Does Internal Capital Market Membership Matter for Financing Efficiency? Evidence from the Euro Area

Abstract

The paper investigates the efficiency of firms’ financing behavior, exploring the effect of the internal capital market (ICM) organizational form on the differences in the cost of capital, capital structure, and the speed of adjustment towards preferred capital structure, between ICM participants and stand-alone peer firms, using two balanced comparable panel data sets of euro area firms of 773 firms each, over the 2004–2013 period. Univariate statistical analysis, document that firms operating within an active ICM exhibit, on average, lower costs of capital than their comparable stand-alone counterparts. The paper also documents that on average financial leverage ratios are significantly higher for ICM firms than for stand-alone, and that both ICM and stand-alone firms tend to have preferred target leverage ratios. Results from dynamic panel data regression document that both, firms integrated in internal capital markets and single-segment firms, adjust dynamically their financial leverage towards their preferred targets at different speeds. These findings are consistent with the view that ICM membership is linked to information and agency problems, lowering ICM participants’ cost of capital, having target leverage ratios, and adjusting their capital structures differently than their stand-alone peers.