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Organizational Structure and Performance at Bank Holding Companies

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 Current version: May 1999

Organizational Structure and Performance at Bank Holding Companies

Peter G. Klein

Department of Economics
University of Georgia
Athens, GA 30602-6254
706-542-3697; 706-542-3376 (fax)
klein@econ.uga.edu

Marc R. Saidenberg

Federal Reserve Bank of New York

33 Liberty Street
New York, NY 10045
212-720-5968; 212-720-8363 (fax)
marc.saidenberg@ny.frb.org

Abstract: This paper provides empirical evidence on the relationship between organizational
structure and performance at bank holding companies (BHCs). First, we study a panel of U.S.
commercial banks to see how holding-company affiliation affects lending, capital, and income.
We find that membership in a multi-bank BHC allows banks to do more lending, and hold less
capital, than unaffiliated banks, suggesting that these organizations benefit from access to
internal capital markets that reallocate resources within the firm. Second, we use a panel of
publicly traded BHCs to examine how the number of commercial bank charters affects lending,
capital, income, and market measures of efficiency. Our approach here is similar to that used in
the “diversification-discount” literature in empirical corporate finance. Consistent with this
literature, we find that BHCs with many subsidiaries are valued at a discount relative to similar
BHCs with fewer subsidiaries. The discount is statistically significant even while controlling for
size and economic conditions. Furthermore, looking within firms, we find that the market tends
to favor reductions in the number of banking units operated by BHCs. This suggests that bank
consolidation does, on average, improve bank performance.

JEL: G21, L22

Preliminary draft; comments welcome. We are grateful to Joe Sinkey and Phil Strahan for helpful comments and
discussions. The first author thanks the University of Georgia Research Foundation for financial support. The views
expressed in this paper are not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve
System.
 1

1. Introduction

The current wave of mergers, restructurings, and consolidations in banking raises new

questions about the efficient boundary of the firm in this industry. Large, diversified banking

firms benefit from potential economies of scope, reduction of risk, and access to internal capital

markets. However, increased size, scope, and complexity can bring additional overhead costs,

agency problems, and inefficient cross-subsidization. To gain these advantages at least cost,

banks must find an organizational form appropriate for governing large numbers of financial

transactions. Until recently, a bank’s choice of organizational form was strictly limited: it could

diversify across state lines only by adopting the holding-company structure, a loose conglomera-

tion of separately chartered member banks. Now, following the Riegle–Neal Interstate Banking

and Branching Efficiency Act of 1994, banks can branch directly across state lines, diversifying

without bearing the costs of managing multiple, independently chartered subsidiaries. It is

therefore important to know if the benefits of geographic diversification are best realized within

the holding-company form, or within a more consolidated structure such as an interstate branch-

banking organization.

This paper provides empirical evidence on the relationship between organizational form and

performance at bank holding companies (BHCs). First, we study a panel of U.S. commercial

banks to see how holding-company affiliation affects lending, capital, and income. Consistent

with an earlier study (Klein and Saidenberg, 1998), we find that membership in a holding

company allows banks to do more lending, and hold less capital, than unaffiliated banks. They

also earn enough income to compensate for the administrative costs of internal organization.
 2

These results are consistent with an efficiency explanation for diversification stressing internal-

capital-market advantages, rather than an empire-building explanation.

Second, we use a panel of publicly traded BHCs to examine how the number of commercial-

bank charters affects lending, capital, income, and market measures of efficiency. Our approach

is similar to that used in the “diversification-discount” literature in empirical corporate finance

(Lang and Stulz, 1994; Berger and Ofek, 1995; Servaes, 1996). This literature studies the

market’s evaluation of diversification into unrelated industries. We look at the relationship

between organizational structure and market performance at multi-divisional firms in the same

industry. Consistent with the literature on unrelated diversification, we find that BHCs with

many subsidiaries are valued at a discount relative to similar BHCs with fewer subsidiaries. The

discount is statistically significant even while controlling for size and economic conditions.

Furthermore, looking within firms, we find that the market tends to favor reductions in the

number of banking units operated by BHCs. This suggests that bank consolidation does, on

average, improve bank performance.

