Do financial conglomerates create or destroy economic value?

This paper investigates whether functional diversification is value-enhancing or value-destroying in the financial services sector, broadly defined. Based on a U.S. dataset comprising approximately 4060 observations covering the period 1985–2004, we report a substantial and persistent conglomerate discount among financial intermediaries. Our results suggest that it is diversification that causes the discount, and not that troubled firms diversify into other more promising areas. In addition, the discount applies to all financial services activity-areas with the exception of investment banking and is stable over different combinations of financial activity-areas with the exception of commercial banking units combined with insurance companies and/or investment banking activities.     

Is the diversification discount caused by the book value bias of debt?

We analyze whether the diversification discount is driven by the book value bias of corporate debt. Book values of debt may be a more downward biased proxy of the market value of debt for diversified firms, relative to undiversified firms, as diversification leads to lower firm risk. Thus, measures of firm value based on book values of debt undervalue diversified firms relative to focused firms. Our paper complements recent literature which uses market values to test the risk reduction hypothesis for a subsample of firms for which debt is traded. Alternatively, we employ market value of debt estimates for the whole firm universe. Consistent with the above hypothesis, we show that the use of book values of debt underestimates the value of diversified firms. There is no discount for mainly equity financed firms and lower distress risk and equity volatility for diversified firms. More concentrated ownership increases firm valuation.     

THE GRAMM‐LEACH‐BLILEY ACT OF 1999: RISK IMPLICATIONS FOR THE FINANCIAL SERVICES INDUSTRY

We document significant risk changes in the financial services industry following the passage of the Gramm‐Leach‐Bliley Act of 1999. Banks experience an increase in risk regardless of whether they have taken steps to participate actively in the investment banking business. Insurance companies also experience an increase in risk, whereas securities firms experience a decrease in risk. We attribute the increase in risk for banks and insurance companies to the fact that the securities business is relatively more risky, and the decline in risk for securities firms to the fact that they can now diversify into relatively less risky banking and insurance businesses.     

Is there a diversification discount in financial conglomerates?

This paper investigates whether the diversity of activities conducted by financial institutions influences their market valuations. We find that there is a diversification discount: The market values of financial conglomerates that engage in multiple activities, e.g., lending and non-lending financial services, are lower than if those financial conglomerates were broken into financial intermediaries that specialize in the individual activities. While difficult to identify a single causal factor, the results are consistent with theories that stress intensified agency problems in financial conglomerates engaged in multiple activities and indicate that economies of scope are not sufficiently large to produce a diversification premium.     

The impact of geographic diversification on firm performance

This paper empirically examines the economic effects of both corporate industrial and geographic diversifications. Using a sample of 28,050 firm-year observations from 1990 to 1998, we find that industrial and geographic diversifications are associated with firm value decrease. Consistent with Denis et al. [Denis, D. J., Denis, D. K., and Yost, K. (2002). Global diversification, industrial diversification, and firm value. Journal of Finance, 57, 1951-1979], the costs of corporate diversification may outweigh the benefits of diversification. We find that geographically diversified firms have higher R&D expenditures, advertising expenses, operating income, ROE and ROA than industrially diversified firms. In addition, higher R&D expenditures create value for multi-segment global firms, but not for single-segment global firms. This result implies that there exists an interaction effect between industrial and geographic diversification. We also examine the effects of agency cost issues, as characterized by the diversification discount, on both industrial and geographic diversification. Consistent with the agency explanation, firms with high equity-based compensation are associated with higher firm value than firms with low equity-based compensation. Also, we find that firms with a higher insider ownership percentage are associated with higher excess value.     

Corporate use of derivatives and excess value of diversification

We provide a link between diversification discount and corporate use of financial derivatives. We show that diversified firms benefit from financial risk management. Our findings are consistent with the notion that derivative usage lowers information asymmetry and thereby reduces the negative valuation effects of diversification. Our evidence complements the earlier findings of both the risk management literature and diversification discount literature and is robust to controls for endogeneity and information asymmetry levels.     

Managerial compensation and the debt placement decision

Extant research argues that borrowing from financial intermediaries subjects managers to external monitoring. However, given managers' flexibility in choosing the type of debt financing, why would managers submit themselves to external monitoring? Recent theory points to the role of managerial incentive compensation. Specifically, it is argued that managers will borrow from financial intermediaries if their compensation is tied to firm performance. Additionally, it is noted that a more optimal compensation scheme will induce managers to undertake intermediated loans only when the firm is sufficiently profitable. Such a compensation scheme is likely to exist in opaque firm settings where borrowing from financial intermediaries can serve to signal firm profitability. Our study provides corroborative evidence. We find that the choice of syndicated bank loans is positively associated with CEO equity incentives. Second, this syndicated debt-incentive compensation link is influenced by firm profitability, particularly among information problematic firms. Overall, our study points to the role of incentive compensation in the debt placement decision.     

