International Conglomerate Banking

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International Conglomerate Banking

International Conglomerate Banking

The emergence of financial conglomerates is one of the major financial developments of recent years.1 Financial conglomerates are institutions that provide under a single corporate umbrella banking, insurance and other financial products. Conglomeration has been motivated by cost advantages from economies of scale and scope in insurance sales and securities underwriting, and by the perceived advantages of risk diversification.2. The recognition of the importance of conglomeration for the financial sector has led the Group of Ten to study its potential implications for public policy. This paper is concerned with risk taking and risk shifting in financial conglomerates, and their implications for optimal capital regulation.

We analyze the extent to which risk-taking incentives in financial conglomerates and their optimal capital regulation are affected by organizational form. (Dierick, 2004) and (Shull and White, 1998) discuss the different legal structures available to conglomerates. Although the choice of legal structure may be restricted by regulation, 4 it is essentially a choice between structuring the conglomerate as an integrated entity subject to a unique liability constraint, or structuring it as a holding company and allowing its various divisions to fail independently. For example, universal banks are structured as integrated entities and are engaged in the same activities as bank holding companies. The conglomerate's capital regulation is constrained by its organizational form. Integrated entities face a single capital requirement, while the regulator can set separate capital requirements for each division of a decentralized conglomerate.

Decentralized conglomerates can take advantage of the separate capital requirements for their constituent divisions by transferring assets between divisions in order to avoid high capital charges. This process is popularly referred to as regulatory, or capital, arbitrage. Regulators usually regard capital arbitrage as a risk of conglomeration: see for example Dierick (2004). The Joint Forum (2001) provides an extensive discussion of regulatory arbitrage and is ambivalent as to its effects, concluding that it must be accompanied by evidence of adequate risk management practices.5 In contrast, because integrated conglomerates have a consolidated balance sheet, they cannot engage in regulatory arbitrage. They can however achieve inter-divisional diversification (see Mälkönen, 2004 and Allen and Jagtiani, 2000). Practitioners have argued that conglomerate diversification will reduce bankruptcy risk and therefore that it should be rewarded with reduced capital requirements (see Oliver et al., 2001). This raises two questions:

(i) Does diversification within integrated conglomerates indeed reduce risk taking? and

(ii) What are the effects of the capital arbitrage that accompanies decentralized conglomeration?

Our answers to these questions challenge some commonly-held views on conglomeration. First, we show that diversification within integrated conglomerates increases risk-taking incentives. As a result, it may even lower welfare relative to the standalone institution case. Second, we show that capital arbitrage within holding company conglomerates can raise welfare by increasing market discipline. This effect is further strengthened to the extent that the non-bank divisions in conglomerates have a lower social cost of failure than banks.

The intuition for our results is as follows. In our model, banks are specialist investors in ...
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