Banking Deregulation and Investment-Cash Flow Sensitivity

Motivation: Prior empirical studies show that there exists a declining pattern of investment-cash flow sensitivity during the banking deregulation period in the United States, but it is still unclear whether such deregulatory reforms that increase competition affect the sensitivity of investment to internally generated cash flows. This research provides empirical evidence to explain banking deregulation as an important determinant of the documented declining trend of investment-cash flow sensitivity. Premise: This study investigates the important role of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (IBBEA) in explaining the documented declining trend of firms' investment-cash flow sensitivity. We predict that banking deregulation progress relaxes geographical restrictions on bank expansion and facilitates bank loan issuance as a main source of external financing, and ultimately, reduces the sensitivity of investment to internally generated cash flows. Approach: We implement a difference-in-difference approach to investigate the effects of both the interstate and intrastate banking deregulation on sensitivity of investment to internal cash flow at the firm-year level over the period 1970 to 2006. We also follow the conventional investment literature and apply the Erickson-Whited estimators to control for the measurement error of Tobin's q. Results: We document that there exists a material drop in the firm's sensitivity of investment to cash flow following the deregulation of restrictions on interstate and intrastate banking. Particularly, such reduction effects are strong among firms in industries that rely heavily on external finance, and among firms that geographically located in the urban areas. Furthermore, we show that the reduction effects of banking deregulation on investment-cash flow sensitivity is more pronounced for financially constrained firms with low hedging needs than for constrained firms with high hedging needs. Conclusion: Banking deregulation changes improve competition among banks and promote the use of bank loans as external financing, and thus reduce sensitivity of investment to internally generated cash flows. Such reduction effects are mainly driven by financially constrained firms with low hedging needs and are more pronounced among urban firms than among small-city and rural-based firms. Consistency: This research provides important implications on the role of financial market development for corporate investment. By making bank loans a more available external source of financing to firms after deregulation, competition-enhancing deregulatory changes reduce the sensitivity of investment to cash flows.