The Information Role of Financial Intermediaries: Evidence from Costly Internal Capital Allocations

Abstract

Are banks information producers? Recent work (e.g., Maskara and Mullineaux, 2011) has challenged the validity of decades of event study-based evidence due to sample selection bias. We develop a novel approach that is immune to this shortcoming and find that equity injections can reveal insights into a bank’s private information. Specifically, our results offer direct evidence that banks produce information about future local economic outcomes. Our experiment exploits a regulatory constraint that made internal capital allocations to subsidiaries costly for a subset of banks. We find costly allocations correlate strongly with future deterioration in subsidiary performance and small business real outcomes, whereas costless allocations do not. We are the first to show that banks’ information production role is very strong for the smallest, private firms - a segment excluded by the prior event study literature.

Keywords: Financial Intermediation, Revealed Preferences, Internal Capital Markets, SME, Financial Crises