Should Financial Institutions own equity? -A Test of the ‘German Bank Influence Model’

This paper tests two competing hypotheses about the influence of financial institutions as large shareholders on the performance of their industrial portfolio firms: the superior monitoring hypothesis versus the rent extraction hypothesis. The methodology of this study exploits the abolishment ofcapital gains taxes on interfirm share holdings in Germany in two ways. First, the surpriseannouncement of the tax reform constitutes a natural experiment that allows analyzing the marketresponses to anticipated changes in firms’ ownership structures cross-sectionally. Second, abnormalreturns of portfolio firms around actual sales and acquisitions by financial institutions are analyzed inan event study. Altogether, there is virtually no evidence in favor of the superior monitoringhypothesis, which predicts a positive effect of having a financial institution as a shareholder on theperformance of the portfolio firm. Moreover, I find only moderate support of the rent extractionhypothesis, which implies a negative relationship between firm performance and a shareholderbelonging to the financial industry. Overall, the link between financial institutions as shareholders andfirm performance is found to be markedly weak, if existent at all. This result helps to reconcile thehighly heterogeneous findings of prior static studies.