Corporate ownership as a means to solve adverse selection problems in a model of asymmetric information and credit rationing

This paper analyzes an asymmetric information model where the financing needs of entrepreneurs are obtained from two sources. We show that adverse selection is only important if the credit constraint of banks is not too tight. Next, we show that banks can induce a pattern of corporate ownership, whereby safe firms end up owning shares in risky firms. This particular type of an incentive compatible debt contract can solve the adverse selection problem caused by credit rationing under asymmetric information. Our theory gives a theoretical backing for the existence of business groups containing firms that operate in diversified markets.