This paper develops a model of business groups in emerging markets where banks do not have sufficient capability to accurately distinguish between good (or high productivity) and bad (or low productivity) borrower firms. However, the bank can observe whether each firm repays on the repayment day, infer the probability of bad firms among the defaulted, and use liquidation as a screening device to select good firms. For stand-alone firms, the bank may find it optimal to liquidate all the defaulted, given that the chance of bad firms among the defaulted is large. In contrast, for business conglomerates, the optimal policy can be a full bailout since conglomeration, through cross debt payment guarantees, hinders the bank from obtaining information on the productivity of individual firms that is needed to sort out the firms to be liquidated. Expectation of such a bailout policy may encourage risk-averse firms to form a conglomerate to serve as an information-diluting device that helps eliminate the risk of liquidation.

Executive Summary

I. Introduction

II. The Basic Model

III. Liquidation as a Screening Device

IV. Conglomerates and Optimal Bailout

V. Conglomeration Choice and Macroeconomic Implications

VI. Extensions and Discussions

VI. Conclusion

Appendix

References