Like Lang and Stulz (1994), Servaes (1996), Rajan, Servaes, and Zingales (1997), and other

recent papers on diversification, we use Tobin’s q, the present value of future cash flows divided

by the replacement cost of assets, to measure firm value. Because Tobin’s q is market based and

forward looking, it has several advantages over balance-sheet measures of performance and

efficiency. Moreover, as firms with low q ratios have low expected cash flows relative to the

amount of invested capital, q can be interpreted as a measure of the firm’s investment opportu-

nity set and as a measure of managerial inefficiency or agency conflict within the firm.
 3

Our initial analysis focuses on the 1990–94 period, immediately before the implementation of

Riegle–Neal. We estimate panel-data regressions of lending activity, capital, accounting income,

and q on the number of commercial bank subsidiaries (measured in logs) and two control

variables, size (measured as the log of total assets) and local economic conditions (a size-

weighted average of personal income growth rates in the states in which the BHC operates). All

our regressions include time-fixed effects. We estimate both a firm-specific, random-effects

model and a model with firm-specific fixed effects. This second specification controls for any

unobservable firm-specific characteristics. In both specifications, we find that lending (total

loans as a share of assets) is positively related to the number of subsidiaries. We also find that

return on equity and return on assets are generally negatively related to the number of subsidiar-

ies, reflecting the higher costs of running an organization with multiple, independently chartered

subsidiaries.

Turning to the valuation results, in all specifications we find a negative and statistically

significant relationship between the number of subsidiaries and q. Banks with more commercial-

bank subsidiaries trade at a discount relative to banks with fewer commercial-bank subsidiaries,

controlling for size and economic conditions. The results from the model with firm-specific fixed

effects imply that the market values a reduction in the number of independently chartered

subunits. These results suggest that corporate structure significantly affects expected future

profitability: the costs of managing more complex organizations outweigh the benefits associated

with a more fragmented, decentralized corporate structure.

Our interpretation is consistent with recent findings that diversified BHCs benefit from

access to internal capital markets (Demsetz, 1996; Houston, James, and Marcus, 1997, 1998).
 4

Klein and Saidenberg (1998) compared diversified BHCs with pure-play portfolios composed of

shares of single banks, weighted to correspond to the BHCs’ distributions of activities across size

and state. They found that diversified BHCs could do more lending and hold less capital than

their portfolio benchmarks, suggesting that these organizations benefit from access to internal

capital markets that reallocate resources within the firm. Here, we ask how well the internal

capital market works in firms with different corporate structures. Our results suggest that the

benefits of internal capital markets may best be realized within firms with fewer independently

chartered subunits. These firms enjoy access to internal capital markets without the additional

costs of managing a diverse, multi-unit organization.

The remainder of the paper is organized as follows. Section 2 reviews the literature on bank

diversification, distinguishing between efficiency and agency explanations. Section 3 presents

estimates of the effects of holding-company affiliation on lending, capital, and income for

individual banks. Section 4 focuses on the banking organization itself and study the effects of the

number of subsidiaries on lending, capital, income, and market value. Section 5 concludes.

2. Bank diversification, organization, and efficiency

Since the Bank Holding Company Act of 1956, geographic restrictions on banks have been

slowly lifted, enabling banks to expand gradually across state lines. Although barriers to

interstate banking were not completely removed until the enactment of the Riegle–Neal Act,

regional and interstate pacts enabled BHCs to operate across state lines.1 Berger, Kashyap, and

1
Riegle–Neal does not eliminate all interstate branching restrictions, however. It limits the total amount of bank
and thrift deposits a banking organization may reach by merger to 30 percent in a single state and 10 percent
nationwide.
 5

Scalise (1995) estimate that by 1994, a BHC in a typical state had access to nearly 70 percent of

U.S. gross domestic banking assets.

As banks expand, they have also begun to consolidate. Over a third of all banking organiza-

tions disappeared during the 1979–94 period, while total banking assets continued to increase

(Berger, Kashyap, and Scalise, 1995). Between 1988 and 1997, the numbers of standalone banks

and top-level BHCs both fell by almost 30 percent, while the share of total U.S. banking assets

held by the top eight banking organizations rose from 22.3 percent to 35.5 percent (Berger,

Demsetz, and Strahan, 1999). In 1998, four of the top ten U.S. “mega-mergers,” based on market

values, occurred in financial services: Travelers–Citicorp ($72.6 billion), NationsBank–

BankAmerica ($61.6 billion), Norwest–Wells Fargo ($34.4 billion), and Banc One–First Chicago

($29 billion).2

In part, these structural changes are due to technological innovations such as new financial

instruments and risk-management techniques, ATMs, phone centers, and on-line banking which

permit greater economies of scale (Radecki, Wenninger, and Orlow, 1997). Deregulation,

however, is an equally important cause of diversification and consolidation.3 Prior geographic

restrictions on competition may have allowed inefficient banks to survive, and the gradual

removal of these restrictions has transformed the structure of the industry. Jayaratne and Strahan

(1998) show that state-level merger and acquisition activity increased substantially as those states

