PDF-JFE 04 71 2-4 Bailout and Conglomeration

7/27/2019 PDF-JFE 04 71 2-4 Bailout and Conglomeration

http://slidepdf.com/reader/full/pdf-jfe-04-71-2-4-bailout-and-conglomeration 1/33

Journal of Financial Economics 71 (2004) 315–347

Bailout and conglomeration$

Se-Jik Kima,b,*aResearch Department, International Monetary Fund, Washington, DC 20431, USA

bKorea Institute for International Economic Policy, Yomgok-dong, Seoul, South Korea

Received 10 May 2002; accepted 5 November 2002

Abstract

This paper develops a model of business groups in emerging markets where banks cannot

accurately distinguish between good (high productivity) and bad (low productivity) borrower

firms. For stand-alone firms, banks can infer the proportion of bad firms among those that

default on contracted debt repayments, and might optimally choose to liquidate all defaulting

firms in order to reduce the number of bad firms. Business groups, however, obscure the

productivity of individual firms. The optimal policy might then be full bailout so as not to riskeliminating good firms. Given the bank’s bailout policy, risk-averse firms might form a

conglomerate to reduce the risk of liquidation.

r 2003 Elsevier B.V. All rights reserved.

JEL classificaion: G14; G21; G33; L22

Keywords: Bailout; Business groups; Bank loans; Institutions

1. Introduction

It is well known that in emerging markets with weak institutions, business

conglomerates often play a dominant role in private sector activity. This raises

important questions: Why are business groups so pervasive in these markets? More

ARTICLE IN PRESS

$I am very grateful to Leonardo Bartolini, Patrick Bolton, Eduardo Borensztein, Haizhou Huang,

Simon Johnson, E. Han Kim, Assaf Razin, Hyun Song Shin, an anonymous referee, and participants in

the seminar at the IMF research department, Harvard Institute for International Development, the Bank

of Korea, and the 2000 AEA/KAEA Meetings for valuable comments. The views expressed in this paperare those of the author, and do not necessarily represent those of the IMF.

*Corresponding author. Tel.: 00-1-202-623-9020; fax: 00-1-202-623-4740.

E-mail address: [email protected] (S.-J. Kim).

0304-405X/$ - see front matter r 2003 Elsevier B.V. All rights reserved.

doi:10.1016/S0304-405X(03)00191-0



specifically, what are the key benefits of forming a business conglomerate in

emerging market economies, where bank loans account for a large share of corporate

financing? This paper presents a theory of business groups. In particular, I develop a

model suggesting that business groups arise because in the event of default, group-affiliated firms have a higher chance of being bailed out by the bank than do

unaffiliated firms.

The key questions of this paper bear on recent empirical literature that has

evaluated whether affiliation with a business group is associated with superior or

inferior corporate performance. In advanced economies like the U.S., it has been

well documented that highly diversified corporations tend to systematically

underperform focused corporations (e.g., Lang and Stulz, 1994; Shin and Stulz,

1998; Rajan et al., 2000). The underperformance or ‘‘discount’’ of diversified firms is

often thought to reflect agency problems and the resulting inefficiency of resource

allocation through internal capital markets. For example, Scharfstein and Stein

(2000) suggest that the rent-seeking behavior of division managers can induce

inefficient cross-subsidization or overspending in poorly performing divisions.

However, the benefits of group affiliation might be totally different in emerging

markets than in developed economies, given that the optimal corporate structure

could critically depend on the institutional environment. Some recent studies have

empirically explored the performance of group-affiliated firms in emerging markets

in a cross-country context and found that business groups erode the value of firms

(e.g., Mitton, 2002; Lins and Servaes, 2001; Lemmon and Lins, 2001). For example,

using a sample from seven Asian emerging markets, Lins and Servaes (2001) findthat firms belonging to business groups trade at a discount compared to unaffiliated

firms. Further, some researchers have begun to study individual emerging market

economies to evaluate how country-specific institutional factors affect the value

creation of business groups or politically connected firms in the economy (e.g.,

Khanna and Palepu, 2000; Joh, 2003; Bae et al., 2002; Johnson and Mitton, 2003; La

Porta et al., 2002). In the case of India, Khanna and Palepu (2000) find that affiliates

of the most highly diversified Indian business groups outperform the unaffiliated

firms, which suggests that internal capital markets within Indian groups effectively

mimic the functions provided by financial markets in advanced economies. However,

Joh (2003) finds evidence that group-affiliated firms in Korea have lower profitabilitythan stand-alones, and Bae et al. (2002) also find, using merger activity data, that

Korean business groups erode the value of firms. They interpret their evidence as

reflecting the transfer of resources out of a company to its controlling shareholders,

which is dubbed ‘‘tunneling’’ by Johnson et al. (2000b). Further, Johnson and

Mitton (2003) find that some of the loss in market value for politically connected

Malaysian firms during the recent financial crisis can be attributed to the fall in the

value of their political connections. La Porta et al. (2002) suggest that related loans

in Mexico take place on better terms than arm’s-length lending, though with higher

default rates.

Despite such a large and growing body of empirical literature, however, the modelof business groups in emerging markets has rarely been explored, with the exception

of a study by Wolfenzon (1999) that focuses on the effect of pyramidal groups on the

ARTICLE IN PRESS

S.-J. Kim / Journal of Financial Economics 71 (2004) 315–347 316



controlling shareholders’ expropriation of minority shareholders.1 In particular,

there have been few studies addressing key financial motives for conglomeration in

emerging markets where corporate financing depends heavily on bank loans and

hence the bank’s choice between bailout and liquidation is of critical importance.2

My theory of business groups in emerging markets, notably Korean chaebols, fills

the gap between the empirical and theoretical literature. In particular, this theory

could explain business groups in economies where corporate financing depends

heavily on bank loans. The theory is partly motivated by the fact that in most

developing economies with weaker investor protection, the stock market is less

developed and the bank loan is an important, and often the most important, source

of corporate financing.3 The debt-equity ratios of Korean firms, for example,

reached 350% on average in 1996, with bank loans taking the major share of

corporate debts. Given the importance of bank loans in emerging markets, the main

focus of my theory is naturally on the interactions between the lender banks and the

borrower firms, particularly the interrelationship between bank bailouts and the

conglomeration of firms. This is in sharp contrast to most existing studies (including

the formal model of Wolfenzon), which have focused on agency problems between

controlling shareholders and minority shareholders that could be more serious in

economies with heavy dependence on stock market financing.

The key idea of the theory is that conglomeration is a device designed by firms to

maximize the chance of bailout (or minimize the risk of liquidation) in the event of

default on their bank loans. Given the institutional environment this paper focuses

on (that is, high dependence on bank loans relative to equity), firms can easily fallinto default when they experience adverse shocks. The bank’s refusal to bail out a

firm that is in default would mean that the firm loses everything. Hence, firms with

a large bank loan try hard to secure a bailout or raise the chance of a bailout as a

precaution in case of a possible default in the future. An effective mechanism for

achieving this goal is conglomeration: an affiliation with a business group can raise

the chance of bailout, because conglomerates (formed through cross-debt payment

ARTICLE IN PRESS

1See Prescott and Townsend (1999) for a model of collective organizations. Although it is not exactly a

model of business groups, it suggests that collective organizations share risk and mitigate moral hazard

through joint monitoring or joint operation of technology.2 In general, theoretical work on institutions and corporate finance in emerging markets, let alone

conglomeration, is only just beginning. Shleifer and Wolfenzon (2000) develop a simple equilibrium model

to examine how poorer shareholder protection affects the entrepreneur’s decisions on equity financing and

expropriation of shareholder wealth. Acemoglu et al. (2002) present a model where the firm’s (or the

capitalist’s) choice on the age and skill of a manager depends on the stage of development and institutional

environment. These two studies do not address the issues of business conglomerates and the bank’s bailout

decision, however.3See La Porta et al. (1997) for the role of investor protections in the development of equity markets. See

also, e.g., La Porta et al. (1998, 2000), Johnson and Shleifer (2000), Friedman and Johnson (2000),

Johnson et al. (2000a), Claessens et al. (2000), and Glaeser et al. (2001) for a variety of recent studies on

corporate governance. For example, Johnson et al. (2000a) show that weaker legal institutions for

corporate governance have stronger adverse effects on the extent of currency depreciation and stock

market declines, as experienced in the Asian crisis.




guarantees) can obscure the information that would be used by the bank in deciding

whether or not to liquidate defaulting firms.

To develop the theory more formally, this paper presents a heterogeneous agent

model of business conglomerates, particularly in emerging market economies withweak institutions. In particular, the model assumes that there are two types of firms

which stochastically differ in productivity: good firms and bad firms. While both

types can receive a positive productivity shock, good firms have a higher probability

of doing so than bad firms. In addition, the size of a positive shock is the same

regardless of whether the firms are categorized as good or bad. The model also

assumes the prevalence of weak banking institutions that do not have sufficient

capability to accurately distinguish between good and bad firms. This assumption

captures the fact that in emerging markets, the capacity of banks to assess the

profitability of firms is often far less developed than in advanced economies.

However, banks can obtain information on repayments of the borrower firms.

According to a debt contract, each firm that borrows from the bank must repay a

pre-specified amount to the bank after the productivity shock is revealed. Given that

only firms that have had a positive productivity shock can repay, the bank can

observe whether each borrower firm repays or not. In addition, control of the

defaulting firm passes to the bank, as assumed in the incomplete contracting theory

of debt (e.g., Hart, 1995; Hart and Moore, 1994; Bolton and Scharfstein, 1990, 1996;

Townsend, 1979).

In addition, the model assumes that the key function of business conglomerates is

to cross-guarantee debt payments. Cross-debt payment guarantees allow defaultedmembers of a conglomerate to raise financing with backing from non-defaulted

members. In many emerging markets, cross guarantees, including implicit forms

such as cross shareholdings, are huge. A notable example is Korea where cross-debt

payment guarantees (even after excluding implicit forms) reached over 300% of

paid-in capital for the 30 largest conglomerates in the early 1990s. The cross

guarantees indeed have often been considered a key financial motive for

conglomeration and even a chief culprit in the recent crisis in East Asian

countries.

