Credit supply and capital structure adjustments

• Author: Shofiqur Rahman
• Date: 01 December 2020
• DOI: http://doi.org/10.1111/fima.12293
• Published date: 01 December 2020

DOI: 10.1111/fima.12293

ORIGINAL ARTICLE

Credit supply and capital structure adjustments

Shofiqur Rahman

Finance Department, College of Business, New

MexicoState University, Las Cruces, New Mexico

Correspondence

ShofiqurRahman, Finance Department, College

ofBusiness, New Mexico State University, 1780 E.

UniversityAvenue, Las Cruces, NM 88003.

Email:shofi@nmsu.edu

Abstract

Using the staggered deregulation of the U.S. banking industry as a

series of exogenousshocks, I study the effect of the credit supply on

the speed of capital structure adjustment. I find robust evidence that

interstate and intrastate banking deregulation are positively asso-

ciated with leverage adjustments. Specifically,the speeds of adjust-

ment to target leverage are faster in the postderegulation periods.

I also find that the positive effect is driven by firms that are finan-

cially constrained, are financially dependent on banks, and have less

access to the public debt market and byderegulated banks’ ability to

geographically diversify the credit risk.

1INTRODUCTION

Recent studies establish that firms have target capital structures.1Despite efforts to attain these targets, firms often

deviate and face nontrivial costs to offset these deviations (Fischer,Heinkel, & Zechner, 1989; Leary & Roberts, 2005).

Thus, the partial adjustment model to investigate firms’ rebalancing of debt ratios toward targets has gained consid-

erable attention (Flannery & Rangan, 2006; Hovakimian, Opler, & Titman, 2001; Leary& Roberts, 2005; Strebulaev,

2007). Although the previous literature has examined many dimensions along which adjustment speeds may vary,

thesedimensions are themselves endogenous characteristics and the results are susceptible to endogeneity concerns.2

Because it uses exogenousvariation in the availability of capital, this paper overcomes this identification challenge and

allows for a much cleaner estimate of the effects of relaxing capital constraints on observed capital structure activity.

Specifically, exploiting the staggered deregulation of the U.S. banking industry as a series of exogenous shocks, this

paper examines the effect of credit supply on the speed of capital structure adjustment and finds that the leverage

adjustment speed is faster in the postderegulation period.

As capital market supply frictions, credit supply conditions are considered to be important input to the capital

structure decision of firms (Faulkender & Petersen, 2006; Graham & Harvey, 2001; Graham, Harvey, & Puri, 2015;

c

2019 Financial Management Association International

1The surveyevidence of Graham and Harvey (2001) indicates that about 80% CFOs in their sample firms have target debt ratios and other firms pay atten-

tion to target ratios while issuing debt and equity.Examples of studies providing empirical evidences on this issue include Rajan and Zingales (1995), Leary

and Roberts (2005), Flannery and Rangan (2006), Lemmon, Roberts, and Zender (2008), Huang and Ritter (2009), Frankand Goyal (2009), and DeAngelo,

DeAngelo,and Whited (2011).

2See,for example, Graham and Leary (2011) for a review of the empirical capital structure literature.

Financial Management. 2020;49:949–972. wileyonlinelibrary.com/journal/fima 949

950 RAHMAN

Leary,2009; Lemmon & Roberts, 2010; Titman, 2002). Central to the credit supply chain are commercial banks, which

are the largest sources of external financing for corporate borrowers in the United States.3Thus, the history of U.S.

banking deregulation provides a useful setting to empirically identify and assess the impact of deregulation on a firm’s

financial policies. Existing studies find that the credit market environment (i.e.,banking c ompetitionas a consequence

of banking deregulations) led to substantial and beneficial real effects on the economy (Beck, Demirgüç-Kunt, & Mak-

simovic, 2004; Berger,Demsetz, & Strahan, 1999; Bonaccorsi di Patti & Dell’Ariccia, 2004; Cetorelli & Strahan, 2006;

Strahan, 2003). It is only recently that studies havebegun to investigatehow banking deregulation affects public com-

panies (Carow, Kane, & Narayanan,2006; Francis, Hasan, & Wang, 2014; Karceski, Ongena, & Smith, 2005). However,

researchers still know very little about the persistent effects, if any,of banking deregulation on corporate borrowers.