2
By contrast, the 1989 acquisition of RJR-Nabisco by Kohlberg Kravis Roberts & Co., considered the capstone
of the “decade of greed,” was valued at only $24.7 billion.
3
Kroszner and Strahan (1999) show that deregulation is itself endogenous: deregulation occurred later in states
with relatively more small banks (which are likely to oppose relaxation of interstate banking restrictions) and a
relatively large insurance sector in states where banks can sell insurance. Their findings tend to be more consistent
with private-interest than public-interest explanations for regulation.
 6

joined interstate banking arrangements. As a result, the percentage of deposits held by subsidiar-

ies of out-of-state BHCs increased from two percent in 1979 to 28 percent in 1994 (Berger,

Kashyap, and Scalise, 1995). Moreover, the Glass-Steagall prohibition on combining commercial

and investment banking is slowly being lifted. In 1987 the Federal Reserve Board began

permitting BHCs to engage in limited nonbank activities through “Section 20” affiliates. Section

20 activities were originally limited to five percent of a subsidiary’s total revenue, but the limit

was raised to ten percent in 1989 and 25 percent in 1996.

The banking literature offers both efficiency and agency explanations for diversification and

consolidation. In the efficiency view, product and geographic diversification allows banks to

reduce firm-specific risk by holding a greater variety of assets and offering a greater variety of

services (Saunders, Strock, and Travlos, 1990). However, risk reduction alone is not a complete

efficiency rationale for diversification. For publicly traded banks, at least, shareholders can

reduce their risk by holding a diversified portfolio of non-diversified banks, gaining the risk-

reducing advantages of diversification without incurring the costs of managing a large organiza-

tion (Levy and Sarnat, 1970). Risk pooling at the level of the firm should actually be more costly

than risk pooling at the level of the individual investor, since the transaction costs of buying or

selling stock are presumably lower than the transaction costs of adding or liquidating a division

(Williamson, 1975, p. 144). Diversification to reduce risk does, of course, benefit managers, who

may try to reduce their own “employment risk” at the expense of the value of the firm (Amihud

and Lev, 1981). Consequently, diversification is thought to be beneficial only if it also provides

economies of scope.
 7

There are at least two potential sources of scope economies in financial services: “internal” or

cost economies of scope, in joint production and marketing, and “external” or revenue economies

of scope in consumption. Internal economies of scope may come from excess capacity in

computer and telecommunications equipment that can be used for a variety of products, or from

customer information (credit histories, ratings, and the like) that can be used jointly to produce

multiple outputs (Clark, 1988, Mester, 1987). External economies of scope exist if there are

benefits to the consumer of “one-stop shopping” for various financial services (Berger,

Humphrey, and Pulley, 1996).

Undoubtedly, scale and scope economies are important determinants of bank structure and

conduct (see Berger and Humphrey, 1997, for an overview.) However, these properties of cost

and revenue functions do not fully account for the size and shape of organization. Economies of

scope imply joint production, but the joint production need not take place within a single bank or

even within a single BHC. Absent contracting costs, two separate banks (or BHCs) could simply

contract to share the inputs, facilities, or whatever accounts for the relevant scope economies

(Teece, 1980, 1982). The cost-saving advantages of joint production and marketing, for example,

could be achieved by two separate firms contracting to share facilities, customer data, and

marketing information. For the consumer, the advantages of one-stop shopping for bank,

insurance, and securities transactions can also be realized by contractual agreements among the

various providers. In neither case is organizational integration necessary, unless the costs of

writing or enforcing the relevant contracts are greater than the benefits from joint production.
 8

Whether the firms will integrate depends primarily on the comparative costs and benefits of

contracting, not on the underlying production function.4

Alchian (1969), Williamson (1975, pp. 155–75), and more recently Gertner, Scharfstein, and

Stein (1994) and Stein (1997) offer an explanation for the diversified firm based on intra-firm

capital allocation. In this theory, the diversified firm is best understood as an alternative

resource-allocation mechanism. Capital markets act to allocate resources between single-product

firms. In the diversified, multi-divisional firm, by contrast, resources are allocated via an internal

capital market: funds are distributed among profit-center divisions by the central headquarters

(HQ) of the firm. This miniature capital market replicates the allocative and disciplinary roles of

the financial markets, ideally shifting resources toward more profitable activities. For a diversi-

fied bank, the internal capital market could shift funds to subsidiaries with sudden capital

requirements, or to subsidiaries with access to particularly attractive lending opportunities.

