPV +DYH ,QIRUPDWLRQ WKDW ,QYHVWRUV 'R 1RW +DYHf -RXUQDO RI )LQDQFLDO (FRQRPLFV 2n+DUD 0DXUHHQ DQG :D\QH 6KDZ f f'HSRVLW ,QVXUDQFH DQG :HDOWK (IIHFWV 7KH 9DOXH RI %HLQJ n7RR %LJ WR )DLOnf -RXUQDO RI )LQDQFH 3DVVPRUH :D\QH DQG 6WHYHQ $ 6KDUSH f f2SWLPDO %DQN 3RUWIROLRV DQG WKH &UHGLW &UXQFKf )LQDQFH DQG (FRQRPLF 'LVFXVVLRQ 6HULHV )HGHUDO 5HVHUYH %RDUG 3HHN -RH DQG (ULF 6 5RVHQJUHQ f f%DQN 5HJXODWLRQ DQG WKH &UHGLW &UXQFKf -RXUQDO RI %DQNLQJ DQG )LQDQFH

PAGE 91

6KDUSH 6WHYHQ $ f f%DQN &DSLWDOL]DWLRQ 5HJXODWLRQ DQG WKH &UHGLW &UXQFK $ &ULWLFDO 5HYLHZ RI WKH 5HVHDUFK )LQGLQJVf )HGHUDO 5HVHUYH %RDUG RI *RYHUQRUV :RUNLQJ 3DSHU 6WHLQ -HUHP\ & f f,QWHUQDO &DSLWDO 0DUNHWV DQG WKH &RPSHWLWLRQ IRU &RUSRUDWH 5HVRXUFHVf 1DWLRQDO %XUHDX RI (FRQRPLF 5HVHDUFK :RUNLQJ 3DSHU 7DNHGD &DURO\Q 7 f f(FRQRPLF 'HWHUPLQDQWV RI &RQWLQJHQW &RPPLWPHQW $FWLYLW\ DQG WKH (IIHFW RI 5LVN%DVHG &DSLWDOf 8QLYHUVLW\ RI )ORULGD :RUNLQJ 3DSHU 7KDNRU $QMDQ 9 f f&DSLWDO 5HTXLUHPHQWV 0RQHWDU\ 3ROLF\ DQG $JJUHJDWH %DQN /HQGLQJ 7KHRU\ DQG (PSLULFDO (YLGHQFHf -RXUQDO RI )LQDQFH :DOO /DUU\ DQG 3HWHUVRQ f f%DQN +ROGLQJ &RPSDQ\ &DSLWDO 7DUJHWV LQ WKH (DUO\ V 7KH 5HJXODWRUV 9HUVXV WKH 0DUNHWVf -RXUQDO RI %DQNLQJ DQG )LQDQFH :LOOLDPVRQ 2OLYHU ( f 0DUNHWV DQG +LHUDUFKLHV $QDO\VLV DQG $QWLWUXVW ,PSOLFDWLRQV &ROOLHU 0DFPLOODQ 3XEOLVKHUV ,QF 1HZ
PAGE 92

%,2*5$3+,&$/ 6.(7&+ 'DYLG )UHGHULF 0DUFXV ZDV ERUQ WKH WKLUG FKLOG RI -HIIHU\ 1HDO DQG (OOHQ -DQHW 0DUFXV RQ 6HSWHPEHU LQ (DX &ODLUH :LVFRQVLQ +H DWWHQGHG WKH 8QLYHUVLW\ RI &RORUDGR DW %RXOGHU IURP 'DYLG JUDGXDWHG 0DJQD &XP /DXGH ZLWK D %DFKHORU RI 6FLHQFH )ROORZLQJ JUDGXDWLRQ 'DYLG ZRUNHG IRU WZR \HDUV EHIRUH HQUROOLQJ DW WKH 8QLYHUVLW\ RI )ORULGD DV D GRFWRUDO VWXGHQW

PAGE 93

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

PAGE 94

/' c$ 81,9(56,7< 2) )/25,'$


xml version 1.0 encoding UTF-8
REPORT xmlns http:www.fcla.edudlsmddaitss xmlns:xsi http:www.w3.org2001XMLSchema-instance xsi:schemaLocation http:www.fcla.edudlsmddaitssdaitssReport.xsd
INGEST IEID E9E8LU2HK_VN2QW5 INGEST_TIME 2014-07-22T21:29:24Z PACKAGE AA00018866_00001
AGREEMENT_INFO ACCOUNT UF PROJECT UFDC
FILES


EFFECTS OF CAPITAL REGULATION AND INFORMATION
ASYMMETRIES ON BANK LENDING
By
DAVID FREDERIC MARCUS
A DISSERTATION PRESENTED TO THE GRADUATE
SCHOOL OF THE UNIVERSITY OF FLORIDA IN PARTIAL
FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY
UNIVERSITY OF FLORIDA
1996
UNIVERSITY OF FLORIDA LIBRARES

ACKNOWLEDGMENTS
I owe special thanks to Professors Chris James, Joel Houston, Mike Ryngaert, and Mark
Flannery for their excellent guidance and many patient discussions. I have also benefited
greatly from conversations with Professors Jon Hamilton, Carolyn Takeda, Charles
Hadlock, and Jon Garfinkel. Most of all, I owe an enormous debt to my family, and
especially my wife Deborah, for their dedication to helping me realize my goal.
11

TABLE OF CONTENTS
page
ACKNOWLEDGMENTS ii
ABSTRACT iv
CHAPTERS
1 INTRODUCTION 1
2 BACKGROUND DISCUSSION 8
Literature on Capital Regulation and Bank Growth 8
Internal Additions to Capital and Bank Holding Companies 15
3 DATA 22
4 BANK HOLDING COMPANY ANALYSIS 27
5 BANK SUBSIDIARY ANALYSIS 44
6 EXTERNAL CAPITAL ISSUANCE 57
7 SUMMARY AND CONCLUSIONS 78
APPENDIX ESTIMATION OF RISK-WEIGHTED ASSETS 80
REFERENCES 84
BIOGRAPHICAL SKETCH. 87
in

Abstract of Dissertation Presented to the Graduate School of the University of Florida in
Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy
EFFECTS OF CAPITAL REGULATION AND INFORMATION ASYMMETRIES ON
BANK LENDING
By
David Frederic Marcus
August 1996
Chairman: Christopher M. James
Major Department: Finance, Insurance, and Real Estate
This paper provides evidence that asymmetric information problems increase the
costs of external finance for banking firms. Specifically, I find a positive and significant
relation between bank loan growth and internally generated additions to capital.
Consistent with the hypothesis that capital requirements limit bank financing choices, this
cash flow sensitivity of investment is positively related to the extent that capital
requirements are binding. I also find that the formulation of the capital ratio itself is
important in determining bank loan growth. Specifically, with regulators enforcing
leverage-based capital standards, banks can rely on a buffer stock of securities to fund
investment in a liquidity crisis. However, the use of risk-based standards substantially
reduces the effectiveness of securities as financial slack. My results also suggest that bank
holding companies establish internal capital markets to allocate scarce capital among their
subsidiaries in response to costly external finance. I find that investment by bank
IV

subsidiaries is more sensitive to the cash flows and capitalization of its holding company
than its own cash flows and capitalization. Finally, I find that the severity of information
asymmetries affects both the likelihood of an external capital issuance and the expected
costs of issuance. I find a negative relation between the cash flow sensitivity of investment
and the probability that banks issue external capital. I also find that firms that anticipate
larger external finance costs exhibit significantly higher cash flow sensitivities of
investment.
v

CHAPTER 1
INTRODUCTION
Over the last fifteen years, banks operating in the United States have faced
increasingly stringent capital requirements. Concurrently, the growth rate of bank lending
has been sharply declining. Recent empirical work has questioned whether the more rigid
capital standards induced the slowdown in loan growth.1 These studies rely on the critical
assumption that banks face information asymmetries which create a wedge between
internal and external financing costs. This results in capital market frictions that tie loan
growth to internally generated funds.2 Previously, scholars believed that the federal safety
net covering deposits removed financial firms from this problem. However, capital
requirements restrict the amount of (insured) debt funds that banks can utilize. As a
result, banks may benefit from holding capital greater than regulatory requirements
(surplus capital) as financial slack. This suggests that banks with more surplus capital
should invest more, and their investment should be less constrained by internally generated
funds than banks with less surplus capital. Moreover, increases in capital requirements
can prompt a decline in lending as banks replenish their surplus capital to its (new) optimal
level.
1 For an excellent review see Berger and Udell (1994) and Sharpe (1995).
2 See Fazzari, Hubbard, and Petersen (1988); Hoshi, Kashyap, and Scharfstein
(1991), and Bernanke, Gertler, and Gilchrist (1994).
1

2
A second effect of capital regulation is that the formulation of regulatory capital
ratios affects bank liquidity stocks. During the 1980s, regulators relied on leverage-based
requirements, mandating minimum capital levels per total assets. Under leverage-based
requirements, banks facing a funding shortage can support new loans through the
liquidation of other assets, namely securities, without changing required capital levels. In
this vein, security holdings may substitute for surplus capital by decreasing the dependency
on internally generated funds. However, beginning in 1990 regulators adopted risk-based
standards which require minimum capital per risk-weighted assets. Risk-weighted assets
are determined by assigning a weight based on credit risk to every bank asset. Since
securities receive a lower risk weight than loans, asset substitution could substantially
influence capital adequacy. In particular, an increase in loans increases the amount of
required bank capital even if securities are liquidated. Therefore, a change from leverage
to risk based standards may affect loan growth by reducing the role of securities as
liquidity and effectively increasing banks’ desired surplus capital.
Given the existence of capital market frictions which tie investment to earnings, the
magnitude of the effect of internally generated funds may proxy for the size of the wedge
in financing costs. As a result, banks that are more constrained by internally generated
funds may be more concerned about facing a funding shortage. This suggests that these
banks may have a larger incentive to hedge their risks and therefore may rely more heavily
on derivatives and other off-balance sheet assets. Moreover, these banks may be less
likely to issue external capital and may anticipate larger costs when bringing capital issues
to the market (either in the form of underwriter fees or abnormal stock returns).

3
Most recent studies on capital regulation and loan growth focus on the adoption of
risk-based requirements and the simultaneous “credit crunch” of the early 1990s (in which
banks allegedly decreased lending in response to the new capital standards). In general,
these studies document a positive correlation between loan growth and capitalization
Nonetheless, whether the decline in growth results from more stringent capital
requirements is not obvious. In particular, the observed relationship between loan growth
and capitalization may arise from either capital market imperfections or simply because
earnings and capitalization proxy for the profitability of lending opportunities.
An additional problem with prior studies of the relationship between capital
regulation and loan growth is that most concentrate on individual bank data. However,
the majority of banks are subsidiaries of multiple bank holding companies. If holding
companies manage capital on a consolidated basis, one would expect at best a weak link
between investment and earnings at the subsidiary level. Moreover, regulators have
recently attempted to require holding companies to inject capital into undercapitalized
subsidiaries.3 This ‘source of strength’ doctrine mandates that bank holding companies
must downstream capital to its subsidiary banks if they fail capital standards, as long as
this act does not cause the holding company itself to fail capital requirements. Thus, it
follows that the primary determinant of loan growth should be the capitalization and
earnings of the holding company and not the subsidiary bank.
In this paper I investigate the relationship between loan growth and internally
generated funds for a sample of 289 publicly traded bank holding companies from 1982-
3 See Keeton (1990), Fallon (1991), and Wall and Petersen (1995)

4
1994. Following the approach of Fazzari, Hubbard, and Petersen (1988), 1 assume that
capital market imperfections create a wedge between internal and external financing costs.
As a result, banks prefer to grow with internally generated funds. To control for growth
opportunities I include a measure of Tobin’s Q and the bank’s previous loan growth as
explanatory variables. I test the hypothesis that capital requirements increase banks’ costs
of finance, and therefore I expect a negative relation between the overall sensitivity to
internally generated funds and surplus capital. In addition, I test the hypothesis that the
formulation of capital standards affects the role of securities holdings as liquidity. In
particular, I expect a negative relation between the sensitivity to internally generated funds
and securities holdings to exist while regulators impose leverage-based standards, but not
risk-based standards. I also examine the relation between the overall sensitivity to
internally generated funds and the amount of off-balance sheet assets utilized to test how
the severity of capital market imperfections affects banks’ incentives to hedge risks.
To further test the existence of capital market frictions, I follow an approach
similar to Lamont (1993) and examine the relation between loan growth of individual bank
subsidiaries of multiple bank holding companies and the subsidiary’s own earnings, as well
as the earnings of other subsidiaries within the same holding company.4 A finding that
subsidiary banks are more constrained by the earnings of the rest of the holding company
than its own earnings is consistent with the operation of an internal capital market. Since
holding company wide earnings may proxy for investment opportunities at the subsidiary
4 Lamont (1993) examines investment of firms with subsidiaries in both oil and
non-oil related business. His results suggest that investment of non-oil related subsidiaries
is positively related to the cash flows of the oil subsidiaries.

5
bank, I include both loan growth at other subsidiaries and the earnings of all non-bank
subsidiaries within the holding company as explanatory variables. As an additional test I
examine how the severity of information asymmetries at the holding company level affect
subsidiary bank dependence on both its own and holding company earnings.
An additional test on the effects of capital market frictions is to examine the
relation between the severity of information asymmetries and external capital issuances.
Following Bayless and Chaplinsky (1991, 1996), I develop a model which predicts
security issuance based on firm and market characteristics. Assuming the overall
sensitivity to internally generated funds proxies for the severity of capital market frictions,
banks that are more constrained by internally generated funds are expected to be less likely
to issue external capital. To control for a potential causality problem, 1 test this relation
using a lagged value of the sensitivity to internally generated funds. Because capital
deficient banks are likely to be the most constrained by internally generated funds and the
most in need of an external capital issuance, I include a dummy variable for whether banks
maintain minimum capital ratios as an explanatory variable.
Continuing along these lines, the costs associated with bringing an external capital
issue to the market should be related to the degree of information asymmetries. Following
Calomiris and Himmelberg (1995), I estimate underwriting fees associated with security
issuance after controlling for selectivity bias and examine the relation between these fees
and the sensitivity to internally generated funds. In addition, I predict the abnormal stock
returns associated with the announcement of a security issuance. A finding of a positive
relation between these costs of external finance and the sensitivity to internally generated

6
funds provides additional support for the hypothesis that the reliance on internal funds
proxies for the severity of capital market frictions.
Overall, I find a strong positive correlation between bank holding company loan
growth and internally generated additions to capital after controlling for differences in
growth opportunities. Consistent with the hypothesis that capital requirements increase
banks’ financing costs, I find that the sensitivity of loan growth to earnings is significantly
greater among banks that are close to or below the minimum capital requirement. In
addition, I find that securities holdings provide banks with significant financial slack by
decreasing the dependency on internally generated funds. Moreover, after the
implementation of risk-based standards in 1990, loan growth is unrelated to securities
holdings, suggesting that the type of capital requirement enforced can have a significant
impact on loan growth. Also, consistent with the hypothesis that the severity of
information asymmetries influences the incentives to hedge, I find that banks that are more
constrained by internally generated funds hold more off-balance sheet assets.
In tests of the relation between loan growth and earnings at the subsidiary level, I
find that subsidiary loan growth is positively related to both its own earnings and the
earnings of other bank subsidiaries within the holding company. However, the sensitivity
of loan growth to the earnings of other subsidiaries is significantly greater than the
subsidiary’s own earnings. Moreover, subsidiary loan growth is unrelated to its own
capitalization, but positively related to the holding company’s capitalization. I also find
that subsidiary loan growth is negatively related to loan growth at other subsidiaries within
the holding company. This is consistent with the operation of an internal capital market in

7
which the overall investment capacity of the holding company is constrained. In addition,
I find that subsidiary loan growth is positively related to the earnings of non-bank
subsidiaries within the holding company. Furthermore, I find that as holding companies
become more constrained by internally generated funds, subsidiaries grow slower and
become more dependent on holding company earnings.
Finally, I examine the relation between the severity of information asymmetries, the
decision to issue external capital, and costs associated with an external capital issuance. I
find that the severity of information asymmetries affects banks’ decisions to issue external
capital. In particular, my results document a negative relation between the overall
sensitivity to internally generated funds and the probability that the firm chooses to issue.
In tests of the relation between issuance costs and information asymmetries, I find that
banks that anticipate higher costs of security issuance are more constrained by internally
generated funds. Specifically, I find that the sensitivity to internally generated funds is
significantly higher for banks which expect high underwriting fees for issuing external
funds or large negative abnormal stock returns following the announcement of a security
issuance.
The remainder of the paper is organized in six chapters. Chapter 2 provides a
background discussion on the effects of capital requirements on bank investment activity.
Chapter 3 describes the data and empirical methodology. Chapter 4 documents empirical
tests for the holding company sample, while Chapter 5 documents the subsidiary bank
sample. Chapter 6 presents the external capital issuance analysis, and Chapter 7
summarizes and concludes.