For instance, how does banking deregulation impact the leveragepolicies of nonbanking firms? Do firms deviate from

their target leveragemore frequently and adjust back to the target more quickly due to the increased supply of credit?

This paper seeks fill this gap by answering these questions.

A number of studies argue that banking deregulation increased the credit supply (Demyanyk, Østergaard, &

Sørensen, 2007; Francis et al., 2014; Goetz, Laeven,& Levine, 2013) and lowered loan pricing (Rice & Strahan, 2010).

The underlying mechanism of this seems straight forward and fairly intuitive. By allowing banks to enter into new geo-

graphical areas, state-level deregulation increased competition and, with the adoption of better screening and moni-

toring technologies, facilitated banks’ geographic diversification of credit risk. As such, the benefits of banking dereg-

ulation lead to better access to the capital market for corporate borrowers (i.e., relaxation of financial constraints). I

hypothesize that U.S. banking deregulation is associated with faster capital structure adjustment toward the target.

The findings of heterogeneous adjustment speeds in pre- and postderegulation periods support the hypothesis that

firms have target debt ratiosand, when moving to the targets, face transaction costs that are affected by a supply-side

factor,such as credit supply.

Toexamine the role of banking deregulation on the speed of adjustment, I utilize interstate banking and intrastate

branching deregulation in the U.S. banking industry from 1970 to 1994 and employ a difference-in-difference

approach.4Consistent with the prediction, the results suggest that leverage adjustment speeds are faster in the post-

deregulation period. For example, the adjustment speeds for book leveragein the pre-deregulation period are 36.6%

(interstate) and 35.7% (intrastate). In the post period, these speeds rise to 42.8% and 42.3%, respectively. In other

words, banking deregulation increases the adjustment speed by a relative 16.9% (interstate) and 18.5% (intrastate).

Focusing on the supply-side factor, I further examine the underlying mechanisms through which banking deregula-

tion affects adjustment speed. I argue that the main channels behind this faster leverage adjustment speed are the

relaxation of financial constraints and a greater willingness of deregulated banks to takerisks after they are geograph-

ically diversified. Specifically,out-of-state banks are now willing to extend more corporate loans with favorable terms,

increasing the overall credit supply in the capital market.As the traditional diversification concept implies, banks will

take greater credit risks if the economic conditions of the state in which they entered are less correlated with their

existing exposure. Indeed, the diversification of credit risk will be maximized if the correlation is highly negative. I

employ a series of cross-sectional tests. First, to the extent that banking deregulation increases the credit supply and

eases financial constraints,I expect financially constrained firms to be the ones who benefit the most and display faster

adjustment speeds in the post period. Consistent with this prediction, I find that the impact of deregulation is stronger

among financially constrained firms, firms with a greater dependency on banks, and firms with limited access to the

public debt market. In addition, if the economic conditions of a state are highly negatively correlated with those of the

United States, the out-of-state banks will likely extendgreater credit to firms that are headquartered in that state. To

3Asan intermediary, banking institutions are important suppliers of credit and play a major role in firms’ financing decisions. In other words, the leverage rat io

ofa firm is a function of access to bank loans (e.g., credit supply). For example, Houston and James (1996) argue that commercial banks are the largest private

borrowingsource for both private and public U.S. firms (Hadlock & James, 2002; Kashyap, Rajan, & Stein, 2002).

4Examples of other studies that use the same difference-in-difference approach to investigate the gradual removal of restrictions on banks’ geographical

expansion (e.g.,inter- and intrastate branching) include Black and Strahan (2002), Jayaratne and Strahan (1996), Kerr and Nanda (2009), Amore, Schneider,

andŽaldokas (2013), and Francis, Hasan, and Wang (2014).