Further, the model assumes weak institutions with regard to information

disclosure of the firms. In particular, there is no law or regulation that forces aconglomerate to disclose accurate information about its individual member firms. As

a result, when a conglomerate is in default, the bank cannot tell which of the member

firms is responsible. This assumption reflects the fact that in emerging market

economies, legislated disclosure requirements are often weak and inadequate (see La

Porta et al., 1997, 1998). In Korea, for example, before the 1997 financial crisis,

business conglomerates were not required to report combined financial statements

that net out intra-group transactions, nor to prepare financial statements that are

audited in accordance with international standards. As a result, the extent of hidden

information has often been substantial. In the case of the Daewoo group, the hidden

deficit found after its collapse in 1999 amounted to $40 billion.Under the assumptions of the model described above, several important

conclusions follow. First, the bank’s liquidation of defaulted firms (rather than

ARTICLE IN PRESS




bailout) can be used as a screening device to select good firms. Given a debt contract,

the bank observes whether each of the borrower firms repays or not on the

repayment day. When repayments of individual firms are observed, the bank still

cannot tell whether a particular firm is good or bad, but can make an inference aboutthe probability that a defaulting firm is good or bad given the underlying probability

distribution of good and bad firms. Based on this signal extraction, the bank can

make the choice between bailout or liquidation of defaulted firms. The choice

depends on the benefits and costs of liquidation (or the costs and benefits of bailout).

Liquidation is costly since it implies a reallocation of capital from one firm to

another, which requires some adjustment costs. On the other hand, liquidation is

beneficial because it prevents bad firms from operating alongside good firms, and

therefore raises capital productivity and output in the future. If the chance of bad

firms among the defaulted is much higher than among the non-defaulted, and hence

the benefit is larger, the optimal policy will be a ‘‘no-bailout’’ (or ‘‘full liquidation’’)

policy.

Second, given weak information disclosure, the presence of conglomerates

could change the bank’s optimal bailout decision from zero bailout to full bailout.

The intuition is clear. For stand-alone companies, the bank might find it optimal

to liquidate all defaulters. This is because the bank can obtain some information

on the productivity of each stand-alone firm based on whether it repays or not, and

the default (non-repayment) of a stand-alone firm is more likely to reflect its

underlying low productivity. In this case, the benefit of liquidation due to

improvement in the quality of borrower firms might outweigh its cost. In contrast,for conglomerates, the optimal policy might be full bailout. Under the cross-

guarantee contract, all the member firms belonging to a conglomerate can default

regardless of the productivity shock. Given no mechanism for information

disclosure, the bank can then observe the default of a conglomerate as a whole,

but cannot obtain any information on the productivity shock to each member firm.

That is, the default of a conglomerate does not provide a sufficient signal to the

bank. Under these circumstances, the conglomerate as a whole (formed from both

good and bad firms in the original sample) might not be sufficiently bad to be

liquidated, and therefore the benefit of liquidation might not be large enough to

justify the cost.Third, given the bank’s optimal bailout policy, risk-averse firms with rational

expectations might prefer forming a conglomerate because they can use it as an

information-diluting device. Because firms are aware that there would be full bailout

for defaulting conglomerates, a moral hazard problem arises. By joining a

conglomerate, individual firms can dilute the information that can be extracted by

the bank from the default of firms after the revelation of productivity shocks. The

information-diluting or noise-signaling strategy allows firms to avoid liquidation by

reducing the bank’s incentive to liquidate them. This explains the fact that in

emerging markets, large conglomerates tend to be bailed out by the bank much more

frequently than do stand-alone firms. In Korea, for example, liquidity constraintsthat could lead to bankruptcy are more stringent for non-conglomerates than for

conglomerate firms (Hahm et al., 1998).

ARTICLE IN PRESS




Finally, the model suggests that conglomeration can induce a lower gross domestic

product and that the equilibrium with conglomerates can be suboptimal. The reason

is that conglomeration prevents the bank from enhancing the quality composition of

the corporate sector (and hence the average productivity of capital invested) in aneconomy. This result matches the recent experience of some emerging market

economies like Korea, where business conglomerates have lower profitability than

stand-alone firms (e.g., Joh, 2003; Bae et al., 2002). This result is also consistent with

recent corporate sector reforms in the crisis-hit Asian countries under the IMF

program, whose key elements included strict regulations on cross-debt payment

guarantees and cross shareholdings of business conglomerates (see, e.g., Chopra

et al., 2002; Berg, 1999).

The model used in this study can be adapted to accommodate three slightly varied

situations: a case in which a conglomerate is formed by a single entrepreneur; a case

in which loans can have different maturities; and a case in which there is a central

bank. However, these variations do not alter the results of this study on a bank’s

ultimate decision about its optimal bailout policy.

The remaining sections of this paper are organized as follows. Section 2 presents

the basic model. Sections 3 and 4 examine the bank’s optimal bailout policy in the

case of stand-alones and conglomerates, respectively. Section 5 analyzes the firms’

optimal decision on conglomeration, and Section 6 discusses some extensions of the

model. Section 7 concludes the paper.

2. The basic model

The model emerging market economy, which incorporates a heavy dependence on

bank loans for corporate financing (possibly due to weak investor protection), has

two types of players: firms and banks. The economy lasts two periods, t ¼ 1; 2:

2.1. Firms

The economy consists of a continuum of risk-averse entrepreneurs defined on the

interval ½0; 1: Each entrepreneur is the sole owner of a firm (with this assumption,there is no agency problem between controlling and minority shareholders). They

have no wealth of their own in the initial period, but can borrow capital for

production from the bank.

Firms produce a homogeneous output using capital as the only input given a

linear technology yt ¼ Atk t; where k t is the amount of capital invested and At is

the contemporaneous firm-specific productivity shock, which can vary across

firms. The assumption of heterogeneous productivity and homogeneous output

allows us to focus on the effect of business conglomerates on quality composition

but to assume away the issue of diversification across different products or

industries.Firms come in two varieties, good (high average productivity) and bad (low

average productivity), depending on the probability distribution of productivity

ARTICLE IN PRESS




shocks. The idiosyncratic shock affecting good firms, which is independently

distributed across periods ðt ¼ 1; 2Þ and agents, is given by

At ¼ A with probability p;0 with probability 1 À p;

(ð1Þ

while the shock affecting bad firms is

At ¼A with probability d; dop;

0 with probability 1 À d:

(ð2Þ

That is, good firms get the positive shock A > 0 with a higher probability, p; in each

period. This is the crucial difference between good and bad firms: good firms are, a

priori or on average, more productive than bad firms, guaranteed by the restriction

p > d:In the model, however, the type of each individual firm is not known to the bank,

capturing the fact that in emerging markets, the bank’s capability to distinguish

between good and bad firms is less developed than in advanced economies. For

simplicity, the type of an individual firm is also not known to the entrepreneur of

that firm at the beginning of the first period (Appendix A studies the case of private

information where each entrepreneur knows his or her own type while others do

not). Even after the productivity shock is revealed, the firm type cannot be known

for certain because the size of the positive shock is the same ðAt ¼ AÞ for both types.

Hence the incomplete information persists in the final period (the second period

here). At the beginning, some fraction x of the firms are good and the rest are bad.

The parameters ðp; d; xÞ are known to everybody in the economy at the beginning of

the first period.

2.2. Conglomeration

Entrepreneurs can form a business conglomerate based on a contract of cross-debt

payment guarantees with others (cross guarantees can take implicit forms such as

cross shareholdings). According to the cross- guarantee contract, member firms that

have had a good productivity shock in the first period are obliged to raise financingto make debt repayments for members that have had a bad productivity shock.

The contractibility of the cross guarantees depends on who the members are.

There are nðX1Þ groups, each of which is populated with a continuum of

entrepreneurs of measure qðo1=nÞ: For simplicity, these n groups of people are

called ‘‘families’’ throughout the paper. The ‘‘family’’ here can be interpreted not

only as people with blood relations, but also as a tight network of friends who can

easily acquire information from and effectively enforce contracts between each other.

In Korea, for example, many chaebols are controlled by close relatives from one

family—the Doosan group is run by four brothers from the Park family, and the

Kumho group by brothers from another Park family. But there are also differenttypes of chaebols. The LG group has been run by brothers from two different

families with close relationships (the Koo and Huh families), and many of the top

ARTICLE IN PRESS




managers of the Daewoo group attended the same high school (see Jung-Ang Ilbo,

1996). Even in the case of Korean conglomerates run by one family, their close

friends usually participate in the chaebol as top executives. Close ties of relatives and

friends have also been reported to decide the amount of commercial loans and theterms of borrowing in Mexico (La Porta et al., 2002), and to affect the market value

of firms in Malaysia (Johnson and Mitton, 2003). Furthermore, social ties that are

tight enough to facilitate collective punishment as a contract enforcement

mechanism are reported to have existed even among the eleventh-century Maghribi

traders (Greif, 1993).

The output of a firm run by an entrepreneur who belongs to one of the n families is

observable (and verifiable) to those belonging to the same family, but not to others.

In addition, the contract of cross guarantees is enforceable without costs among

those belonging to the same family (for example, through inner-family punishment

such as ostracism). This allows the cross guarantees of debt payment in the first

period to be contractible among those who belong to the same family. Given this

assumption, a conglomerate founded by a family can emerge (the case of a

conglomerate founded by one entrepreneur will be discussed in Section 6). In

addition, the size of a conglomerate is restricted to that of a family or smaller. 4

To have some unaffiliated firms in the model, I assume that there are

entrepreneurs (with a measure of 1 À nq) who do not belong to any of the n families

and hence cannot make any effective contract of cross guarantees. For simplicity, I

also assume that there is no profit sharing through cross shareholdings, and therefore

each member of a conglomerate gets its own profit. This assumption can be easilyrelaxed without altering the main results of the paper because cross shareholdings

play the same role as cross guarantees in eliminating the risk of being liquidated. The

substitutability between cross guarantees and cross shareholdings is illustrated by the

recent experience in Korea. Under the IMF rescue program, the government of

crisis-hit Korea forced the top 30 conglomerates to reduce cross-debt payment

guarantees from 55.9% of paid-in capital in 1996 to 9.7% in 1999. In response,

however, the Korean conglomerates raised the portion of cross shareholdings from

33.3% to 44.1% during the same period.

At the beginning of the first period, each entrepreneur makes a decision about

whether to join a conglomerate or not, to maximize expected utility. All theentrepreneurs in the economy have an identical utility function that depends only on

consumption in the final period (i.e., the second period in our two-period model),

uðc2Þ: Each entrepreneur, regardless of joining a conglomerate, has only one income

source which is his or her own profit, and therefore seeks to maximize the expected

utility derived from firm profits in the second period.

ARTICLE IN PRESS

4Differences in information and enforcement costs across families could explain why a large portion of

conglomerates, particularly in emerging markets, are family owned or family based. Using data on 27

economies, La Porta et al. (1999) find that large corporations are typically controlled by families or the

state. Burkart et al. (2002) suggest that family firms that are often inherited over several generations are

prevalent in emerging markets, reflecting financial underdevelopment and less effective legal protection of

shareholders of the counties.




2.3. The bank and debt contract

The economy has a risk-averse representative bank interacting with heterogeneous

firms. The bank here can be interpreted as representing the banking system, whichincludes not only commercial banks and other financial institutions that make loans

to firms, but also the central bank which often works as the lender of last resort and

final decision-maker for bailouts (the case of distinguishing between different types

of banks will be discussed in Section 6).

