Banking deregulation, consolidation, and corporate cash holdings: U.S. evidence

Abstract

This paper tests the effects of banking deregulation on the cash policies of nonbanking firms in the United States. We document a significant and negative relation between intrastate banking deregulation and corporate cash holdings. We show that the negative relation is driven by financially constrained firms, especially by constrained firms with low hedging needs. Further, we construct indexes measuring the intensity of bank consolidation in local markets. We find that the intensity of in-market bank mergers is negatively related to corporate cash holdings. However, in-market bank mergers in highly concentrated markets tend to be positively related to corporate cash holdings.

Introduction

As financial intermediaries, banks are responsible for channeling crucial resources from savings to investment. Historically, banking institutions have faced restrictions on expanding both within and across state borders, which heavily influence banking competition and efficiency. Restrictions on geographic expansion have relaxed since the 1970s in the United States, and the Riegle-Neal Interstate Banking and Branching Efficiency Act (Riegle-Neal Act) of 1994 permits interstate banking and intrastate branching in almost all states. A large literature studies how these regulatory changes affect the efficiency, profitability, and lending behavior of banking organizations (Berger et al., 1999, Bikker and Haaf, 2002). Additionally, many studies attempt to understand how bank customers fare after deregulation, especially small, privately held businesses (Berger et al., 1998, Chava et al., 2013, Goldberg and White, 1998). Existing literature generally establishes that “banking deregulation led to substantial and beneficial real effects on the economy.” (Strahan, 2003)

However, only recently do researchers look into how banking deregulation and consolidation affect public companies (Carow et al., 2006, Karceski et al., 2005). Despite the evidence of temporary shock that bank mergers have on their corporate customers’ stock prices, researchers know little about the persistent effects, if any, of banking deregulation and consolidation on corporate borrowers. For instance, do nonbanking firms change their financial behaviors because of banking deregulation and continuous consolidation in the banking industry? If so, how do they respond to the drastically changing environment in the banking markets? Focusing on one dimension of banking deregulation—the removal of limits on bank entry and expansion—we intend to fill this void by investigating whether and to what extent banking deregulation and consolidation affect financial policies of exchange-listed companies, using corporate cash policy as an example.

Commercial banks perform an important function of providing liquidity to their corporate borrowers (Hadlock and James, 2002, Kashyap et al., 2002).³ Recently, academics and practitioners have devoted considerable attention to the increases in cash holdings of U.S. firms over the last three decades (Opler et al., 1999). The decision to hold cash is intriguing because cash is the most liquid and least productive asset and has no explicit rate of return. Of the many explanations, the empirical evidence lends the most support to precautionary motives (Opler et al., 1999). Liquid assets are crucial to nonfinancial firms when profitable investment opportunities exist and access to external capital is costly. The flexibility provided by hoarding cash thus gives liquid assets economic value. However, most of the explanations for hoarding liquid assets focus on firm-specific factors. It is not clear, therefore, whether firms respond to changing financial environments and adjust their financial policies accordingly. In this paper, we draw a link between the puzzling phenomenon and the drastic changes in banking industry following banking deregulation and consolidation. We intend to provide some new insights into a relatively old strand of literature on corporate liquidity (Baumol, 1952, Whalen, 1966).

Our central contribution is that we establish a robust link between banking deregulation and the cash policies of corporate customers. The history of banking deregulation in the U.S. is particularly useful for identifying and assessing the effects of banking deregulation on the financial polices of firms in the nonbanking sector from an empirical standpoint. Because different states deregulated at different times since the 1970s and the Riegle-Neal Act of 1994 removes restrictions on banks’ geographic expansion in almost all states, we focus on the 1970–1994 time span. We treat the staggered timing of deregulation as a series of exogenous shocks that help us estimate the effects of deregulation on corporate cash policy through a “difference-in-difference” approach. The paper’s major finding is that both intrastate and interstate banking deregulation is significantly and negatively associated with the quantity of liquid assets that nonfinancial firms hold, although the effect of interstate banking deregulation is weaker. In addition, we document the negative relation is mainly driven by financially constrained firms, especially by constrained firms with low hedging needs.

Our paper is also the first to test the relation between banking deregulation and public firms’ financial policies. The results strongly support the notion that increased openness and competition in the U.S. banking market are beneficial to nonfinancial firms by providing them deeper access to external financial resources. Given the severity of the global financial crisis, numerous firms are facing liquidity shortages, which substantially impede economic recovery. Many academic researchers and governments are reevaluating their approaches to bank regulation and are emphasizing the potential dangers of financial deregulation. Our work does not directly investigate the current crisis per se. However, the evidence presented in this paper strongly suggests that a competitive and open banking market is crucial for helping nonfinancial firms obtain liquidity. Given the importance of the public firms we examine in this paper, our paper provides novel and important insights into the reform of regulatory systems.

Our second contribution is to add new evidence on how different types of bank consolidations affect corporate cash policies, taking into consideration banking structure in local markets. There has been a long debate regarding the effects of bank competition and concentration on economic activities (Beck et al., 2006, Bikker and Haaf, 2002). On one hand, the first-order effect of banking deregulation is no doubt associated with increased competition, because banks are no longer protected from competitive pressures following the fall of nationwide barriers to interstate and intrastate banking. Conventional banking theory suggests that as competition increases, banks are more likely to charge lower interest rates on loans, thereby leading to an increase in the equilibrium supply of loans (Klein, 1971). On the other hand, bank mergers and acquisitions (M&As) with prior market overlap may result in increased concentration and market power in certain local markets, which in turn lead to higher interest rates if banks are not willing to pass on their synergy gains to corporate customers (Erel, 2011). In this paper, we use Labor Market Areas (LMAs) as units of local markets to create a set of indexes measuring the actual intensity of bank M&As. We find that in-market bank mergers tend to be negatively related to corporate cash holdings. However, in highly concentrated banking markets, in-market bank M&As are positively associated with corporate cash holdings. We make further distinctions among rural firms, small city firms, and urban firms, and we find consistent results relating corporate cash holdings to the intensity of bank M&As in the local markets. Therefore, our paper sheds new light on the economic role of bank concentration and competition.

We also contribute to the literature on cash holdings by identifying the external financing environment as an important determinant of corporate cash policy. Hoarding cash is not only driven by firm-specific factors, but also a response to dynamic financial environments. Corporate managers should therefore not ignore the impact of external environments when making relevant decisions, especially during worldwide financial crises and credit crunches.

The rest of this study is organized as follows. In Section 2, we provide background information on the deregulation of the U.S. banking industry and review related literature. In Section 3, we detail our data collection and variable construction. In Section 4 we discuss our empirical identification strategies and report results. Section 5 summarizes and concludes.