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An internal capital market is both a capital allocation method and a department within a company that distributes money to other sections of the company. Unlike an external capital market, an internal capital market owns the sections of the company it gives money to, increasing control over the funds. An advantage of owning the business units is that it is much easier to control who receives the money, which can reduce the chances of fraud. Another advantage is that the department can change the allocation if the money is used inappropriately.
There are two types of capital markets: external and internal. With an external capital market, money is lent to outside individuals and companies that are not associated with the company that distributes the money. In an internal capital market, money is sent to business units owned by the company, often increasing control over funds, unless there are unscrupulous employees trying to steal the money. A foreign market makes money by charging interest on borrowed money, while a home market makes money through projects and work done with the money.
An advantage of using this approach is that the money is much easier to track than if it were being used by entities outside the company. For example, the department can talk to and check the business unit’s spending to make sure the money is being used correctly and can tell the unit how it can or cannot spend the money. The department will also know exactly who is handling the money and exactly where it is going, which can reduce the chances of fraud.
The allocation need not be static with an internal capital market, and rarely is. Money allocation typically depends on how well the business unit is doing, which makes it easier for the department to reward successful units and cap capital for unsuccessful units. For example, if a business unit is doing poorly and is unable to turn a profit, the allocation to that unit will decrease or stop altogether. The money would then go to more successful units to help make more money for the company.
Additional workers may be needed with an internal capital market, which may increase costs. These additional workers ensure that money is properly allocated and tracked. With large companies, this can be very expensive because many people may be needed to properly care for business units.