Banking crises,financial dependence,and growth

This paper contributes to the literature that analyzes the mechanisms linking financial shocks and real activity. In particular, we investigate the growth impact of banking crises on industries with different levels of dependence on external finance. If banks are the key institutions allowing credit constraints to be relaxed, then a sudden loss of these intermediaries in a system in which such intermediaries are important should have a disproportionately contractionary impact on the sectors that flourished due to their reliance on banks. Using data from 38 developed and developing countries that experienced financial crises during the last quarter century, we find that those sectors that are highly dependent on external finance tend to experience a substantially greater contraction of value added during a banking crisis in countries with deeper financial systems than in countries with shallower financial systems. Our results do not suggest, however, that on net the externally dependent firms fare worse in deep financial systems.     

Valuing the Potential Transformation of Banks into Financial Service Conglomerates: Evidence from the Citigroup Merger

The merger between Citicorp and Travelers Group on April 6, 1998 could have emitted two relevant signals for firms that provide financial services. The first signal is the endorsement by two prominent financial institutions that benefits from cross‐selling of bank services with insurance services, brokerage services, and other financial services can be realized. The second signal is that regulators will allow the combination of commercial banking with insurance underwriting and full‐service brokerage, paving a path for similar combinations in the future. We document a favorable share price response for commercial banks, insurance companies, and brokerage firms, which supports the argument that the merger sets a precedent for other combinations between banks and nonbank financial services that will facilitate cross‐selling and efficiencies.     

The anatomy of bank diversification

We use panel data from nine countries over the period 1996–2008 to test how revenue diversification affects bank value. Relying on a comprehensive framework for bank performance measurement, we find robust evidence against a conglomerate discount, unlike studies concerned with industrial firms. Rather, diversification increases bank profitability and, as a consequence also market valuations. This indirect performance effect does not depend on whether diversification was achieved through organic growth or through M&A activity. We further demonstrate that previous results in the literature on the impact of diversification on bank value presumably differ due to the way diversification is measured, and the negligence of the indirect value effect via bank profitability. Our evidence against a conglomerate discount in banking remains robust also during the sub-prime crisis.     

Mixing and matching: Prospective financial sector mergers and market valuation

Which types of mergers are likely to be most productive for banks and other financial firms in the US? From a management perspective, mixing disparate firms may be difficult, but may offer significant gains from diversification. The opposite applies to matching similar firms. This paper considers life insurance, property and casualty insurance, securities, and commercial firms as potential matches for banks. It examines a measure of diversification gains from potential consolidation, based on option pricing, and a model of the “building blocks” of the industries, based on arbitrage pricing theory. The results identify potential diversification gains from virtually all combinations involving banking and insurance, which arise because common factors are combined in different ways and because insurance is already well diversified.     

On the exposure of insurance companies to sovereign risk—Portfolio investments and market forces

A sovereign debt crisis can have significant knock-on effects in the financial markets and put financial stability at risk. This paper focuses on the transmission of sovereign risk to insurance companies as some of the largest institutional investors in the sovereign bond market. We use a firm level panel dataset that covers large insurance companies, banks and non-financial firms from nine countries over the time period from 1 January 2008–1 May 2013. We find significant and robust transmission effects from sovereign risk to domestic insurers. The impact on insurers is not significantly different from that on banks but larger than for non-financial firms. We find that systemically important insurers are more closely linked to the domestic sovereign. Based on European data, we show that risks in sovereign bond portfolios are an important driver of insurer risk, which is not reflected in current insurance regulation (incl. Solvency II in Europe).     

Diversification,corporate governance and firm value in small markets: evidence from New Zealand

We find that diversified firms in New Zealand are associated with a value discount of 19–42 per cent relative to single‐segment (undiversified) firms. Although several competing explanations have been offered in the literature, we find that the strength of corporate governance explains between 15–21 per cent of this discount. Specifically, board size, busyness of directors, CEO ownership and whether or not compensation of directors includes equity‐based components collectively explain a large part of the reported discount. Our results from companies trading in New Zealand complement recent findings in the US by not only confirming the existence of a diversification discount but also emphasizing the role of poor governance in destroying shareholder wealth by pursuing a value‐destroying corporate strategy. All our results hold after controlling for potential endogeneity in the decision to diversify and the choice of corporate governance structure by employing two‐way fixed‐effects and dynamic‐panel generalized method of moments regression techniques.     

Requiem for a Market Maker: The Case of Drexel Burnham Lambert and Junk Bonds

This article adds to both the financial intermediation and market microstructure literature by examining the market reactions surrounding the withdrawal of a major financial intermediary and market maker from a specific securities market. We examine the exit of Drexel Burnham Lambert (Drexel) from the junk bond market in 1990. At the time Drexel exited the market by declaring bankruptcy, it was the dominant market maker and underwriter of junk bonds. We examine the impact of Drexel's failure on direct and indirect holders of junk bonds by investigating the effect of Drexel's collapse on junk bond returns, and on the stock returns of a group of firms that, on average, held significant amounts of junk bonds. We find that the collapse of Drexel had a significant impact on junk bond prices in general, and a greater impact on the prices of lower-quality junk bonds in particular. We interpret this result to imply that the value of the liquidity services supplied by Drexel was higher for lower-quality junk bonds. Additionally, we find that junk bonds underwritten by Drexel, as opposed to other investment banks, experienced a significant decline in price over the months leading up to Drexel's failure announcement. This suggests that the monitoring services provided by Drexel for the bonds it underwrote would not be replaced easily by other financial intermediaries operating in the junk bond market. Our results also indicate that the stock returns of life insurance companies with relatively high junk bond exposure tended to be affected more negatively by Drexel's financial distress than the stock returns of life insurance companies with relatively low junk bond exposure.     

