Lina Lu, Marco Macchiavelli, Jonathan Wallen
We study the internal and external capital markets of large U.S. bank holding companies. Within the bank holding company, commercial bank and dealer divisions have different investment opportunities, raise capital externally and actively share some capital internally. We develop and test a simple model where a bank division raises funding from both internal and external capital markets subject to frictions. Empirically, we measure marginal returns to dealer investment opportunities using arbitrage spreads. We show that when spreads widen, the dealer raises additional capital through both internal and external markets. The dealer raises 3 times more capital internally than externally, implying that there are larger frictions to external capital. However, both sources of additional capital are slow to respond to investment opportunities. These internal and external frictions cause capital to be partially segmented. As a result, capital directly held by the dealer price its own investment opportunities, even when controlling for the liquidity of the bank holding company.