Banks’ Equity Stakes and Lending: Evidence from a Tax Reform

We study how a bank’s equity stake in a borrowing firm affects lending to that firm. As identification, we use a German tax reform that permitted banks to sell their equity stakes in industrial companies without incurring capital gains taxes. Using difference-in-difference estimation, we find that after the tax reform banks sell their equity stakes in industrial firms and increase lending to these firms by 60% or one euro for every three euros of equity divested. Thus, contrary to prior cross-sectional studies, we find that banks’ debt and equity investments are substitutes. This substitutability stems from banks that limit their exposure to a single firm: a bank increases its lending more if the divested equity stake is larger relative to the bank’s capital or if the bank has higher leverage. Consistent with this explanation, a bank that sells equity in a firm increases lending not only to that firm, but also to other firms that are in the same industry or have high stock return correlation with that firm. Our findings suggest that banks regard equity and debt investments as substitutes because they are concerned about their risk exposure to the firm.