The Diversification and Cost Effects of Interstate Banking

This study examines recent interstate bank geographic diversification inside the United States. More than 80 holding companies that gradually evolved into interstate banking companies were tested for significant linkages to risk and efficiency indicators. The study finds that while geographic expansion frequently is associated with increases in risk, when banking firms were grouped by threshold levels of geographic diversification more highly diversified interstate banks appear to achieve reductions in risk exposure and operating costs. The study's results suggest the spread of interstate banking may change the industry's risk and cost profile significantly with profound implications for the future of the deposit insurance fund.     

Ownership structure and the cost of corporate borrowing

This article identifies an important channel through which excess control rights affect firm value. Using a new, hand-collected data set on corporate ownership and control of 3,468 firms in 22 countries during the 1996–2008 period, we find that the cost of debt financing is significantly higher for companies with a wider divergence between the largest ultimate owner’s control rights and cash-flow rights and investigate factors that affect this relation. Our results suggest that potential tunneling and other moral hazard activities by large shareholders are facilitated by their excess control rights. These activities increase the monitoring costs and the credit risk faced by banks and, in turn, raise the cost of debt for the borrower.     

Corporate leverage and the collateral channel

We investigate whether and how corporate leverage depends on the structure of corporate assets. Based on a large panel dataset of US firms from 1990 to 2010, we show that property, plant and equipment are important drivers of the collateral channel, while inventories and receivables are less important. The collateral channel is more pronounced for firms that have to rely on banks and trade creditors to raise debt finance, but it has become weaker for these firms after the start of the financial crisis. Our study provides new evidence on the cross-sectional and time-varying importance of the collateral channel for corporate leverage.     

Corporate Insurance and Debt: The Case of China*

Finance theorists have long argued that corporate purchases of property insurance can reduce the probability and hence the expected costs of financial distress. And by so doing, the corporate use of insurance can reduce borrowing costs and/ or increase debt capacity, reduce the overall cost of capital, and increase firm value. This article attempts to apply this argument to the case of publicly traded companies in China, which provides a particularly interesting environment given the significant presence of both foreign direct investment and state shareholdings in its corporate sector. From their study of several hundred Chinese companies during the period 1997‐2003, the authors report the following conclusions: Companies with higher borrower costs tend to purchase more property insurance, which in turn has the effect of increasing their debt capacity. Smaller companies are more likely than larger firms both to insure their assets and to purchase more property insurance (as a percentage of assets), reflecting their greater vulnerability to financial shocks and larger potential benefit from insurers' real advisory services (such as loss prevention advice). Companies with more and larger growth opportunities are more likely to purchase insurance, reflecting their higher expected costs of financial distress (from possible underinvestment) than firms with limited growth opportunities. Companies with higher levels of state ownership tend to insure their assets to a greater extent, suggesting that the managers of such companies insure to protect their job security, particularly as the availability of state subsidies to the Chinese corporate sector has declined since market reforms were initiated in 1978.     

Winners and Losers as Financial Service Providers Converge: Evidence from the Financial Modernization Act of 1999

The Financial Modernization Act of 1999 dramatically increased insurers' and investment banks' authority to provide an array of financial services and allowed commercial banks to offer investment banking and insurance services. In this paper we examine the market response to this legislation. We find a strong positive response among insurance companies and investment banks, and no significant response among commercial banks. Larger institutions in all three financial sectors earn higher abnormal returns. Additionally, better performing banks earn higher abnormal returns. Our results suggest that allowing financial convergence can add value through synergies and that large players are needed to exploit the scope economies.     

Is bank diversification a linking channel between regulatory capital and bank value?

This study investigates the interrelationship between bank regulatory capital and bank diversification. We argue that regulatory capital might act as a substitutive mechanism of diversification to alleviate a bank's default risk. As a result, regulatory capital is likely to discourage firms from excessive diversification, which might in turn indirectly improve bank value. Using a sample of listed banks in developed countries from 2011 to 2017, we find that total regulatory capital is inversely associated with bank diversification. Narrower regulatory capital ratios only have a significant association with income-based but not with asset-based diversification. Our results also reveal an indirect effect of regulatory capital on bank value mediated by bank diversification (i.e. indirect-only mediation). Overall, our study provides novel insights into the complementarity of the institutional and strategic domains so as to understand the far-reaching implications of regulation reforms for the strategic behaviour of banking companies.