CHAPTER 2
BACKGROUND DISCUSSION
Literature on Capital Regulation and Bank Growth
Bank capital regulation has changed substantially over the past fifteen years.
Before 1981, regulators relied solely on discretion when evaluating a bank’s capital
adequacy. To eliminate potential bias in the examination process, regulators adopted a
minimum leverage-based capital ratio in 1981.' A problem with leverage-based standards
is that the riskiness of bank assets is not considered when determining the minimum capital
level. Accordingly, banks had incentives to alter the riskiness of their asset portfolios. In
response, regulators created risk-based standards, which were implemented beginning in
1990.2 These new guidelines assign risk weights to all bank assets, including off-balance
sheet assets, based on credit risk.3 For example, commercial and industrial loans receive
100% risk weight, while cash and Treasury securities receive a risk weight of zero.
Some recent theoretical models have attempted to link capital regulation and bank
growth. Using an options-pricing model, Furlong and Keeley (1989) investigate how
1 Regulations required that banks maintain a minimum total capital ratio of 5.5%.
In 1985, regulators increased the standard to 6%.
2 Regulators imposed a minimum risk-based ratio of 7.25% beginning in 1990, and
8% beginning in 1992.
3 See Bank Holding Company Supervision Manual, section 4060, for a complete
description of risk-based capital standards.
8

9
increases in requirements affect bank risk taking behavior. Public opinion held that banks
would respond to increased requirements by increasing asset risk to offset the cost of
holding more capital. Contrary to this prediction, Furlong and Keeley show that banks
actually decrease asset risk following an increase in requirements. Although this is
excellent news for the FDIC, it has less to say about how bank growth responds, if at all,
to changes in capital requirements.
Passmore and Sharpe (1994) analyze how economic shocks and regulatory shifts
affect a profit maximizing bank. One prediction of their model is that increased capital
requirements cause a slowdown in loan growth by raising the marginal cost of funds. In
addition, they provide evidence that the resultant decline in bank lending may be most
pronounced at highly capitalized banks. This occurs because banks hold capital as a buffer
against regulatory intervention and funding shortages. One reason why banks may choose
high capital ratios is that they face high costs of capital shortages. Therefore, these firms
may react more to an increase in required capital ratios. This finding is at odds with the
popular notion that banks which are close to minimum standards would be the most
affected by an increase in capital requirements.4 This work allows for the possibility that
well capitalized institutions may be affected by increases in capital standards. In
particular, I test the hypothesis that banks rely on surplus capital (amount above
regulatory requirements) as a buffer stock against funding shortages.
4 Berger and Udell (1994) note that the commercial and industrial lending decline
in the early 1990s was not concentrated in banks with low risk-based capital ratios. In
turn, they cite this as evidence that risk-based standards were unlikely to have caused the
credit crunch.

10
Thakor (1995) develops an asymmetric information model in which banks perform
two key lending functions: pre-lending screening and post-lending monitoring. One result
of his model is that an increase in capital requirements elevates the endogenously
determined probability of a borrower being credit rationed by the entire banking system,
thereby reducing aggregate lending. This is consistent with Passmore and Sharpe and
suggests that the recent increase in capital standards may have significantly contributed to
the simultaneous decline in loan growth.
Because securities receive a lower risk-weight than loans, a change from leverage
to risk-based standards can have a significant impact on bank behavior. First, securities
require little or no capital backing, which increases their attractive relative to loans.
Consequently, banks may have gained incentive to shift assets out of loans and into
securities. Second, the role of securities as liquidity may have been diminished. With
regulators enforcing leverage-based requirements, banks could rely on a buffer stock of
securities to fund growth during a liquidity crisis. However, with risk-based standards
capital ratios decline following this type of asset substitution. Therefore, banks may have
experienced a drain on liquidity following this change in regulatory regimes. These
problems led recent empirical studies to investigate whether the regime shift induced the
“credit crunch” of the early 1990s. To date, the literature offers mixed predictions.
Peek and Rosengren (1995) and Hancock and Wilcox (1993) examine how loan
growth differs for banks based on whether they pass or fail capital requirements. Peek and
Rosengren (1995) study growth of New England banks which underwent formal
regulatory enforcement actions between 1989 and 1993. After controlling for size, time,

11
and region, they find that banks under formal action grow at a significantly slower pace.
In addition, they find that these banks were growing at a faster pace than other banks in
the quarters leading up to the enforcement actions. Thus, their evidence is consistent with
regulatory intervention significantly decreasing loan growth. This suggests that if the
change to risk-based standards caused an increase in regulatory intervention, then this
change may have contributed to the credit crunch.
However, the authors provide no proof of an increase in the number of banks with
enforcement actions based on the change to risk-based standards. In fact, the large
number of institutions under formal action may reflect the regional economic difficulties
during their sample period and not changes in capital regulations. Also, they do not
include a control period to compare the relationship between enforcement actions and
growth. Although this does not take away from their insight that in the 1990s regulatory
intervention has substantial effects (for New England banks), it does limit their ability to
test whether the change to risk-based standards had any impact on loan growth.
Hancock and Wilcox (1993) study the cross-sectional determinants of bank loan
and security growth during 1990 and 1991 based on whether banks experienced a “capital
shortfall” during their sample period. Capital shortfall is defined as the difference between
the actual 1990 year end capital and the regulatory minimum based on the 1990 beginning
of year total assets and a 5% capital requirement.5 In short, their findings reveal that a
capital shortfall has a large negative cross-sectional effect on loan growth in 1990.
5 The authors reasoned that banks could largely anticipate the amount of capital
that would be on the books at year end, and that this is the figure that should influence
growth.

12
A potential problem with this study is the authors’ treatment of capital shortfall.
They assume that a 5% minimum leverage-based standard (introduced in 1981) remains in
effect through 1991. However, capital standards have been increased twice since 1981.6
Hence, the authors significantly understate the number of banks experiencing a capital
shortfall, and actually focus on only the most capital deficient banks. Therefore,
ascertaining exactly how a capital shortfall affects growth is difficult given the formulation
of these tests.
Due to the possible incentive banks may have gained to shift assets out of loans
and into securities, Haubrich and Wachtel (1993) explore how risk-based standards may
influence asset portfolio choice. The authors sort banks according to risk-based ratios and
analyze subsequent changes in portfolio mix. Their results suggest that banks in lower
capital groups tend to shift toward assets with lower risk weights, and in particular away
from commercial loans and into Treasury securities. They interpret this as evidence that
risk-based standards may have partially caused the credit crunch.
Since the authors fail to provide a benchmark period for comparing bank behavior,
however, it is possible that any changes in portfolio mix observed is simply optimal
rebalancing without regard to capital requirements. Likewise, the authors do not control
for bank size, growth opportunities, loan loss provisions, or previous growth, all of which
may significantly impact asset portfolio shifts.
6 It could be argued that the change to risk-based standards did not constitute an
increase in requirements since some banks would actually find their required capital
declining due to the new standards. However, for the majority of banks, and especially the
larger banks, the change to risk-based standards can be considered an increase in
requirements.

13
Given the existence of capital market imperfections, loan growth may be directly
related to capitalization. In this vein, Bernanke and Lown (1991) and Berger and Udell
(1994) investigate a direct link between capitalization and growth. Bernanke and Lown
(1991) examine growth as a function of beginning of period capital ratios. In their
interpretation, coefficients on capitalization serve to identify short run effects over a
period during which capital might be reasonably treated as exogenous. Relying on
aggregate state level data, their findings suggest that loan growth is positively related to
capitalization A potential problem with this study is the utilization of state level data.
This analysis is likely to drop potentially important information specific to individual
banks.
Probably the most cited study in this area, Berger and Udell (1994) use a long
panel of observations to investigate asset growth’s relationship with capitalization. In
particular, they examine differences in asset expansion during the credit crunch (early
1990s) relative to earlier years, especially with regard to capitalization. They find that
loan growth during the credit crunch does not appear to be consistently more sensitive to
capitalization than it was in the 1980s. In addition, they find that the decline in lending
was not concentrated in banks with low capital ratios. The authors interpret these findings
as evidence that risk-based standards were unlikely to have been the culprit behind the
contraction in lending during the early 1990s.
A basic problem in interpreting these results is that no change in coefficient
estimates does not necessarily imply no impact from increased regulatory standards.
Specifically, if all banks respond in a similar fashion to the change in regulations, then

14
coefficient estimates may not change at all. Therefore, the finding that loan growth is not
more affected by capitalization during the 1990s is not proof that the change to risk-based
standards had no effect. Moreover, the finding of a decline in lending at banks with high
capital ratios does not imply that the change in capital standards had no effect. Recall that
Passmore and Sharpe (1994) find that reductions in lending may be more severe at banks
with high capital ratios.
In this study, I test for the effects of capital regulation on loan growth in two ways.
First, consistent with prior studies 1 expect a positive relation between capital and growth.
More specifically, I hypothesize that banks consider the cushion between their capital and
required capital as a type of financial slack. Thus, an external shock which depletes this
slack could induce a slowdown in growth. Second, I test for the effects of the change to
risk-based standards through the relation between securities holdings and growth. In
particular, I expect securities to be positively related to growth in the 1980s, but unrelated
to growth in the 1990s, since risk-based standards may diminish the effectiveness of
securities as a buffer stock.
To improve upon previous studies, I provide evidence of an increase in the number
of capital deficient banks following the change to risk-based standards. 1 employ a long
panel of observations to observe bank behavior over time. Moreover, I use a number of
control variables to alleviate problems associated with bank growth opportunities and size.
Finally, I calculate surplus capital, which is in the same spirit as Hancock and Wilcox’s
capital shortfall. However, my measure requires banks to comply with capital
requirements exactly as defined by regulations.

15
Internal Additions to Capital and Bank Holding Companies
It is widely accepted that banks play an important role in mitigating information
problems. Given this role, assuming that at least some bank assets will be difficult for
outsiders to value seems logical. Even so, access to federally insured deposits and the
absence of capital requirements may insulate banks from any adverse selection problems in
raising external funds. However, limited deposit insurance combined with capital
requirements suggest that banks must raise at least some funds in markets in which
asymmetric information may create a wedge between internal and external financing
costs.7 This implies that the more constrained banks are by capital requirements, the more
sensitive their growth might be to internally generated additions to capital (earnings
available to augment regulatory capital).8
A number of studies (some cited above) examine the empirical relation between
bank growth and capitalization, and in particular investigate the sensitivity of growth to
capital shocks. However, except work by Baer and McElravey (1993), studies do not
explicitly examine the sensitivity of loan growth to internal additions to capital. Since an
underlying assumption for capital shocks to adversely affect loan growth is capital market
friction which creates a wedge between internal and external finance costs, loan growth is
expected to be positively related to internal additions to capital.
7 See Myers and Majluf (1984), and Fazzari, Hubbard, and Petersen (1988).
8 Due to the way in which capital requirements are calculated, internal additions to
capital differs slightly from internally generated cash flows for non-financial firms.
Chapter 3 discusses the differences in detail

16
Baer and McElravey (1993) investigate the relation between growth and internally
generated capital, and specifically address the issue of whether banks manage their assets
as if external finance is costly. Moreover, they examine how changes in capital
requirements might influence growth. Their results indicate that banks manage assets as if
there are significant costs with issuing new equity, or in other words, internally generated
capital strongly influences growth. They also find that growth explained by regulatory
capital increased dramatically following the introduction of specific minimum capital
standards in 1981. This suggests that banks view capital requirements as important, and
that increases in standards may have significant negative effects on growth
A problem with their methodology is that the authors do not explicitly include
market or bank level economic control variables, such as Tobin’s Q, previous growth, or
loan loss provisions. In addition their measure of internally generated capital is after
deductions for dividend payments and loan loss provisions. Since these are both
endogenous choice variables management has in its control, the inclusion of these items in
regressions may lead to misleading results. The authors also do not mention liquidity,
specifically securities holdings, playing a role in their investment model. This is surprising
since similar studies for non-financial firms generally recognize firm liquidity as an
important determinant of growth. Although it is conceivable that the availability of
insured deposit financing obviates the need to worry about liquidity, the existence of
capital requirements limits the amount of deposit financing allowable. As a result, liquidity
should be an important contributor to investment.

17
Most prior studies on bank growth and capitalization rely on bank subsidiary data.
However, if asymmetric information problems create capital market frictions, for most of
banks these frictions will occur at the holding company level. This is because usually the
parent company and not the subsidiary accesses the capital market. By definition, a bank
holding company is any organization which owns or controls at least 25 percent of any
class of voting stock of a commercial bank.9 Since the 1970s, bank holding companies
have dominated bank ownership, holding more than 90 percent of all commercial bank
assets in the United States in 1993. While the formulation of holding companies allows
banks to circumvent branching restrictions and other regulations imposed on individual
banks, the operation of a holding company also provides a mechanism for consolidating
the management and funding operations of individual subsidiary banks.
In the absence of regulations restricting bank holding companies from managing
capital on a consolidated basis, loan growth would be sensitive to the internally generated
capital of the entire holding company. Moreover, subsidiary bank loan growth would be
related primarily to the capitalization and earnings of the holding company, and not its
own capitalization and earnings. However, some restrictions on inter-company transfers
may potentially weaken the relation between subsidiary growth and holding company
earnings. For example, if holding companies are restricted in their ability to upstream
capital from subsidiaries, then each subsidiary’s loan growth should partially depend on its
own earnings.
9 The 1970 Amendments to the Bank Holding Company Act of 1956 provide a
definition of a bank holding company and establishes limits on the activities in which
holding companies may engage.

18
One restriction, in particular, is the requirement that all subsidiaries plus the
holding company must individually maintain minimum capital ratios. This “building block”
approach implies that failure of any subsidiary to meet capital standards will impede the
holding company’s ability to manage capital on a consolidated basis.10 A second
restriction is the Federal Reserve policy of viewing the holding company as a “source of
strength” to individual subsidiaries. This creates an obligation for the holding company to
downstream capital to inadequately capitalized subsidiaries. As a result, holding
companies may not be able to allocate capital to subsidiaries with positive NPV projects.
Finally, sections 23A and 23B of the Federal Reserve Act place restrictions on inter¬
company transfers. Specifically, dividends, fees, and intercompany asset sales are
restricted to transfers of less than 10 percent of the bank’s capital.11 Again, these
restrictions limit the ability of the holding company to allocate capital on a consolidated
basis.
I analyze the effects of capital market imperfections on the sensitivity of bank
investment, at both the holding company and subsidiary level, to internally generated
additions to capital. I assume that loan growth (net of loan losses) is the banking
equivalent of investment by non-financial firms.12 Given the existence of capital market
10 See the Bank Holding Company Supervision Manual, sections 2010 and 4060.2.
11 See section 2020.1 of the Bank Holding Company Supervision Manual.
12 Bank investment in real assets is less than 3 percent of total assets. Arguably,
investment should consider securities. However, one motive for bank investment in
securities is liquidity. I control for securities holdings as a form of bank liquidity when
analyzing loan growth.

19
imperfections which create a wedge between internal and external finance, one would
expect a positive relation between holding company loan growth and internally generated
funds. Moreover, since capital requirements limit a bank’s ability to substitute deposits for
equity, 1 expect the sensitivity of loan growth to internally generated funds (investment-
cashflow sensitivity) to be greatest for firms where the capital requirement is most binding.
1 also examine how the nature of enforced capital requirements affects bank
investment-cashflow sensitivities. In particular, with regulators mandating leverage-based
capital standards, securities holdings may substitute for surplus capital as financial slack.
This is because banks can fund growth through the liquidation of securities without
changing required capital levels. Therefore, I expect the investment-cashflow sensitivities
to be decreasing the in amount of securities (relative to assets) that banks hold on their
balance sheets during the 1980s. However, beginning with the introduction of risk-based
standards in 1990, securities holdings may no longer be as efficient at providing financial
slack, and as a result 1 expect the investment-cashflow sensitivities to be unrelated to
securities holdings in the 1990s.
A common criticism of studies of the cash flow sensitivity of investment is that
current cash flow may be correlated with the profitability of investment opportunities. As
a result, even without capital market imperfections, investment may be positively related
to cash flows. I address this issue by including in the analysis the bank’s market to book
value of assets as a measure of Tobin’s Q. In addition, I include the bank’s previous
growth as a second proxy for growth opportunities. I expect a positive relation between
loan growth and both the market to book ratio and lagged loan growth.

20
An additional check on the existence of capital market frictions is to examine the
operation of the internal capital market within a holding company. Specifically, if a
positive correlation between cash flows and loan demand drives the relation between cash
flows and loan growth, then subsidiary loan growth should be positively related to
subsidiary cash flows. Moreover, holding company cash flows (net of the subsidiary’s
cash flows) will be related to loan growth at the subsidiary level only to the extent that
they proxy for local demand characteristics. It is likely that holding company cash flows
are a poorer proxy for local demand then subsidiary cash flows. Thus, in the absence of
capital market imperfections, they would be expected to be less important than the
subsidiary’s own cash flows. Hence, a finding of holding company cash flows being more
important than subsidiary cash flows would be consistent with the hypothesis of costly
external capital.
Furthermore, a finding of subsidiary loan growth being positively related to the
cash flows of non-bank subsidiaries within the holding company can be interpreted as
strong evidence that external finance is costly and holding companies operate and internal
capital market. Indeed, it seems unlikely that in absence of costly external finance,
subsidiary bank loan growth would be at all related to non-bank cash flows of the holding
company since arguably these non-bank cash flows are less likely to proxy for local loan
demand.
As a final test on the existence of capital market frictions, I examine the
information asymmetry surrounding external capital issuances. If the magnitude of the
investment-cashflow sensitivity proxies for the severity of capital market frictions that

21
banks face, banks with a large investment-cashflow sensitivity are expected to be less
willing to issue external capital. I develop a logit model which predicts banks’ decision to
issue external capital based on firm and market characteristics. A finding of a negative
relation between the probability of issuance and the investment-cashflow sensitivity
provides evidence that the investment-cashflow sensitivity proxies for the severity of
information asymmetries.
The severity of information asymmetries may also be related to the expected costs
of bringing an external capital issue to the market. To test this hypothesis, I estimate the
relation between investment-cashflow sensitivities and costs associated with security
issuance. Following Calomiris and Himmelberg (1995), I estimate anticipated
underwriting fees based on firm characteristics, after controlling for selectivity bias. In a
likewise fashion, I estimate expected abnormal stock returns associated with the
announcement of a security issuance. A finding that banks that anticipate larger
underwriting fees or more negative abnormal stock returns have higher investment-
cashflow sensitivities would provide additional support for the hypothesis that expected
external finance costs affect banks’ dependence on internally generated funds.

