The role of Internal Capital Markets in pooling and allocating financial resources.

To what extent will the Internal Capital Market improve the efficiency of pool and allocating financial resources in business groups?

INTRODUCTION

Since 1975, Williamson initially proposed that group enterprises could create the Internal Capital Markets to overcome the drawbacks of External Capital Market. Extensive research of Internal Capital Markets' advantages and disadvantages have been conducted. Generally, corporations in External Capital Markets get loans from outside investors. And in most work, External Capital Markets is believed to be the major component of the capital market. It is evitable that outside investors might not have all useful information at the same time as the corporation's managers, which is called the information asymmetry.

However, in the Internal Capital Markets, financial resources are mainly sent to the business units within the group enterprises. Therefore, information asymmetry would be diminished in Internal Capital Markets, and conglomerates are able to allocate financial resources in a relatively more discreet and efficient way. As Lundstrum stated in 2000, the Internal Capital Markets' effect on the value of the firm is positive. Therefore, It is the most efficient method for business groups to pool and allocate money.

This essay aims to show to what extent the Internal Capital Market will improve the efficiency of allocating financial resources in business groups. Firstly, this essay defines the Internal Capital Markets and give some backgrounds to the forming reasons of Internal Capital Market in group enterprises. Secondly, it demonstrates the main functions of Internal Capital Markets. Then, the two types of capital market would be compared from the advantages, potentially influential factors, and efficiency, showing that - especially in business groups - the Internal Caiptal Market plays a major role in pool and allocating financial resources.

DEFINITION

Alchian (1969) and Williamson (1975) initially observed and defined the investment funds market within General Electric. According to Alchian, "The investment funds (capital) market within General Electric is fiercely competitive and operates with greater speed to clear the market and to make information more available to both lenders and borrowers than in the external "normal" markets." Therefore, the Internal Capital Markets can be broadly defined in two aspects:

Primarily, the Internal Capital Markets is concerned about financial liquidity problems between the Group and its divisions or subsidiary companies, as well as between the various segments within the Group. Moreover, enterprise group is the centre in the Internal Capital Markets. Enterprise group, in order to attract capital and loans within the group, can establish an internal bank or finance company to assume the role of internal financial intermediaries. Although some companies may choose not to create the complicated internal fund settlement system, but the group headquarters would take the responsibility to pool and allocate capital to their business units.

Secondly, diversification of subsidiaries is the other basic factor of internal markets. Because the diversification not only internalizes transactions of goods and services, but it also internalizes transactions of capital in Conglomerates (HOSKISSON & TURK, 1990). Only with the diversified subsidiaries, the business groups can appropriately avoid the investment risks. Hence, the Internal Capital Markets are made ​​up of two basic components: a control centre and diversified subsidiaries or divisions.

Functions

Efficient allocation of resources is the goal of economics, and in modern economic society, capital is a critical component of enterprise resource. While capital markets channel savings and investment between individual or institutional investors, and investees like firms, individuals or the government. Because of the markets, business groups are able to choose to absorb capital for investment from External Capital Markets or Internal Capital Markets. Generally, researches tend to concentrate on providers of funds that are external to the firm, such as banks, the stock market. And according to several experts' opinion, the external capital markets have dual functions, supplying diversified forms of investment finance and disciplining companies that are inefficient, or fail to achieve basically the profit goal.

Yet, essential components of the process of capital allocation take place in the Internal Capital Market. Moreover, it differs from external markets due to its characters in access to information, incentives, control rights, or angency problems. A growing literature has been developed in researching the functions of Internal Capital Markets in group businesses. Briefly, it can be concluded into the following aspects:

1. Information advantage

The increasingly significant information problems between "external" investors and investee companies contributes to the formations of the internal markets. Thus, the internal markets are superior to the external because of arising the greater (cheaper) information about people and proposals and reallocation of resources.

In the traditionally external markets, the invested enterprises managers' access to information is superior to that of the investor, yet the managers have the decision right in the presence of vital information problems. Furthermore, due to the lack of the instant and detailed information on the business groups, the lenders in the capital markets could make incorrect investment decisions. This phenomenon is called information asymmetry which could contribute to serious issues in pooling and allocating capital in External Capital Markets. For instance, the inaccurate and misleading information could lead to investors' decision and forecast error, which means the investors' judgements and anticipations about the invested enterprises can be incorrect. The consequence of such mistakes is the failure of the whole investment. Thus, the information asymmetry could cause inefficiency in allocating funds in External Capital Markets. According to Hubbard and Palia's research in 1999, it is because of the asymmetry that group enterprises may choose to form their own Internal Capital Markets in the absence of informationally well-developed External Capital Markets.

