Financially Interlinked Business Groups

Financial interlinkage, in the form of cross-holding of equity and debtbetween firms, characterizes business groups in many countries. We suggestthat such financial interlinkage can be viewed as a way to solve creditrationing caused by asymmetric information. If firms possess better informationabout each other than a bank, then business groups can be a mechanismto induce firms to sort on the basis of this information. Banks can offer amenu of contracts that vary in the extent of financial interlinkage to inducefirms to self-select on the basis of the equilibrium composition of the businessgroups they can form.[...]