CHAPTER 3
DATA
I collect bank holding company data from the Federal Reserve Y-9 tapes from
1982-1994 (annual observations). Banks included in the sample are required to have a
minimum of two years of data, a non-negative book value of equity, and an available
market value of common equity. All stock price data come from the CRSP and NASD
master tapes. The final holding company sample contains 289 banks and 2229
observations.
Subsidiary bank data are collected from the Federal Reserve Reports of Income
and Condition (Call Reports). Call report data is only available from 1985-1989.
Subsidiary banks are required to have at least two year-end observations and be part of a
multiple bank holding company. I restrict the sample to multi-bank holding companies
because I am interested in examining whether holding companies act as an internal capital
market. In addition, the subsidiaries must be part of a holding company included in the
holding company sample described above. The subsidiary bank sample contains 2339
different bank subsidiaries of 215 holding companies yielding 7023 observations.
Studies of investment spending for nonfinancial firms consider investment to be a
function of internally generated funds after controlling for firm growth opportunities (see
for example Fazzari, et. al (1988)). Typically, investment is considered changes in
property, plant, and equipment, deflated by the firm’s capital stock at the beginning of the
22

23
period. Capital stock is usually proxied by property, plant, and equipment. In addition,
the existing literature generally deflates internally generated funds by the capital stock. I
consider bank investment to be the change in loans outstanding, and the capital stock to be
the beginning of period loans outstanding. Therefore, investment (loan growth) is defined
as the percentage change in loans outstanding.
The appropriate measure of internally generated funds for banking firms differs
slightly from the measure used in studies of nonfmancial firms. Specifically, studies of
nonfinancial firms generally measure internally generated cash flows as net income before
extraordinary items plus depreciation. However, banks may not be as constrained by cash
flow as nonfinancial firms because of the availability of insured deposit financing.
Nevertheless, they are constrained by the amount of debt financing they can utilize.
Regulations mandate capital requirements which limit banks’ ability to borrow, and thus
banks should be concerned with the amount of regulatory capital that they generate. I
measure internally generated funds as net income before extraordinary items plus
depreciation and additions to loan loss provisions (since loan loss provisions are a non¬
cash expense and are included in regulatory capital), and I scale this measure by the
beginning of period loan balance.1 To control for differences in investment opportunities,
I use the holding company’s market to book ratio ( a proxy for Tobin’s Q) at the end of
the prior year and the bank’s previous period loan growth. Furthermore, I include the log
of assets as a control for economies of scale.
1 Results are similar if I do not include additions to loan losses as part of internally
generated funds. The results are also similar if I deduct dividend payments from internally
generated funds. See Chapter 4 for more detail.

24
To determine the effect of capitalization on loan growth, I estimate surplus capital
for all banks, both holding companies and subsidiaries. Surplus capital is defined as the
bank’s beginning of year capital ratio minus the end of year required ratio.2 I choose the
end of year required ratio because this requirement is always at least as strict as the
current requirement. This assumes that banks have perfect foresight regarding short term
capital requirements, earnings and growth. Tests rely on the total or Tier II capital ratio.3
The Tier II ratio is chosen because regulations currently allow banks to pass the Tier I
ratio and yet fail the Tier II ratio, but not the reverse. Specifically, the secondary portion
of Tier II capital (loan losses and subordinated debt) is restricted to be no greater than the
primary portion of capital. In addition, current regulations require 4 percent Tier I and 8
percent Tier II capital ratios. Hence it is obvious that banks which pass the Tier II
requirement must by definition have passed the Tier I requirement.
Surplus capital provides an indication of financial slack, i .e., the cushion banks
have in their capital ratios (similar to the cash and liquid assets measure used in studies of
nonfinancial firms). 1 also include a dummy variable, BIND, which equals one if capital
surplus is non-positive, and zero otherwise. This variable indicates whether a bank failed
to meet the minimum capital requirement in any given year.
2 Data for risk-based capital ratios are not available. Therefore, I rely on a
methodology presented by Takeda (1994) to estimate risk-based ratios. See Appendix for
a description of this methodology.
3 Tier II capital is defined as total equity plus subordinated notes plus the
allowance for loan losses all scaled by assets (either total or risk-weighted). Total equity
includes both common and preferred equity. Tests were also performed using the primary
or Tier I ratio (simply total equity over assets), with similar results.

25
Required capital ratios have varied over time. From 1981-1989, regulators
enforced leverage-based capital ratios which they define as total equity plus subordinated
notes plus the allowance for loan losses, all divided by total assets. Required ratios were
5.5 percent from 1981-1984 and 6 percent from 1985-1989. In the 1990s, risk-based
capital ratios became enforced, with the only change in the calculation of the capital ratio
being the substitution of risk-weighted assets for total assets.4 Required ratios were 7.25
percent from 1990-1991, and 8 percent from 1992-1994.
In addition, I study announcements of all external security offerings which
augment regulatory capital (except for initial public offerings) by bank holding companies
that were publicly traded in the United States from 1982-1994. These offerings consist of
common stock, preferred stock, or subordinated notes. The initial sample of issuances
was collected from the Investment Dealer’s Digest (IDD). I searched Dow Jones News
Retrieval for the announcement of these issuances and used these dates as the initial
announcement date. If no mention of the offering was found on Dow Jones News
Retrieval, I used the registration date listed in the IDD. The final sample contains 461
security offerings by 157 different bank holding companies.
To calculate abnormal returns following the announcement of a security offering, I
use the standard event study methodology (see Asquith and Mullins (1986)). All stock
return data are collected from either the CRSP or NASD data tapes. Abnormal returns for
security / on event date t are defined as:
See Appendix for estimation of risk-weighted assets.
4

26
AR¡t = Rit - (a, + $Rm)
where R^, and Rmt are the rate of return on security i and the return on the CRSP equally
weighted index on event day t respectively. The coefficients a and P are ordinary least
squares estimates of the intercept and slope of the market model regression. The
estimation period used for the market model comes from the period t= -100 through t= -
20 (where t=0 equals the event day).
The average abnormal return for a portfolio of N securities is:
N
AAR, = -T AR,
N frf "
The test statistic, Z„ for AAR, is based on the standardized abnormal return SAR¡,5, has a
unit-normal distribution, and is calculated as:
Z,-t SAR„ I JÑ
/ = 1
5 Where SAR* = AR,, / Sit,
2 i (R ,-R )2 ,
s = [s*[i +-L+—um———]]'
" ' go 80
E (KrRj
fc=l
and S¡ is the residual standardized error from the market model regression, Rmfc the return
on the market portfolio for the Mi day of the estimation period, and R^ the average return
of the market portfolio for the estimation period.

CHAPTER 4
BANK HOLDING COMPANY ANALYSIS
Table 1 provides descriptive statistics for the bank holding company sample. The
holding companies in my sample are relatively large, with median assets of over $2.6
billion during the entire sample period. As expected, loans make up the majority of bank
assets, with more than 62 percent of aggregate bank assets allocated to loans for the full
sample. In addition, securities holdings make up a large portion of bank assets,
comprising more than 14 percent of aggregate bank assets. For the full sample, the
median bank holding company’s Tier II capital ratios exceeded the regulatory minimum by
approximately two percentage points. Furthermore, only about 6 percent of banks failed
to meet minimum capital standards.
Loan growth at the holding company level averaged about 6 percent a year.
Internal additions to capital for the average and median bank was approximately 1.5
percent of loans per year. Given capital requirements less than 8 percent, internal
additions to capital appear, on average, to be sufficient to support the observed asset and
loan growth.
One purpose of this paper is to examine possible effects of changes in capital
regulation on loan growth. From 1982-1994, capital regulation can be classified into three
regimes. The first, from 1982-1984, marks the introduction of minimum leverage-based
capital standards. Coincidentally, this period also corresponds with the announcement of
27

28
Table 1
Descriptive statistics (means, with medians in parentheses) for 289 publicly traded bank
holding companies.2
variable
lull sample
1982-1984
1985-1989
1990-1994
Total Assets (millions)
10,300
(2,621)
7,911
(2,074)
9,260
(2,545)
12,700
(3,619)
Loan Growthb
0.062
(0.076)
0.109
(0.121)
0.078 *
(0.090) *
0.020 *
(0.029) *
Internal Additions to
Capital/ Loans,.,'
0.014
(0.016)
0.017
(0.017)
0.014 *
(0.016) *
0.013
(0.016)
Market / Book Assets'1
1.005
(0.999)
0.986
(0.985)
1.010 *
(1.004) *
1.010
(1.003)
Book Capital in Excess
of Requirement / Assetse
0.024
(0.020)
0.019
(0.016)
0.020
(0.018)
0.031 *
(0.028) *
Percentage with Capital
less than requirement.
5.65%
8.12%
3.83% *
6.41% *
Aggregate Industry
Loans / Assets
62.28%
60.14%
64.42%
61.25%
Aggregate Industry
Securities / Assets
14.62%
11.29%
13.12%
16.87%
Number of Observations
2229
431
940
858
a. Data are from the Federal Reserve Y-9 tape.
b. Loan growth equals change in total loans outstanding divided by loans outstanding at time t-1.
c. Internal additions to capital equals net income plus changes in loan loss provisions (up to regulatory
maximum).
d. Market to book value of assets equals (Total Assets - Book Equity + Market Equity) / Total Assets. Market
Equity equals the market value of common equity from CRSP. The ratio is calculated at year end for the prior
year.
e. Book capital in excess of requirement equals the bank’s book capital for regulatory minimum Tier II capital
ratio. Tier II capital equals common stock, preferred stock, plus eligible subordinated debt and loan loss
reserves. For the period 1982-1984 the requirement is 5.5% of total assets. For 1985-1989 the requirement is
6%. Beginning in 1990, the requirement is based on risk-weighted assets. For 1990-1991, the minimum is
7.25% of risk-weighted assets, while from 1992-1994 the minimum is 8%.
* mean or median significantly different from previous time period at better than the 5% level.

29
the ‘too big to fail’ policy in which certain banks were deemed too important to be
allowed to fail.1 O’Hara and Shaw (1990) document that following this announcement,
large banks experienced an increase in stock price, which they attribute to be due to the
expanded conjectural guarantees. The second regime lasts from 1985-1989, when
regulators increased the minimum capital requirement from 5.5 to 6 percent In addition,
regulators attempted to remove the expanded conjectural guarantees implied by the ‘too
big to fail’ policy. Finally, the third regime starts in 1990 and begins the era of risk-based
capital standards.
Table 1 provides the descriptive statistics by the three regulatory regimes. Notice
that with each regime, loan growth has declined (both average and median). If bank
growth opportunities have also declined, this could explain the decrease in loan growth.
Market to book ratios (a proxy for Tobin’s Q) have increased since the early 1980s,
indicating that overall growth opportunities have improved. However, a potential
explanation for why overall growth opportunities improved while loan growth suffered is
that off-balance sheet growth drives the increase in market to book ratios.
A second possibility for why loan growth has suffered could be a simultaneous
decline in bank internal additions to capital. While it’s true that internal additions to
capital declined since the first regime, the amount of the decline hardly matches the
substantial pace of the decline in lending.
1 This policy implies that regulators will attempt to bail out any large institution
which is insolvent Furthermore, since the FDIC effectively insured all bank debt (not just
small deposits) in the Continental Illinois case, management of large banks may have
reasonably assumed that the federal safety net had been expanded.

30
Changes in capital regulation could induce a slowdown in lending if banks become
inclined to increase surplus capital. First, if penalties from being undercapitalize increase,
then banks will desire a larger buffer from regulatory intervention. Second, if risk-based
capital standards reduce the effectiveness of securities as financial slack, banks will require
more surplus capital as compensation for their lost liquidity. While average and median
surplus capital do not appear to be any different in the first or second regimes, since 1990
banks have increased surplus capital by more than one percentage point. The number of
capital deficient banks increased from just less than 4 percent in the mid 1980s to more
than 6 percent in the 1990s. Moreover, from 1990 to 1992, almost 10 percent of banks
failed capital standards (not reported).
If risk-based standards increase the attractiveness of securities relative to loans,
banks may increase the proportion of securities in their portfolio. Consistent with this
hypothesis, securities holdings increased from about 13 to almost 17 percent of aggregate
bank assets, while loans fell from 64 to 61 percent of aggregate assets following the
introduction of risk-based standards in 1990. Thus the change to risk-based capital may
have caused many banks to fail capital standards, induced banks to desire a larger surplus
capital, and given banks incentives to shift assets out of loans and into securities, all of
which may have contributed to the concurrent decline in loan growth.
If capital market imperfections create a wedge between internal and external
finance costs for banks, then inadequately capitalized banks may be more likely to pass up
profitable new lending opportunities than adequately capitalized banks. To test this
hypothesis, I examine whether loan growth is related to capitalization for the banks in my

31
sample. However, loan growth and capitalization may be correlated for other reasons. In
particular, loan losses are likely to be correlated with loan demand, causing a positive
correlation between loan growth and capitalization. Therefore, I also examine the relation
between internal additions to capital and bank capitalization.
Table 2 presents the results of this analysis. The top portion of the table analyzes
differences in holding company loan growth in three different capitalization categories,
failure to meet capital requirements, capital in excess of requirements by 2 percentage
points or less, and capital in excess of requirements by greater than 2 percentage points.
Loan growth at inadequately capitalized banks was significantly less than loan growth at
either of the other two categories. In addition, there is no difference between loan growth
at either of the two adequately capitalized categories. Moreover, as shown in the bottom
portion of the table, the amount of internal capital generation increases significantly with
capitalization, suggesting that performance strongly influences capital adequacy.
That loan growth is correlated with capitalization is consistent with capital
requirements and costly external finance constraining loan growth. However, as
mentioned above the finding that internal additions to capital is correlated with
capitalization may drive this result. Since loan losses and poor performance are likely to be
correlated with weak loan demand, the positive relation between loan growth and
capitalization may reflect demand as opposed to supply characteristics. To address these
concerns, I examine the relation between loan growth and internal additions to capital.
In Table 3,1 present the results of a fixed-effects regression relating loan growth
to internal additions to capital, the market to book value of assets, previous loan growth,

32
Table 2
Differences in loan growth and internal additions to capital based upon whether minimum
capital requirements are binding for a sample of 289 bank holding companies from 1982-
1994.
Loan Growth
Mean
Median
1. Capital less than or equal to regulatory
minimum, N=126
-0.032%
-0.034
2. Capital greater than regulatory minimum
by 2% or less, N=968
0.066
0.083
3. Capital greater than regulatory minimum
by more than 2%, N=1143
0.069
0.077
Test statistic of difference between 1 and 2.
t=7.64
z=7.75
Test statistic of difference between 1 and 3.
t=7.97
z=8.01
Test statistic of difference between 2 and 3.
t=0.72
z=0.08
Internal Additions to Capital
Mean
Median
1. Capital less than or equal to regulatory
minimum, N=107
0.002
0.005
2. Capital greater than regulatory minimum
by 2% or less, N=908
0.015
0.013
3. Capital greater than regulatory minimum
by more than 2%, N=931
0.017
0.019
Test statistic of difference between 1 and 2.
t=7.23
z=8.95
Test statistic of difference between 1 and 3.
t=9.83
z=l 1.10
Test statistic of difference between 2 and 3.
t=6.92
z=10.28

33
Table 3
Fixed effects regressions relating loan growth to internal additions to capital, capital
requirements, and firm financial characteristics. The sample consists of 289 bank holding
companies from 1982-1994 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,
.,) / Loans,.,
Coefficient
(1)
(2)
Additions to Capital / Loans,.,*
4.771 **
3.906 **
(0.269)
(0.198)
Surplus Capital / Assets,.,b
0.824 **
(0.155)
Bind0
-0.061 **
(0.009)
Surplus Capital * Additions to
-27.80 **
Capital / Loans,.,
(4.471)
Bind * Additions to Capital / Loans,.,
1.006*
(0.512)
Securities / Assets,.,
0.138 **
0.133 **
(0.039)
(0.039)
Market / Book Assets,.,
0.270 **
0.260 **
(0.049)
(0.049)
log (Assets,.,)
-0.063 **
-0.064 **
(0.005)
(0.005)
Lag loan growth
0.078 **
0.078 **
(0.009)
(0.009)
R2
0.383
0.385
N (categories)
1987 (289)
1987 (289)
F statistic, Bank dummies
2.278 **
2.571 **
a. Additions to capital equals net income plus changes in loan loss provisions (up to regulatory maximum).
b. Surplus capital equals actual capital less capital required to meet minimum regulatory standards.
c. Bind=l if surplus capital is less than or equal to zero, =0 otherwise.
*, ** denote significance at the 5% and 1% levels respectively.

