Working Paper: NBER ID: w17717
Authors: Gregor Matvos; Amit Seru
Abstract: When external capital markets are stressed they may not reallocate resources between firms. We show that resource allocation within firms' internal capital markets provides an important force countervailing financial market dislocation. Using data on US conglomerates we empirically verify that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model of internal capital market to separately identify and quantify the forces driving the reallocation decision and how these forces interact with external capital market stress. The frictions in internal capital markets drive a large wedge between productivity and investment: the weaker (stronger) division obtains too much (little) capital, as though it is 12 (9) percent more (less) productive than it really is. The cost of accessing external capital funds quadruple during extreme financial market dislocations, making resource allocation within firms significantly cheaper. The estimated model allows us to simulate the propagation of the 2007/2008 financial market dislocation. The counterfactual out of sample simulated data is remarkably consistent with the actual data and shows that improved resource allocation in internal capital markets offset financial market stress during the recent financial crisis by 16% to 30% relative to firms with no internal capital markets.
Keywords: resource allocation; financial market dislocation; internal capital markets; conglomerates; productivity
JEL Codes: D92; E22; G01; G3; L21; L25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Improved resource allocation within firms via internal capital markets (D25) | Mitigates the adverse effects of financial market dislocation (E44) |
| Internal capital markets (G39) | Relative valuation increase for diversified conglomerates (G39) |
| External market conditions (TED spread) (E43) | Internal allocation of capital (G31) |
| Internal capital markets become increasingly valuable when external financing is costly (G32) | Resource allocation efficiency (D61) |
| Stronger divisions receive less capital than warranted (D29) | Distortion in capital allocation due to managerial preferences (D29) |
| Weaker divisions receive more capital than justified (P19) | Distortion in capital allocation due to managerial preferences (D29) |