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

This post is based on a recent paper authored by Raffaele Santioni, Fabio Schiantarelli, and Philip E. Strahan. Raffaele Santioni is an economist at the Bank of Italy, DG Economics, Statistics and Research. Fabio Schiantarelli is Professor of Economics, Boston College and Research Fellow at the IZA Institute of Labor Economics. Philip E. Strahan holds the John L. Collins, S.J. Chair in Finance at Boston College Carroll School of Management and a Faculty Research Fellow at the National Bureau of Economic Research.

The Italian banking system began experiencing large credit losses starting at the beginning of the 2008 Global Financial Crisis and increasing further with the onset and deepening of the Euro Crisis in 2011. By December of 2015, aggregate bad loans had reached about €200 billion, or approximately 8% of total loans outstanding. Losses are substantially higher when other troubled loans not yet written off are included. Unlike other recent banking problems, where losses were concentrated in real estate or sovereign debt exposure, most of these losses—close to 80%—come from bad debts in lending to non-financial businesses.

As a result of these banking system-wide losses, the availability of credit in Italy has been constrained. A number of recent studies, for example, find that credit supply by distressed banks was reduced in Italy during both the 2007-2008 Global Financial Crisis as well as the more recent Euro crisis and this has had negative consequences for firms’ investment. Losses at banks, combined with a weak legal system, have made the situation even worse because Italian firms sometimes delay payments to banks weakened by past losses and facing large time and legal expenses associated with enforcing loan defaults in court. In addition, bank distress from exposure to risky sovereign debt has also reduced credit supply and helped propagate the Euro crisis from distressed to non-distressed countries across the Euro system. This distress is one important reason for Italy’s poor growth performance.

Our study shows that Italian business groups—coalitions of firms with ownership connections and centralized coordination—have helped firms survive the ongoing crisis by shielding them from the effects of their banks’ problems. Business groups are very important in Italy. In 2014, one-third of total employment in industry and services occurs at firms affiliated with Italian business groups (5.6 million employees). They produce over than €376 billion in value added, or 55 percent of the total in industrial and service sectors. Unlike countries such as Japan, these business groups remain at arm’s length from banks. Despite this separation, we show that firms in Italian business groups are less exposed to bank distress because they use their own internal capital market as a substitute for external finance. Groups move capital from cash-rich to cash-poor firms, thereby benefiting firms that otherwise would face binding external financial constraints. Group-affiliated firms also share financial resources obtained externally (i.e., funds from banks), but this mechanism weakens during the years of banking distress. Thus, sharing of internal cash resources supplants sharing of external finance resources during these years.

In the first portion of our study, we show that affiliation with business groups helps firms survive the recent financial and economic downturn. Firms in large business groups are approximately 11 percentage points more likely to survive from 2006 to 2013, compared with unaffiliated firms. Firms in small groups are also more likely to survive, although the difference is smaller. To understand the role of internal capital markets, we report results that account for firm fundamentals, such as sales growth and cash flow. Like the simple comparisons, these models imply that the survival value of group affiliation becomes stronger during the crisis years. Moreover, controlling for fundamentals has only a small effect on the survival value of group affiliation because such affiliation provides benefits beyond factors that might improve firm sales or firm profitability. Consistent with internal capital markets driving this difference, we show that survival increases not only when own fundamentals are stronger, but also when fundamentals of other group-affiliated fundamentals are stronger.

In the second portion of our study, we show that firms substitute toward the internal capital market when the banking system becomes distressed. Intra-group capital flows from firms with high cash flow to those with low cash flow increases during the crisis years, and also toward firms with high investment opportunities. Moreover, the marginal effect on transfers of negative shocks to a firm cash flow is greater for high sales firms. We are also able to 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.

Much research in both finance and economics suggests that weakness in the financial sector can worsen business downturns. Banks typically reduce their lending in order to strengthen their own balance sheets, but this behavior, while optimal from the point of view of bank owners and creditors, may be harmful to borrowers with potentially strong investment opportunities. This process has been shown to be playing out now in Italy. Our results suggest that business groups help alleviate some of negative feedback from the distressed financial sector to the real economy by funneling internal cash to support continued investment despite tight external credit markets. In ongoing research, we plan to explore further how investment and employment responds differentially to bank distress, comparing group-affiliated with unaffiliated firms.

The complete paper is available for download here.

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