34
bank size, asset composition, and two variables designed to measure the extent to which
the bank faces binding capital requirements. These two variables are surplus capital,
defined as the difference between bank capital ratios and the required ratio, and a dummy
variable that takes on the value of one if surplus capital is non-positive and zero otherwise.
Furthermore, I interact these two variables with internal additions to capital to investigate
whether the cashflow sensitivity of loan growth varies depending on whether the holding
company faces a binding capital constraint. I assume that the lower the surplus capital, the
greater the likelihood that capital requirements are binding. These are the banks that are
most likely to constrain loan growth because of high external finance costs.
As shown in Table 3, loan growth is positively related to internal additions to
capital even after controlling for differences in growth opportunities with the market to
book ratio and previous loan growth. This is consistent with external finance being costly
relative to internal finance. In addition, loan growth is positively related to surplus capital,
and is significantly lower for holding companies which fail to meet capital requirements.
Furthermore, the sensitivity of loan growth to internal additions to capital decreases as
surplus capital increases. Notice a similar result that the sensitivity is significantly higher
for capital deficient banks. These results are consistent with the hypothesis that the loan
growth of capital constrained banks is significantly more sensitive to internally generated
funds than it is for banks that maintain adequate capital. This also suggests that increases
in capital standards may influence loan growth by diminishing surplus capital for all banks.
Following an increase in capital standards the percentage change in the predicted
sensitivity of loan growth to internal additions to capital will be largest for banks that had

35
the largest surplus capital (lowest sensitivity) before the change. This is consistent with
Passmore and Sharpe’s hypothesis that the decline in lending may be most severe at well
capitalized institutions.
Since banks may be able to fund loan growth by selling securities holdings, the
sensitivity of loan growth to internal additions to capital may also be negatively related to
securities holdings.2 On the other hand, securities may only provide this type of financial
slack to banks that are not constrained by capital requirements. That is, capital
constrained banks need to increase capital, and therefore selling securities to fund growth
may not be an option. To investigate these possibilities, Table 4 presents regression
results relating loan growth to the same measures used in Table 3, plus six additional
interaction variables. These interaction variables are designed to explain the role of
securities as financial slack. In particular, I expect that the sensitivity of loan growth to
internal additions to capital to be decreasing in the amount of securities holdings, and this
relationship to be less important for banks which fail to maintain minimum capital ratios.
Like the results presented in Table 3, Table 4 provides evidence that banks view
external finance as more expensive than internal finance as indicated by the positive
coefficient on internal additions to capital. Moreover, these results support the claim that
surplus capital is positively related to loan growth, and negatively related to the sensitivity
of loan growth to internal additions to capital. In three of the four regressions presented,
the coefficient on the interaction between internal additions to capital and securities is
2 Even with risk-based standards, this may be true since banks can sell securities
with a non-zero risk weight or that have a capital gain to fund loan growth without
penalizing capital ratios.

36
Table 4
Fixed effects regressions relating loan growth to internal additions to capital, capital
requirements, and firm financial characteristics. The sample consists of 289 bank holding
companies from 1982-1994 (standard errors in parentheses).
Dependent Variable = (Loanst - Loans,., ) / Loans,.,
coefficient
0)
(2)
(3)
(4)
Additions to Capital / Loans,.,a
4.737 **
(0.316)
4.446 **
(0.345)
4.763 **
(0.419)
4.623 **
(0.351)
Surplus Capital / Assets,.,b
0.678 **
(0.153)
0.661 *
(0.298)
Bindc
-0.061 **
(0.009)
-0.012
(0.019)
Surplus Capital *Additions to
Capital / Loans,.,
-18.89 **
(4.417)
-19.47 *
(8.964)
Bind * Additions to Capital /
Loans,.,
0.916
(0.514)
-0.388
(1.172)
Securities / Assets,.,
0.206 **
(0.044)
0.182 **
(0.046)
0.204 **
(0.059)
0.212 **
(0.475)
Securities * Additions to
Capital / Loans,.,
-2.763 *
(1.288)
-2.619**
(1.375)
-2.876
(1.906)
-3.441 **
(1.401)
Surplus Capital * Securities /
Assets,.,
0.077
(1.329)
Bind * Securities / Assets,.,
-0.318**
(0.110)
Surplus Capital * Securities *
Additions to Capital / Loans,.,
1.749
(34.88)
Bind * Securities * Additions
to Capital / Loans,.,
8.313
(6.750)
Market / Book Assets,.,
0.287 **
(0.049)
0.256 **
(0.049)
0.287 **
(0.049)
0.260 **
(0.049)
log (Assets,.,)
-0.066 **
(0.005)
-0.064 **
(0.005)
-0.066 **
(0.005)
-0.065 **
(0.005)
Lag loan growth
0.080 **
(0.009)
0.077 **
(0.009)
0.080 **
(0.009)
0.076 **
(0.009)
R2
0.373
0.386
0.373
0.389
N (categories)
1992 (289)
1987 (289)
1992 (289)
1987 (289)
F statistic, Bank dummies
2.304 **
2.489 **
2.301 **
2.502 **
a. Additions to capital equals net income plus changes in loan loss provisions (up to regulatory maximum).
b. Surplus capital equals actual capital less capital required to meet minimum regulatory standards.
c. Bind= 1 if surplus capital is less than or equal to zero, =0 otherwise.
*, ** denote significance at the 5% and 1% levels respectively.

37
negative and significantly different from zero at the one percent level. This is consistent
with the hypothesis that securities holdings serve as a buffer stock against funding
shortages. The negative coefficient on the interaction between BIND and securities
indicates that the role of securities as financial slack is less important for capital deficient
banks. In particular, the estimated coefficient on securities holdings for capital deficient
banks (by combining the two coefficients) is not significantly different from zero. These
results suggest that both surplus capital and securities holdings serve as liquidity by
decreasing banks’ dependency on internally generated additions to capital.
This paper is interested in examining the effect of changes in capital regulations on
loan growth, specifically with regard to risk-based capital standards. Specifically, with
regulators enforcing risk-based standards, the role of securities as financial slack may be
significantly diminished. To investigate further, Table 5 presents results of fixed-effects
regression models of loan growth to the same measures used in Table 3, while allowing
coefficients on key explanatory variables to change with each regulatory regime. This will
enable me to investigate if changes in regulation altered the determinants of the loan
growth equation.
Surprisingly, results indicate that in the first regime (1982-1984), capital surplus
did not influence loan growth. This is consistent with banks believing that capital
requirements were not stringently enforced. A possible explanation for this is the
expanded conjectural guarantees implied by ‘too big to fail.’ In regimes two (1985-1989)
and three (1990-1994), surplus capital is positively related to loan growth and negatively
related to the sensitivity of loan growth to internal additions to capital. On the other hand,

38
Table 5
Fixed effects regressions relating loan growth to internal additions to capital, capital
requirements, and firm financial characteristics. The sample consists of 289 bank holding
companies from 1982-1994 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,., ) / Loans,.,
coefficient
(1)
(2)
Additions to Capital / Loans,.,
5.348 ** (0.351)
4.783 ** (0.346)
Surplus Capital / Assets,., * timel
0.238 (0.549)
Surplus Capital / Assets,., * time2
1.987 ** (0.290)
Surplus Capital / Assets,., * time3
0.767 ** (0.179)
bind * timel
0.026 (0.028)
bind * time2
-0.055 ** (0.015)
bind * time3
-0.084** (0.014)
Surplus Capital * timel * Additions to Capital/Loans
-4.385 (28.87)
Surplus Capital * time2 * Additions to Capital/Loans
-61.31 ** (13.10)
Surplus Capital * time3 * Additions to Capital/Loans
-28.16** (5.028)
bind * timel * Additions to Capital
-0.974 (2.009)
bind * time2 * Additions to Capital
0.513 (0.782)
bind * time3 * Additions to Capital
-0.149 (0.740)
Securities / Assets,., * timel
0.553 ** (0.875)
0.449 ** (0.079)
Securities / Assets,., * time2
0.187 ** (0.053)
0.256 ** (0.050)
Securities / Assets,., * time3
0.013 (0.049)
0.036 (0.048)
Securities * timel * Additions to Capital/Loans
-11.30** (4.196)
-8.119 ** (3.235)
Securities * time2 * Additions to Capital/Loans
-7.718** (1.808)
-3.275 ** (1.620)
Securities * time3 * Additions to Capital/Loans
2.360 (0.048)
-0.038 (1.451)
Market / Book Assets,.,
0.231 ** (0.048)
0.223 ** (0.049)
log (Assets,.,)
-0.024 ** (0.007)
-0.024 ** (0.007)
Lag loan growth
0.058 ** (0.010)
0.058 ** (0.010)
R2
0.439
0.431
N (categories)
1990 (289)
1990 (289)
F statistic, Bank dummies
2.022 **
2.152**
*, ** denote significance at the 5% and 1% levels respectively.

39
securities holdings appear to be significant contributors of financial slack up until the
1990s. Specifically, the regime three coefficients on securities holdings (and the
interaction variables) are not significantly different from zero. Moreover, these
coefficients are significantly different from previous period coefficients suggesting a real
change in the value added of securities holdings. This suggests that the change to risk-
based standards significantly altered the role of securities as liquidity. As a result, this
change in regulatory regimes may have induced a slowdown in bank growth.
The results presented in Tables 3-5 indicate a negative relation between surplus
capital and the sensitivity of loan growth to internal additions to capital. In addition, the
results demonstrate that securities holdings are also negatively related to this sensitivity, at
least before the introduction of risk-based capital standards. However, whether a firm’s
overall investment-cashflow sensitivity is negatively related to surplus capital, after
controlling for the effect of securities remains a question. Table 6 presents results of the
predicted sensitivity of loan growth to internal additions to capital from regression (1) in
Table 5.3 To estimate this overall sensitivity, I simply calculate the total effect of internal
additions to capital by multiplying the coefficient estimates on the interaction terms by the
appropriate variables, and adding these products to the coefficient of additions to capital.
This allows the estimate of the investment-cashflow sensitivity to vary by bank and year.
Notice that the mean and median investment-cashflow sensitivity is largest for banks that
fail to meet minimum capital standards (significantly different from the sensitivity for the
3 Results are similar if the investment-cashflow sensitivities are estimated from
regressions in Table 4.

Table 6
Characteristics of predicted investment-cashflow sensitivity
40
Variable=Predicted Investment-Cashflow Sensitivity estimated from coefficients on Additions to Capital
and interaction terms from regression (1), Table 5.
Descriptive Statistics, by Capitalization
mean
median
full sample, N=2229
3.706
3.774
1. Capital less than or equal to regulatory minimum, N=126
4.534
4.559
2. Capital greater than regulatory minimum by 2% or less, N=960
4.003
4.019
3. Capital greater than regulatory minimum by more than 2%, N= 1143
3.365
3.469
Test statistic of difference between 1 and 2.
t= 19.94
z=15.44
Test statistic of difference between 1 and 3.
t=39.37
z= 18.20
Test statistic of difference between 2 and 3.
t=36.66
z=32.05
Table 7
Fixed effects regressions relating the predicted investment-cashflow sensitivity to off-
balance sheet assets and other firm financial characteristics. Off-balance sheet assets data
are available beginning in 1991. The sample consists of 230 bank holding companies from
1991-1994 (standard errors in parentheses).
Dependent Variable=Predicted Investment-Cashflow Sensitivity estimated from coefficients on Additions to
Capital and interaction terms from regression (1), Table 5.
Variable
(1)
(2)
Constant
3.261 **
8.795 **
(0.052)
(1.325)
Off Balance Sheet Assets,.,/ Assets,.,
0.875 **
0.661 **
(0.227)
(0.207)
Bind
0.548**
(0.059)
Log (Assets,.,)
-0.364 **
(0.087)
R2
0.097
0.220
N
651
651
F statistic, Bank dummies
13.93 **
13.62 **
*, ** denote significance at the 5% and 1% levels respectively.

41
full sample, and from adequately capitalized banks at better that the one percent level).
Moreover, the sensitivity decreases in groups based on capitalization. Therefore, even
after controlling for the effect of securities, the investment-cashflow sensitivities are
negatively related to surplus capital.
This overall investment-cashflow sensitivity may proxy for the severity of capital
market frictions. If a larger sensitivity indicates more severe information asymmetries,
banks with higher investment-cashflow sensitivities may face higher costs of external
finance. As a result these banks may have increased incentives to hedge the risks inherent
in their asset portfolios. This implies that the amount of off-balance sheet assets as a
proportion of total assets may be positively related to the investment-cashflow sensitivity.
Table 7 presents fixed-effects regression results relating the investment-cashflow
sensitivity to off-balance sheet assets. Because of reporting requirements, complete off-
balance sheet data are only available beginning in 1991. Results indicate that banks with
larger investment-cashflow sensitivities use more off-balance sheet assets, presumably to
hedge against funding shortages. These results also provide evidence that larger banks are
less constrained by internally generated funds. All together, these results support the
hypothesis that the investment-cashflow sensitivity proxies for the severity of information
asymmetries.
As a check on the robustness of the results presented above, I perform a series of
tests intended to examine the stability of the coefficient estimates. Results for these tests
are not reported, however, tables are available upon request. To control for the possibility
that results are being driven by merger and acquisition activity, I perform all above tests

42
scaling observations by year end data. Results are qualitatively similar. I also perform the
regressions limiting bank loan growth to be less than 25 percent. In addition, I choose
other various limits for loan growth, none of which make a substantial impact on the
results. As a control for possible bias due to firms not surviving the sample period, I
estimate the basic regressions presented in Table 3 for the 97 banks which survive the
entire period. Results are consistent with previous results.
One possible difference for the relation between investment and cash flow for
banking firms relative to nonfinancial firms is that a large portion of the cash flow from a
new investment may be received up front. In particular, new loan originations usually
generate immediate fee income for banks, unlike investment for industrial firms which may
take years after the initial investment before income is realized. To investigate this further,
I examine the degree of autocorrelation in additions to capital. I find that there is a strong
one period correlation of more than 50 percent. Additionally, the second and third lagged
observations are correlated at more than 10 percent, although the partial correlation
coefficient is very small after the first period. Moreover, the results of an ARMA model
using four lagged observations are consistent with a strong one period correlation, with
subsequent periods significantly related, although to a much smaller extent.
A possible interpretation of these results is that the positive relation between loan
growth and internal additions to capital is not due to firms investing when they generate
income, rather they generate income when they invest. To address this concern, I estimate
the basic regressions replacing additions to capital with a lagged observation of additions
to capital. Results are consistent with previous results.

43
Furthermore, the formulation of internal additions to capital assumes that all bank
income which augments capital is available to fund loan growth. This implies that banks
may alter dividend policy to meet investment needs. However, it is possible that banks
find dividend cuts prohibitively expensive, and therefore do not vary dividend policy. In
addition, the inclusion of loan losses may bias estimates if firms manipulate these
provisions to their advantage. Therefore, I repeat the basic regression using three
variations of internal additions to capital. Variation one is simply the original definition
minus dividend payments. Variation two is defined as net income minus dividends (no
treatment for loan loss provisions). Finally, variation three is simply net income. Results
are qualitatively similar.
Loan growth may measure investment with error. Specifically, banks can invest in
loan commitments, which generate fee income and now require capital backing. Thus, I
estimate the regressions replacing loan growth with growth in loans and loan
commitments. Because of reporting requirements, growth in loan commitments is only
available beginning in 1990. Results from a heteroskedastic consistent model (I choose not
to use fixed-effects due to the small number of observations per firm) conform with
previously reported results, and support the hypothesis that external finance is costly and
that the sensitivity of investment to internal additions to capital is negatively related to
surplus capital. Moreover, securities holdings are not related to growth in this particular
model. This provides additional support that with risk-based capital standards, the role of
securities as financial slack has been diminished (since data is only available for these tests
in the 1990s).

CHAPTER 5
BANK SUBSIDIARY ANALYSIS
The above results are consistent with capital regulation significantly affecting bank
loan growth. Moreover, these results lend credence to the argument that banks find it
more costly to raise capital externally than through internal funds. To further examine this
issue, this chapter analyzes bank subsidiary loan growth as it relates to holding company
and subsidiary characteristics. Table 8 documents the descriptive statistics for bank
subsidiaries in my sample. Loan growth averaged about 9.5 percent a year, while internal
additions to capital averaged around 1.5 percent of total loans. Furthermore, the median
subsidiary and holding company’s Tier II capital ratio exceeded the regulatory minimum
by slightly less than 2 percentage points.
The bottom section of Table 8 describes differences in subsidiary loan growth
based on capitalization of both holding companies and subsidiaries. The median loan
growth of subsidiaries whose holding company was inadequately capitalized was just over
1 percent. However, median growth of subsidiaries whose holding company was
adequately capitalized was significantly greater, at over 7.5 percent. In addition, there
appears to be no difference in subsidiary loan growth based on whether the subsidiary
itself maintains adequate capital ratios. These results are consistent with bank holding
companies operating capital on a consolidated basis.
44

Table 8
Descriptive statistics of subsidiaries of 215 publicly traded multiple bank holding
companies from 1985-1989a
45
variable
mean
median
Subsidiary Total Assets (millions)
250
99
Internal Additions to Capital / LoansBank
0.018
0.018
Internal Additions to Capital / LoansH.netb
0.014
0.016
Internal Additions to Capital / LoansNon Bmkc
0.004
0.004
Securities / Assets
0.219
0.205
Lead Bank Assets / Holding Company Assets
0.354
0.244
(Book Capital in Excess of Requirement / Assets)Bank
0.024
0.018
(Book Capital in Excess of Requirement / Assets)H
0.019
0.017
Subsidiary Bank Loan Growth
0.096
0.075
Subsidiary Bank Loan Growth if holding company
capital is less than regulatory minimum, N=240
0.028
0.012
Subsidiary Bank Loan Growth if holding company
capital is greater than regulatory minimum, N=7037
0.098
0.076
Test Statistic of Difference in Subsidiary Loan Growth
based on holding company capitalization
t=5.34
z=5.48
Subsidiary Bank Loan Growth if its capital is less than
regulatory minimum, N=275
0.095
0.073
Subsidiary Bank Loan Growth if its capital greater
than regulatory minimum, N=7002
0.111
0.108
Test Statistic of Difference in Subsidiary Loan Growth
based on its own capitalization
t=0.84
z=1.6
a. Data are from the Federal Reserve Reports of Income and Condition (Call Reports).
b. Internal Additions to Capital H-Net equals holding company additions to capital less the bank’s additions to
capital divided by holding company loans less loans of the subsidiary bank.
c. Internal Additions to Capital non-bank equals holding company additions to capital net of the aggregate
additions to capital of all bank subsidiaries divided by holding company loans less loans of the subsidiary bank.

