Financially interlinked business groups

Financial interlinkage, in the form of cross-holding of equity and debt bet ween firms, characterizes business groups in many countries. We suggest tha t such financial interlinkage can be viewed as a way to solve credit ration ing caused by asymmetric information. If firms possess better information a bout each other than a bank, then business groups can be a mechanism to ind uce firms to sort on the basis of this information. Banks can offer a menu of contracts that vary in the extent of financial interlinkage to induce fi rms to self-select on the basis of the equilibrium composition of the busin ess groups they can form.