At the beginning of the first period, the representative bank has k amount of

money to lend.5 The bank can fully diversify risks, and seeks to maximize its

expected revenues at the end of the final period (the second period), denoted by V :The bank does not own any production technology, so it has to lend all its money to

entrepreneurs.

It makes loans according to a debt contract that specifies an initial payment on the

loan to be made at the end of the first period (denoted by d ); if firms are not able to

pay the required initial payment d ; they are declared in default. Bolton and

Scharfstein (1996) call this type of default liquidity defaults, and distinguish them

from strategic defaults that occur because managers want to divert cash to

themselves. To focus on the effect of liquidation on the quality composition of

capital, I do not explicitly introduce strategic defaults.

The bank, which does not know the type of each firm, cannot directly observe an

individual firm’s output regardless of whether the firm is affiliated or unaffiliated. As

a result, the bank cannot tell which member of a defaulting conglomerate isresponsible for the default. This captures the fact that institutions in emerging

markets are weak with regard to information disclosure.

However, the bank observes whether each borrower firm makes its contracted

first-period repayment or not, and therefore can distinguish the firms that pay d from

those that cannot (or the non-defaulted from the defaulted). In this way, d works as

a monitoring device.

In case of default, control of all the assets of the firm (particularly on physical

capital k ) passes to the bank. The bank can then bail out the failed firm by lending it

an amount of money d so that it can meet the first-period repayment requirement.

This type of bailing out is equivalent to rolling over, or not requiring the failed firmsto pay d to the bank.

Alternatively, the bank can liquidate the firm. The liquidation of a firm and

transfer of its capital to a new firm generates costs. More specifically, if k amount of

capital is liquidated by the bank, the post-liquidation value of capital is given by

L ¼ lk ; where l Að0; 1Þ is a positive constant capturing the liquidation value of capital

ARTICLE IN PRESS

5The current model, for simplicity, does not explicitly introduce households as depositors or investors.

However, we could interpret that its money to lend ðk Þ originates from households’ deposits or savings. Of

course, if we explicitly introduced households’ optimal saving behavior, it could then be shown that the

size of initial deposits saved by the households ðk Þ is affected by the bank’s bailout-liquidation decision. In

particular, higher liquidation (i.e., lower bailout) of defaulted firms would raise the productivity of capital

by transferring capital from failed firms to non-failed firms, which in turn may boost household savings.




relative to its original value. Since l is less than one, the bank’s liquidation of a firm is

costly. The smaller l is, the more costly liquidation is.

The bank decides on the fraction f of the defaulted stand-alone firms it bails out

and, correspondingly, the fraction ð1 À f Þ it will liquidate. It also decides on thefraction f C of the defaulted conglomerates it bails out.

In addition, the debt contract recognizes that the bank has access to a technology

(e.g., court system, reputational punishment, etc.) that allows it to claim a fraction

fðo1Þ of the second-period output produced by any firm (regardless of

conglomeration). Notice that the debt contract explicitly allows for default,

liquidation, bailout (forgiveness), and incomplete recovery in the second period.

2.4. Timing of events

The model’s timeline is presented in Fig. 1. The model economy has two periods,

t ¼ 1; 2: The first period consists of the following sequence of events. At the very

beginning, the bank lends capital across firms. At the second stage, firms decide on

whether to join a conglomerate or not. Then the firms engage in production activity

using capital borrowed from the bank, which is followed by the stage where the

idiosyncratic productivity shock ðA1Þ is revealed. At the final stage, based on

production outcome affected by the productivity shock, repayment occurs.

The assumption that the bank’s lending precedes the firm’s conglomeration

decision is innocuous. To illustrate, imagine that the bank makes a lending decision

after finding out which firms join conglomerates and which do not, and preferslending only to stand-alones. Firms then would declare that they will remain stand-

alones to receive loans from the bank, before the bank’s loan decision. However,

once the bank loan is made, firms might revoke their early stand-alone declaration

and join a conglomerate if there is no mechanism to enforce the declaration.

Expecting such behavior from the firms, the bank would be indifferent to whether

the loan is made before or after the firm’s decision on conglomeration. Further,

commercial banks might prefer making loans to group-affiliated firms rather than

stand-alones even when firms’ decisions on joining a conglomerate precedes banks’

loan decisions. To illustrate, assume that the central bank, having enough liquidity

for bailout, works as a final decision-maker on the bailout-liquidation choice. Alsosuppose that individual commercial banks, which do not have enough liquidity, can

ARTICLE IN PRESS

Fig. 1. Sequence of events.




make loans to only a few firms so that they cannot fully diversify their lending risks.

In this case, the central bank would find it optimal to bail out group-affiliated firms.

Expecting such behavior of the central bank, small commercial banks would prefer

making loans to conglomerates, which could substantially reduce their loan risks.Therefore, the timing assumption does not alter the main results of the paper, such as

a higher optimal bailout ratio for conglomerates.

In the second period, the bank makes its capital allocation decisions, the key

decision being the bailout decision—whether to forgive defaulted firms (and by

doing so, to let them continue to use capital), or not to forgive them (hence to

transfer the capital to non-defaulted firms). Then non-defaulted firms and defaulted-

but-bailed-out firms engage in production using capital reallocated by the bank,

which is followed by the revelation of the productivity shock ðA2Þ and the second-

period repayment. Finally, agents in the economy consume what they end up with.

3. Liquidation as a screening device

Let us now examine the bank’s optimal decisions, of which the most important is

the bailout decision made at the beginning of the second period. This section focuses

on the case where there is no conglomerate, and illustrates how non-bailout (or

liquidation) can be used as a screening device among heterogeneous firms.

At the beginning of the first period, the bank decides how to allocate capital

among the different firms. The decision in the first period is trivial. The risk-aversebank lends the same amount to all firms. By doing so, the bank, which cannot

distinguish good firms from bad, can fully diversify its risks. The amount loaned to

each firm is k ; given the assumption of a continuum of entrepreneurs defined on the

interval ½0; 1:After the firms engage in production with the initially allocated capital k ; the first-

period idiosyncratic productivity shock is revealed. Then two groups of firms

emerge—those with a shock realization equal to A1 ¼ A and those with a shock

realization A1 ¼ 0: The firms in the first group produce the same amount of output

ð y1 ¼ Ak Þ; while the firms in the second group produce nothing ð y1 ¼ 0Þ: Note that

both groups of firms include high- and low-productivity firms, and in a rationalexpectations equilibrium the proportion of these firms in the firm population is well

known as shown below.

At the end of the first period, based on the productivity shock, repayment takes

place. If the output of a firm in the first period is not sufficient to cover the payment

due on the loan, d ; the firm is declared in default and control passes to the bank. To

ensure that d works as a monitoring device, the firms that produce nonzero outputs

in the first period should not default and the firms that produce nothing should be in

default. So the bank sets d at any level to satisfy the condition 0od oAk :In the beginning of the second period, the bank makes a decision on whether to

bail out the defaulted firms or liquidate them. This bailout-liquidation choice is a keydecision on capital allocation for the second period. Note that if the bank could

accurately identify good and bad types among the failed firms, it would bail out only

ARTICLE IN PRESS




the good types and let the bad types go bankrupt. But this is not possible, since the

only means for the bank to evaluate the firms is by observing whether they have

repaid d or not. The condition of incomplete information thus persists even at

the beginning of the second period when bailout or liquidation should occur (as atthe beginning of the first period when lending occurs); the type of each firm cannot

be verified even after its first-period repayment is observed.

To analyze the decision of the bank at the beginning of the second period, denote

the number (more precisely, the measure) of failed and surviving firms at the end of

the first period by N f and N s; respectively. Since xp good firms and ð1 À xÞd bad

firms have a positive shock in the first period ðA1 ¼ AÞ; the measures of surviving

and failed firms at the end of the first period are given by

N s ¼ xp þ ð1 À xÞd; ð3Þ

N f ¼ 1 À N s ¼ xð1 À pÞ þ ð1 À xÞð1 À dÞ: ð4Þ

Therefore, in the sample of defaulted firms at the end of the first period there are

xð1 À pÞ good firms and ð1 À xÞð1 À dÞ bad firms, for a total of N f :Note that the restriction p > d guarantees that the ratio of surviving good firms to

total surviving firms at the end of the first period will be higher than the ratio of

failed good firms to total failed firms:

xp

xp þ ð1 À xÞd>

xð1 À pÞ

xð1 À pÞ þ ð1 À xÞð1 À dÞ: ð5Þ

Notice that the expression on the left side of (5) denotes the conditional probability

that a firm which does not fail at the end of the first period is good, while the

expression on the right denotes the conditional probability that a firm which has

failed is good. This expression suggests that due to the repayment observation

following the revelation of the shock in the first period, the bank can partially

separate two groups whose expected productivities differ, and therefore may have

better capital allocation in the second period.

How does the bank determine which firms to bail out and which to liquidate?

Recall that the bank cannot determine which of the failed firms are good and which

are bad. It therefore makes its bailout decision not firm by firm, but as a fraction of the aggregate. At the beginning of the second period, the bank has to decide on the

fraction f of failed firms that it will bail out, though which firms are bailed out

is randomly determined. Therefore, the bank bails out fxð1 À pÞ good firms and

f ð1 À xÞð1 À dÞ bad firms.

This bailout affects the capital allocation. The bank lends money d to failed but

bailed-out firms. With the bailout money (whose total is fdN f ), the firms will then

repay the same amount of money to the bank so that they can meet the repayment

requirement. Hence, there will be no change in the bank’s money position induced by

bailout. However, the bank’s capital position will increase because of the repayments

of non-failed firms and the liquidation of some failed firms. Total revenue fromrepayments of surviving firms amounts to ð1 À N f Þd ; while the revenue from

liquidation is ð1 À f ÞN f lk : Therefore, the total cash flow from liquidation and

ARTICLE IN PRESS




repayment is given by F ¼ ð1 À N f Þd þ ð1 À f ÞN f lk : After receiving repayments and

making liquidations, the bank has additional capital in the amount F to lend to firms

for their operations in the second period.

For simplicity, assume that output can be reinvested and hence transformed intocapital without any cost. In addition, capital does not depreciate, and is irreversible

so that it cannot be transformed into consumption goods. These assumptions are

innocuous and substantially simplify the calculations in the latter part of this paper.

Now suppose that the bank lends all of the capital to firms for production in the

second period. In addition, suppose that each firm that has defaulted but has been

bailed out does not receive new capital, while each firm that has not defaulted in the

first period receives the same amount of additional capital at the beginning of the

second period (we can show that under certain conditions, this capital allocation rule

is the result of the bank’s optimal decision on the allocation of new capital across

surviving firms and bailed-out firms). Then, the amount of capital that a bailed-out

firm has in the second period, denoted by k B2 ; is given by

k B2 ¼ k ð6Þ

which is the same as in the first period.

