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 risk eliminating good firms. Given the bank's bailout policy, risk-averse firms might form a conglomerate to reduce the risk of liquidation.

The technological constraints on sustaining production chains have been discussed extensively by development economists, but the role of financial linkages has received less attention. In a model of recursive moral hazard for a manufacturing supply chain, we show that the structure of interlocking receivables and payables serve as the glue for the production chain that sustains complex manufacturing output. The inefficiency associated with recursive moral hazard can be mitigated through optimal delays in payments along the chain. However, efficiency requires large stocks of working capital, and invoice prices are high due to implicit amortization costs of inter-firm credit.