According to the internal-capital-markets theory, diversified institutions arise when capital-

market frictions permit internal management to allocate and manage funds more efficiently than

the external capital market. These efficiencies may come from several sources. First, HQ

typically has access to information unavailable to external parties, which it extracts through its

own internal auditing and reporting procedures (Williamson, 1975, pp. 145–47).5 Second,

managers inside the firm may also be more willing to reveal information to HQ than to outsiders,

4
There is a large empirical literature adopting this “comparative-contracting” approach. Following Coase
(1937), Williamson (1975, 1985, 1996), Klein, Crawford, and Alchian (1978), and Grossman and Hart (1986), this
research seeks to explain firm boundaries as responses to contracting hazards brought about by relationship-specific
assets, uncertainty, frequency, and other conditions of trade. For a survey of the empirical literature see Shelanski
and Klein, 1995.
5
Myers and Majluf (1984) show that if the information asymmetry between a stand-alone firm and potential
outside investors is large enough, the firm may forego investments with positive net present value rather than issue
risky securities to finance them.
 9

since revealing the same information to the capital market would also reveal it to rivals,

potentially hurting the firm’s competitive position.6 Third, HQ can intervene selectively, making

marginal changes to divisional operating procedures, whereas the external market can discipline

a division only by raising or lowering the share price of the entire firm. Fourth, HQ has residual

rights of control that providers of outside finance do not have, making it easier to redeploy the

assets of poorly performing divisions (Gertner, Scharfstein, and Stein, 1994). More generally,

these control rights allow HQ to add value by engaging in “winner picking” and “loser sticking”

among competing projects when credit to the firm as a whole is constrained (Stein, 1997). Fifth,

the internal capital market may react more “rationally” to new information: those who dispense

the funds need only take into account their own expectations about the returns to a particular

investment, and not their expectations about other investors’ expectations. Hence there would be

no speculative bubbles or waves.

Not all explanations for diversification claim efficiency. In the agency or entrenchment view

managers diversify, especially by acquisition, primarily to increase their compensation, job

security, or span of control (Amihud and Lev, 1981; Born, Eisenbeis, and Harris, 1988).

Managers may entrench themselves by investing in projects for which they have specialized

expertise—an idiosyncratic filing system, for example (Shleifer and Vishny, 1989)—or by

investing in projects with noisier returns (Edlin and Stiglitz, 1995). Diversification may allow

cross-subsidization of unprofitable divisions, whose losses do not appear on consolidated balance

6
Bhattacharya and Ritter (1983) model the tradeoff between the benefits of external finance and the loss of firm
value from revealing private information to rivals. They find that limited revelation to outside parties can be
sustained in equilibrium.
 10

sheets. Diversification via acquisition can also be a form of “empire building,” if expansion into

particular industries is a key to rapid growth.

Matsusaka (1997) offers an alternative, “match-seeking” theory of diversification. In his

theory, firms possess certain capabilities, but these capabilities are not always known. Diversifi-

cation can be a form of experimentation in which firms try to discover what capabilities they

possess. A diversified firm may be valued at a discount because its current lines of business

include some not consistent with its capabilities; however, conglomeration is necessary if the

firm is to discover where it should eventually refocus. Boot, Milbourn, and Thakor (1998) offer a

related explanation for bank diversification: Banks expand their scale and scope to develop early

expertise in related, nonbank activities, should those activities become profitable (and permissi-

ble) in the future. However, if entering new lines of business requires irreversible investments,

then expansion may be harmful, should those potential profit opportunities fail to materialize.

Unfortunately, the banking literature says less about the internal structure of the diversified

organization itself. Clearly, large, diversified organizations have potential advantages. However,

increased size, scope, and complexity can bring additional overhead costs, agency problems, and

inefficient cross-subsidization. It is important to know, therefore, in what form the potential

benefits of product and geographic diversification are best exploited. Are economies of scale and

scope best realized within a small, narrowly diversified holding company, or within a larger,

more widely diversified organization? Moreover, can access to internal capital markets be

effectively coordinated by banks within a BHC or is there a further advantage to consolidating

activities within a single bank?

 11

Hughes, Lang, Mester, and Moon (1998) study the link between the structure of the branch

network and profit, risk, efficiency, and market value for a sample of BHCs in 1994. They find

that BHCs with a less complex branch structure, under certain circumstances, are more efficient

and more highly valued. We focus instead on the organizational structure of the banking

company, asking if internal-capital-market advantages are strongest within banking organizations

with multiple independently chartered subsidiaries, or within similarly sized banks with fewer

subsidiaries. These are important questions now that the Riegle–Neal Act allows banks to branch

directly across state lines, realizing the benefits of internal capital markets without adopting the

holding-company structure.

The following section explores the advantages of access to internal capital markets by

exploring how banks that are members of multi-bank bank holding companies (MBHCs) differ

from unaffiliated banks. Section 4 asks if the form of the internal capital market matters.

Specifically, controlling for the size of the banking organization, are internal capital markets best

exploited in BHCs with many subsidiaries, or in more consolidated organizations?

