Working Paper

Do Costly Internal Equity Injections Reveal Bank Expectations about Post-Crisis Real Outcomes?

Abstract: We construct a novel signal of bank expectations utilizing confidential data and a regulatory constraint imposed on bank internal capital markets during the 2008 crisis that made internal equity injections to commercial bank subsidiaries difficult to reverse. When the US government initiated a $176 billion recapitalization program during the crisis, this constraint made it costly ex-ante for multi-bank holding companies (MBHC) to use these funds for the purpose of recapitalizing subsidiaries against future anticipated losses; in contrast, lending the funds to subsidiaries was exempt from the constraint and thus carried an option value for future reallocations across sibling subsidiaries. Several findings emerge. First, we show that MBHCs treated internal equity injections as a scarce resource when emergency funds arrived, whereas single-bank holding companies did not because the constraint was not costly for them. Second, we find that excess internal equity injections by MBHCs form a signal of their expectations for post-crisis subsidiary outlook—i.e., future profitability, supervisory ratings, and credit originations. Third, the geographical aggregation of these individual bank signals predicts the long-run real effects of the 2008 crisis on small businesses across US states—i.e., post-crisis growth in small business revenues, employment, establishments, payroll, and wages. Our study provides a more direct test of "banks as efficient information producers" (e.g., Diamond (1984), Fama (1985)), and is the first to show that credible signals of this bank knowledge can be extracted from the internal capital markets, allowing regulators to forecast in real time a geographical rank-order for post-crisis real outcomes at small firms. This new policy tool can be seen as a potential side benefit of government-sponsored bank recapitalization programs, of which there have been 33 in the past 40 years worldwide.

Keywords: Macrofinance; Financial Crises; Banks; financial intermediation; internal capital markets; SME; TARP;

JEL Classification: G01; G21; G28; G30;

https://doi.org/10.21144/wp23-03

Bibliographic Information

Provider: Federal Reserve Bank of Richmond

Part of Series: Working Paper

Publication Date: 2022-12-21

Number: 23-03