But the capital of a firm that has not failed, denoted by k S2 ; is given by

k S2 ¼ ððA þ 1Þk À d Þ þ d þ ð1 À f Þlk N f

1 À N f

ð7Þ

where the first item of the right side, ððA þ 1Þk À d Þ; represents the residual after

repayment per firm, and the second item captures the total additional capital given to

each surviving firm, which must be equal to the total amount obtained from

liquidation and repayment divided by the number of surviving firms, ð1 À N f Þ:Then what fractions of good and bad firms produce positive output and pay the

bank in the first and second period, respectively? And what fractions produce and

pay nothing in each of the two periods? Given Eqs. (1) and (2), xp good firms and

ð1 À xÞd bad firms have positive output ð y1 ¼ Ak Þ and repay d to the bank in the first

period. And the p fraction of the former and d fraction of the latter, that is, xp2 good

firms and ð1 À xÞd2

bad firms, have positive outputs and make repayments in thesecond period as well (as illustrated in Table 1). But xpð1 À pÞ good firms and

ð1 À xÞdð1 À dÞ bad firms, though having produced positive outputs in the first

period, have zero output in the second period.

In addition, xð1 À pÞ good firms and ð1 À xÞð1 À dÞ bad firms have zero output

ð y1 ¼ 0Þ and hence cannot repay d to the bank in the first period. If the bank bails

out fraction f of them, ð1 À f Þxð1 À pÞ good firms and ð1 À f Þð1 À xÞð1 À dÞ bad

firms cannot participate in production in the second period, while fxð1 À pÞ good

firms and f ð1 À xÞð1 À dÞ bad firms can. Then fraction p of bailed-out good firms and

fraction d of bailed-out bad firms, that is, fxð1 À pÞp good firms and f ð1 À xÞð1 À dÞd

bad firms, have positive outputs in the second period even though they producednothing in the first period. But fxð1 À pÞ2 good firms and f ð1 À xÞð1 À dÞ2 bad firms

have zero output in the second period as well.

ARTICLE IN PRESS




The expected second-period total output of firms that have been bailed out is thengiven by

EY B ¼ f fxð1 À pÞp þ ð1 À xÞð1 À dÞdgAk

fN f ;sAk ; ð8Þ

where N f ;s represents the measure of the firms that have an adverse shock in t ¼ 1;but a favorable shock in t ¼ 2; that is, N f ;s xð1 À pÞp þ ð1 À xÞð1 À dÞd:

The expected second-period total output of firms that have not defaulted at the end

of the first period is

EY S ¼ fðxpÞp þ ðð1 À xÞdÞdgAk S2

N s;sA ðA þ 1Þk þ ð1 À f Þlk N f

1 À N f

; ð9Þ

where N s;s is the measure of the firms that have positive shocks in both t ¼ 1 and

t ¼ 2; that is, N s;s xp2 þ ð1 À xÞd2:Note that from the standpoint of the bank, firm-specific idiosyncratic shocks can

be fully diversified. Hence the risk-averse bank does not need to be concerned about

the variability of total revenue from lending, which depends on the total output of

the borrower firms. Because of the law of large numbers, the expected output is equalto the actual output: EY B ¼ Y B and EY S ¼ Y S; where Y B and Y S represent the

actual total output for bailed-out firms and surviving firms, respectively.

ARTICLE IN PRESS

Table 1

Productivity shock, output, and repayment over time

Entrepreneurs t ¼ 1 t ¼ 2

Type Measure A1 y1 Repayment A2 y2 Repayment

ð1 À xÞd2 A Ak d A Ak S2 fAk S2

ð1 À xÞdð1 À dÞ A Ak d 0 0 0

Bad type f ð1 À xÞð1 À dÞd 0 0 0 A Ak fAk

f ð1 À xÞð1 À dÞ2 0 0 0 0 0 0

ð1 À f Þð1 À xÞð1 À dÞ 0 0 0 À À À

xp2 A Ak d A Ak S2 fAk S2

xpð1 À pÞ A Ak d 0 0 0

Good type fxð1 À pÞp 0 0 0 A Ak fAk

fxð1 À pÞ2

0 0 0 0 0 0ð1 À f Þxð1 À pÞ 0 0 0 À À À

The table summarizes the measure of good and bad firms that will have one of five combinations of two-

period productivity shocks ðA1; A2Þ; that is, ðA; AÞ; ðA; 0Þ; ð0; AÞ; ð0; 0Þ; and ð0; ÀÞ; respectively, where ‘‘À’’

represents nonparticipation in production. For example, d2 fraction of bad-type firms (i.e., ð1 À xÞd2 firms)

will have positive productivity shocks in both t ¼ 1 and t ¼ 2: Note that in the two-period model, a

positive fraction of bad firms will produce positive output in the final period even in case of no bailout

ð f ¼ 0Þ; while in a multiperiod model, almost all bad-type firms might ultimately produce nothing.




Given this expectation, the bank’s optimization problem at the beginning of the

second period is reduced to maximizing expected revenues at the end of the second

period:

max f

V max f

ffðY B þ Y SÞg: ð10Þ

Recall that f is the fraction of second-period output that the bank can claim (by

some technology) and, therefore, value. Also note that the expected revenues do not

include those from capital but from firms’ output, reflecting the assumption that

capital cannot be transformed into consumption goods and therefore it becomes

useless at the end of the second period.

The derivative of the value function with respect to f is

dV d f

¼ N f ;s À N s;sl N f

1 À N f

fAk : ð11Þ

Given the linear technology assumption, we have bang-bang solutions. The

optimal ratio of bailout, denoted by f Ã; is decided to be f Ã ¼ 0 or f Ã ¼ 1: In

particular, if N f ;soN s;slN f =ð1 À N f Þ; the derivative is negative and we therefore have

f Ã ¼ 0: So we can establish the following proposition.

Proposition 1. If N f ;soN s;slN f =ð1 À N f Þ; the bank ’s optimal policy is zero bailout

ð f Ã ¼ 0Þ:

The intuition behind the proposition is straightforward. Liquidation can be used

as a device for sorting good firms from bad firms. The repayment observation in the

first period allows the bank to partially separate good firms and bad firms, since the

portion of good firms among surviving firms is higher than among failed firms as

shown in Eq. (5) (or equivalently, the portion of bad firms among failed firms is

higher than among surviving firms).6 Using the new information, the bank can raise

the expected productivity of capital by reallocating capital from failed firms to non-

failed firms. However, the reallocation of capital through liquidation (including the

transfer of capital to non-failed firms) generates costs. Hence, the bank’s decision

depends on the benefit from allocating capital to good firms and the costs associatedwith capital transfer. If the former is larger, the optimal policy can be zero bailout. In

particular, as the difference between the chance of a positive shock for bad firms ðdÞ

and good firms ðpÞ increases (so that the firms are more heterogeneous), the benefit

from liquidating failed firms becomes larger and therefore the chance of a zero-

bailout policy also increases.

ARTICLE IN PRESS

6The existing literature in the Schumpeterian tradition has usually focused on the cleansing effect of

recessions or negative shocks (see Caballero and Hammour, 1994). In our model, however, revelation of

shock itself, positive or negative, has cleansing effects on the economy because shocks eliminate more of

inefficient firms as far as bad firms have a higher probability of failure. In addition, the liquidation policy

can magnify the cleansing effect in our model. In a similar setting, Kim and Izvorski (2002) explore how

business cycles and capital market opening affect the optimal bailout decision, and how the cleansing

effect of recessions can be amplified by the liquidation decision.




4. Conglomerates and optimal bailout

The previous section examines the optimal bailout policy when each of

the entrepreneurs remains independent and does not join any conglomerate. Inthis situation, the bank’s optimal bailout policy includes zero bailout. This

section considers when some individual entrepreneurs or firms join a

conglomerate.

Suppose that at the beginning of the first period, fraction t of the firms join

conglomerates, and ð1 À tÞ firms do not (how the fraction t is determined will be

discussed in the next section). As before, the key function of conglomerates is to

provide member firms with cross-debt payment guarantees. Given the cross

guarantees, the expected output of a member firm at the end of the first period is

given by ½xp þ ð1 À xÞdAk ; which is equal to the actual per-firm output of a

conglomerate that consists of an infinite number of firms (because of the law

of large numbers). If the bank sets the required repayment per firm d such that

½xp þ ð1 À xÞdAk > d ; conglomerates will not default in any circumstance, which is

the equivalent of an automatic full bailout. Therefore, to derive a nontrivial optimal

bailout policy on conglomerates, the bank sets d as

½xp þ ð1 À xÞdAk od ð12Þ

so that bailout is not automatic. The condition suggests that the total output of non-

failed firms in a conglomerate is not enough to meet the repayment requirement forboth failed and non-failed firms in a conglomerate. Therefore, it is certain that given

cross-debt payment guarantees, the conglomerate as a whole fails to repay the pre-

specified per-firm amount d and so does each member firm, failed or non-failed. To

be an effective monitoring device for stand-alones as well, d should be set at a level

higher than ½xp þ ð1 À xÞdAk but lower than Ak :As in the previous section, assume that new loans are not provided to any

defaulting stand-alone firm or any firm belonging to a defaulting conglomerate, but

only to non-defaulted firms. Given (12), at the end of the first period, conglomerates

will default for sure, so the measure of total defaulting firms attached to

conglomerates will be t: Among stand-alones, N f fraction of the firms will fail, sothe total number of failed non-conglomerates will be ð1 À tÞN f :

In this situation, what is the optimal bailout policy? At the beginning of the second

period, the bank will decide its optimal bailout policy, or the bailout rate for non-

conglomerates ð f Þ and conglomerates ð f CÞ; to maximize the expected revenue from

lending at the end of the second period. The expected revenue is fraction f of the

total output of borrower firms at the end of the second period, while total output is

composed of three elements: the expected second-period total output of stand-alone

firms that have been bailed out ðEY BÞ; that of the conglomerates that have been

bailed out ðEY CÞ; and that of the firms that have not defaulted at the end of the first

period ðEY SÞ: Alternatively, we can assume that f is different for each of the threegroups (for example, higher f for bailed-out stand-alones or group-affiliated firms),

but this assumption does not affect the qualitative results.

