Institutions

Financial interlinkage, in the form of cross-holding of equity and debt between Þrms, characterize business groups in many countries. We suggest that such Þnancial interlink-age can be viewed as a way to solve credit rationing caused by asymmetric information. If Þrms possess better information about each other than a bank, then business groups can be a mechanism to induce Þrms to sort on the basis of this information. Banks can offer a menu of contracts that vary in the extent of Þnancial interlinkage to induce Þrms to self-select on the basis of the equilibrium composition of the business groups they can form