This paper analyzes the optimality of conglomeration. We show that the potential benefits of conglomeration depend critically on the effectiveness of market discipline for stand-alone activities. Effective market discipline reduces the benefits of conglomeration. With ineffective market discipline of stand-alone activities, conglomeration would further undermine market discipline, but may nevertheless be beneficial. In particular, when rents are not too high, the diversification benefits of conglomeration dominate the negative incentive effects. A more competitive environment therefore induces conglomeration. We also show that introducing internal cost-of-capital allocation schemes creates internal market discipline that complements the weak external market discipline of a conglomerate. Our analysis sheds light on the Barings debacle and other recent developments in the banking sector. Journal of Economic Literature Classification Numbers: G20, G21, G34.

In this article, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors, and explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency (CRA) and a firm through its credit watch procedures. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of rating changes.

In this article, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a “focal point” for firms and their investors, and explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency (CRA) and a firm through its credit watch procedures. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of rating changes.