Relationships Between the Two Sides of the Balance Sheet: A Canonical Correlation Analysis

Abstract

AN INDEPENDENCE OF THE asset and liability composition of the firm is implied in much modern financial theory; the independence of investing and financing decisions is a prominent part of Modigliani and Miller's classic capital structure research. While the separation of financing and investing decisions is an invaluable assumption which greatly simplifies many corporate financial decisions, the actual balance sheets of modern corporations do not exhibit an independence between the two sides of the balance sheet. The purposes of this paper are (1) to identify relationships between the two sides of the balance sheet exhibited by these corporations and (2) to explain the nature of these relationships.The independence of asset and liability composition is explicit in Modigliani and Miller's capital structure propositions [15]. In their 1958 article, they demonstrate that, given a stream of risky earnings, the total market value of the firm and cost of capital are independent of capital structure (M & M's Proposition I). Furthermore, the cutoff rate for an investment project is completely independent of the way an investment is financed (M & M's Proposition III), thus implying a complete separation between the investing and financing decisions of the firm.'The teaching of corporate finance, as reflected in the major textbooks, compartmentalizes the decision areas of finance and, within each compartment, management is assumed to attempt to maximize the firm's wealth, holding the other areas of the firm constant. For example, capital budgeting decisions are made given a cost of capital or required rate of return (a capital project is evaluated independent of how it is financed), or the capital structure is chosen given the character of the firm's assets. Cash, receivables, and inventory balances tend to be optimized independently. There is a tradeoff between the rigor afforded by global models of the firm (such as the CAPM) versus the realism afforded by 1 The separation theorem simply means that an individual's risk preferences are independent of the optimal portfolio of risky assets. In the Sharpe-Lintner capital asset pricing model [13,19], the individual's choice of assets and financing is dichotomized: first, the optimal combination of risky assets (where the capital market line is tangent to the efficiency frontier) is determined, and, second, the optimal amount of borrowing or lending at the risk free rate (where the capital market line is tangent to the individual's highest indifference curve) is chosen. In the capital asset pricing model, the combination of risky assets is independent of the individual's risk preferences and also dichotomized from the amount of borrowing/lending (leverage). Of course, if the borrowing rate had a nonzero correlation with the returns on at least one asset, the optimum mix of risky assets would be affected by the amount of borrowing. 974The Journal of Finance

A Canonical Correlation Analysis of Commercial Bank Asset/Liability Structures

“…In the same large bank group, canonical variable 2R has a very large loading for equity capital (Y 6 ) on the right-hand side of the balance sheet and somewhat smaller positive loadings for liquid securities (X 2 ) and investment securities (X 3 ) on the asset side. The linkage of higher levels of equity capital and liquid investments is similar to that found in [22] dealing with nonfinancial firms. Unlike the earlier study dealing with a heterogeneous set of nonfinancial firms (i.e., utilities, drug companies, airlines, etc.…”

“…A recent article by Stowe, Watson, and Robertson [22] examines the relationships between the two sides of the balance sheets of a cross-section of 510 large, nonfinancial corporations. They used canonical correlation analysis to explore relationships between the structure of the left-and right-hand sides of the balance sheet.…”

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