3. Effects of holding-company affiliation on bank lending, capital, and income

To assess the advantages of access to bank internal capital markets, we begin by estimating

the effects of holding-company affiliation on balance-sheet lending, capital, and income for a

panel of all U.S. commercial banks. Our sample includes all banks for which data were available

from the quarterly Statements of Income and Condition (Call Reports) for the years 1990 to

1994. Table 1 provides descriptive statistics for the panel. As seen in the table, about 30 percent

of banks in the sample are affiliated with multi-bank BHCs. The banks average $314 million in
 12

assets, ranging from $234,000 to $210 billion. Table 1 also reports the average total assets of the

“banking organization,” defined as the BHC for affiliated banks and the bank itself for

standalone banks.

[Table 1 about here]

Table 2 reports panel-data regressions of two balance-sheet characteristics, lending and

capital, and two measures of accounting profit, ROA and ROE, on a dummy variable indicating

MBHC affiliation and two control variables, bank size and banking organization size. Lending is

measured by the loans-to-assets ratio (total loans divided by total assets). Capital is measured by

the capital-asset ratio (total capital divided by total assets). ROA (return on assets) is defined as

net income divided by total assets. ROE (return on equity) is defined as net income divided by

total equity. Bank size is measured by the log of total bank assets, and banking-organization size

is measured by the log of total assets of the overall banking organization. All four regressions

include year-fixed effects. As seen in the table, banks affiliated with MBHCs do 2.3 percentage

points more lending, and hold about 1 percentage point less capital, than unaffiliated banks,

controlling for bank and organization size. (The differences are significant at the 5% and 1%

levels, respectively.) Measured by return on assets, banks affiliated with MBHCs earn about the

same as unaffiliated banks; measured by return on equity, they earn almost a full percentage

point more (significant at the 1% level).

[Table 2 about here]

 13

These results are consistent with our earlier study of lending, capital, and income at the

holding-company level (Klein and Saidenberg, 1998). There we used a portfolio-simulation

technique to estimate the “imputed value” of diversified MBHCs. Using a sample of MBHCs

from 1990 to 1994, we constructed pro forma benchmark portfolios for each MBHC composed

of shares of single banks, weighted to correspond to the MBHC’s distribution of activities across

size and state. Comparing the performance and characteristics of the MBHCs with those of their

pure-play portfolio benchmarks, we found that MBHCs hold less capital and do more lending, on

average, than their pure-play benchmarks. They also earn enough income to compensate for the

administrative costs of internal organization.

Taken with the results presented here, this suggests that MBHCs enjoy the benefits of both

geographic diversification and access to internal capital markets. When a particular subsidiary

needs additional funds, it can draw those funds from another subsidiary within the holding

company. This allows each subsidiary to hold less capital than an unaffiliated bank with similar

asset size and geographic characteristics. A holding company will thus tend to hold less capital in

the aggregate than its pure-play alternative. Moreover, the MBHC subsidiaries can rely on the

internal capital market for loanable funds when high-yield projects become available. Because

affiliated banks do more lending than unaffiliated banks, and since MBHCs do make more

lending in the aggregate than their pure-play benchmarks, bank internal capital markets must

have advantages relative to the external financial markets.

Of course, our results demonstrate only that MBHC subsidiaries are different from unaffili-

ated banks, not that these differences are necessarily due to access to internal capital markets.

Conceivably, these differences could be due to the characteristics of banks that become MBHC
 14

subsidiaries, rather than the effects of MBHC membership itself. For instance, if MBHCs

systematically acquire highly profitable banks, then MBHCs would be more profitable than pure-

play portfolios of non-acquired banks, even if internal-capital-market advantages are not present.

However, the existing empirical evidence on bank acquisitions does not suggest such a pattern.

Hadlock, Houston, and Ryngaert (1990) study 84 bank mergers from 1982 to 1992 and find no

relationship between a bank’s profitability and the probability that it will be acquired.

Moreover, our efficient internal-capital-markets interpretation is consistent with several other

recent studies of MBHC behavior. Demsetz (1996) finds that MBHC subsidiaries are both more

likely to engage in loan sales, and more likely to engage in loan purchases, than banks that are

not part of a holding company. For sales and purchases between banks within the same holding

company, there are at least two reasons why MBHC subsidiaries would appear to be more active

in the secondary market for loans. If the subsidiaries are acting independently, then membership

in the same holding company makes it easier to develop a reputation for truthful disclosure,

helping to overcome the adverse-selection problem associated with such transactions. Alterna-

tively, the holding company itself could be acting as a single agent, using the loan sale to shift

resources from one part of the organization to another. In either case, the resulting benefits would

be aspects of the internal-capital-market advantages described above.

In a more direct test, Houston, James, and Marcus (1997) study the relationship between

lending and cash flows at the MBHC subsidiary level. They find that loan growth at MBHC

subsidiaries is more sensitive to the holding company’s cash flow and capital position than to the

bank’s own cash flow and capital. They also find that bank loan growth is negatively related to

loan growth among the other subsidiaries in the holding company. This implies that MBHCs do
 15

in fact use internal capital markets to allocate funds within their organizations. Similarly, Berger,

Saunders, Scalise, and Udell (1997) find that banks tend to do more lending following a merger.

