How does bank credit affect the shape of business groups' internal capital markets?

In empirical literature, it is hypothesized that the persistence of Business Groups (BGs) is linked to the capability of easing the financing constraints of participating firms through the implementation of an internal capital market (ICM). ICMs enable capital relocation, thus partially offsetting disparities in accessing bank credit. I offer three contributions. First, I formally ground this idea with a dynamic model in which an ICM is endogenously generated as a function of the bank’s lending policy and firms’ production incentives. A novelty in the literature, the model contains a trickle-down mechanism which allows bank credit to circulate across firms via inter-firm loans. Second, I study
the model to understand how the ICM reacts to shocks to the following empirically critical channels: the BG’s debt-to equity ratio, the profitability of production markets and, most importantly, the bank’s credit rationing policy. The model disentangles the contribution of each channel on the
shape of the ICM, as measured in terms of the intensity of firms’ cross-subsidization. In particular, I discover a non-monotonic relationship between the latter dimension and the intensity of cross-subsidization. Third, I match stylized facts of the so called ‘Korean crisis’ and apply the model to discipline some extant results of the empirical literature: I find that a tightening of the financial market, taken in isolation, would contribute to a densification of the ICM structure, reflecting the functioning of the credit reallocation channel described in the literature. At the same time, the magnitude of such effect is not sufficiently strong to overcome the reduction in density as caused by the two alternative channels.

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