Financially Interlinked Business Groups: A Solution to Adverse Selection in Credit Markets

31 Pages Posted: 27 Mar 2000

See all articles by Maitreesh Ghatak

Maitreesh Ghatak

London School of Economics (LSE) - Department of Economics

Raja Kali

University of Arkansas - Department of Economics

Date Written: February 2000

Abstract

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

Ghatak, Maitreesh and Kali, Raja, Financially Interlinked Business Groups: A Solution to Adverse Selection in Credit Markets (February 2000). Available at SSRN: https://ssrn.com/abstract=214190 or http://dx.doi.org/10.2139/ssrn.214190

Maitreesh Ghatak

London School of Economics (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom
44 20 7852 3568 (Phone)
44 20 7955 6951 (Fax)

HOME PAGE: http://sticerd.lse.ac.uk/dps/adds/ghatak/cv-lse-sept02.pdf

Raja Kali (Contact Author)

University of Arkansas - Department of Economics ( email )

Sam M. Walton College of Business
Fayetteville, AR 72701
United States
479-575-6219 (Phone)
479-575-3241 (Fax)

HOME PAGE: http://wcob.uark.edu/rkali/index.html

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