Internal Capital Markets: The Insurance-Contagion Trade-off

This paper shows that the pooling of financial resources in an internal capital market may magnify financial distress situations. This effect, which is closely related to the well-known debt overhang phenomenon, arises when there is a illiquidity in one part of the conglomerate, which then spills over to other divisions. This effect is the flip side of the coinsurance function of con-glomerates, the leading rationale for internal capital markets. We show that contagion will prevail for very volatile firms, whereas coinsurance is likely to dominate for more stable firms. Taking into account that conglomeration is likely to exacerbate incentive problems in the firm, a non-monotonic relationship between the severity of risk and the preference for conglomeration emerges, where the best and the worst firms prefer to incorporate as stand-alone firms. Our model can accounts for the empirical observation that the conglomerate discount tends to increase as financial market conditions worsen. For conglomerates with considerable contagion risks, the discount will actually deepen as the divisions become more closely related, in line with empirical studies.