Internal Capital Markets in Times of Crisis: The Benefit of Group Affiliation

Internal Capital Markets in Times of Crisis: The Benefit of Group Affiliation
Raffaele Santioni, Fabio Schiantarelli, Philip E Strahan
Review of Finance, Volume 24, Issue 4, July 2020, Pages 773–811,

This paper provides the first direct evidence of substitution towards internal capital markets in response to deterioration of the balance sheet condition of a firm’s bank. This substitution allows group-affiliated firms to use internal capital market transfers to better survive the global financial and sovereign debt crises.

We show how firms increase their use of the internal capital market when external capital markets are distressed, using precise information on both firm affiliation with a business group, transfers across affiliated firms, and the specific health of each firm’s bank(s). Firms in business groups share cash resources from affiliated firms and this activity increases when their bank(s) becomes distressed. This behavior is beneficial to firm survival. Diversification strengthens this mechanism by allowing some parts of the group to have excess cash when other parts of the group are cash constrained. Group affiliation may also allow firms to share collateral and/or debt capacity that could help alleviate financial constraints. As we show, firms with high borrowing capacity transfer funds to their group-affiliated cousins.

Italy provides our setting, which is unique because: 1) the financial and banking systems in Italy experienced a large negative shock; 2) business groups, our laboratory to explore internal capital markets, are prevalent; 3) firm-bank connections are observable (from the Italian Credit Register); and, 4) intra-group financial flows are also observable. No other study combines all of these features. Relying on them, we show that when an individual firm’s banking relationships become impaired, its internal capital market becomes more important.

In our first set of results, we show that affiliation with business groups helps firms survive the downturn following the onset of the Euro Crisis. Consistent with internal capital markets helping drive these differences, we show that survival increases not only when a firm’s own fundamentals are stronger, but also when fundamentals of other group-affiliated firms are stronger. We then test how the health of a firm’s bank(s) affects its survival, conditional on fundamentals. We show that the effect of bank health is smaller for group-affiliated firms than for unaffiliated firms.

Because we can observe intra-group transfers, our second and key set of results verifies directly that group-affiliated firms substitute toward the internal capital market when external markets become distressed. First, intra-group capital flows from firms with high cash flow to those with low cash flow and also toward firms with high investment opportunities (proxied by sales growth). Consistent with efficient use of internal capital market, the effect on transfers of negative shocks to firm cash flow is greater for high sales firms. Second, after combining the firm-level data with data drawn from the Italian Credit Register, we link the use of internal capital markets to the relative distress of a firm’s own bank(s). In particular, we show that the internal capital flows are more pronounced among firms with more distressed banks. This is strong evidence that the internal capital substitutes in for the external markets when those markets are distressed.

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