ARTICLE IN PRESS




Given that EY B; EY C; and EY S are determined as in Appendix B, the bank solves

the following optimization problem, taking t as given:

max f ; f C V

max f ; f C f

fðE

Y

B

þE

Y

C

þE

Y

S

Þg: ð13

Þ

The derivative of the value function with respect to f is

dV

d f ¼ ð1 À tÞ N f ;s À N s;sl

N f

1 À N f

fAk : ð14Þ

The derivative of the value function with respect to f C is

dV

d f C¼ t N s;sðA þ 1Þ þ N f ;s À N s;sl

ð1 À N f ÞðA þ 1Þ þ N f

1 À N f

fAk

¼ t N s;sðA þ 1Þð1 À l Þ þ N f ;s À N s;sl

N f

1 À N f

fAk : ð15Þ

The sign of the derivatives depends on the parameter values. Assume that the

parameters satisfy the following condition:

Condition (i)

N s;sl N f

1 À N f

À N s;sðA þ 1Þð1 À l ÞoN f ;soN s;sl N f

1 À N f

: ð16Þ

Then, it can be easily shown that dV =d f o0; but dV =d f C > 0; which suggests that

the bank’s optimal bailout policy is zero bailout for stand-alones but full bailout for

conglomerates.

Proposition 2. If Condition (i) holds, the bank ’s optimal policy is zero bailout for

nonconglomerates ð f Ã ¼ 0Þ and full bailout for conglomerates ð f CÃ ¼ 1Þ; which leads to

f CÃ > f Ã:

Proposition 2 suggests that the presence of conglomerates based on cross-debt

payment guarantees can drastically change the bank’s optimal bailout policy. In

particular, the optimal bailout ratio for conglomerates is higher than for stand-

alones. The key factor behind the result is the role of conglomeration in diluting

information. In the absence of conglomerates, a revelation of productivity shocks(and the ensuing repayment that differs across firms) can provide new information

that is substantial enough to allow the bank to find it more beneficial to liquidate

failed firms (and hence to reallocate capital from the failed to the non-failed).

However, in the presence of conglomerates based on cross guarantees, all the

member firms are defaulting regardless of individual productivity shocks. The

default of a conglomerate as a whole does not provide new information that allows

the bank to better distinguish good firms from bad, given our assumption that the

bank cannot directly observe the output of individual firms. In this way,

conglomeration effectively dilutes the information that can be obtained from the

payment failures of firms.Furthermore, information dilution might explain the notion of ‘‘too big to fail.’’

Define f ÃðmÞ as a bailout ratio for conglomerates with m member firms. In an

ARTICLE IN PRESS




extreme case where m is equal to 1 (the case of independent firms), f Ãð1Þ ¼ 0 as

shown above. In another polar case where m goes to infinity (as in the case of

conglomerates with a continuum of member firms), f ÃðNÞ ¼ 1: We can easily show

that the optimal bailout rate is nondecreasing with the size of a conglomerate,suggesting that the bank tends to bail out larger firms more frequently because of

their greater information dilution.

5. Conglomeration choice and macroeconomic implications

So far we have looked at the bank’s optimal bailout decision at the beginning of

the second period, assuming that the firms’ decision on conglomeration (and hence t)

is given from the previous period. In this section, we go back to the beginning of thefirst period and explore the decisions of individual firms on whether to join a

conglomerate or not. We then examine the macroeconomic implications of

conglomeration.

5.1. Optimal choice of conglomeration

Suppose that at the beginning of the first period, the risk-averse entrepreneur seeks

to maximize expected utility:

maxo ½oEuðc

C

2 Þ þ ð1 À oÞEuðc

NC

2 Þ; ð17Þ

where E is the expectation operator, o is the firm’s choice variable which is one when

it chooses to join a conglomerate and zero otherwise, and cC2 and cNC

2 represent

consumption at the end of the second period in the cases of joining a conglomerate

and remaining independent, respectively. In addition, assume that Condition (i)

continues to hold. So the bank will fully bail out failed conglomerates ð f CÃ ¼ 1Þ; but

fully liquidate failed stand-alones ð f Ã ¼ 0Þ; and such a bailout policy is precisely

foretold by entrepreneurs with rational expectations.

Under these assumptions, entrepreneurs belonging to one of the n families choose

o to maximize the expected utility in the second period, though those who do notbelong to one of the n families cannot choose o (because they cannot make an

effective cross-guarantee contract with any other firm).

In solving the optimization problem at the beginning of the first period,

entrepreneurs belonging to one of the n families compare the expected utility of

joining a conglomerate with that of not doing so. Given that the sole source of

income for entrepreneurs is profit, their expected utility critically depends on both

expected profits and the risk of zero profits (due to liquidation).

Both expected profits and the risk of zero profits differ between the cases of joining

a conglomerate and of not doing so, particularly because the bank will fully bail out

failed conglomerates, but fully liquidate failed stand-alones. Given the bank’sbailout policy, it can be shown that joining a conglomerate will drastically reduce the

risk of zero profits (by N f ;s), while under Condition (i) it will reduce expected profits

ARTICLE IN PRESS




(see Appendix C). So the entrepreneurs’ decision on conglomeration depends on the

relative size of the benefit due to the reduction in the risk of liquidation and the cost

due to the lowering of expected profits.

Whether the benefit of joining a conglomerate is greater than its cost partlydepends on the degree of risk aversion. If risk aversion is large or even modest,

entrepreneurs would be greatly concerned about eliminating the risk of liquidation,

and hence tend to prefer joining a conglomerate. But if risk aversion is infinitesimal

(or there is no risk aversion), entrepreneurs care mostly about expected profits and

little about the risk of liquidation, and prefer to remain independent.

To simplify the result, assume a standard constant relative risk aversion (CRRA)

utility function:

uðcÞ ¼ðc þ eÞ1Às

1 À s; ð18Þ

where s represents the coefficient of relative risk aversion, and e is a positive but

near-zero number (which is introduced to define the utility at zero consumption). In

addition, assume that s is greater than one (s > 1), which is consistent with the

estimates suggested by the existing literature. For example, Friend and Blume (1975),

based on the portfolio holdings of individuals, find that s is definitely larger than one

and probably over two. Mehra and Prescott (1985) find that s must be larger than

ten to explain the large equity premium, and Kocherlakota (1990) and Kandel and

Stambaugh (1991) even suggest that s must be as high as around 14 and 30,

respectively.Under the realistic range for the risk aversion parameter, it then follows that the

benefit of conglomeration due to a reduced risk of liquidation is always greater than

its costs, and so we can establish the following proposition.

Proposition 3. Given the CRRA utility function (18) with s > 1; entrepreneurs

belonging to one of the n families choose to join a conglomerate ðoÃ ¼ 1Þ:

Proof. See Appendix D.

This proposition suggests that risk-averse entrepreneurs might prefer joining aconglomerate even though conglomeration lowers expected profits. The reason is

that from the standpoint of the firms, joining a conglomerate is like having

insurance. Conglomeration, by working as a noise-signaling strategy that dilutes

information, changes the bank’s optimal policy from zero bailout to full bailout.

Given the expectation of the change in the bank’s bailout policy, entrepreneurs have

an incentive to form a conglomerate to reduce the risk of liquidation (and hence the

risk of losing capital).

Even if we assume different types of utility functions such as a quadratic utility

function, negative exponential utility function, or logarithmic function (which is the

limit of the CRRA function as s approaches one), the result does not change. Aslong as the agents have a strictly concave von Neumann-Morgenstern utility

function, they could join a conglomerate and will choose to do so if their risk

ARTICLE IN PRESS




aversion is large enough to make the benefits of conglomeration (due to the reduced

risk of liquidation) outweigh the costs. If, to further explore theoretical possibilities,

we assume that 0osa1 and e is a large positive number, the result would become a

bit complicated, and we would have a slightly modified proposition, stating thatthere exists a threshold level of risk aversion, sÃ; above which the entrepreneurs’

optimal choice is to join a conglomerate.

Now consider the size of each conglomerate and the fraction of conglomerates in

equilibrium. Given our assumption of differences in observability across families, no

entrepreneur in the second period would pay the debt of failed member firms run by

entrepreneurs from different families. Anticipating this, entrepreneurs belonging to

one of the n families form a conglomerate only with those belonging to the same

family. Thus, while indeterminate, the size of each conglomerate does not exceed the

size of a family, q (of course, if a smooth convex enforcement cost function is

assumed, the size of each conglomerate is uniquely determined). In addition, the

fraction of firms that join any conglomerate is determined as t ¼ nq:

5.2. Macroeconomic implications

The model can be used to explore the effect of business conglomerates on the

aggregate output and welfare of an economy. First, it can be shown that the

aggregate output in the first period is the same with conglomeration or non-

conglomeration. Recall that in the first period, regardless of conglomeration, all

entrepreneurs receive the same size of loan from the bank and participate inproduction, and each of them has a xp þ ð1 À xÞd chance of nonzero output. Given

the law of large numbers, it then follows that the actual aggregate output in the first

period with conglomeration or non-conglomeration, denoted by Y C1 and Y NC1 ; is

given by Y C1 ¼ Y NC1 ¼ ðxp þ ð1 À xÞdÞAk :

But the aggregate output in the second period can be lower with conglomeration

than with non-conglomeration. To show this, we compare the expected output of the

entrepreneurs with conglomeration and non-conglomeration. The expected output is

given by N s;sAðA þ 1Þk þ N f ;sAk for conglomeration, and N s;sAððA þ 1Þk þ

lkN f =ð1 À N f ÞÞ for non-conglomeration (see Appendix C). Given Condition (i), it

then follows that the former is smaller than the latter and therefore

Y C2 oY NC2 ; ð19Þ

where Y C2 and Y NC2 represent the actual aggregate output in the second period with

conglomeration and non-conglomeration, respectively. This suggests that an

economy with business conglomerates has a lower gross domestic output in the

second period. In addition, given that entrepreneurs’ profit is fraction ð1 À fÞ of

output, an economy with conglomerates will also have lower aggregate profits in the

second period. This result might also suggest that an economy with conglomerates is

likely to have similar output and profit performance to an economy withoutconglomerates in the early stages of development, while the former tends to suffer

from poorer economic performance in the later stages of development.

ARTICLE IN PRESS




Further, given the consumption function of the model uðc2Þ; it also follows that

conglomeration leads to a lower level of welfare. That is, the equilibrium deviates

from the first-best solution. This suggests that business conglomerates emerge as an

equilibrium outcome despite their inefficiency in terms of output, profit, or welfare.The reason for the efficiency loss in the equilibrium with conglomerates is clear.

The existence of conglomerates, by averting liquidations and the resulting

improvement in quality composition, hinders the society as a whole from achieving

higher average productivity. More specifically, productivity of capital for a firm in an

economy without conglomerates would have been determined on average to be

N s;sAððA þ 1Þ þ lN f =ð1 À N f ÞÞ; as only non-defaulted firms, whose chance of being

the good type is greater, are given capital for production in this case. But the

productivity in an economy with conglomerates will be ðN s;sAðA þ 1Þ þ N f ;sAÞnq þ

N s;sAððA þ 1Þ þ lN f =ð1 À N f ÞÞð1 À nqÞ; as defaulted firms, whose chance of being the

good type is lower, are also participating in production. Given that the existence of

conglomerates leads to more capital being allocated to more of the bad-type firms,

the average productivity of capital will be lower with conglomerates than without

conglomerates (as easily shown by the comparison of the above expressions for the

productivity between the two cases).

