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Agency and Internal Capital Market Inefficiency: Evidence from Banking Organizations

Using banking data, I provide evidence that agency problems are at the root of internal capital market inefficiency. I find that publicly traded bank holding companies (BHCs) are less efficient in their internal capital allocation than non-publicly traded BHCs. This suggests that the divergence of interests between the CEO and the shareholders is an important source of the internal capital misallocation. I also show that BHCs that have a tiered organizational structure are less efficient than non-tiered BHCs, but only within a sample of BHCs that are publicly traded. These findings imply that a greater degree of rent-seeking activity by the division manager contributes to the internal capital market inefficiency only if the top manager herself is an agent. This is consistent with theoretical models that explain internal capital misallocations through the multiple layers of agency within an organization.