Capital markets for large multinational firms can be characterized as external (when capital is supplied by a bank or bond markets, for example) or internal (wherein a firm issues capital to business units in the form of, say, redistributed profits). Of the two, we know less about the inner workings of internal capital, despite their prominence in global capital movements. In recent years, for example, internal capital flows between multinational parent firms and their international affiliates accounted for over 50 percent of total capital inflows in the median country. Internal capital flows are also large relative to aggregate output, amounting to 3.6 percent of GDP in the median country.
We also understand little about how internal capital markets impact the real economy. Do internal capital markets transmit shocks across countries? Which mechanisms and frictions play a role, like managerial biases, access to external credit markets, different currencies, and geographic distance? Do internal capital markets transmit financial and non-financial shocks differently? How large and persistent are the real effects of internal capital market shocks?
To address these questions, the authors study a lending cut by Commerzbank, Germany’s second-largest bank in 2008, whose corporate lending was concentrated in Germany. During the 2008-09 Financial Crisis, Commerzbank experienced significant losses on its financial investments that, while independent of Commerzbank’s corporate lending division, ultimately impacted corporate borrowers because the losses forced Commerzbank to reduce its loan supply. This exogenous shock to the credit supply impacted those multinationals located in Germany with a higher pre-crisis dependence on Commerzbank, but did not directly affect the credit supply of international affiliates of these multinationals.
The authors examine whether and how this lending cut affected international affiliates of impacted German parent companies. In doing so, the authors compare affiliates located in the same country at the same time, so that differences in demand or other country-specific shocks do not affect the estimates. The authors investigate a number of ways that a credit shock to parents could transmit through internal capital markets and affect international affiliates, to find the following:
Bottom line: This work offers new and key insights into the role internal credit markets, including that shocks can transmit across affiliates, that internal capital flows across countries depend on different frictions than flows within domestic business groups, that financial shocks are transmitted strongly within internal capital markets while non-financial shocks have a weaker impact, and that internal capital flows can also cause financial constraints and thereby harm growth.