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Incentives in Internal Capital Markets

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  • Inderst, Roman

    (Sonderforschungsbereich 504)

  • Laux, Christian

    (Sonderforschungsbereich 504)

Abstract

The present paper analyzes the effect of competition for scarce corporate financial resources on managers' incentives to generate profitable investment opportunities. Competition is only unambiguously beneficial if projects are symmetric. If they are asymmetric, competition for corporate financial resources may reduce incentives. This finding may provide a rationale for the diversification discount that is distinct from the explanations based on an inefficient allocation of corporate financial resources. Contracting on the allocation of funds may increase the investment allocation's sensitivity to the quality of investment opportunities and overcome some of the problems when projects are asymmetric. Hence, distorted capital allocation in an internal capital market may serve the purpose of increasing managers' incentives. Finally, we show that profits may decrease if a cash cow project is integrated into an existing internal capital market as this reduces competition. Based on this finding we argue that creating financial constraints may be an optimal response to managerial incentive problems.

Suggested Citation

  • Inderst, Roman & Laux, Christian, 2000. "Incentives in Internal Capital Markets," Sonderforschungsbereich 504 Publications 00-47, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
    • Handle: RePEc:xrs:sfbmaa:00-47
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    Cited by:

    1. Brusco, Sandro & Panunzi, Fausto, 2005. "Reallocation of corporate resources and managerial incentives in internal capital markets," European Economic Review, Elsevier, vol. 49(3), pages 659-681, April.
    2. Felipe Balmaceda, 2002. "Corporate Diversification: Good for Some Bad for Others," Documentos de Trabajo 141, Centro de Economía Aplicada, Universidad de Chile.
    3. Giorgio Barba Navaretti & Giacomo Calzolari & Alberto Franco Pozzolo & Micol Levi, 2010. "Multinational banking in Europe – financial stability and regulatory implications: lessons from the financial crisis [Cross subsidies, external financing constraints, and the contribution of the in," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 25(64), pages 703-753.
    4. Gautier, Axel & Heider, Florian, 2002. "The Benefit and Cost of Winner Picking: Redistribution Vs Incentives," Bonn Econ Discussion Papers 31/2002, University of Bonn, Bonn Graduate School of Economics (BGSE).
    5. Stein, Jeremy C., 2003. "Agency, information and corporate investment," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 2, pages 111-165, Elsevier.
    6. Axel Gautier & Florian Heider, 2001. "What Do Internal Capital Markets Do? Redistribution vs. Incentives," FMG Discussion Papers dp386, Financial Markets Group.

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