46
As described in the previous chapter, loan growth may be related to capitalization
for reasons other than costly external finance. In particular, this relationship may arise due
to bank performance or loan losses. Recall that results presented are consistent with bank
holding companies operating as if external capital is more expensive than internally
generated capital. To further examine this issue, I look at the relationship between loan
growth at individual bank subsidiaries and internal additions to capital at both subsidiary
and holding company levels. To the extent that either subsidiary or holding company
additions to capital are positively related to loan growth (after controlling for the
profitability of the holding company’s lending opportunities), this provides additional
evidence that bank holding companies are liquidity constrained.
Additionally, examining this relationship may alleviate concerns that the observed
correlation between internally generated capital and loan growth at the holding company
level arises because internally generated capital proxies for the profitability of lending
opportunities not captured by Tobin’s Q. Indeed, a finding that subsidiary loan growth is
related to internally generated capital at the holding company’s other subsidiaries and in
particular its non-bank subsidiaries would weaken the validity of this argument. In this
regard, my tests are similar to Lamont (1993) who studied how a subsidiary’s cash flows
affected investment by an unrelated subsidiary within the same firm.
Furthermore, in light of the evidence suggesting that bank holding companies are
liquidity constrained, an interesting issue is how holding companies allocate capital among
their subsidiaries. Stein (1995), following Williamson (1975), argues that capital market
imperfections may give firms incentives to establish internal capital markets to allocate

47
resources more efficiently. Moreover, he speculates that firms with a narrow focus and
hard to value assets may have greater incentives to create internal capital markets. A
finding that subsidiary loan growth is more strongly related to holding company additions
to capital than their own additions to capital would be consistent with bank holding
companies operating internal capital markets and that banks are liquidity constrained
Table 9 presents regression results relating subsidiary loan growth to the same
measures use to explain holding company loan growth in Table 3. One difference in this
table is the inclusion of separate measures for the cash flows produced by the subsidiary
bank and the rest of the holding company. I also use separate measures indicating
capitalization of the subsidiary and the holding company. Regressions are performed
using a between-effects regression which pools the observations for each subsidiary, using
mean values of all variables. This controls for the autocorrelation in the residuals across
the various years for each bank. I choose between-effects rather than fixed-effects due to
the relatively short time period in which I have data (1985-1989). The sample contains
over 2000 subsidiaries with at most 5 years of data per bank. Tests were also performed
with OLS estimates (not reported) with qualitatively similar results.
Results are presented for the full sample, the sample of banks whose assets
represent less than 15 percent of their holding company’s assets (bottom three size
quartiles), and the sample of lead banks in each holding company (the largest subsidiary
within the holding company). For the full sample and the small bank sample, loan growth
at subsidiary banks is positively related to the holding company’s market to book ratio (a
proxy for loan opportunities). In addition, loan growth is positively related to the

48
Table 9
Between effects regressions relating subsidiary loan growth to internal additions to capital,
capital requirements, and subsidiary and bank holding company financial characteristics.
The sample consists of 2339 subsidiaries of 215 multiple bank holding companies from
1985-1989 (standard errors in parentheses)
Dependent Variable = (Loans, - Loans,.,) / Loans,.,
Coefficient
Overall Sample
Small Bank
Lead Bank
0)
(2)
(1)
(2)
(1)
(2)
(IACH-IACB)/(LoanH-LoanB)*
1.69**
(0.184)
1.65**
(0.182)
1.94**
(0.219)
1.90**
(0.218)
0.05
(0.270)
0.03
(0.260)
IACb / LoanB
0.29**
(0.071)
0.25**
(0.069)
0.26**
(0.074)
0.23**
(0.071)
1.86**
(0.531)
j 99**
(0.509)
(Surplus Capital / Assets),,
-0.16
(0.294)
-0.35
(0.33)
0.58
(0.774)
(Surplus Capital / Assets)B
-0.16
(0.108)
-0.17
(0.11)
1.25**
(0.430)
Bind„b
-0.18**
(0.025)
-0.18**
(0.026)
-0.18**
(0.064)
BindB
0.03
(0.019)
0.03
(0.020)
-0.16*
(0.082)
Market / Book„
0.50**
(0.077)
0.47**
(0.077)
0.52**
(0.091)
0.48**
(0.091)
0.30
(0.181)
0.27
(0.178)
(Securities / Assets)B
0.03
(0.03)
0.02
(0.03)
0.02
(0.03)
0.01
(0.027)
0.09
(0.101)
-0.02
(0.093)
R2
0.097
0.116
0.096
0.114
0.125
0.139
N (Categories)
6999
(2339)
6999
(2339)
6328
(2162)
6328
(2162)
762
(278)
762
(278)
a. LAC, = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bindj = 1 if bank capital ratio is less than or equal to the regulatory minimum.
*, ** denote significance at the 5% and 1% levels, respectively

49
subsidiary’s own internal additions to capital. However, loan growth is also significantly
related to the additions to capital produced by all other firms within the holding company
(measured by IACH - IACB). For these samples the coefficient estimates on other
subsidiaries’ cash flow are nearly eight times that of the coefficient estimate on the bank’s
own cash flow. Furthermore, although it does not seem as if there is a strong link between
surplus capital and loan growth, evidence suggests that subsidiaries are less likely to lend
if their holding company (and not the subsidiary itself) is inadequately capitalized.
Results for the lead bank sample differ substantially from the other samples.
Specifically, the lead bank’s own additions to capital are much more strongly correlated
with loan growth than the holding company’s additions to capital. Moreover, loan growth
appears to be positively related to capitalization at the lead bank as indicated by the
positive coefficient on surplus capital and negative coefficient on BIND for the lead bank.
These results should not be surprising, given that the lead bank generates the majority of
the loans, cash flows, and capital at the disposal of the holding company. In particular, the
correlation between the cash flows of subsidiaries and the cash flows of the entire holding
company is only 0.10 for the full sample, yet 0.62 for the lead bank sample.
To further investigate the relation between capitalization and loan growth, Table
10 presents regressions for the full sample and the small bank sample relating loan growth
to additions to capital and three measures for capital adequacy. Each measure is a dummy
variable indicating whether the bank (holding company, subsidiary, or both) fails capital
standards. Results are consistent with those presented in Table 9, and suggest that the
capitalization of the holding company and not the subsidiary bank constrains loan growth.

50
Table 10
Between effects regressions relating subsidiary loan growth to internal additions to capital,
capital requirements, and subsidiary and holding company financial characteristics. The
sample consists of 2339 subsidiaries of 215 multiple bank holding companies from 1985-
1989 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,., ) / Loans,.,
Coefficient
Overall Sample
Small Bank
(1)
(2)
(3)
(1)
(2)
(3)
(IACH-IACB)/(LoanH-LoanB)*
1.69**
(0.182)
1.63**
(0.181)
1.71**
(0.184)
1.94**
(0.217)
1.87**
(0.216)
1.95**
(0.220)
LACB / LoanB
0.29**
(0.069)
0.26**
(0.069)
0.26**
(0.069)
0.24**
(0.071)
0.23**
(0.071)
0.24**
(0.072)
BindH=l andBindB=lb
-0.70**
(0.115)
-0.77**
(0.125)
Bind„
-0.18**
(0.025)
-0.18**
(0.026)
BindB
0.03
(0.019)
0.03
(0.020)
Market / Book„
0.50**
(0.077)
0.47**
(0.077)
0.50**
(0.078)
0.52**
(0.090)
0.49**
(0.090)
0.52**
(0.091)
(Securities / Assets)B
0.02
(0.025)
0.01
(0.025)
0.03
(0.026)
0.003
(0.027)
0.001
(0.027)
0.02
(0.027)
R2
0.11
0.12
0.10
0.11
0.12
0.09
N (Categories)
7023
(2339)
7023
(2339)
7023
(2339)
6328
(2162)
6328
(2162)
6328
(2162)
a. I AC, = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind, = 1 if bank capital ratio is less than or equal to the regulatory minimum.
*, ** denote significance at the 5% and 1% levels, respectively

51
The results presented in Tables 9 and 10 provide support for the hypothesis that
bank holding companies find external finance more costly than internally generated
finance, and in response they establish an internal capital market. This interpretation
follows from the observation that subsidiary loan growth is strongly related to holding
company additions to capital. A competing explanation is that holding company cash
flows proxy for investment opportunities at the subsidiary bank that are not captured by
the holding company’s market to book ratio or in the subsidiary’s own additions to capital.
To address this concern, I include loan growth at other subsidiaries, and cash flows of
non-bank subsidiaries within the same holding company as explanatory variables.
Table 11 documents results including the loan growth of the rest of the holding
company as an additional variable to explain subsidiary loan growth. I still find that loan
growth is positively related to additions to capital at both the holding company and
subsidiary levels, and that the holding company effect remains considerably larger.
Likewise, I still find that binding capital requirements matter at the holding company level,
but not the subsidiary level. Surprisingly, the estimated coefficient on the holding
company’s loan growth is negatively related to subsidiary growth. Conceiving why a
negative coefficient except in the context of an internal capital market in which holding
companies allocate capital across competing uses is difficult. Overall, these results
strongly affirm the conclusion that bank holding companies establish internal capital
markets to allocate capital on a consolidated basis.1
1 The negative coefficient on other subsidiaries’ growth is somewhat sensitive to
sample and specification. If I exclude banks from Texas and Oklahoma (arguably the most
constrained banks), the coefficient is positive, though not significantly different from zero.

52
Table 11
Between effects regressions relating subsidiary loan growth to internal additions to capital,
loan growth in related subsidiaries, capital requirements, and subsidiary and holding
company financial characteristics. The sample consists of 2339 subsidiaries of 215
multiple bank holding companies from 1985-1989 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,.,) / Loans,.,
Coefficient
Overall Sample
Small Bank
Subsidiaries
Lead Banks
(LACH-IACB)/(LoanH-LoanB)‘
2.37**
2.46**
0.85
(0.296)
(0.335)
(0.520)
IACb / LoanB
0.33**
0.32**
2.07**
(0.069)
(0.071)
(0.544)
Bind„b
-0.19**
-0.019**
-0.19**
(0.026)
(0.028)
(0.068)
BindB
0.03
0.03
-0.16*
(0.020)
(0.021)
(0.086)
Loan GrowthHc
-0.05*
-0.06*
-0.04
(0.026)
(0.029)
(0.036)
Market / BookH
0.52**
0.059**
0.34
(0.082)
(0.097)
(0.192)
(Securities / Assets)B
-0.03
-0.04
-0.04
(0.027)
(0.029)
(0.099)
R2
0.12
0.12
0.15
N (Categories)
6999 (2339)
6328 (2162)
762 (278)
a. LAC, = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind, = 1 if bank capital ratio is less than or equal to the regulatory minimum.
c. Loan GrowthH equals loan growth of other subsidiaries in the holding company divided by their beginning of
period loans outstanding.
*, ** denote significance at the 5% and 1% levels, respectively

53
Table 12 presents results from the second robustness check, in which I replace the
holding company’s additions to capital with non-bank subsidiary’s additions to capital.
The results indicate that bank loan growth is positively related to the non-bank cash flows
of the holding company, which provides further evidence that external capital is costly and
banks operate internal capital markets. Moreover, the magnitude of this effect is similar to
the magnitude of the holding company cash flows. Arguably, concluding that these results
are spurious is harder, since it is less likely that non-bank subsidiary cash flows are
positively related to lending opportunities of bank subsidiaries. In this regard, these tests
provide the closest parallel to the experiment provided by Lamont (1993).
As an additional test of the operation of an internal capital market, I examine the
relation between the overall investment-cashflow sensitivity of the holding company and
the subsidiary’s dependence on both the holding company’s and its own cash flows. The
investment-cashflow sensitivity may estimate the magnitude of information asymmetries,
although it is measured with error since it is an approximation using regression coefficients
(see Table 6). To alleviate an errors in variables bias, I use the investment-cashflow
sensitivity lagged one period as an instrumental variable.
The severity of information asymmetries should be directly related to the growth of
individual banks. Therefore, I expect subsidiary loan growth to be negatively related to
the investment-cashflow sensitivity of the holding company. A finding that the importance
of holding company cash flows is positively related to the holding company’s investment-
cashflow sensitivity would provide further evidence of the operation of an internal capital
market. This indicates that the severity of the constraint faced by the holding company

54
Table 12
Between effects regressions relating subsidiary loan growth to internal additions to capital,
capital requirements, and subsidiary and holding company financial characteristics. The
sample consists of 2339 subsidiaries of 215 multiple bank holding companies from 1985-
1989 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,.,) / Loans,.,
Coefficient
Overall Sample
Small Banks
Lead Bank
(Non-Bank IAC)/(LoanH-LoanB)a
0.56**
1.28**
0.09
(0.173)
(0.279)
(0.203)
IACb / LoanB
0.33**
0.28**
1.98**
(0.069)
(0.072)
(0.506)
BindHb
-0.19**
-0.19**
-0.18**
(0.025)
(0.026)
(0.064)
BindB
0.01
0.02
-0.16*
(0.019)
(0.020)
(0.082)
Market / Book„
0.66**
0.69**
0.28
(0.075)
(0.087)
(0.177)
(Securities / Assets)B
0.05*
0.05
-0.02
(0.026)
(0.027)
(0.093)
R2
0.09
0.09
0.14
N (Categories)
6999 (2339)
6328(2162)
762 (278)
a. IAC, = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind; = 1 if bank capital ratio is less than or equal to the regulatory minimum.
*, ** denote significance at the 5% and 1% levels, respectively

55
directly influences the subsidiary’s dependence on holding company earnings. Table 13
presents between effects regressions including the holding company’s investment-cashflow
sensitivity and two interaction variables designed to test the relation between this
sensitivity and subsidiary reliance on both its own and holding company cashflows. These
variables are the interactions between holding company investment-cashflow sensitivity (as
estimated from equation (1) Table 5) and the two cash flow measures used above.2
At first glance, results in Table 13 might appear to be confusing. In particular, the
negative and significant coefficient on the holding company’s cash flows for both the
overall sample and the lead banks may initially cause some concern. However, consider
that this variable appears twice in the regression, the second time interacted with the
holding company’s investment-cashflow sensitivity. This sensitivity averages just under 4
(recall from Table 6), and for the majority of banks lies in a range from 3 to 5. After
combining these two estimates, it becomes clear that the total effect of holding company
cash flows will be positive for virtually all banks. Moreover, the positive coefficient on
the interaction term indicates that the severity of the holding company’s constraint directly
affects the subsidiary’s dependence on holding company earnings. Specifically, as holding
companies become more cash flow constrained, subsidiaries become more reliant on
holding company earnings. Likewise, the negative and significant coefficient on the
holding company’s sensitivity (for the overall sample and small banks) indicates that as
holding company’s become more constrained, their subsidiaries invest less. These results
provide additional evidence that holding companies operate internal capital markets.
2 Results are similar if the sensitivities are estimated from regressions in Table 4.