Our result of underperformance and inefficiency in an economy with conglom-

erates fits the recent experience in many crisis-hit emerging market economies, where

business conglomerates underperformed unaffiliated ones. In Korea, the average

profit rate of the top 30 conglomerates was 0.57% in 1996 and À0:82% in 1997,

much lower than the 1.85% and 0.17% of non-conglomerates (Borensztein and Lee,2002). Even after controlling for various factors that affect profitability, chaebol-

affiliated Korean firms had lower profitability than independent firms during 1993–

1997 (Joh, 2003). Furthermore, Korean chaebol bidders realized negative

announcement returns while non-chaebol bidders had positive announcement

returns during 1981–1997 (Bae et al., 2002). The underperformance of conglomerates

can arise as the controlling shareholder seeks to expropriate wealth from minority

shareholders (‘‘tunneling’’), particularly in an economy where equity financing is

dominant. The poorer performance of conglomerates can also arise as a result of

firms’ efforts to minimize the chance of being liquidated by the bank, particularly in

an economy where debt financing is prevalent.To enhance efficiency, the bank may announce in the beginning of the first period

that it will not bail out any conglomerate. However, the threat of zero bailout for

conglomerates is not credible. In the second period, the bank will find it optimal to

fully bail out any conglomerate (as shown in Section 4), though it has already

announced its policy of no bailout for conglomerates in the first period.

The findings of this section support some regulation of business conglomerates,

including the strict regulation on the cross guarantees of Korean conglomerates

imposed by the IMF after the 1997 financial crisis. Given their poor profitability in

the pre-crisis period, the conglomerates were often considered the key culprits of the

financial crisis (e.g., Kreuger and Yoo, 2002; Feenstra et al., 2002). As long as thecross-debt guarantees are the cause of the inefficiency and underperformance of

the conglomerates, a policy of reducing the cross guarantees is warranted.

ARTICLE IN PRESS




Moreover, we can examine the possible effects of conglomeration and large

bailouts on inflation. For simplicity, consider an economy where both money supply

and the velocity of money are exogenously given by one for both periods. In this

case, given the quantity theory of money equation ðP tY t ¼ M tV t ¼ 1Þ; the price levelof the economy is determined to be the inverse of the aggregate output. In addition,

the inflation rate does not affect the firms’ decision on conglomeration, because a rise

in the inflation rate (or P 2) affects EY B; EY C; and EY S in (13) proportionally. Using

the above results on the aggregate output for each of the two periods, we then have

P C1 ¼ P NC1 and P C2 > P NC

2 ; suggesting that the price level in the second period is

higher in the case of conglomeration than in the case of non-conglomeration. It also

follows that (P C2 =P C1 Þ À 1 > ðP NC2 =P NC

1 Þ À 1: This tells us that the inflation rate is

higher in an economy with conglomerates (and hence with greater bailouts) than

without them.

6. Extensions and discussions

The basic model allows for some extensions to explain various features of

conglomerates and bank loans without altering the main results. In this section, we

address three such extensions: a single owner of a conglomerate, loans of different

maturities, and a central bank as lender of last resort.

6.1. Single owner of a conglomerate

In reality, some conglomerates are formed by many entrepreneurs to support one

another, while others are formed by one entrepreneur. We have so far focused on the

former case, where a conglomerate is formed by a number of entrepreneurs who

maintain their own firms but agree to support one another through a contract of

cross-debt payment guarantees. But a variant of the basic model can also be easily

applied when a conglomerate is formed by one entrepreneur.

In this variant, assume that the output of a firm in the first period is not observable

by any others, and so cross guarantees are not contractible even among thosebelonging to the same family. Original owners or entrepreneurs are now allowed to

sell their firms or buy other firms at the beginning of the first period just after the

bank’s loans have been distributed. In addition, there are m entrepreneurs whose

wealth at the beginning of the first period ðw ¼ W > 0Þ is very large (large enough to

buy all the other firms), while the others have no wealth ðw ¼ 0Þ: For simplicity,

assume that m ¼ 1 and that the original owners of the firms can store what they

receive for selling their firms without depreciation until the end of the second period

to use for consumption. Furthermore, assume that the technology of each firm is

independent of the current owner of the firm. After a firm is sold by the original

owner, then, its probability distribution of productivity shock (described by (1) or(2)) does not change, while obviously the new owner observes the output of the firm.

In all other respects, the model here is the same as the basic model.

ARTICLE IN PRESS




In this situation, a contract of cross guarantees cannot be made among different

entrepreneurs. Hence the entrepreneurs with no initial wealth ðw ¼ 0Þ cannot form a

conglomerate. But these entrepreneurs have two other options. First, they can

remain stand-alones. In this case, the expected profits and the chance of zero profitsare the same as in the basic model. Second, they can sell their firms to the

entrepreneur with large wealth at price P ; which gives them a sure consumption of P

at the end of the second period (it can be interpreted as receiving consumption

insurance in exchange for their firms). Then the risk-averse entrepreneurs with no

initial wealth are willing to sell their firms as long as the selling price of the firm, P ; is

large enough to ensure the following condition:

ðP þ eÞ1Às

1 À s

> EðPNC

2 þ eÞ1Às

1 À s ; ð20Þ

that is, as long as the price is high enough to ensure that selling the firm generates

higher expected utility than remaining a stand-alone firm.

Now consider the entrepreneur with large wealth in the initial period ðw ¼ W Þ:This entrepreneur can purchase the firms owned by others at price P ; and form a

conglomerate consisting of a large number of firms. In this case, the cross guarantees

among the member firms, which are owned by the single entrepreneur, are

automatically ensured. Given the bank’s optimal policy of full bailout for a cross-

guaranteed conglomerate, the entrepreneur can reduce the risk of liquidation for all

the firms purchased. Then the entrepreneur has a sure average profit per firm in thesecond period, which amounts to EPC

2 ¼ ð1 À fÞ½N s;sðA þ 1Þ þ N f ;sAk : Hence the

entrepreneur can generate a sure net profit per firm after subtracting the price,

ðEPC2 À P Þ; by forming a conglomerate. He or she has an incentive to buy all the

firms and form a conglomerate, if the following condition is met:

EPC2 > P ; ð21Þ

that is, if the expected profit per firm is large enough for the entrepreneur with large

wealth to pay the price.It can then be shown that there is a range of prices P for which both conditions

(20) and (21) are satisfied (see Appendix E). That is, for some P ; the entrepreneur

with large wealth has a positive surplus by forming a conglomerate while the

entrepreneurs with no initial wealth are willing to sell their firms. As a result, two

groups of agents emerge: an individual who is the sole owner of a conglomerate, and

individuals who do not own any firms.

When all firms have little initial wealth and, in addition to the representative bank,

there is a second financial institution with sufficient wealth, the latter financial

institution may find it optimal to form a conglomerate which consists of many

member firms that it owns and controls. This variant of the model may explain howbusiness conglomerates controlled by banks, like Japanese conglomerates, emerge

(see Hoshi et al., 1991, for Japanese business groups).

ARTICLE IN PRESS




6.2. Loans of different maturities

An important feature of the basic model is that for any loan, the bank requires

repayment d at the end of the first period, and firms that are not able to make thefirst-period repayment are declared in default. Given this, all the loans in the basic

model can be interpreted as one-period (or short-term) loans, which also implies that

there are no two-period (or long-term) loans.

The absence of two-period loans in the basic model could well capture the fact that

very long-term loans are not frequently made in emerging markets, and maturities of

loans in emerging markets tend to be shorter than in developed economies (see, e.g.,

Friedman et al., 2002). The absence of two-period loans in the basic model can be

viewed as an institutional assumption that fits emerging market economies.

Furthermore, we can go beyond just taking the feature as an institutional

assumption, and derive it as a result of the bank’s optimal decision. To illustrate this,

consider a variant of the model where both one-period and two-period loans are

allowed. Particularly assume that two-period loans, unlike one-period loans, do not

require a repayment at the end of the first period, and so there is no default on two-

period loans in the first period. For simplicity, also assume that the bank has access

to a technology that allows it to claim the same fraction f of the second-period

output of the borrower firms for both one-period loans and two-period loans.

Consider the bank that lends k to each firm regardless of maturities, and let gA½0; 1

denote the fraction of entrepreneurs who receive two-period loans from the bank. And

focus on the case where there are only stand-alone firms and no conglomerates as inSection 3. In this case, the bank chooses g and f to maximize the expected revenues

from lending at the end of the final period (the second period), denoted by V :The expected return of the bank, V ; is given by

V ¼ V Lg þ V Sð1 À gÞ ð22Þ

where V L is the expected revenue from making two-period loans per firm, and V S is

the expected revenue from making one-period loans per firm. Here V S is given by

V S ¼ fðY B þ Y SÞ; as in Section 3, since in the case of one-period loans there are

defaults.

In the case of two-period loans, there is no default, no liquidation, and nosubsequent transfer of capital from one firm to another. Thus, even firms that

produce nothing in the first period can participate in production again in the second

period, using borrowed capital in the first period amounting to k : So V L is given by

V L ¼ fðN s;sAðA þ 1Þk þ N f ;sAk Þ:It can then be shown that the bank’s optimal choice of two-period (long-term)

loans, gÃ; is given by

gÃ ¼ 0; ð23Þ

which suggests that the bank will not make two-period loans even if it is allowed to

(see Appendix F for the proof). The reason is that two-period loans work asautomatic bailouts, even though bailing out stand-alone firms is not optimal from

the standpoint of the bank.

ARTICLE IN PRESS




This suggests that the assumed absence of two-period loans in the basic model is a

feature of optimal lending in emerging markets with weak institutions, particularly

underdeveloped banking systems and weak institutions related to information

disclosure, under which information on the quality of borrower firms is lacking. Theweak institutional environment favors short-term loans that help the bank to acquire

more information on the quality of borrower firms much earlier.

6.3. The central bank as lender of last resort

In the basic model, there is only ‘‘the bank’’ which represents the whole banking

system. However, we can modify the basic model to explicitly distinguish the central

bank from commercial banks.

Suppose that the economy has a continuum of commercial banks defined on the

interval ½0; 1 and the central bank. The central bank is assumed to seek to maximize

the welfare of the economy, or U ¼ EY B þ EY C þ EY S; where EY B; EY C; and EY S

are defined as in Section 4. Also suppose that if a firm defaults, control passes to its

creditor bank, but not to the central bank. Furthermore, assume that the central

bank has the liquidity needed to bail out all the defaulting firms in the second period.

