This study represents an attempt to review, and analytically evaluate, each of the major processes used by industry participants to measure so-called “credit risk” for first mortgage products. The study has three sections: Section I provides a discussion of the general concept of Economic Capital (“EC”), how EC is measured and used by best-practice banks, and how EC concepts used by industry practitioners differ from regulatory definitions of capital.Section II discusses the various types of theoretical “credit risk models” that are used by practitioners to measure EC for mortgages. Section III conducts several empirical experiments in which large historical databases are used to estimate the credit risk models described in Section II.
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During the last decade, a growing number of theoretical and empirical studies have compared financing via internal capital markets of conglomerates, business groups or multinational corporations, with external market finance. Contrary to the case of the conglomerates described in the theoretical literature, where external financing is often assumed to be raised by headquarters and passed through to divisions (e.g. Gertner et al., 1994; Stein, 1997), in practice member firms of business groups and multinationals are often separate legal entities which may also directly access the external capital markets. Within these types of organizations, the external/internal financing decision is likely to be a complex group wide trade-off between benefits and costs of internal and external financing. Empirical evidence of this phenomenon is found by Desai et al. (2004), who show that foreign affiliates of US multinational corporations use parent debt as a substitute for external debt, especially in countries where access to external financing is limited or expensive. They argue that the possibility of raising debt where it is cheapest and the potential for tax arbitrage offers multinational corporations an important advantage over their local competitors. However, many large domestic firms are also tied together through ownership to form a domestic group. Especially in Continental Europe, South East Asia and several emerging market regions (e.g. India) this group organizational form is important. For instance, almost one third of the top 100,000 non-financial companies in the Euro-zone have domestic group ties. The vast majority of these groups does not have a stock exchange quoted component.
This paper is the first to analyze in detail, if and how, internal capital markets within domestic business groups are used to minimize the costs of attracting external financing. It offers the opportunity to evaluate whether or not - likewise international groups - domestic groups can offer their subsidiaries important financing advantages as well. To ensure clean testing we examine the capital structure of large domestic subsidiaries of Belgian private business groups. Firstly, this implies all companies we consider operate under the same tax regime and within the same institutional framework. Secondly, confounding effects are further reduced because of the limits on financing alternatives imposed by the private nature of the groups: external financing will almost always be bank debt. Finally, only larger subsidiaries have an obligation to report detailed information on internal financing. Limiting ourselves to this type of affiliate has the additional advantage that effects from typical financing problems of small firms are avoided within the sample. Within this setting, we contribute to the literature by developing testable hypotheses about the costs and benefits of bank and internal debt5 within global group optimization, and about the nature of the choice between both sources of funding. Using a sample of 553 subsidiaries which are part of 253 different business groups, we model the determinants of the bank and internal debt concentration (i.e. the importance of bank and internal debt as a fraction of total liabilities). Novel to the literature on debt type concentration, we use information from multiple financial statements (at company level and at consolidated group level), which allows us to investigate the importance of affiliate versus group characteristics. Moreover, we use a sample of comparable stand-alone firms as a benchmark to pinpoint the impact of group membership on bank debt concentration.