56
Table 13
Between effects regressions relating subsidiary loan growth to internal additions to capital,
estimated investment-cashflow sensitivity, capital requirements, and subsidiary and holding
company financial characteristics. The sample consists of 2339 subsidiaries of 215
multiple bank holding companies from 1985-1989 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,.,) / Loans,.,
Coefficient
Overall Sample
Small Banks
Lead Bank
(IACH-IACB)/(LoanH-LoanB)“
-1.984**
-0.837
-10.60*
(2.052)
(2.571)
(4.276)
IACB / LoanB
0.616
0.169
11.87*
(1.328)
(1.513)
(6.56)
BindHb
-0.145 **
-0.159**
-0.193 **
(0.022)
(0.023)
(0.069)
BindB
0.026
0.031
0.177 *
(0.017)
(0.019)
(0.087)
Market / Book„
0.344 **
0.468 **
0.221
(0.068)
(0.089)
(0.197)
(Securities / Assets)B
0.032
0.007
-0.063
(0.026)
(0.029)
(0.115)
Holding Company Investment-
-0.038 **
-0.033 *
0.002
Cashflow Sensitivity,.,
(0.023)
(0.013)
(0.044)
(IACH-LACB)/(LoanH-LoanB)d *
1.059*
0.742
2.997 *
Holding Company Investment-
Cashflow Sensitivity,.,
(0.532)
(0.658)
(1.214)
IACb / LoanB * Holding Company
-0.103
0.012
-2.448
Investment-Cashflow
Sensitivity,.,
(0.332)
(0.378)
(1.652)
R2
0.155
0.136
0.169
N (Categories)
6785 (2305)
6186 (2143)
751 (274)
a. IAC, = internal additions to capital (I=H for holding company and B for subsidiary)
b. Bind, = 1 if bank capital ratio is less than or equal to the regulatory minimum.
c. Loan Growth,, equals loan growth of other subsidiaries in the holding company divided by their beginning of
period loans outstanding.
d. Holding Company Investment-Cashflow Sensitivity is estimated from coefficients on internal additions to
capital and interaction variables from regression (1) in Table 5. To alleviate errors-in variables bias, I use the
lag investment-cashflow sensitivity as an instrumental variable.
*, ** denote significance at the 5% and 1% levels, respectively

CHAPTER 6
EXTERNAL CAPITAL ISSUANCE
The above analysis is consistent with the hypothesis that capital market frictions tie
investment to earnings for banks. To further study this issue, this chapter examines the
severity of information asymmetries surrounding external capital issuances. Specifically, if
the magnitude of the investment-cashflow sensitivity proxies for the severity of
information asymmetries, then ceteris paribus the likelihood that banks issue external
capital should be negatively related to this sensitivity. In addition, this sensitivity may
also be related to the expected costs associated with a security issuance. Banks that face
larger information asymmetries may expect higher underwriting fees and more negative
abnormal stock returns associated with an external capital issuance than banks that face
smaller information asymmetries.
Table 14 describes a summary of 461 security issuances by 157 different bank
holding companies from 1982-1994. The timing of security issuances suggests that
increases in capital standards may have induced banks to raise external funds in order to
replenish surplus capital. Notice that the most active issuance years (1985-1987, and
1991-1993) follow increases in capital standards.
Table 14 also documents the average abnormal returns for the security issuances in
my sample. I find that the average abnormal return following the announcement of a
common stock issuance is just less than -1%. Moreover, capital deficient banks
57

Table 14
Summary of bank holding company security issuances from 1982-1994
58
year
common stock
preferred stock
subordinated
notes
total
1982
1
10
4
15
1983
4
19
4
27
1984
9
8
17
34
1985
19
6
26
51
1986
28
4
16
48
1987
7
8
35
50
1988
1
4
9
14
1989
4
6
15
25
1990
2
4
4
10
1991
16
16
18
50
1992
22
18
36
76
1993
9
6
25
40
1994
0
5
16
31
total
122
114
225
461
Mean Offer Size (millions)
95,451
123,128
135,393
124,810
Mean (Offer Size / Assets)
1.0%
0.6%
1.1%
0.9%
Mean Underwriter Fees
4.2%
2.8%
1.4%
2.7%
Mean Abnormal Return
full sample
-1.32%
(z=-5.6, N=105)
0.15%
(z=0.3, N=98)
-0.19%
(z=-0.7,N=158)
-0.42%
(z=-3.5, N=361)
Mean Abnormal Return
if bind=0
-1.49%
(z=-6.4, N=85)
-0.02%
(z=-0.1, N=74)
-0.16%
(z=-0.5, N=144)
-0.48%
(z=-3.5, N=303)
Mean Abnormal Return
if bind=l
0.37%
(z=0.1, N=20)
0.05%
(z=0.7, N=24)
-0.05%
(z=-0.7, N=14)
-0.12%
(z=-0.8, N=58)
Test Statistic of Difference
in Mean Abnormal
Returns, by bind
z=1.50
z=0.39
z= 1.15
z=0.86
Security issuances collected from the Investment Dealers Digest.
Announcement dates collected from Dow Jones News Retrieval

59
experience approximately zero abnormal return, while adequately capitalized banks lose
approximately 1.5% in value. This is consistent with Cornett and Tehranian (1994), and
provides evidence that the market anticipates external equity issues by inadequately
capitalized banks. Also consistent with previous studies, I find that preferred stock and
subordinated note issues do not invoke significant abnormal returns. This may occur
because these securities are less informationally intensive than common stock, so an
issuance of these securities may not elicit as severe of a lemon’s problem.1
A bank’s decision of whether to issue is likely to be related to the information
asymmetries it faces. Therefore, I develop a logit model which predicts the choice to issue
based on firm and market characteristics. Following Bayless and Chaplinsky (1991)
certain factors can be identified which are likely to influence the decision to issue. It can
be shown that an increase in the firm’s stock price increases the share of returns to an
investment project retained by old stockholders and reduces the loss of existing firm value
to new stockholders. Thus, I include the ratio of the last three months’ average stock
price to the prior thirty-six months’ average. In addition, prior studies find that the
aggregate market conditions at the time of issuance have a significant influence on offer
choice. Essentially, firms are more likely to issue equity following strong equity market
performance. To control for market conditions, I include the ratio of the three-month
average market price (CRSP equal weighted index) to the thirty-six month average. The
variable Risk, the standard deviation of the firm’s common stock returns, controls for
stock volatility.
1 See Mikkelson and Partch (1986)

60
In previous chapters, I argue that capital requirements affect bank decision making
by placing a binding constraint on the utilization of debt funds. This suggests that banks
which are capital deficient may be more likely to issue external funds. To control for this
possibility, I include a dummy variable for whether banks fail capital requirements, Bind,
as an explanatory variable. A second implication of this paper is that securities holdings
may provide banks with significant financial slack, especially if regulators enforce
leverage-based capital standards. In particular, firms with sufficient resources allocated to
securities holdings can fund growth through the liquidation of these holdings. As a result,
firms with a large buffer stock of securities may be less likely to issue external funds.
Thus, I include the ratio of securities to assets as an explanatory variable.
In the Myers and Majluf (1984) model, an increase in financial slack increases the
costs of adverse selection. Therefore, and increase in slack reduces the likelihood of an
equity offering. As an additional proxy for slack, I include a variable called free cash flow
(see Bayless and Chaplinsky (1996)). Free cash flow is designed to measure the flow of
funds constraint which motivates firms to issue securities when positive new present value
projects cannot be financed internally. Free cash flow is defined as current net income
less dividends and loan growth (investment). Banks are expected to be more likely to
issue when they have less free cash flow, hence I expect a negative coefficient.
This paper maintains that banks are concerned with the amount of regulatory
capital that they generate internally. Presumably, banks would fund all growth through
internally generated additions to capital if possible. However, that a bank chooses to issue
external funds does not necessarily mean that it requires a capital injection from a

61
regulatory point of view. It could be that sufficient profitable lending opportunities exist
that the bank could not take advantage of without raising external capital. Either way, the
amount of capital generated internally is likely to be an important factor in the decision to
issue external funds. To capture this relationship, I include the additions to capital,
lagged one observation, as an explanatory variable. This variable indicates the amount of
regulatory capital generated in the previous year. A negative coefficient on additions to
capital indicates that banks are more likely to issue if they have not been generating
sufficient capital internally. On the other hand, a positive coefficient indicates that banks
are more likely to issue when they have profitable growth opportunities.
Optimal capital structure theory maintains that firms have target debt ratios.
Because the costs of debt exceed the benefits for debt ratios above the target, firms are
predicted to be more likely to issue the further the firm’s current debt ratio is above the
target ratio. Banks’ optimal capital structure is likely to depend on the current capital
requirements. Indeed, the previous chapters provide evidence that surplus capital is an
important determinant of bank growth. I approximate each bank’s optimal capital
structure as its average surplus capital over the entire sample period (1982-1994).2 The
deviation from the optimal, designated Target, is then calculated as the difference between
this average and the bank’s current period surplus capital. A positive value for Target
indicates that the bank has less surplus capital than optimal. Since all security issues in my
sample augment regulatory capital, I expect a positive coefficient on Target.
2 This definition may not be completely accurate, since the optimal surplus capital
may change as capital standards change. As a separate test, I calculate Target over each
regime. Results are similar.

62
In a recent study, Bayless and Chaplinsky (1996) find that firms are more likely to
issue equity in a ‘hot’ issue market. Drawing on this research, I identify hot issuance
markets, and create an appropriate dummy variable (Hot) to include as an explanatory
variable. To identify hot markets, I use aggregate equity issue volume data from the
Federal Reserve System’s Annual Statistical Digest. I classify the periods using scaled
issue volume, which is monthly issue volume divided by the month end value of
outstanding equity from the CRSP and NASD tapes.3 I rank three-month moving
averages of equity issue volume into quartiles. Hot markets are identified as at least three
contiguous months where equity volume exceeds the upper quartile.
The main purpose of this analysis is to examine the relation between information
asymmetries and the likelihood of issuance. If the predicted investment-cashflow
sensitivity proxies for the severity of capital market frictions, it should be negatively
related to the probability of issuance. The investment-cashflow sensitivity is estimated
using regression (1) from Table 5.4 Specifically, the coefficients on additions to capital
and the interaction variables are combined to predict the sensitivity for each bank in every
year (see Table 6).
Two potential problems arise when including this sensitivity as an explanatory
variable. First, since it is estimated using regression coefficients, it is measured with error.
To alleviate this problem, I instrument for this sensitivity using a lagged observation.
3 Like Bayless and Chaplinsky (1996), results are not sensitive to the use of scaled
volume. If I classify based on nominal dollar or real dollar volume, results are similar.
4 Results are similar if the investment-cashflow sensitivities are estimated from
regressions in Table 4.

63
Second, there may be a causality problem. Banks that issue securities may be less cash
flow constrained not because of information costs but because they raised external capital.
However, it is less likely that banks that issue were also less constrained by cash flow in
the previous year because of the decision to raise funds. Again this can be alleviated by
using the investment-cashflow sensitivity lagged one year.
Table 15 presents descriptive statistics based on whether the bank issues in a given
year, and if so which type of security it issues. Recall from Table 7 that the investment-
cashflow sensitivities are negatively related to bank size. This is consistent with large
banks facing less severe information asymmetries than small banks. Thus it should not be
surprising that banks which issue are significantly larger than banks which do not issue.
The average size for non-issuers is just over six billion, while stock issuers average over
twenty billion. Also, issuers are increasing loans faster and generating more internal
capital (except for preferred stock issuers) than non-issuers. However, issuers also have
significantly less free cash flow. These results are consistent with firms issuing when they
need funds to implement positive net present value projects.
This chapter is interested in examining the relation between the investment-
cashflow sensitivities and the likelihood of security issuance. One implication of capital
market frictions is that firms with more severe information asymmetries will be less likely
to issue external funds. Perhaps surprisingly, non-issuers have significantly lower
investment-cashflow sensitivities than issuers. However, this is likely influenced by the
fact that issuers have significantly less financial slack as measured by surplus capital and
securities holdings, and are more likely to be inadequately capitalized. To further address

64
Table 15
Descriptive statistics (means, with medians in parentheses) for 289 bank holding
companies classified by type of security issuance.3
Variable
no issuance
common stock
issuance
preferred stock
issuance
subordinated
note issuance
Total Assets (millions)
6,533
20,100*
51,300 *
38,600 *
(2,276)
(5,597) *
(32,300) *
(22,800) *
Loan Growthb
0.061
0.191*
0.087
0.152 *
(0.076)
(0.151)*
(0.055)
(0.116)*
Internal Additions to
0.014
0.019*
0.015
0.019*
Capital/ Loans,.,0
(0.017)
(0.019)*
(0.014)
(0018)
Market / Book Assets'1
1.005
1.004
0.991 *
1.006
(0.999)
(0.996)
(0.989) *
(1.000)
Book Capital in Excess
0.025
0.017 *
0.017 *
0.023
of Requirement / Assets e
(0.021)
(0.014)*
(0.010) *
(0.017) *
Securities / Assets
0.215
0.193 *
0.134*
0.165*
(0.208)
(0.195)
(0.119)*
(0.159)*
Riskf
0.023
0.022
0.023
0.019
(0.018)
(0.017
(0.018)
(0.016)
Predicted Investment-
3.688
3.915 *
4.072 *
3.903 *
Cashflow Sensitivity®,.,
(3.758)
(3.915)*
(4.174)*
(4.006) *
Free Cash Flow/Loans,,h
-0.055
-0.185 *
-0.082 *
-0.144 *
(-0.066)
(-0.145) *
(-0.048)
(-0.110) *
Percentage with Capital
less than requirement.
4.55%
9.02% *
21.9% *
9.78% *
Number of Observations
1954
122
114
225
a. Data are from the Federal Reserve Y-9 tape.
b. Loan growth equals change in total loans outstanding divided by loans outstanding at time t-1.
c. Internal additions to capital equals net income plus changes in loan loss provisions (up to regulatory
maximum).
d. Market to book value of assets equals (Total Assets - Book Equity + Market Equity) / Total Assets. Market
Equity equals the market value of common equity from CRSP. The ratio is calculated at year end for the prior
year.
e. Book capital in excess of requirement equals the bank’s book capital for regulatory minimum Tier II capital
ratio. Tier II capital equals common stock, preferred stock, plus eligible subordinated debt and loan loss
reserves. Forthe period 1982-1984 the requirement is 5.5% of total assets. For 1985-1989 the requirement is
6%. Beginning in 1990, the requirement is based on risk-weighted assets. For 1990-1991, the minimum is
7.25% of risk-weighted assets, while from 1992-1994 the minimum is 8%.
f. Risk equals the standard deviation of the firm’s daily stock return, after adjustmg for bid-ask bounce.
g. Investment-Cashflow Sensitivity is estimated using coefficients on internal additions to capital and
interaction variables from regression (1) in Table 5.
h. Free Cash Flow is net income less dividends and loan growth.
* denotes significantly different from the no investment sample at better than the 5% level.

65
this issue, I estimate probit regression models of security choice while controlling for the
investment-cashflow sensitivity, surplus capital, and securities holdings.5
The sample contains a pooled time-series cross section of data. As a result,
observations may not be independent, especially for the common stock issuance model In
particular, if a bank issues common stock in any given year, it is likely to not issue again in
the next year. In fact, for only twenty out of one hundred and twenty-two issues did a
bank issue common stock in consecutive years. Likewise, forty-two out of one hundred
and fourteen preferred stock, and sixty-eight out of two hundred and twenty-five
subordinated note issues occurred from a bank in consecutive years. To address this
problem, I include a dummy variable indicating whether the bank issued in the previous
year.6 Specifically, I create four dummy variables (any security, common stock, preferred
stock, and subordinated note) to include in the appropriate regressions, and expect the
coefficients to be negative.
Table 16 presents the results from probit models which estimate the decision to
issue based on the aforementioned firm and market characteristics. Because the
investment-cashflow sensitivity is related to capitalization and securities holdings, I
estimate the regressions both with and without this variable. Regardless of security type,
5 Results are similar using logit regressions
6 As a separate test, I estimate the probit models for each year independently. In
these regressions, the coefficient estimates were relatively stable for the any issuance,
preferred stock, and subordinated note models. However, for the common stock model,
coefficients were not as stable. Moreover, in all models, coefficient estimates were not as
significant as those presented in Table 15, perhaps due to the use of many fewer
observations.

Table 16
Probit regressions relating a security issuance to firm financial characteristics. Year dummy variables included (results not reported).
The sample consists of 289 bank holding companies from 1982-1994 (standard errors in parentheses).
Dependent Variable=ISS,= l if issuance, =0 otherwise8
coefficient
is
iSS^y
ISSC
ISSC
issp
issp
iss„
issm
Investment-Cashflow Sensitivity,.1b
-0.5 (0.1)*
-0.6 (0.2)*
-0.9 (0.2)*
-0.1 (0.2)
Issued Last Year =1 if yes, 0 if no.
-0.4 (0.1)*
-0.4 (0.1)*
-0.5 (0.2) *
-0.5 (0.2)*
-0.7 (0.2)*
-0.6 (0.2)*
-0.5 (0.1)*
-0.5 (0.1)*
Bind
0.5 (0.2)*
0.6 (0.2)*
0.5 (0.2)*
0.7 (0.2)*
0.5 (0.2)*
0.6 (0.2)*
0.3 (0.2)
0.3 (0.2)
Price'
1.0 (0.5)*
1.1 (0.5)*
0.9 (0.6)
1.1 (0.6)*
1.2 (0.7)
1.4 (0.7)*
0.4 (0.9)
0.4 (0.8)
Marketd
16 (3.8)*
17 (3.8)*
14 (4.9) *
15 (5.0)*
14 (5.9) *
17 (6.3)*
10 (4.8)
10 (4.8) *
Risk'
1.4 (3.7)
1.3 (3.8)
11 (9.2)
12 (9.8)
1.3 (4.3)
1.3 (4.6)
0.9 (4.4)
0.9 (4.4)
Risk2
-3.4 (9.2)
-3.3 (10)
-59 (68)
-70 (76)
-3.1 (6.6)
-3.0 (7.7)
-2.4 (5.6)
-2.4 (5.6)
log (Total Assets,^)
0.4 (0.03)*
0.4 (0.04)*
0.2 (0.04) *
0.3 (0.04)*
0.4 (0.05)*
0.5 (0.1)*
0.5 (0.1)*
0.5 (0.1)*
Hot Issuance Market
0.04 (0.1)
0.03 (0.1)
-0.04 (0.1)
-0.04 (0.1)
0.04 (0.1)
0.04 (0.1)
0.03 (0.1)
0.03 (0.1)
Free Cash Flow / Loans,.!
-1.3 (0.5)*
-0.7 (0.5)
-0.3 (0.6) *
-0.7 (0.6)
-1.2 (0.6)*
-0.7 (0.6)
-1.2 (0.6)*
-1.2 (0.6)*
Lag (Additions to Capital/ Loans,. ,)
6.9 (3.5)*
4.4 (3.6)
8.5 (4.0) *
5.9 (4.1)
-4.3 (4.5)
-4.3 (4.6)
5.9 (4.6)
5.8 (4.8)
Targetf
2.2 (2.8)
1.3 (2.8)
-1.3 (3.2)
-1.4 (3.1)
-5.8 (3.4)
-5.8 (3.4)
2.5 (3.4)
2.4 (3.4)
Securities / Assets,.,
-1.2 (0.5)*
-1.5 (0.6)*
-0.9 (0.5) *
-0.7 (0.7)
-1.3 (0.6)*
-1.3 (0.6)*
-0.3 (0.7)
-0.3 (0.9)
N (Pseudo R squared)
1879(0.22)
1879 (0.23)
1879 (0.09)
1879(0.11)
1879(0.27)
1879(0.30)
1879(0.29)
1879(0.30)
a. ISS, equals a dummy variable for security issuance in a given year (any=any security, c=common stock, p=preferred stock, sn=subordinated notes).
b. Investment-Cashflow Sensitivity is estimated using coefficients on internal additions to capital and interaction variables from regression (1) in Table 5.
c. Price=3 month average stock price / 36 month average price
d. Market=3 month average value of CRSP value-weighted index / 36 month average
e. Risk= standard deviation of daily stock return
f. Target = the bank’s average surplus capital over the entire sample period minus it’s actual surplus capital.
* denote significance at the 5% level.

