Do Internal Capital Markets in Business Groups Reduce Financial Constraints?

Abstract

We develop a simple model of investment in business groups subject to moral hazard. Our model suggests that productivity and pledgeable income are the drivers of resources in the internal capital markets of these groups. This prediction can be use to explain on the grounds of efficiency some results that have been interpreted in the literature as evidence of "socialist" cross-subsidization in business groups. One important implication of our model is that group firms with strong financial conditions (high pledgeable income) tend to be favored by the internal capital market while group firms with weak financial conditions (low pledgeable income) tend to give support to it. This is in sharp contrast with the hypothesis that internal capital markets in business groups can overcome the failures of external finance markets. However, this doesn't mean that internal capital markets are detrimental to economy. Finally, we derive novel empirical implications from our model that can be object of future empirical works.

Keywords: Internal Capital Markets, Business Groups, Financial Constraints, Corporate Governance, Efficient Capital Allocation

JEL Classification: G31, G32, L22