Our results suggest that this may be because the bank now has access to funds taken from within

the larger, merged entity.

4. Effects of organizational form on lending, capital, income, and market value

The results of the previous section show that banks affiliated with MBHCs do more lending

and hold less capital, on average, suggesting that access to internal capital markets has significant

advantages. However, a BHC can have an internal capital market with only two member banks.

Why, then, should we observe MBHCs with as many as 86 independently chartered subsidiaries?

In other words, for a banking organization of given size, how are internal-capital-market

advantages best exploited?

To address this question, we gathered a panel of publicly traded BHCs to see how the number

of commercial bank charters affects lending, capital, income, and market value. We began by

identifying more than 350 publicly traded BHCs by comparing institutions’ names in both 1985

and 1995 regulatory reports to names on the Center for Research in Security Prices (CRSP)

tapes. To minimize survivorship bias in the final sample, we built the data set by tracking the

1986 and 1995 subsamples throughout the intervening years. Again, our analysis draws on data

from the 1990–94 period. We limit our analysis to those BHCs for which we could find an

unambiguous match between the CRSP tapes and the consolidated financial statements (the

Y-9C reports) describing BHC characteristics. This resulted in a sample of 367 BHCs, or 1,321

BHC observations over the five-year period.

 16

For each BHC observation, we computed four ratios: loans to assets, capital to assets, return

on assets, and return on equity. We constructed balance-sheet and income ratios for each BHC as

asset-weighted averages of the ratios for its commercial bank subsidiaries, using Call Report

data. Using stock-price data from publicly traded BHCs, we computed Tobin’s q, which we

define as the ratio of the market value of capital to the replacement cost of capital. Replacement

cost is difficult to measure, and it is particularly problematic at banks. We use the book value of

tangible equity as a proxy for replacement cost, and measure firm value as the ratio of the market

value of equity divided by the book value of tangible equity. The future profitability of the

BHC—profitability stemming from efficiency, market power, or lending relationships—will be

reflected in the numerator but not the denominator. Thus q captures the present value of the BHC

in a way that permits comparison across banks.

Table 3 provides descriptive statistics for the sample of publicly traded BHCs. The average

BHC has slightly more than five commercial bank charters (with a minimum of one and a

maximum is 86). The banking organizations average $8.3 billion in assets, ranging from $102

million to $250 billion.

[Table 3 about here]

To assess the effects of the number of subsidiaries, we estimated panel-data regressions of

lending, capital, income, and market value on the number of independently chartered subsidiaries

(in logs), the size of the holding company (log of total assets), and an index of state-level

economic conditions. The index is defined as an asset-weighted average of the state-level income
 17

growth rates for all states in which the BHC operates. We estimate both a random-effects model

and a model with firm-fixed effects. All the regressions include year-fixed effects.

Table 4 presents results of the random-effects model. As seen in the first row of the table, the

elasticity of both lending and capital with respect to the number of charters is positive and

significant. The coefficients on income are also positive, though not significant. Most important,

the coefficient on q is negative and significant. The market appears to be imposing a diversifica-

tion discount—or, more precisely, a number-of-charters discount—on large, highly diversified

BHCs.

[Table 4 about here]

Next, we re-estimated the same five regressions, adding firm-fixed effects to control for

unobservable firm-specific characteristics. The fixed-effects model allows us to simulate

balance-sheet and market-value reactions to changes in the number of independently chartered

subsidiaries within a single banking organization. The results here are generally stronger than in

the random-effects model. The coefficient on lending is positive and significant (at the 5% level).

The coefficient on capital is negative but not significant. The coefficients on both income

measures are negative and significant at the 1% level. Finally, the coefficient on q is negative and

significant at the 1% level. This implies that the market favors a reduction in the number of
 18

independently chartered subsidiaries. Similarly, accounting income improves when the number

of subsidiaries falls, holding constant bank size and local economic conditions.7

[Table 5 about here]

The signs on our significant coefficients are economically significant. In the q regression, for

example, the coefficient on the number of subsidiaries (measured in logs) is !0.099. Evaluated at

the mean, a one-standard-deviation reduction in the log of the number of subsidiaries (equivalent

to a 2.8-unit reduction in the number of subsidiaries) increases q by about ten percent. Stated

differently, if a BHC has five subsidiaries (the mean in our sample is 5.39), reducing the number

of subsidiaries to four increases q by 0.02. This is a smaller “diversification discount” than that

found by Lang and Stulz (1994), Berger and Ofek (1995), and other authors. However, those

studies measure the effects of two factors: changes in organizational structure and changes in

product diversification. Because we are looking within a single industry, our results pick up only

the effects of changes in organizational structure. Not surprisingly, we find a smaller discount

than that reported in the diversification literature.