Consider first the case where commercial banks do not have sufficient capital to

bail out defaulting firms in the second period. For example, suppose that each

commercial bank has a small amount of initial capital ðk 0Þ and each firm’s

production requires a minimum amount of capital, which is k 0: Each bank then must

lend all of its capital to only one firm at the beginning of the first period. Also assumethat commercial banks have to repay a certain amount to their depositors at the end

of the first period.

In this case, when a firm defaults, the liquidity-constrained creditor bank cannot

bail it out (and the creditor bank itself is also in default). But the central bank, if it

wants, can provide creditor banks with liquidity, which in turn can be used to bail

out defaulting firms. So the central bank here can work as the lender of last resort

and the final decision-maker on bailout. Furthermore, given that the central bank

seeks to maximize the welfare of the economy, it will try to be involved in bailouts

even though control does not pass to it. In particular, the central bank chooses the

bailout rate for non-conglomerates and conglomerates ( f and f C

) to maximize socialwelfare.7

ARTICLE IN PRESS

7As a further extension, we would introduce a political economy version of the model, in line with recent

political economy models such as Acemoglu et al. (2002) and Grossman and Helpman (1999). In

particular, we may assume that bailout decisions are made by the policymaker who maximizes her private

return or bribe (as in political economy models), rather than the welfare-maximizing central bank (as in

the model of this section). In this variant model as well, however, it can be shown that conglomerates

emerge as an equilibrium outcome though the equilibrium is suboptimal. This is because the bribe-

maximizing policymaker, lobbied by entrepreneurs, would not curb conglomeration at the expense of the

general public’s interest. This suggests that the main result of the basic model continues to hold in the

political economy version of the model. In addition, the equilibrium with conglomerates, despite its

suboptimality, emerges under various situations, for example, when the profit-maximizing bank or the

welfare-maximizing central bank has no credible mechanism to prevent conglomeration or when the bribe-

maximizing policymaker is lobbied by entrepreneurs.






conglomeration in emerging markets. While the model works nicely for many

emerging market economies (such as Korea), it might not explain all the features of

business conglomerates in emerging markets, which can take slightly different forms

across countries. Therefore, further studies that incorporate additional factorscontributing to conglomeration (for example, vertical integration that reduces

transaction costs, mitigation of weak investor protection, and pooling of industry-

specific risks through diversification) would provide a useful complement to this

paper.

The model in this paper also generates a number of testable predictions that have

not yet been proposed by other models of emerging market corporate finance: for

example, conglomerates with larger cross-debt payment guarantees and cross

shareholdings tend to be bailed out more frequently; and economies with weaker

institutions and less developed financial markets tend to have more conglomerates.

Testing such predictions, using firm-level data of a country or across countries,

should be given a high priority in future research.

Appendix A. The case of private information

This appendix examines the bank’s bailout policy in the case of private

information, where each entrepreneur knows his or her own firm type while others

do not (Sections 2–5 consider the case where nobody knows their type).

Suppose that the utility function is given by uðcÞ ¼ ðc þ eÞ

1Às

=ð1 À sÞ; wheres > 1 and e is a near-zero number, and that entrepreneurs expect the bank to

fully bail out failed conglomerates (as in the basic model without private

information).

For the bad-type firms (belonging to one of the n families), the expected profits for

the cases of remaining stand-alone and joining a conglomerate that will be fully

bailed out are given by EPNC2 ¼ ð1 À fÞd2AððA þ 1Þk þ lkN f =ð1 À N f ÞÞ and EPC

2 ¼

ð1 À fÞ½d2ðA þ 1Þ þ dð1 À dÞAk ; while EPC2 À EPNC

2 > 0: So, for bad firms, the

expected profit is always larger in the case of joining a conglomerate than remaining

stand-alone. If the bank fully bails out failed conglomerates, bad firms prefer joining

a conglomerate.For the good type, the expected profits for the cases of remaining stand-alone and

joining a conglomerate are given by EPNC2 ¼ ð1 À fÞp2AððA þ 1Þk þ lkN f =ð1 À N f ÞÞ

and EPC2 ¼ ð1 À fÞ½p2ðA þ 1Þ þ pð1 À pÞAk : If ð1 À N f Þ=ð1 À N f þ lN f Þop; we have

EPC2 À EPNC

2 o0; that is, the expected profit is smaller in the case of joining a

conglomerate than remaining stand-alone. So for the range of parameters satisfying

ð1 À N f Þ=ð1 À N f þ lN f Þop; one may conjecture that good firms might possibly

prefer remaining stand-alones rather than joining a conglomerate. However, given

the assumptions that s is greater than one and e is near zero, it can be shown (similar

to the proof of Proposition 3 in Appendix D) that they always prefer joining a

conglomerate.So both bad- and good-type firms will join a conglomerate ðoÃ ¼ 1Þ: In addition,

the bank, which cannot distinguish between the two types, will fully bail out

ARTICLE IN PRESS




conglomerates as in the basic model. This suggests that the introduction of private

information does not alter the bank’s optimal bailout policy.

As a further extension, consider the case where s is greater than one and e

is a large number. In this case, if the bank always fully bailed out failedconglomerates and s is lower than a threshold ðsosÃÃÞ; good firms’ optimal

choice of conglomeration would be oÃ ¼ 0; while bad firms’ choice would be

oÃ ¼ 1:However, such separation between the two types cannot be an equilibrium

outcome since the bank’s optimal policy for conglomerates is no longer a full-

bailout. Given the information set, including parameter values, the bank can infer

that if some of the firms have joined a conglomerate while others have not, the

firms that have joined conglomerates must be the bad type. Due to the signaling

effect, the bank would liquidate all the failed conglomerates at the beginning of the

second period. The bad-type firms, at the beginning of the first period, also anticipate

this change in the bank’s bailout policy, and hence they do not join any

conglomerate.

This suggests that the bad type will always follow the behavior of the good type on

conglomeration based on cross guarantees, and therefore there is no separating

equilibrium even in the case of private information.

Appendix B. Derivation of EY B; EY C and EY S in (13)

The derivation of EY B is straightforward. Similar to Eq. (8), we have

EY B ¼ f ð1 À tÞ½xð1 À pÞp þ ð1 À xÞð1 À dÞdAk

¼ f ð1 À tÞN f ;sAk : ðB:1Þ

To derive EY C; note that the member firms of a conglomerate that had a positive

shock in the first period have capital ðA þ 1Þk ; while the members that had an

adverse shock have capital k : Using this, we have

EY C ¼ f Ct½½xp2 þ ð1 À xÞd2AðA þ 1Þk þ ½xð1 À pÞp þ ð1 À xÞð1 À dÞdAk

¼ f Ct½N s;sðA þ 1Þ þ N f ;sAk : ðB:2Þ

Finally, to derive EY S; note that given condition (12), all of the firms that have not

defaulted are stand-alones. Also note that in the second period, each of the non-

failed (and stand-alone) firms has four different sources of capital: capital carriedover from the first period, k ; reinvestment of output, Ak ; capital reallocated from

liquidated stand-alone firms, ð1 À f Þlk ðN f ð1 À tÞÞ=ð1 À N f Þð1 À tÞ; and that from

ARTICLE IN PRESS




conglomerated firms, ð1 À f CÞlk ðtM =ð1 À tÞð1 À N f ÞÞ; where M ¼ ½xp þ ð1 À xÞd

ðA þ 1Þ þ ½xð1 À pÞ þ ð1 À xÞð1 À dÞ ¼ ð1 À N f ÞðA þ 1Þ þ N f : Using this, we have

EY S ¼ ð1 À tÞ½xp2 þ ð1 À xÞd2A

Â ðA þ 1Þk þ ð1 À f Þlk N f ð1 À tÞ

ð1 À N f Þð1 À tÞþ ð1 À f CÞlk

tM

ð1 À tÞð1 À N f Þ

¼ ð1 À tÞN s;sA ðA þ 1Þk þ ð1 À f Þlk N f

1 À N f

þð1 À f CÞlk tM

ð1 À tÞð1 À N f Þ

: ðB:3Þ

Appendix C. Conglomeration effects on zero-profit risks, EP2; and E y2

This appendix derives the expected output ðE y2Þ; the expected profits ðEP2Þ;and the risk of zero profits in the second period in the cases of joining a

conglomerate and of not doing so, and examines the effect of conglomeration on

those variables.

In the case of remaining stand-alones, the entrepreneur, who does not know his or

her firm type, expects to have consecutive positive output in the first and second

periods with probability p2 if it is a good firm (whose probability is x) and with

probability d2 if it is a bad firm (whose probability is 1 À x). Given zero bailout for

non-conglomerates, the firm does not expect positive profits in the second period

except in the above cases of positive outputs in both periods. So the entrepreneur

expects positive profits in the second period with a chance of N s;s ¼ xp2 þ ð1 À xÞd2;and zero profits with a chance of 1 À N s;s:

In case of positive profits, the entrepreneur expects the capital in the beginning of

the second period to be k S2 ¼ ðA þ 1Þk þ lkN f =ð1 À N f Þ; which reflects the transfer of

capital from liquidated firms. Using these, the expected output and profits in this

case are given by

E yNC2 ¼ N s;sA ðA þ 1Þk þ lk

N f

1 À N f ðC:1Þ

and

EPNC2 ¼ ð1 À fÞN s;sA ðA þ 1Þk þ lk

N f

1 À N f

: ðC:2Þ

In the case of joining a conglomerate, the entrepreneur can have a positive output

in the second period even when it has an adverse shock in the first period. The chance

of having an adverse shock for t ¼ 1 and a positive shock for t ¼ 2 is pð1 À pÞ if it is

a good firm and dð1 À dÞ if it is a bad firm. So the entrepreneur expects positive

profits with a chance of the sum of N s;s ¼ xp2 þ ð1 À xÞd2 and N f ;s ¼ xð1 À pÞp þ

ð1 À xÞð1 À dÞd; and zero profits with a chance of 1 À N s;s À N f ;s:Using these, the expected output and profits are

E yC2 ¼ N s;sAðA þ 1Þk þ N f ;sAk ðC:3Þ

ARTICLE IN PRESS




and

EPC2 ¼ ð1 À fÞ½N s;sðA þ 1Þ þ N f ;sAk : ðC:4Þ

A comparison between the two cases suggests that joining a conglomerate raisesthe chance of having positive profits by N f ;s; compared to the case of remaining

stand-alone. In addition, given Condition (i), we have

E yC2oE yNC

2 and EPC2oEPNC

2 ; ðC:5Þ

which tells us that both the expected output and the expected profits are lower in the

case of joining a conglomerate.

