Internal versus External Capital Markets

This paper presents a framework for analyzing the costs and benefits of internal vs. external capital allocation. We focus primarily on comparing an internal capital market to bank lending. While both represent centralized forms of financing, in the former case the financing is owner-provided, while in the latter case it is not. We argue that the ownership aspect of internal capital allocation has three important consequences: 1) it leads to more monitoring than bank lending; 2) it reduces managers' entrepreneurial incentives; and 3) it makes it easier to efficiently redeploy the assets of projects that are perfotming poorly under existing management.