How might consolidation improve performance? The literature on economic organization

suggests several possibilities. Hierarchical organization can reduce opportunistic behavior

(Williamson, 1975), improve coordination within the firm (Keren and Levhari, 1983), and

internalize externalities among the subunits (Simon, 1973). Moreover, decentralized,

7
To see if these results were being driven by mergers, we re-estimated the regressions allowing for an
asymmetric response to changes in the number of bank charters. We found statistically significant responses in both
directions, suggesting that the results are not exclusively due to value-reducing mergers.
 19

multidivisional firms are subject to special difficulties—rent seeking by divisional managers

(Scharfstein and Stein, 1996), bargaining problems (Rajan, Servaes, and Zingales, 1997) and

bureaucratic rigidity (Shin and Stulz, 1998)—which consolidation may improve. Consolidation

imposes costs as well: slower response times (Geanakoplos and Milgrom, 1991), influence

activities (Milgrom and Roberts, 1990), and the loss of specific, local knowledge (Hayek, 1945).

The optimal organizational structure balances the benefits and costs of consolidation at the

margin (Jensen and Meckling, 1995). Our results suggest that the optimal structure is more

consolidated than that permitted before deregulation.

For banks, then, both current profitability (measured by accounting income) and expected

future profitability (measured by q) are clearly affected by organizational form, controlling for

organization size and the states in which the organization operates. Our results imply that the

average diversified MBHC could improve its performance by consolidating, operating in the

same states and on the same scale but with fewer independently chartered subsidiaries. This

suggests that the current wave of consolidations, following the implementation of the

Riegle–Neal Act, is at least partly driven by efficiency considerations.

Consolidation may be interpreted as a continuation of the selection process in which better-

managed, more efficient banks expand at the expense of inefficient ones. This process, long

retarded by prohibitions on interstate banking and intrastate branching, led to improved bank

performance in the 1970s and 1980s. Jayaratne and Strahan (1998) study the evolution and

performance of the banking industry during this period and find that average bank efficiency

improves substantially once restrictions on intrastate branching (and, to a lesser extent, interstate

banking) are removed. Our results suggest a further insight: bank performance depends not only
 20

on the degree of geographic diversification, but also on the organizational structure through

which the bank diversifies.

5. Conclusion

Our analysis provides evidence on the relationship between organizational structure and

performance at BHCs. The first part demonstrates that access to internal capital markets is

valuable: banks affiliated with an MBHC do more lending, and hold less capital, than unaffili-

ated banks. This suggests that these organizations benefit from access to internal capital markets

that reallocate resources within the firm. The second part shows that the structure of the internal

capital market is important: BHCs with many subsidiaries are valued at a discount relative to

similar BHCs with fewer subsidiaries. The discount is statistically significant even while

controlling for size and economic conditions. Finally, looking within firms, we find that the

market tends to favor reductions in the number of banking units operated by BHCs. For these

reasons, we expect banks to consolidate their operations further as interstate branch banking

restrictions are lifted.

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Table 1
Bank summary statistics. Pooled data from 1990 to 1994. N=57,077.

Mean Standard deviation

Multi-bank BHC indicator 0.307 0.461
Total bank assets ($ billion) 0.314 2.987
Total banking organization assets ($ billion) 3.050 13.897
Loans-to-assets ratio 0.538 0.158
Capital-asset ratio 0.096 0.062
Return on assets 0.009 0.009
Return on equity 0.096 0.118
 26

Table 2
Panel regressions of bank balance-sheet variables—loans-to-assets ratio (LTA), capital-asset ratio (KA),
return on assets (ROA), and return on equity (ROE)—on a multi-bank bank holding company (MBHC)
indicator variable and the logs of total bank assets and total banking organization assets. Regressions
include time-fixed effects and bank-specific random effects. Pooled data from 1990 to 1994. N=57,077.
Standard errors in parentheses. ***, **, and * indicate statistical signnificance at the 1, 5, and 10 percent
levels, respectively.