67
inclusion of the investment-cashflow sensitivity increases the pseudo R squared of the
model (and log likelihood ratio). Moreover, in three of four models after controlling for
capitalization and securities holdings, I find a negative and significant relation between the
choice of issuance and the investment-cashflow sensitivity. This provides evidence that
investment-cashflow sensitivities proxy for the severity of information asymmetries.
Consistent with the hypothesis that capital requirements impose binding
constraints, I find that the probability of issuing external funds is greater for banks that fail
capital requirements. Specifically, for the any security, common stock, and preferred
stock models, coefficient estimates on Bind, are positive and significant after controlling
for the investment-cashflow sensitivity. Moreover, the negative coefficients on securities
indicate that banks with more securities holdings are less likely to raise external capital.
This provides further evidence that banks rely on buffer stocks of capital and securities to
fund growth during a liquidity crisis.
The coefficient estimates on the dummy variable for issuance in the previous year
are negative and statistically significant for all four issuance models. This supports the
notion that banks are unlikely to issue external capital securities in consecutive years.
Also, the negative coefficients on free cash flow indicate that banks are more likely to
issue capital when they need funds to support growth.
As a second test of the relation between information costs and external capital
issuances, I examine the relation between investment-cashflow sensitivities and banks’
anticipated costs of security issuance. Following Calomiris and Himmelberg (1995), I
estimate expected underwriting costs based on firm characteristics and sort firms into high

68
and low cost categories. Using these categories, I determine whether high cost firms
display greater investment-cashflow sensitivities than low cost firms. Calomiris and
Himmelberg identify certain characteristics which are important in determining
underwriting fees. I use similar bank characteristics to estimate the fee model.
In Calomiris and Himmelberg, financial working capital, leverage, and sales are the
most important characteristics. I estimate financial working capital as securities holdings,
and control for leverage with capitalization. Translating sales to a banking firm
characteristic, I choose internally generated additions to capital. I pick additions to capital
over income because capital requirements cause banks to be concerned with the amount of
regulatory capital that they generate. I also include free cash flow to capture the flow of
funds constraint that motivates banks to issue. In addition, I include size, the deviation
from optimal capital structure (Target), and the volatility of stock returns (Risk)7
As in Calomiris and Himmelberg, this is not intended to be a structural model. The
process of experimentation that yields the model was an search for a model that
maximized adjusted R squared. Because of this problem, I choose not to focus on
individual coefficient estimates, rather I am more concerned with the accuracy of
predictions based on this model (the correlation between actual fees and predicted fees for
common stock issuances is more than 0.8). Moreover, I will sort firms into categories
based on this prediction so as not to rely on the prediction itself, but only a dummy
variable which indicates whether the prediction is over or under the median prediction.
7 I experiment with a number of alternative specifications, but report only the one
which yielded the largest adjusted R squared.

69
Table 17 presents results from a heteroskedastic consistent regression relating the
underwriting fees to firm characteristics. The most important firm characteristics in
determining fees are size and the amount of internal capital generation. Also, the adjusted
R squared for these models are similar to those from Calomiris and Himmelberg.
Because I am interested in using information about issuers to estimate the external
financing costs of non-issuers, I correct for potential selectivity bias before applying the
model to construct expected underwriting costs for issuers and non-issuers. That is, the
decision to issue is not random, and that decision is likely to be correlated with some or all
of the regressors in the underwriting fee model. To correct for this problem, I use a two-
step Heckman procedure in which the decision to issue is modeled as a probit model. The
probability of issuing derived from this probit enters as an explanatory variable in the
underwriting fee model. Since a probit model has been specified in Table 16,1 rely on this
model for the Heckman procedure. Because my goal is to use predictors from the
Heckman procedure to explain differences in investment-cashflow sensitivities, I use the
probit model without the investment-cashflow sensitivity as an explanatory variable.
The results from the underwriting fee model and the probit model after correcting
for selectivity bias are presented in Table 18. The coefficients from the underwriting fee
model are used to construct predicted values of the cost of issuing each type of security
for all firms. I then create a dummy variable (High Fees) which equals one if the predicted
fees are above the median predicted fees, or zero otherwise for each security type. This
dummy variable is employed to estimate the relation between expected issue costs and the
sensitivity to internally generated funds.

70
Table 17
Heteroskedastic consistent regressions relating total underwriting expense to firm
characteristics. Year dummy variables included (results not reported). The sample
consists of 289 bank holding companies from 1982-1994 (standard errors in parentheses).
Dependent Variable= percentage fees associated with:
Variable
Common Stock
Preferred Stock
Subordinated Notes
Bind*
-0.001
0.002
-0.001
(0.002)
(0.002)
(0.003)
Log (Total Assets,.,)
-0.007 **
-0.006 **
-0.006 **
(0.001)
(0.001)
(0.002)
Free Cash Flow / Loans,.,b
-0.001
0.002
-0.005
(0.005)
(0.003)
(0.014)
Lag (Additions to Capital /
-0.147
-0.189 *
-0.389 *
Loans,.,)
(0.084)
(0.085)
(0.177)
Securities / Assets,.,
0.025 *
-0.016
0.001
(0.013)
(0.018)
(0.024)
Target0
-0.085
-0.069
0.092
(0.076)
(0.042)
(0.095)
Riskd
0.748 **
0.426 **
0.432
(0.247)
(0.152)
(0.523)
Risk2
-4.635 **
-2.075
-3.697
(1.777)
(0.763)
(8.207)
N (Adjusted R2)
109 (0.661)
95 (0.419)
116 (0.417)
a. Bind =1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank's average surplus capital over the entire sample period minus it’s actual surplus capital.
d. Risk= standard deviation of daily stock return
*, ** denote significance at the 5% and 1% levels, respectively

71
Table 18
Regression models relating underwriting fees to firm characteristics, correcting for selectivity bias
using Heckman’s two step procedure, (standard errors in parentheses)
common stock
preferred stock
subordinated notes
Variable
Probit Model
(l=issuer)
% fee
Probit Model
(l=issuer)
% fee
Probit Model
(l=issuer)
% fee
Bind8
0.03
(0.067)
0.01
(0.01)
-0.06
(0.143)
0.002
(0.003)
0.28 *
(0.138)
0.002
(0.003)
Log (Total Assets,.,)
0.11 **
(0.018)
-0.01 **
(0.001)
0.33 **
(0.021)
-0.01 **
(0.001)
0.79 **
(0.022)
-0.01 **
(0.001)
Free Cash Flow /
Loans,.,b
-2.08 **
(0.117)
-0.002
(0.005)
-1.19**
(0.114)
0.002
(0.008)
-1.21 **
(0.116)
-0.01
(0.006)
Lag (Additions to
Capital / Loans,.,)
9.63 **
(2.062)
-0.17
(0.106)
-5.27 **
(2.167)
-0.19
(0.109)
37.2 **
(2.148)
-0.28
(0.176)
Securities / Assets,.,
-9.14**
(0.332)
0.02
(0.017)
-2.50 **
(0.319)
-0.01
(0.024)
-10.8**
(0.336)
-0.03
(0.024)
Target8
54.3 **
(2.126)
-0.08
(0.083)
11.7 **
(1.945)
-0.08
(0.122)
21.2 **
(2.084)
0.19
(0.113)
Riskd
-3.22 *
(1.415)
0.87 **
(0.271)
-8.73 **
(2.062)
0.42 *
(0.25)
-0.71
(1.475)
0.20
(0.504)
3 month avg Stock
Price / 36 month avg
5.68 **
(0.289)
6.25 **
(0.287)
15.1 **
(0.797)
3 month avg Market
Price / 36 mo avg
-35.3 **
(1.979)
0.71
(2.089)
-22.9 **
(2.072)
Hot
0.28 **
(0.055)
0.25 **
(0.059)
-0.59 **
(0.057)
Issued in the Previous
Year =1 if yes, 0 if no.
-0.42 **
(0.103)
-0.35 **
(0.112)
0.01
(0.095)
Inverse Mills Ratio
from Probit'
0.003 **
(0.0002)
-0.002
(0.0135)
0.01 **
(0.002)
a. Bind =1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank’s average surplus capital over the entire sample period minus it’s actual surplus capital.
d. Risk= standard deviation of daily stock return
e. Inverse Mills Ratio = the probability of issuance derived from the Probit model
*, ** denote significance at the 5% and 1% levels, respectively

72
Table 19 presents fixed-effects regressions of loan growth identical to the model from
Table 3 with one important difference. I include the interaction of the variable High Fees with
additions to capital. The three categories of regressions indicate the security type for which the
underwriting fees are predicted. Because of a potential simultaneity bias induced by estimating
fees and then using the estimation as an explanatory variable, I instrument for this variable with a
lagged observation of High Fees. This interaction term is designed to test the hypothesis that
firms which anticipate larger external finance costs are more constrained by internally generated
funds. Regardless of security type, banks which anticipate higher than median underwriting fees
are more sensitive to internally generated funds.8 In other words, expected external finance costs
affect a bank’s reliance on internally generated funds. This finding provides evidence that the
magnitude of the investment-cashflow sensitivity proxies for the size of the wedge between
internal and external financing costs.
Continuing along these lines, the expected abnormal returns following the announcement
of a security issuance may proxy for expected costs of issuance, and therefore may be related to
the investment-cashflow sensitivities. Using the same specifications from the underwriting fees
model, I estimate the abnormal stock returns based on firm characteristics using weighted least
squares, weighing each observation by the standard error from a market model regression. Table
20 presents results that indicate that abnormal returns are difficult to predict with observable
characteristics, as the adjusted R squared from these models is much lower than from the
underwriting fee models. However, this problem should simply introduce more noise in the
8 In additional tests, I divided firms into quartiles based on expected financing
costs. In these tests I find a significant difference between the highest and lowest quartile.
I also find a significant difference between the top two quartiles.

73
Table 19
Fixed effects regressions relating loan growth to internal additions to capital, expected
underwriting fees, and firm financial characteristics. The sample consists of 289 bank
holding companies from 1982-1994 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,., ) / Loans,.,
Variable
common stock
preferred stock
subord. notes
Additions to Capital /
Loans,.,
4.67 **
(0.231)
3.59 **
(0.188)
4.66 **
(0.234)
3.76 **
(0.201)
4.45 **
(0.242)
3.65 **
(0.202)
High Fees,., * Additions to
Capital / Loans,.,"
0.38*
(0.186)
0.39*
(0.184)
0.34 *
(0.179)
0.39*
(0.177)
0.82 **
(0.165)
0.93 **
(0.216)
Surplus Capital / Assets,.,
0.93 **
(0.162)
0.91 **
(0.164)
0.82 **
(0.165)
Surplus Capital *Additions
to Capital / Loans,.,
-30.7 **
(4.588)
-30.4 **
(4.615)
-26.6 **
(4.761)
Bind"
-0.05 *
(0.009)
-0.05 **
(0.009)
-0.05 **
(0.009)
Bind * Additions to Capital
/ Loans,.,
0.46
(0.459)
0.99*
(0.512)
0.71
(0.514)
Securities / Assets,.,
0.13 **
(0.039)
0.15 **
(0.039)
0.13 **
(0.040)
0.13 **
(0.040)
0.13 **
(0.040)
0.13 **
(0.039)
Market / Book Assets,.,
0.26 **
(0.048)
0.27 **
(0.049)
0.27 **
(0.048)
0.26 **
(0.049)
0.25 **
(0.048)
0.24 **
(0.048)
log (Assets,.,)
-0.07 **
(0.005)
-0.07 **
(0.005)
-0.07 **
(0.006)
-0.07 **
(0.005)
-0.07 **
(0.005)
-0.07 **
(0.005)
Lag loan growth
0.07 **
(0.010)
0.07 **
(0.010)
0.07 **
(0.010)
0.07 **
(0.010)
0.05 **
(0.011)
0.04 **
(0.012)
R2
0.379
0.377
0.379
0.375
0.383
0.379
N (categories)
1986
(289)
1986
(289)
1986
(289)
1986
(289)
1986
(289)
1986
(289)
F statistic, Bank dummies
2.33 **
2.62 **
2.33 **
2.60 **
2.37 **
2.65 **
a. High Fees =1 if the firms predicted fees from the Underwriting Fees model in Table 18 (corrected for
selectivity bias) are greater than the median predicted fees, =0 otherwise.
b. Bind=l if surplus capital<=0,0 otherwise.
*, ** denote significance at the 5% and 1% levels, respectively

74
Table 20
Weighted least squares regressions relating abnormal stock returns following the
announcement of a security issuance to firm characteristics. Observations are weighted
by the standard errors from a market model regression. Year dummy variables included
(results not reported). The sample consists of 289 bank holding companies from 1982-
1994 (standard errors in parentheses).
Dependent Variable= abnormal stock returns associated with:
Variable
Common Stock
Preferred Stock
Subordinated Notes
Bind"
0.03 **
-0.01
-0.01
(0.012)
(0.011)
(0.001)
Log (Total Assets,.!)
0.001
0.004
0.002
(0.002)
(0.004)
(0.002)
Free Cash Flow / Loans,.!b
-0.03
0.03 *
0.02
(0.023)
(0.013)
(0.011)
Lag (Additions to Capital /
-0.31
-0.17
0.32
Loans,.,)
(0.457)
(0.366)
(0.233)
Securities / Assets,.,
-0.01
0.02
0.01
(0.065)
(0.077)
(0.031)
Target'
-0.08
-0.17
0.08
(0.377)
(0.366)
(0.193)
Riskd
-0.76
0.06
-1.15
(0.802)
(0.637)
(0.872)
Risk2
6.18
1.06
12.9
(5.972)
(3.121)
(12.07)
N (Adjusted R2)
107(0.166)
90 (0.339)
155 (0.158)
a. Bind = 1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank’s average surplus capital over the entire sample period minus it’s actual surplus capital.
d. Risk= standard deviation of daily stock return
*, ** denote significance at the 5% and 1% levels, respectively

75
estimates and bias against finding any relation between expected costs and investment-
cashflow sensitivities.
Table 21 presents results from the probit and abnormal return models using the
Heckman procedure correcting for selectivity bias. As before, the coefficients from the
abnormal return model are used to construct predicted values of the cost of issuing each
type of security for all firms. I then create a dummy variable (Large Abnormal Returns)
which equals one if the predicted abnormal returns are more negative than the median
predicted returns, or zero otherwise for each security type. This dummy variable is
employed to estimate the relation between expected costs and the sensitivity to internally
generated funds.
Table 22 presents results from a fixed effects regression model of loan growth,
including the interaction between Large Abnormal Returns and additions to capital.
Again, because of a potential simultaneity bias resulting from estimating costs, I
instrument for this variable with a lagged observation of Large Abnormal Returns. As in
the underwriting fee models, regardless of security type, banks that expect abnormal
returns more negative than the median expected abnormal return are significantly more
constrained by internally generated additions to capital. This suggests that expected
abnormal stock returns influence the dependence on internally generated additions to
capital, and that banks that anticipate larger external finance costs are more constrained by
additions to capital than banks that anticipate smaller costs. Overall, these results provide
evidence that investment-cashflow sensitivities proxy for the severity of information
asymmetries.