Appendix D. Proof of Proposition 3

To prove this proposition, we need to compare the expected utility between the

cases of remaining stand-alone and joining a conglomerate.

In the case where the entrepreneur remains a stand-alone, the expected utility is

given by

EðcNC

2 þ eÞ1Às

1 À s

¼

½ð1 À fÞAððA þ 1Þk þ lkN f =ð1 À N f ÞÞ þ e1Às

1 À sN s;s

þe1Às

1 À sð1 À N s;sÞ: ðD:1Þ

In the case of joining a conglomerate, the expected utility is

EðcC

2 þ eÞ1Às

1 À s

¼

½ð1 À fÞAðA þ 1Þk þ e1Às

1 À sN s;s

þ½ð1 À fÞAk þ e1Às

1 À sN f ;s þ

e1Às

1 À sð1 À N s;s À N f ;sÞ: ðD:2Þ

Then the difference between the expected utility of the above two cases, denoted

by DEU ðsÞ; is given by

DEU ðsÞ E

ðcC2 þ eÞ1Às

1 À s

À E

ðcNC2 þ eÞ1Às

1 À s

¼½ð1 À fÞAðA þ 1Þk þ e1Às

1 À sN s;s

þ½ð1 À fÞAk þ e1Às

1 À sN f ;s À

e1Às

1 À sN f ;s

À½ð1 À fÞAððA þ 1Þk þ lkN f =ð1 À N f ÞÞ þ e1Às

1 À sN s;s: ðD:3Þ

Given that e is positive and near zero and s > 1; it follows that ðe1Às=ð1 À sÞÞN f ;s

can be approximated by lima-

0

þ ða1Às=ð1 À sÞÞN f ;s

¼ ÀN: From (D.3), it then

follows that for any s > 1; we have

DEU ðsÞ > 0: ðD:4Þ

ARTICLE IN PRESS




Appendix E. Proof of the existence of P that satisfies (20) and (21)

Note that for risk-averse agents, it holds that ðEPC2 þ eÞ1Às=ð1 À sÞ > EððPC

2 þ

eÞ1Às=ð1 À sÞÞ: Then there exists some P ðoEPC2 Þ (i.e., P satisfying (21)) such that

ðP þ eÞ1Às

1 À s> E

ðPC2 þ eÞ1Às

1 À s

: ðE:1Þ

As shown in Section 5, for agents with risk aversion s > 1 we have EððPC2 þ

eÞ1Às=ð1 À sÞÞ > EððPNC2 þ eÞ1Às=ð1 À sÞÞ which, together with (E.1), implies that

there exists some P ðoEPC2 Þ that satisfies the condition (20).

Appendix F. Proof of (23)

Note that under Condition (i), f ¼ 0 maximizes V S (as f ¼ 0 maximizes

fðY B þ Y SÞ in Section 3).

Then the maximized value of V S is given by

V S ¼ fN s;sA ðA þ 1Þk þ lk N f

1 À N f

: ðF:1Þ

Using (F.1), the derivative of V with respect to g then is given by dV =dg ¼

V L À V S ¼ fAk ½N f ;s À N s;slN f =ð1 À N f Þ; which is negative under Condition (i).

References

Acemoglu, D., Aghion, P., Zilibotti, F., 2002. Distance to frontier, selection, and economic growth.

NBER Working Paper 9066.

Bae, K.-H., Kang, J.-K., Kim, J.-M., 2002. Tunneling or value added? Evidence from mergers by Korean

business groups. Journal of Finance 57, 2695–2740.

Berg, A., 1999. The Asia crisis: causes, policy responses, and outcomes. IMF Working Paper 99/138.

Bolton, P., Scharfstein, D., 1990. A theory of predation based on agency problems in financial contracting.

American Economic Review 80, 94–106.

Bolton, P., Scharfstein, D., 1996. Optimal debt structure and the number of creditors. Journal of Political

Economy 104, 1–25.

Borensztein, E., Lee, J.-W., 2002. Financial crisis and credit crunch in Korea: evidence from firm-level

data. Journal of Monetary Economics 49, 853–875.

Burkart, M., Panunzi, F., Shleifer, A., 2002. Family firms. NBER Working Paper 8776.

Caballero, R., Hammour, M., 1994. The cleansing effect of recessions. American Economic Review 84,

1350–1368.

Chopra, A., Kang, K., Karasulu, M., Liang, H., Ma, H., Richards, A., 2002. From crisis to recovery in

Korea: strategy, achievements and lessons. In: Coe, D., Kim, S.-J. (Eds.), Korean Crisis and Recovery.

IMF and KIEP, Washington DC and Seoul, pp. 13–104.

Claessens, S., Djankov, S., Lang, L., 2000. The separation of ownership and control in East Asian

corporations. Journal of Financial Economics 58, 81–112.

Feenstra, R., Hamilton, G., Lim, E.-M., 2002. Chaebol and catastrophe: a new view of the Korean

business groups and their role in the financial crisis. Asian Economic Papers 1 (2), 1–45.

Friedman, E., Johnson, S., 2000. Tunneling and propping. Unpublished working paper. Rutgers

University and MIT.

ARTICLE IN PRESS




Friedman, E., Johnson, S., Mitton, T., 2002. Corporate governance and corporate debt in Asian crisis

countries. In: Coe, D., Kim, S.-J. (Eds.), Korean Crisis and Recovery. IMF and KIEP, Washington

DC and Seoul, pp. 293–324.

Friend, I., Blume, M., 1975. The demand for risky assets. American Economic Review 65, 900–922.Glaeser, E., Johnson, S., Shleifer, A., 2001. Coase versus the Coasians. Quarterly Journal of Economics

116, 853–899.

Greif, A., 1993. Contract enforceability and economic institutions in early trade: the Maghribi traders’

coalition. American Economic Review 83, 525–548.

Grossman, G., Helpman, E., 1999. Competing for endorsements. American Economic Review 89,

501–524.

Hahm, H., Ferri, G., Bongini, P., 1998. Corporate bankruptcy in Korea: only the strong survive?

Unpublished working paper. World Bank.

Hart, O., 1995. Firms, Contracts, and Financial Structure. Oxford University Press, Oxford.

Hart, O., Moore, J., 1994. A theory of debt based on the inalienability of human capital. Quarterly Journal

of Economics 109, 841–879.

Hoshi, T., Kashyap, A., Sharfstein, D., 1991. Corporate structure, liquidity, and investment: evidencefrom Japanese industrial groups. Quarterly Journal of Economics 106 (1), 33–60.

Joh, S.-W., 2003. Corporate governance and firm profitability: evidence from Korea before the economic

crisis. Journal of Financial Economics 68, 287–322.

Johnson, S., Mitton, T., 2003. Cronyism and capital controls: evidence from Malaysia. Journal of

Financial Economics 67, 351–382.

Johnson, S., Shleifer, A., 2000. Coase and corporate governance in development. Unpublished working

paper. MIT and Harvard University.

Johnson, S., Boone, P., Breach, A., Friedman, E., 2000a. Corporate governance in the Asian financial


Johnson, S., La Porta, R., Lopez-De-Silanes, F., Shleifer, A., 2000b. Tunneling. American Economic

Review (Papers and Proceedings) 90, 22–27.

Jung-Ang Ilbo, 1996. People Who Run Korean Business World. Jung-Ang Ilbo Press, Seoul, Korea.Kandel, S., Stambaugh, R., 1991. Asset returns and intertemporal preferences. Journal of Monetary

Economics 27, 39–71.

Khanna, T., Palepu, K., 2000. Is group affiliation profitable in emerging markets? An analysis of

diversified Indian business groups. Journal of Finance 55, 867–891.

Kim, S-J., Izvorski, I., 2002. Aggregate shock, capital market opening, optimal bailout and structural

reform. Unpublished working paper. IMF and IIF.

Kocherlakota, N., 1990. On tests of representative consumer asset pricing models. Journal of Monetary

Economics 26, 285–304.

Kreuger, A., Yoo, J., 2002. Falling profitability, higher borrowing costs, and chaebol finances during the

Korean crisis. In: Coe, D., Kim, S.-J. (Eds.), Korean Crisis and Recovery. IMF and KIEP,

Washington DC and Seoul, pp. 157–196.

Lang, L., Stulz, R., 1994. Tobin’s q, corporate diversification and firm performance. Journal of Political

Economy 102, 1248–1280.

La Porta, R., Lopez-De-Silanes, F., Shleifer, A., Vishny, R., 1997. Legal determinants of external finance.

Journal of Finance 52, 1131–1150.

La Porta, R., Lopez-De-Silanes, F., Shleifer, A., Vishny, R., 1998. Law and finance. Journal of Political

Economy 106, 1113–1155.

La Porta, R., Lopez-De-Silanes, F., Shleifer, A., 1999. Corporate ownership around the world. Journal of

Finance 54, 471–517.

La Porta, R., Lopez-De-Silanes, F., Shleifer, A., Vishny, R., 2000. Investor protection and corporate

governance. Journal of Financial Economics 58, 1–25.

La Porta, R., Lopez-De-Silanes, F., Zamarripa, G., 2002. Related lending. NBER Working Paper

8848.Lemmon, M., Lins, K., 2001. Ownership structure, corporate governance, and firm value: evidence from

the East Asian financial crisis. Unpublished working paper. University of Utah.

ARTICLE IN PRESS




Lins, K., Servaes, H., 2001. Is corporate diversification beneficial in emerging markets? Unpublished

working paper. University of Utah and London Business School.

Mehra, R., Prescott, E., 1985. The equity premium: a puzzle. Journal of Monetary Economics 15,

145–161.Mitton, T., 2002. A cross-firm analysis of the impact of corporate governance on the East Asian financial


Prescott, E., Townsend, R., 1999. The boundaries and connectedness of collective organizations.

Unpublished working paper. Federal Reserve Bank of Richmond and University of Chicago.

Rajan, R., Servaes, H., Zingales, L., 2000. The cost of diversity: the diversification discount and inefficient

investment. Journal of Finance 55, 35–80.

Scharfstein, D., Stein, J., 2000. The dark side of internal capital markets: divisional rent-seeking and

inefficient investment. Journal of Finance 55, 2537–2564.

Shin, H.-H., Stulz, R., 1998. Are internal capital markets efficient? Quarterly Journal of Economics 113,

531–552.

Shleifer, A., Wolfenzon, D., 2000. Investor protection and equity markets. NBER Working Paper 7974.

Townsend, R., 1979. Optimal contracts and competitive markets with costly state verification. Journal of Economic Theory 21, 265–293.

Wolfenzon, D., 1999. A theory of pyramidal ownership. Unpublished working paper. University of

Michigan, Ann Arbor.

ARTICLE IN PRESS


Documents

PDF-JFE 04 71 2-4 Bailout and Conglomeration