The 'Misallocation' of Internal Financing

This paper investigates the "misallocation" implications of corporate internal financing. We introduce corporate risk management into a standard continuous-time heterogeneous agent model with incomplete markets. We show that the economy's ability to allocate resources through the price mechanism is bounded by corporate internal savings as there is no market to equalize the marginal value of internal resources across firms. In other words, corporate cash can help achieve dynamic efficiency across times at the firm level but not static efficiency across individuals at the macro level. More importantly, misallocation -- defined as the static resource allocation efficiency across individuals -- increases in an economy where firms rely more on internal financing due to the increased earnings risk. Finally, our model can quantitatively match the deteriorating capital allocation efficiency in the U.S. data