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Internal Capital Markets inside Financial Firms : Rent-Seeking Behavior Versus Cost of Capital

  • M. Idriss GHODBANE

    (UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut de Recherches Economiques et Sociales (IRES))

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    In this paper we build a two-tiered agency model of a financial firm that incorporates rent-seeking behavior from division managers, risk aversion from outside investors in a context of incomplete market and imperfect competition. We find no evidence for any socialism inside internal capital markets. Indeed we establish that divisions with better investment opportunities and high risk levels are allocated more capiral relatively to other divisions. Divisions with poor investment opportunities and low risk level are allocated more cash wage budget. We also establish a positive correlation between the size of the division and its risk level. This result suggests that large banks are more risky than small ones. This conclusion is in accordance with the idea claimed by many authors, that the wave of merger and acquisitions in the banking industry increases the systemic risk inside the financial system.

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    Paper provided by Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) in its series Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) with number 2002001.

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    Length: 49
    Date of creation: 01 May 2002
    Date of revision:
    Handle: RePEc:ctl:louvir:2002001
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    1. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
    2. Alan J. Auerbach, 1988. "Corporate Takeovers: Causes and Consequences," NBER Books, National Bureau of Economic Research, Inc, number auer88-1, December.
    3. Larry H.P. Lang & Rene M. Stulz, 1993. "Tobin's Q, Corporate Diversification and Firm Performance," NBER Working Papers 4376, National Bureau of Economic Research, Inc.
    4. David S. Scharfstein & Jeremy C. Stein, 2000. "The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment," Journal of Finance, American Finance Association, vol. 55(6), pages 2537-2564, December.
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