Identifying the Valuation Effects and Agency Costs of Corporate Diversification

The following post comes to us from Martin Goetz of the Federal Reserve Bank of Boston; Luc Laeven of the International Monetary Fund and Professor of Finance at Tilburg University; and Ross Levine, Professor of Economics at UC Berkeley.

In our paper, Identifying the Valuation Effects and Agency Costs of Corporate Diversification: Evidence from the Geographic Diversification of U.S. Banks, forthcoming in the Review of Financial Studies, we develop and implement two new approaches for identifying the causal impact of the geographic diversification of bank holding company (BHC) assets on their market valuations. Although we provide some evidence about the factors underlying observed changes in market valuations, our major contribution is in improving identification, not in constructing better measures of scale economies, agency problems, or other factors associated with market valuations. Furthermore, although we primarily use both identification strategies to evaluate the net effect of geographic diversification on BHC valuations, they can be employed to assess an array of questions about bank behavior.

At the core of both identification strategies, we exploit the cross-state, cross-time variation in the removal of interstate bank branching prohibitions to identify an exogenous increase in geographic diversity. From the 1970s through the 1990s, individual states of the United States removed restrictions on the entry of out-of-state banks. Not only did states start deregulating in different years, but states also signed bilateral and multilateral reciprocal interstate banking agreements in a somewhat chaotic manner over time. There is enormous cross-state variation in the twenty-year process of interstate bank deregulation, which culminated in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1995.

There are good economic and statistical reasons for treating the process of interstate bank deregulation as exogenous to bank valuations. Restrictions on interstate banking protected banks from competition for much of the twentieth century. During the last quarter of the century, technological and financial innovations eroded the value of these restrictions. For example, Kroszner and Strahan (1999) find that checkable money market mutual funds facilitated banking by mail and phone, and improvements in data processing, telecommunications, and credit scoring weakened the advantages of local banks. They hold that these innovations reduced the willingness of banks to fight for the maintenance of protective regulations, triggering deregulation. Furthermore, we find no empirical evidence that valuations or changes in valuations affected the timing of deregulation. And, there is no evidence that states signed bilateral and multilateral interstate banking arrangements based on BHC valuations or their distance from other states. Thus, the process of interstate bank deregulation appears to be a fairly chaotic process that provides a useful laboratory for evaluating the impact of BHC diversification on valuations.

The first identification strategy uses the state-time variation in the dynamic process of interstate bank deregulation as an instrument for the geographic diversity of BHCs. While past researchers have treated interstate bank deregulation as a single, discrete event, typically dating deregulation as the year in which a state first allows banks from any other state to enter (e.g., Klein and Saidenberg 2010), we believe that we are the first to exploit the state-specific process of deregulation to examine the ability of banks in one state to diversify into other states. In this first strategy, we only provide information on the dynamic impact of diversity of a state’s “average” BHC, because our instrument does not have a BHC-specific component.

The second identification strategy embeds the state-time variation in the dynamic process of interstate bank deregulation into a gravity model of individual BHC investments in “foreign” states to develop a BHC-specific instrumental variable of diversification. Inspired by Frankel and Romer’s (1999) study of international trade, we construct a BHC-specific instrument for geographic diversity in the following manner. First, for each BHC in each period, we use a gravity model to estimate the share of assets it will hold in each “foreign” state, conditional on there being no regulatory prohibitions on establishing a subsidiary in that state. Second, based on this estimate – and imposing a zero when there are regulatory prohibitions on interstate banking – we compute the projected geographic diversity of each BHC in each period. This gravity-deregulation model produces the instrumental variable that we employ to identify the causal impact of geographic diversity on Tobin’s q at the BHC level – that is, this identification strategy differentiates among banks within the same state. We believe that we are the first to extend the gravity model to examine the cross-state expansion and investment decisions of individual banks.

Both identification strategies indicate that increases in geographic diversity reduce BHC valuations. This finding holds after controlling for BHC fixed effects, state-quarter fixed effects, and a wide array of time-varying BHC characteristics, such as size, growth, profitability, and the capital–asset ratio, that also exert an influence on valuations. Even when conditioning on the degree to which the BHC engages in a diversity of activities, the median q of other banks in the state, and the concentration of the local banking market, there is still a significant, negative impact of geographic diversity on q. Furthermore, we find no evidence that changes in the accounting value of assets around the time of mergers and acquisitions or changes in the debts of banks drive the results. These findings indicate that the valuation-reducing effects of diversification, such as those potentially arising from an intensification of agency problems, outweigh the valuation-increasing effects of diversification, such as those potentially produced by scale economies.

Although our major contribution is showing that diversification lowers BHC valuations, we also examine several potential explanations of this finding. First, the results do not seem to be driven simply by competition, where interstate bank deregulation triggers an intensification of competition within a state that lowers expected profits and valuations. Rather, the results hold when controlling for each bank’s profitability and the degree of competition within its local banking market. Moreover, we instrument for each BHC’s level of diversification, so that we distinguish among banks within the same state and include a set of time-varying state fixed effects that account for unobservable effects, such as banking competition, at the state level. Thus, we identify the impact of an increase in the diversification of a BHC on its market valuation, not the effects of interstate deregulation on overall bank competition at the state level.

Second, additional evidence suggests that the drop in BHC valuations is associated with an increase in the benefits flowing to the BHC’s corporate insiders and a reduction in loan quality, consistent with an intensification of agency problems within BHCs. Specifically, diversification (i) increases the incidence and magnitude of loans to corporate insiders (i.e., executive officers, directors, principal shareholders, and their related interests) and (ii) increases the proportion of nonperforming loans. Although the totality of the findings in this paper are consistent with the view that diversification intensifies agency problems within BHCs, future research will need to develop and examine more precise measures of agency problems before one can draw sharper inferences about the precise mechanisms through which geographic diversity lowers BHC valuations.

The full paper is available for download here.

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