Corporate Finance

Asymmetric information in corporate finance refers to the concept that managers and other
insiders of a corporation possess superior knowledge compared to market players regarding the
worth of the firm's assets and investment prospects. The asymmetry in question gives rise to the
potential for the market to inaccurately value the firm's assertions, creating a beneficial
opportunity for corporate financing decisions (Klein, O'Brien, & Peters, 2002). Riley (2001)
highlights in his comprehensive analysis that the concept of capital structure has been
significantly influenced by the thorough examination of information asymmetry. In their
comprehensive review of capital structure theories that are not driven by taxes, Harris and Raviv
(1991) analyze the significant advancements in asymmetric information and capital structure.
They note that, at that time, theoretical research on the subject had reached a stage where further
progress was becoming less fruitful. Capital structure signaling models with fixed investment
provide many empirical predictions. If the degree of profitability is a determining factor for
superior quality, and if we believe that there is asymmetrical availability of knowledge about a
firm's earnings, then more successful enterprises are motivated (and capable) to maintain greater
levels of debt to communicate their worth to the market. However, Harris and Raviv (1991) have
noted that some empirical studies, such as Titman and Wessels (1988), have shown a contrasting
result - a negative correlation between financial leverage and profitability when examining
different companies at a given point in time. The empirical conclusion is confirmed by extensive
research conducted by Rajan and Zingales (1995), Frank and Goyal (2000), and Fama and
French (2002).
Banking
Financial restrictions faced by a subsidiary of a conglomerate, due to difficulties in accessing
external capital markets caused by uneven distribution of information, can be reduced by the
subsidiary's ability to use the internal capital market of the related conglomerate. Alchian (1969),
Weston (1970), Gertner, Scharfstein, and Stein (1994), Li and Li (1996), and Stein (1997),
among other researchers, contend that internal capital markets can alleviate the issue of
asymmetric information and enhance the allocation of funds within a conglomerate, thereby
improving investment efficiency. On the other hand, it can be argued that internal capital markets
might decrease investment efficiency due to conflicts of interest between division managers and
the CEO, as well as between the CEO and shareholders (e.g., Scharfstein and Stein 2000, Rajan,
Servaes, and Zingales 2000).
Banks lacking surplus capital to cover more loans on their balance sheet can nonetheless
generate loans and subsequently sell them. Furthermore, banks that are associated with an
MBHC (multibank holding company) have an advantage when it comes to conducting
transactions in the secondary loan market compared to standalone banks. This is because there is
a problem of asymmetric information between loan sellers and buyers in the secondary loan
market, which makes it challenging to sell and risky to buy loans from banks that are not
affiliated with an MBHC. MBHCs have two clear motivations for transferring money and loans
amongst their subsidiaries to alleviate the financial limitations that these companies are
suffering. The initial motive is bank regulation, as each bank subsidiary must adhere to a
minimum needed capital ratio. Therefore, MBHCs are motivated to transfer funds from
subsidiaries with higher capitalization to subsidiaries with lower capitalization and transfer assets
from subsidiaries with lower capitalization to subsidiaries with higher capitalization, when a
subsidiary with lower capitalization is close to or below its minimum capital requirement.
Another factor that can lead to an internal transfer of funds within an MBHC is the variation in
loan origination prospects among its subsidiaries. The implementation of this production
advantage incentive is likely to lead to MBHCs reallocating resources from subsidiaries with less
favorable loan origination prospects to those with more favorable loan origination prospects.
Alternatively, subsidiaries of MBHC that have more favorable loan origination prospects may
originate loans and then transfer them to their associated subsidiaries that have less favorable
loan origination prospects. The efficiency of the holding company's operations may be improved
by allowing bank subsidiaries with a comparative advantage in originating loans, such as strong
local loan demand, local monopoly power, or better expertise in loan origination, to specialize in
this area. Therefore, a bank subsidiary that has a competitive edge over its other affiliates in
initiating loans does not have to limit its lending based on its capital, as long as the holding
company has enough capital to support the new loans (Holod & Peek, 2010) .
Research on internal capital markets in the banking industry has employed methodologies akin to
those utilized for nonfinancial companies. In this approach, bank loan growth is treated as a
parallel to investment made by a nonfinancial firm, yielding findings that align with those
observed for nonfinancial enterprises. Houston, James, and Marcus (1997) present evidence that
the expansion of loans at subsidiary banks is influenced by the cash flow of the holding company
and the loan growth of other subsidiaries within the same holding company. In addition, banks
that are part of multibank holding companies (MBHCs) experience less impact on their loan
growth from factors such as their own cash flow, capital ratio, and liquid assets ratio. Instead,
their loan growth is more influenced by local economic conditions, in contrast to stand-alone
banks. Furthermore, when monetary policy becomes tighter, MBHC-affiliated banks face fewer
constraints on their loan growth due to their own cash flow, compared to stand-alone banks.
These findings were reported by Houston and James in 1998 and Campello in 2002.