76
Table 21
Regression models relating abnormal stock returns to firm characteristics, correcting for
selectivity bias using Heckman’s two step procedure, (standard errors in parentheses).
common stock
preferred stock
subordinated notes
Variable
Probit Model
(l=issuer)
Abnormal
Return
Probit Model
(l=issuer)
Abnormal
Return
Probit Model
(l=issuer)
Abnormal
Return
Bind"
0.46 **
(0.064)
0.02 *
(0.008)
0.05
(0.145)
-0.01
(0.010)
0.40 **
(0.140)
-0.01
(0.003)
Log (Total Assets,.,)
0.04*
(0.019)
0.002
(0.003)
0.40 **
(0.021)
0.01 *
(0.004)
0.04 *
(0.019)
0.002 *
(0.001)
Free Cash Flow /
Loanst.,b
0.23 *
(0.119)
-0.03
(0.019)
-1.31 **
(0.116)
0.03
(0.023)
0.15
(0.123)
0.02 **
(0.006)
Lag (Additions to
Capital / Loans,.,)
-17.5 **
(2.089)
-0.02
(0.440)
-8.72 **
(2.273)
-0.17
(0.358)
4.69*
(2.117)
0.25 *
(0.129)
Securities / Assets,.,
-5.73 **
(0.316)
0.001
(0.072)
-3.44 **
(0.345)
-0.01
(0.070)
-1.85 **
(0.305)
0.03 *
(0.013)
Target"
18.7 **
(1.858)
-0.25
(0.362)
19.8 **
(2.169)
-0.02
(0.373)
6.53 **
(1.862)
0.04
(0.109)
Riskd
-27.31 **
(2.112)
-0.48
(0.884)
-5.23 **
(2.026)
0.86
(0.819)
-13.1 **
(2.121)
-1.48*
(0.628)
3 month avg Stock
Price / 36 month avg
3.82 **
(0.531)
7.60 **
(0.288)
-5.48 **
(0.703)
3 month avg Market
Price / 36 mo avg
30.8 **
(2.057)
18.6 **
(2.267)
15.0**
(2.075)
Hot
0.13 *
(0.057)
-0.32 **
(0.061)
-0.12*
(0.058)
Issued in the Previous
Year =1 if yes, 0 if no.
-0.41 **
(0.102)
-0.37 **
(0.118)
-0.33 **
(0.077)
Inverse Mills Ratio
from Probit"
0.01
(0.018)
0.02
(0.012)
-0.02 **
(0.001)
a. Bind =1 if surplus capital is less than or equal to zero, =0 otherwise
b. Free Cash Flow= net income less dividends and investment.
c. Target = the bank’s average surplus capital over the entire sample period minus it’s actual surplus capital.
d. Risk= standard deviation of daily stock return
e. Inverse Mills Ratio = the probability of issuance derived from the Probit model
*, ** denote significance at the 5% and 1% levels, respectively

77
Table 22
Fixed effects regressions relating loan growth to internal additions to capital, expected
abnormal stock returns, and firm financial characteristics. The sample consists of 289
bank holding companies from 1982-1994 (standard errors in parentheses).
Dependent Variable = (Loans, - Loans,.,) / Loans,.,
Variable
common stock
preferred stock
subord. notes
Additions to Capital / Loans,.,
4.52 **
(0.242)
3.77 **
(0.207)
4.51 **
(0.233)
3.66**
(0.204)
4.68 **
(0.227)
3.76**
(0.199)
Large Abnormal Returns,., *
Additions to Capital / Loans,.,8
0.32 *
(0.177)
0.37 *
(0.178)
0.85 **
(0.210)
0.84 **
(0.209)
0.72 **
(0.189)
0.76 **
(0.189)
Surplus Capital / Assets,.,
0.80 **
(0.163)
0.87 **
(0.155)
0.95 **
(0.159)
Surplus Capital *Additions to
Capital / Loans,.,
-26.5 **
(4.722)
-27 7 **
(4.458)
-30.9 **
(4.551)
Bindb
-0.05 **
(0.009)
-0.06 **
(0.009)
-0.06 **
(0.009)
Bind * Additions to Capital /
Loans,.,
0.21
(0.533)
1.02 *
(0.511)
0.97 *
(0.501)
Securities / Assets,.,
0.12**
(0.039)
0.12 **
(0.039)
0.13 **
(0.039)
0.13 **
(0.038)
0.11 **
(0.040)
0.11 **
(0.040)
Market / Book Assets,.,
0.26 **
(0.047)
0.25 **
(0.048)
0.26 **
(0.049)
0.24 **
(0.049)
0.24 **
(0.049)
0.22 **
(0.049)
log (Assets,.,)
-0.07 **
(0.005)
-0.07 **
(0.005)
-0.06 **
(0.005)
-0.07 **
(0.005)
-0.07 **
(0.005)
-0.07 **
(0.005)
Lag loan growth
0.07 **
(0.009)
0.07 **
(0.009)
0.08 **
(0.009)
0.08 **
(0.009)
0.06 **
(0.010)
0.06 **
(0.010)
R2
0.355
0.351
0.385
0.384
0.383
0.379
N (categories)
1968
(289)
1968
(289)
1968
(289)
1968
(289)
1968
(289)
1968
(289)
F statistic, Bank dummies
2.35 **
2.62 **
2.34 **
2.63**
2.36 **
2.63 **
a. Large Abnormal Returns =1 if the firms predicted abnormal stock returns from the Abnormal Stock Returns
model in Table 21 (corrected for selectivity bias) are more negative than the median predicted abnormal return,
=0 otherwise.
b. Bind=l if surplus capital<=0,0 otherwise.
*, ** denote significance at the 5% and 1% levels, respectively

CHAPTER 7
SUMMARY AND CONCLUSIONS
Overall, my results suggest that asymmetric information problems increase the
costs of external finance for banking firms. In particular, I find a positive and significant
relation between bank loan growth and internally generated additions to capital.
Moreover, consistent with the hypothesis that capital requirements limit bank financing
alternatives, this cashflow sensitivity of investment is positively related to the extent that
capital requirements are binding. This relationship implies that increases in capital
standards, which increase the likelihood that capital requirements are binding, could
induce a slowdown in loan growth.
I also find that the formulation of the capital ratio itself is important in determining
bank loan growth. Specifically, with regulators enforcing leverage-based capital
standards, banks can rely on a buffer stock of securities to fund investment in a liquidity
crisis. This results in a negative relation between the cashflow sensitivity of investment
and securities holdings. However, the use of risk-based standards substantially reduces
the effectiveness of securities as financial slack. As a result, the change from leverage-
based to risk-based standards may have caused banks to desire more surplus capital, and
therefore may have had a negative impact on loan growth.
My results also suggest that bank holding companies allocate capital in a way
consistent with the operation of an internal capital market by holding companies that find
78

79
equity expensive to raise externally. Specifically, 1 find that investment by bank
subsidiaries is more sensitive to the cash flows and capitalization of its holding company
than its own cash flows and capitalization. I also find that subsidiary investment is
significantly related to the non-bank earnings of its holding company. These results are
consistent with the hypothesis of costly external finance, and suggest that empirical studies
of the effects of changes in capital requirements should be considered on the holding
company level and not the individual bank level.
Finally, 1 find that the severity of information asymmetries affects both the
likelihood and the costs of an external capital issuance. In particular, I find a negative
relation between the cash flow sensitivity of investment and the probability that banks
issue external capital. I also find that firms which anticipate underwriting fees larger than
the median expected fee for an external capital issuance exhibit significantly higher cash
flow sensitivities of investment. Moreover, banks expecting abnormal stock returns more
negative than the median expected abnormal return following the announcement of an
external capital issue are significantly more constrained by internally generated funds.
These results provide evidence that investment-cashflow sensitivities proxy for the severity
of capital market imperfections.

APPENDIX
ESTIMATION OF RISK-WEIGHTED ASSETS
A data set with complete risk-weighted assets data is available to me for 98 bank
holding companies on December 31, 1995.' These data disaggregate total risk-weighted
assets into three major categories: balance sheet assets, loan commitments, and
derivatives. Table 23 presents descriptive statistics. The sample contains both very large
and small banks, as total assets range from a low of SI 05 million to Citicorp’s $216
billion. In addition, risk-weighted assets range from $51 million to $230 billion. By far,
balance sheet assets contribute the most to risk-weighted assets. For many banks, mostly
small ones, off-balance sheet assets hardly add to risk-weighted assets at all. Therefore,
for the most accurate approximation of total risk-weighted assets, I estimate each major
component separately. That is, I decompose risk-weighted assets into its three broad
categories. A regression for each component is specified, and parameter estimates
obtained. The regressions are specified as follows:
RWBS = (XjLOANS + a2SECS
RWLC = PjSLC + p2LC + P2LOC
RWD = YjFEXPURCH + y2FEXPOPT + y3FEXWOPT + y4FEXSWP + Y5FUTURES
+Y6WOPT +Y7POPT +YgSWAPS
1 Data set supplied by Carolyn Takeda. Before December 1991, the breakdown of
risk-weighted assets into its components is not available.
80

81
Table 23
Descriptive Statistics of 98 bank holding companies at year-end 1991. Data were
collected from the Federal Reserve Y-9 Data Tapes. This sample consists of banks for
which complete risk-based capital data was available *
Variable
Mean
Median
Min
Max
Total Assets (millions)
17,474
5,317
105
216,920
Risk-Weighted Assets (millions)
14,700
3,787
51
238,000
Risk-Weighted Assets, from on-
balance sheet items (millions)
9,738
2,229
18
165,000
Risk-Weighted Assets, from loan
commitments (millions)
2,435
216
20
54,800
Risk-Weighted Assets, from derivative
assets (millions)
424
0
0
108,000
Loans / TA
0.6008
0.6358
0.1266
0.8057
Securities / TA
0.2399
0.2233
0.0348
0.6152
(Loans, - Loans,.,) / Loans,.,
0.0054
-0.0044
-0.3558
0.3206
Internal Additions to Capital / Loans,.,
0.0096
0.0120
-0.0213
0.0219
Market / Book Assets
1.0182
1.0149
0.9554
1.2055
Book Capital in Excess of Requirement
/ Assets
0.0228
0.0226
-0.0072
0.2046
* Special thanks to Carolyn Takeda for use of this data set.

82
WOPT
POPT
SWAPS
RWBS
LOANS
SECS
RWLC
SLC
LC
FEXPURCH
FEXPOPT
FEXWOPT
FEXSWP
FUTURES
LOC
RWD
risk-weighted assets attributable to the balance sheet
loans outstanding
securities held
risk-weighted assets attributable to loan commitments
stand-by letters of credit
loan commitments
lines of credit
risk-weighted assets attributable to derivative assets
foreign exchange purchase commitments
foreign exchange purchase options
foreign exchange written options
foreign exchange swaps
futures and forwards
written options
purchase options
non-foreign exchange swaps.
Actual risk-based capital data are used as the dependent variables, and broad
classifications of on and off-balance sheet components are used as the independent
variables. Coefficient estimates from these equations are then used to approximate the
risk-weights assigned to each component for purposes of computing total risk-weighted
assets. Consequently, this procedure approximates risk-based capital ratios for all banks
from 1990 to present.2
Table 24 presents the regression results. As expected, the coefficient on loans is
very significant and close to unity. Moreover, the results estimate the risk-weight on
stand-by letters of credit to be approximately one. 3 The next largest risk-weight comes
from securities, at 0.34. No variable has a coefficient significantly greater than one, which
is consistent with risk-based capital standards.
2 Reporting requirements from 1990 to present ensure sufficient off-balance sheet
data to estimate risk-weighted assets for the majority of firms in the sample.
3 Coefficient not significantly different from one.

83
Table 24
Least squares estimation of risk-weighted assets (RWA). Data were collected from the
Federal Reserve Y-9 Data Tapes. A sample of 98 firms contains complete RWA data for
year-end 1991. These observations are used to estimate components of RWA. RWA is
decomposed into three categories, balance sheet assets, off-balance sheet loan
commitments, and derivative sheet assets. Regressions use the actual amount of RWA
attributable to a category as the dependent variable. Broad classes of asset items are used
as independent variables. Regressions are performed using White's correction for
heteroskedasticity. Standard errors are in parenthesis.
Variable
RWA: Balance
Sheet Assets
RWA: Loan
Commitments
RWA: Derivative
Assets
Loans
*** 1.0197
(0.0403)
Securities
0.3393
(0.2396)
Stand-by Letters of
Credit
*** 1.3174
(0.3134)
Loan Commitments
*** 0.1483
(0.0424)
Lines of Credit
-0.5543
(1.5209)
Foreign Exchange (FEX)
Purchase Comm.
*** 0.0069
(0.0008)
Foreign Exchange
Purchase Options
*** 0.3266
(0.0528)
Foreign Exchange
Written Options
***-0.2819
(0.0482)
Foreign Exchange Swaps
*** 0.0435
(0.0012)
Futures and Forwards
*** -0.0069
(0.0006)
Written Options (non
FEX)
-0.0039
(0.0075)
Purchase Options (non
FEX)
*** 0.0201
(0.0058)
SWAPS (non FEX)
*** 0.0134
(0.0001)
N
Adjusted R Squared
98
0.9940
98
0.9793
98
0.9999
*, **, *** denote significant at the 10%, 5%, and 1% levels respectively.

REFERENCES
Asquith, Paul and D. Mullins (1986). “Equity Issues and Offering Dilutions,” Journal of
Financial Economics 15, 61-89.
Baer, Herbert L. and John N. McElravey (1993). “Capital Shocks and Bank Growth,
1973-1991,” Federal Reserve Bank of Chicago Economics Perspectives 17, 2-21.
Bayless Mark, and Susan Chaplinsky (1991). “Expectations of Security Type and the
Information Content of Debt and Equity Offers,” Journal of Financial
Intermediation 1,195-214
, (1996). “Is There a ‘Window of Opportunity’ for Seasoned Equity
Issuance?” Journal of Finance 51, 253-278.
Berger, Alan N. and Gregory F. Udell (1994). “Did Risk-Based Capital Allocate Bank
Credit and Cause a 'Credit Crunch' in the US?” Journal of Money, Credit, and
Banking 26, 585-634.
Bemanke, Ben S., M Gertler and S. Gilchrist (1994). “The Financial Accelerator and the
Flight to Quality,” National Bureau of Economic Research Working Paper.
Bernanke, Ben S. and Cara S. Lown (1991). “The Credit Crunch,” Brookings Papers on
Economic Activity 2, 205-248.
Calomiris, Charles, and Charles Himmelberg (1995). “Investment Banking Costs as a
Measure of the Cost of Access to External Finance,” National Bureau of
Economic Research Working Paper.
Cornett, Marcia M. and Hassan Tehranian (1994). “An Examination of Voluntary Versus
Involuntary Security Issuances by Commercial Banks,” Journal of Financial
Economics 35,99-122.
Fallon, Kieran (1991). “Source of Strength or Source of Weakness? A Critique of the
‘Source of Strength’ Doctrine in Banking Reform,” New York University Law
Review 66, 1344-1403.
84

85
Fazzari, Steven M., R. Glenn Hubbard and Bruce C. Petersen (1988), “Financing
Constraints and Corporate Investment,” Brookings Papers on Economic Activity
1, 141-195.
Federal Reserve Board of Governors (1996). Bank Holding Company Supervision
Manual. Federal Reserve, Washington D C.
Furlong, Frederick T. and Michael C. Keeley (1989). “Capital Regulation and Bank Risk-
Taking: A Note,” Journal of Banking and Finance 13, 883-892.
Hancock, D and J. Wilcox (1993). “Has There Been a ‘Capital Crunch’ in Banking? The
Effects on Bank Lending of Real Estate Market Conditions and Bank Capital
Shortfalls,” Journal of Housing Economics 3,31 -50.
Haubrich, Joseph G. and Paul Wachtel, (1993). “Capital Requirements and Shifts in
Commercial Bank Portfolios,” Federal Reserve Bank of Cleveland Economic
Review 29, 2-15.
Hoshi, T., A. Kashyap and D. Scharfstein (1991). “Corporate Structure, Liquidity, and
Investment,” Quarterly Journal of Economics 106, 33-59.
Keeton, William (1990). “Bank Holding Companies, Cross-Bank Guarantees, and Source
of Strength,” Federal Reserve Bank of Kansas City Economic Review 75, 54-67.
Lamont, Owen (1993). “Cashflow and Investment: Evidence From Internal Capital
Markets,” Massachusetts Institute of Technology Working Paper.
Mikkelson, Wayne H. and Megan Partch (1986). “Valuation Effects Of Security
Offerings and the Issuance Process,” Journal of Financial Economics 15, 31-60.
Myers, Stewart C. and Nicholas S. Majluf (1984). “Corporate Financing and Investment
Decisions when Firms Have Information that Investors Do Not Have,” Journal of
Financial Economics 13,187-221.
O'Hara, Maureen, and Wayne Shaw (1990). “Deposit Insurance and Wealth Effects: The
Value ofBeing 'Too Big to FailJournal of Finance 45, 1587-1600.
Passmore, Wayne and Steven A. Sharpe, (1994). “Optimal Bank Portfolios and the Credit
Crunch,” Finance and Economic Discussion Series 94-19, Federal Reserve Board.
Peek, Joe and Eric S. Rosengren (1995), “Bank Regulation and the Credit Crunch,”
Journal of Banking and Finance 19, 679-693.

86
Sharpe, Steven A. (1995). “Bank Capitalization, Regulation, and the Credit Crunch: A
Critical Review of the Research Findings,” Federal Reserve Board of Governors
Working Paper.
Stein, Jeremy C. (1995). “Internal Capital Markets and the Competition for Corporate
Resources,” National Bureau of Economic Research Working Paper.
Takeda, Carolyn T. (1994). “Economic Determinants of Contingent Commitment
Activity and the Effect of Risk-Based Capital,” University of Florida Working
Paper.
Thakor, Anjan V (1996). “Capital Requirements, Monetary Policy, and Aggregate Bank
Lending: Theory and Empirical Evidence,” Journal of Finance 51, 279-324.
Wall, Larry and D. Peterson (1995). “Bank Holding Company Capital Targets in the
Early 1990s: The Regulators Versus the Markets,” Journal of Banking and
Finance 19, 563-575.
Williamson, Oliver E. (1975). Markets and Hierarchies: Analysis and Antitrust
Implications. Collier Macmillan Publishers, Inc., New York.

BIOGRAPHICAL SKETCH
David Frederic Marcus was born the third child of Jeffery Neal and Ellen Janet
Marcus on September 4, 1968, in Eau Claire, Wisconsin. He attended the University of
Colorado at Boulder from 1986-1990. David graduated Magna Cum Laude with a
Bachelor of Science. Following graduation, David worked for two years before enrolling
at the University of Florida as a doctoral student.
87

I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy.
^ChrístophepM^James, ühairman
SunBank Professor of Finance,
Insurance, and Real Estate
I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy.
7
Dr. Jóel F. Houston
Associate Professor of Finance
Insurance, and Real Estate
I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy.
Dr. Michael D Ryngaert
Associate Professor of Finance
Insurance, and Real Estate
I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a dissertation for
the degree of Doctor of Philosophy.
This dissertation was submitted to the Graduate Faculty of the Department of Finance,
Insurance, and Real Estate in the College of Business Administration and to the Graduate School
and was accepted as partial fulfillment of the requirements for the degree of Doctor of
Philosophy.
August, 1996
Dean, Graduate School

LD
1780
1996
,¡A322-
UNIVERSITY OF FLORIDA
3 1262 08555 0852