LTA KA ROA ROE

MBHC indicator 0.023** !0.011*** 0.0002 0.007***

(0.002) (0.001) (0.0002) (0.002)

Log (total bank assets) 0.041*** !0.041*** 0.001*** 0.012***

(0.001) (0.0004) (0.0001) (0.001)

Log (total banking organization !0.007*** 0.009*** !0.0001** !0.0004

assets) (0.001) (0.0002) (0.0001) (0.0007)

Year indicator:

1991 !0.010*** 0.001* 0.0004*** 0.006***

(0.001) (0.0003) (0.0001) (0.001)

1992 !0.017*** 0.005*** 0.003*** 0.032***

(0.001) (0.0003) (0.0001) (0.001)

1993 !0.006*** 0.010*** 0.004*** 0.037***

(0.001) (0.0003) (0.0001) (0.001)

1994 0.018*** 0.011*** 0.003*** 0.034***

(0.001) (0.0004) (0.0001) (0.001)

Constant 0.166*** 0.447*** !0.004*** !0.061***

(0.009) (0.004) (0.001) (0.008)

Firm-fixed effects? no no no no

R2 0.054 0.065 0.042 0.040

 27

Table 3
BHC summary statistics. Pooled data from 1990 to 1994. N=1321.

Mean Standard deviation

Number of bank charters 5.39 9.03
Log (number of bank charters) 1.03 1.04
Total BHC assets ($ billion) 8.31 23.87
Log (BHC assets) 0.607 0.108
Loans-to-assets ratio 0.61 0.11
Capital-asset ratio 0.08 0.02
Return on assets 0.008 0.008
Return on equity 0.084 0.191
Market-to-book equity ratio 1.26 0.62
 28

Table 4
Panel regressions of BHC balance-sheet variables—loans-to-assets ratio (LTA), capital-asset ratio (KA),
return on assets (ROA), and return on equity (ROE)—and market-to-book equity (q) on the log of the
number of bank charters, log of total assets, and state economic conditions. Regressions include time-
fixed effects and BHC-specific random effects. Pooled data from 1990 to 1994. N=1321. Standard errors
in parentheses . ***, **, and * indicate statistical signnificance at the 1, 5, and 10 percent levels,
respectively.

LTA KA ROA ROE q

Log (number of banks) 0.007* 0.0014** 0.0004 0.008 !0.049*

(0.004) (0.0007) (0.0004) (0.009) (0.026)

Log (total assets) 0.001 !0.004*** 0.0001 0.008 0.027

(0.003) (0.001) (0.0002) (0.006) (0.023)

Economic conditions !0.464*** !0.002 0.086*** 1.268*** 1.940**

(0.144) (0.027) (0.018) (0.453) (0.844)

Year indicator:

1991 !0.012** 0.001 !0.003*** !0.063*** 0.189***

(0.006) (0.001) (0.001) (0.020) (0.035)

1992 !0.037*** 0.006*** 0.001 0.005 0.473***

(0.005) (0.001) (0.001) (0.016) (0.028)

1993 !0.030*** 0.012*** 0.001 !0.004 0.500***

(0.006) (0.001) (0.001) (0.020) (0.035)

1994 !0.009 0.011*** 0.001 !0.015 0.441***

(0.006) (0.001) (0.001) (0.022) (0.040)

Constant 0.620*** 0.133*** 0.004 !0.058 0.577*

(0.047) (0.008) (0.003) (0.081) (0.313)

Firm-fixed effects? no no no no no

R2 0.032 0.149 0.117 0.053 0.125

 29

Table 5
Panel regressions of BHC balance-sheet variables—loans-to-assets ratio (LTA), capital-asset ratio (KA),
return on assets (ROA), and return on equity (ROE)—and market-to-book equity (q) on the log of the
number of bank charters, log of total assets, and state economic conditions. Regressions include BHC-
specific and time-fixed effects. Pooled data from 1990 to 1994. N=1321. Standard errors in parentheses .
***, **, and * indicate statistical signnificance at the 1, 5, and 10 percent levels, respectively.

LTA KA ROA ROE q

Log (number of banks) 0.012** !0.0004 !0.003*** !0.053*** !0.099***

(0.005) (0.001) (0.001) (0.019) (0.031)

Log (total assets) 0.008 !0.018*** !0.001 0.051 !0.030

(0.010) (0.002) (0.001) (0.036) (0.059)

Economic conditions !0.399*** !0.039 0.033* 0.071 1.544*

(0.149) (0.027) (0.020) (0.536) (0.869)

Year Indicator:

1991 !0.014** 0.003** !0.002** !0.028 0.202***

(0.006) (0.001) (0.001) (0.022) (0.036)

1992 !0.039*** 0.009*** 0.0012* 0.012 0.482***

(0.005) (0.001) (0.0008) (0.018) (0.029)

1993 !0.033*** 0.016*** 0.002** 0.010 0.516***

(0.007) (0.001) (0.001) (0.024) (0.038)

1994 !0.013 0.016*** 0.002** !0.002 0.459***

(0.008) (0.001) (0.001) (0.028) (0.045)

Constant 0.508*** 0.327*** 0.030 !0.589 1.415*

(0.143) (0.026) (0.019) (0.512) 0.830

Firm-fixed effects? yes yes yes yes yes

R2 0.156 0.312 0.093 0.025 0.449

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