Financially Interlinked Business Groups: A Solution to Adverse Selection in Credit Markets
31 Pages Posted: 27 Mar 2000
Date Written: February 2000
Financial interlinkage, in the form of cross-holding of equity and debt between firms characterize business groups in many countries. We suggest that such financial interlinkage can be viewed as a way to solve credit rationing caused by asymmetric information. If firms possess better information about each other than a bank, then business groups can be a mechanism to induce firms to sort on the basis of this information. Banks can offer a menu of contracts that vary in the extent of financial interlinkage to induce firms to self-select on the basis of the equilibrium composition of the business groups they can form. This can solve inefficient credit rationing and thereby enhance efficiency. However, since this mechanism exploits local information, if there is heterogeneity in access to informational networks, financial interlinkage and the associated formation of business groups may worsen overall efficiency.
JEL Classification: D82, G30, L14, O16
Suggested Citation: Suggested Citation