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Internal versus External Capital Markets

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  • Robert H. Gertner
  • David S. Scharfstein
  • Jeremy C. Stein

Abstract

This paper presents a framework for analyzing the costs and benefits of internal vs. external capital allocation. We focus primarily on comparing an internal capital market to bank lending. While both represent centralized forms of financing, in the former case the financing is owner-provided, while in the latter case it is not. We argue that the ownership aspect of internal capital allocation has three important consequences: 1) it leads to more monitoring than bank lending; 2) it reduces managers' entrepreneurial incentives; and 3) it makes it easier to efficiently redeploy the assets of projects that are performing poorly under existing management.

Suggested Citation

  • Robert H. Gertner & David S. Scharfstein & Jeremy C. Stein, 1994. "Internal versus External Capital Markets," NBER Working Papers 4776, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:4776
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    References listed on IDEAS

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    1. Hart, Oliver & Moore, John, 1990. "Property Rights and the Nature of the Firm," Journal of Political Economy, University of Chicago Press, vol. 98(6), pages 1119-1158, December.
    2. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-1366, September.
    3. Aghion, Philippe & Tirole, Jean, 1997. "Formal and Real Authority in Organizations," Journal of Political Economy, University of Chicago Press, vol. 105(1), pages 1-29, February.
    4. Hart, O. & Moore, J., 1989. "Default And Renegotiation: A Dynamic Model Of Debt," Working papers 520, Massachusetts Institute of Technology (MIT), Department of Economics.
    5. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
    6. Patrick Bolton & David S Scharfstein, 1993. "Optimal Debt Structure with Multiple Creditors," CEPR Financial Markets Paper 0032, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
    7. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 691-719, August.
    8. Paul Asquith & Robert Gertner & David Scharfstein, 1994. "Anatomy of Financial Distress: An Examination of Junk-Bond Issuers," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 625-658.
    9. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
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