Who Finances Durable Goods and Why It Matters: Captive Finance and the Coase Conjecture

• Author: JUSTIN MURFIN,RYAN PRATT
• Date: 01 April 2019
• Published date: 01 April 2019
• DOI: http://doi.org/10.1111/jofi.12745

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 2 •APRIL 2019

Who Finances Durable Goods and Why It Matters:

Captive Finance and the Coase Conjecture

JUSTIN MURFIN and RYAN PRATT∗

ABSTRACT

We propose that, by financing their own product sales through captive finance sub-

sidiaries, durable goods manufacturers commit to higher resale values for their prod-

ucts in future periods. Using data on captive financing by the manufacturers of heavy

equipment, we find that captive-backed models have lower price depreciation. The

evidence is consistent with captive finance helping manufacturers commit to ex-post

actions that support used machine prices. This, in turn, conveys higher pledgeabil-

ity for captive-backed products, even for individual machines financed by banks.

Although motivated as a rent-seeking device, captive financing generates positive

spillovers by relaxing credit constraints.

ASUBSTANTIAL SHARE OF DURABLE goods financed with credit in the United States

is not financed by banks, but rather by the manufacturer of the good itself. For

firms making new investments in equipment used in agriculture, construction,

logging, manufacturing, and printing, the share of financing done by the wholly

owned subsidiary lenders of equipment manufacturers was 58% as of 2013

and ranged from dominant (76% in agricultural equipment) to nontrivial (18%

in printing) (see Figure 1). And while manufacturers are important lenders

within each of these industries, they are also sizable enough to be important

in aggregate. For example, manufacturing firms such as Toyota, John Deere,

and Caterpillar originate loan portfolios in a given year that would rank them

among the top banks in terms of business and non-credit card installment lend-

ing (as of 2012, #9, 15, and 17, respectively).1Recent work by Stroebel (2016)

∗Justin Murfin is with Cornell. Ryan Pratt is with Brigham Young University. This paper was

formerly entitled “Captive Finance and the Coase Conjecture.” Wethank the Editor, Bruno Biais, as

well as an anonymous Associate Editor and two anonymous referees for helpful comments. We also

thank Jean-Noel Barrot, TanakornMakaew, Rich Matthews, Ralf Meisenzahl, Rodney Ramcharan,

Adriano Rampini, seminar participants at YaleSchool of Management, BYU economics and finance

departments, Southern Methodist University,University of Rochester, Ohio State, Drexel, Tulane,

University of Colorado, University of Pittsburgh, University of Illinois, Federal Reserve Bank

of Philadelphia, Dartmouth Tuck, MIT Sloan, Temple University, University of South Carolina,

and conference participants at Red Rock Finance Conference, Olin Corporate Finance Conference,

Financial Research Association Annual Meeting, Northern Finance Association Conference, and

American Finance Association Annual Meeting. We have read the Journal of Finance’s disclosure

policy and have no conflicts of interest to disclose.

1This is based on bank holding company call report data, where, for comparability, bank loan

portfolios exclude interbank, charge card, and mortgage lending.

DOI: 10.1111/jofi.12745

755

756 The Journal of Finance R

20 40 60 80

20 40 60 80

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

AGRICULTURE CONSTRUCTION LIFT TRUCKS

LOGGING MACHINE TOOLS PRINTING

% New Machines Captive Financed

Figure 1. Captive finance and durable investment. The figure plots the percentage of new

durable goods investment financed by captive finance subsidiaries of manufacturers in a variety of

industries. Industry definitions were chosen by Equipment Data Associates, which provided these

summary statistics. (Color figure can be viewed at wileyonlinelibrary.com)

and Benmelech, Meisenzahl, and Ramcharan (2017) further demonstrates the

importance of these vertically integrated lenders in the markets for new hous-

ing and cars, respectively.

As the line between traditional banking and manufacturing firms’ bank-like

activities—so-called “captive finance”—is increasingly blurred, a natural ques-

tion arises. What are the economic motives behind manufacturers financing

their own sales? If banks are specialists in credit evaluation, monitoring, and

fundraising and thus are natural candidates to finance durable goods invest-

ment, what is the comparative advantage of captive finance?

In this paper, we explore a set of candidate answers to the questions above

that are informed by the expansive literature on durable goods. We begin with

the insight that, because consumers of durables care about the future value

of their goods, durable goods producers require credible means of assuring

customers that machines bought today will retain their value tomorrow. By

linking future periods’ profits to the future value of products sold today

(whether through collateral value on loans or residual values on leases), cap-

tive finance might serve as a way for manufacturers to signal or commit to high

future resale values for their product line, supporting rents today.

Following this intuition, we explore the link between who finances capital—

whether traditional banks or the manufacturer itself—and realized resale

Captive Finance and the Coase Conjecture 757

values of the same capital. Combining auction data that allow us to mea-

sure depreciation rates for varying makes and models of heavy construction

equipment with new data on the financing provided by captives in support of

equipment sales, we document a robust link between products’ realized depre-

ciation paths and the financing support offered by captive lenders: on average,

moving from zero captive financing for a given make and model to machine

sales being 100% financed by the manufacturer is associated with a 14 to 20

percentage point decrease in observed depreciation. These results are driven

by the source of financing and do not depend on the nature of the financing

contract. Captive lending and leasing portfolios are both associated with lower

depreciation, but in equilibrium, installment loans are more prevalent.

Given the strong observed correlation between captive financing and the

realized price depreciation associated with financed products, we proceed by

exploring the potential mechanisms at play.Here, we differentiate between two

closely related ideas. On the one hand, we emphasize a new idea to the vendor

financing literature: that captive finance may be operating as a solution to the

famous Coase conjecture (Coase (1972)). Coase argues that even a monopolist

producer of a durable good faces competition from its own future production,

as customers may choose to delay their purchases if they expect prices to fall.

Absent the ability to commit to future production, this competition can erode

the producer’s market power, as customers will be unwilling to pay monopolist

prices today if they expect prices to fall tomorrow. Bulow (1982)showsthat,by

leasing rather than selling their products, manufacturers internalize the price

impact of their own future production choices, which enables them to commit

to higher future prices and thereby boosts buyers’ willingness-to-pay today. We

argue that this intuition holds for vendor financing more broadly, including

both leases and loans. We refer to this explanation as the “commitment” view

of captive financing.

This idea is distinct from an intuitive and closely related interpretation: that

lower depreciation rates on captive-financed machines are driven by higher

ex-ante quality of captive-backed machines (and not the ex-post commitment

of their manufacturers), which manifests in longer productive lives and hence

slower depreciation. This would arise naturally, for example, in markets with

information asymmetry whereby the vendor’s choice to finance its own product

provides a signal of quality, as suggested in Stroebel (2016), Emery and Nayar

(1998), Long, Malitz, and Ravid (1993), and Lee and Stowe (1993). In this

case, the association between captive finance and high future resale values

may arise through variation in ex-ante unobservable machine characteristics

as opposed to (or in addition to) ex-post producer actions. Hereafter, we refer

to this explanation as the “information asymmetry” view of captive finance.

While the commitment and information asymmetry hypotheses both predict

a relationship between price depreciation and captive finance, we can distin-

guish the two through a simple decomposition of depreciation, about which the

hypotheses produce competing predictions. To see this, notice that the annual

depreciation of a given machine (we will use a 2002 John Deere tractor as a

motivating example) can be parsed into two distinct pieces: (i) the change in