In contrast, it is claimed, by Alchian (1969) and Williamson (1975), that the internal markets could make information more available between the borrowers and lenders than in the external markets. In the Internal Capital Markets, the group enterprises could share and exchange the information about the financial status and investment projects. The convenient information interchange in internal markets can effectively shield projectforfinancing.

2. Control rights and incentives

The efficiency of an internal capital market cannot be roughly attributed to the centralized information and capital resources. Otherwise, the Internal Capital Markets can be directly replaced by the centralized source financial resources. To be more specific, capital resources from a single supplier, in the External Capital Markets. In contrast with external bank lending, internal capital allocation gives the business group's headquarters the rights of control over the assets in question. Due to the control rights over the assets of subsidiaries or divisions, the incentives of monitoring in internal markets are increased.

Gertner,Scharfsteinand Stein (1994) state difference of the ownership and the incentive system between the Internal Capital Markets and the External Capital Markets. In the external markets, the lenders and borrowers could not directly transact with each other, only through financial intermediaries,such as banks or financial companies. Apparently, financial intermediaries do not own any companies of the lenders and borrowers.

However, headquarters in the Internal Capital Markets takes ownership to the subsidiaries or divisions to which it reallocates capital. Grossman and Hart (1986) demonstrate that giving control rights to the suppliers of financial resources, in the internal markets, can optimize the incentive system from two main aspects:

1. Increasing monitoring incentives

Despite the internal and external providers of financial resources have the same ability to monitor, internal providers could choose to monitor more intensely. This mainly can be attributed to the internal lenders' control right over the assets. Thus, the internal lenders could get more interest from monitoring. Moreover, the lenders and borrowers, in the Internal Capital Markets, are associated with a better flow of information .

2. Decreasing entrepreneurial incentives.

Giving control rights to capital providers through an internal capital allocation process is costly, however, in that it diminishes managerial incentives. Because the manager does not have control, he is more vulnerable to opportunistic behaviour by corporate headquarters. Thus, the manager may not get all of the rents from his efforts, which reduces his incentives.

Unlike external bank lending, internal capital allocation gives corporate headquarters the residual rights of control over the assets in question. Therefore, it appears that the ownership aspect of the internal capital allocation has two significant consequences: it leads to more monitoring and better asset redeployability than bank lending, but this comes at the cost of reducing managers' entrepreneurial incentives.

3. Agency problems

It appears that the Internal Capital Markets effectively avoid the agency problems and impose costs on a capital-sufficient line of business, namely effectively diminish the agency fees and transaction costs.

In the External Capital Markets, the agency problem arises because savers that invest in business projects of companies typically do not intend to involve in their management. Consequently, once lenders have invested their financial resources in business projects, the self-interested managers in borrowers have incentives to make decisions against the investors' interests. For example, if investors acquire an equity stake in an enterprise, the managers in investee companies can use those funds to pay excessive compensation, or make unreasonable investments or operational decisions that are harmful to the interests of outside investors (Jensen and Meckling, 1976). Furthermore, agency frameworks raise a number of important questions for financial reporting and disclosure researchers which can deeply influence the efficiency of the External Capital Markets.

Whereas, the business group's headquarters is responsible for pooling and allocating capital to the business units and subsidiary companies. Thus, the headquarters not only making investment decisions, but also participate in the process of borrower's decision-making. Consequently, the managers would spare no efforts to make decisions that can benefit both the lenders and borrowers. Due to the Optimal contracts between investors and entrepreneurs, the Internal Capital Markets can solve the agency problems in the External Capital Market.

CONCLUSION

Reference

1. WILLIAMSON. 0. E., 1975, Markets and Hierarchies: Analysis and Antitrust Implications (Free Press: New York).
2. Alchian. A. A., 1969, Corporate Management and Property Rights. In: Henry. Manneed. Economic Policy and the Regulation of Corporate Securities (American Enterprise Institute, Washington, D. C).
3. ROBERT £. HOSKISSON & THOMAS A. TURK, 1990, “Corporate Restructuring: Governance and Control Limits of the Internal Capital Market. ” Academy of Management Review.
4. Lundstrum, L., “The Diversified Firm’s Valuable Internal Capital Market.” Corporate Finance Review 5, 23–31.
5. Robert H.Gertner,David S. Scharfsteinand Jeremy C. Stein, 1994, Internal Versus External Capital Markets, National Bureau of Economic Research.
6. Grossman, Sanford, and Oliver Hart, 1986, "The Costs and Benefits of Ownership: A TheoryofVerticalandLateral Integration. ” Journal of Political Economy,