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Regulating Financial Conglomerates

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  • Freixas, Xavier
  • Lóránth, Gyöngyi
  • Morrison, Alan

Abstract

We investigate the optimal regulation of financial conglomerates that combine a bank and a non-bank financial institution. The conglomerate’s risk-taking incentives depend upon the level of market discipline it faces, which in turn is determined by the conglomerate’s liability structure. We examine optimal capital requirements for standalone institutions, for integrated financial conglomerates, and for financial conglomerates that are structured as holding companies. For a given risk profile, integrated conglomerates have a lower probability of failure than either their standalone or decentralized equivalent. However, when risk profiles are endogenously selected conglomeration may extend the reach of the deposit insurance safety net and hence provide incentives for increased risk-taking. As a result, integrated conglomerates may optimally attract higher capital requirements. In contrast, decentralized conglomerates are able to hold assets in the socially most efficient place. Their optimal capital requirements encourage this. Hence, the practice of ‘regulatory arbitrage’, or of transferring assets from one balance sheet to another, is welfare-increasing. We discuss the policy implications of our finding in the context not only of the present debate on the regulation of financial conglomerates but also in the light of existing US bank holding company regulation.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5036.

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Date of creation: May 2005
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Handle: RePEc:cpr:ceprdp:5036

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Keywords: capital regulation; financial conglomerate; regulatory arbitrage;

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Cited by:
  1. Moreno, Diego & Takalo , Tuomas, 2012. "Optimal bank transparency," Research Discussion Papers 9/2012, Bank of Finland.
  2. Claudio Dicembrino & Pasquale Lucio Scandizzo, 2012. "Can Portfolio Diversification increase Systemic Risk? Evidence from the U.S and European Mutual Funds Market," CEIS Research Paper 240, Tor Vergata University, CEIS, revised 11 Jul 2012.
  3. Eling, Martin & Gatzert, Nadine & Schmeiser, Hato, 2009. "Minimum standards for investment performance: A new perspective on non-life insurer solvency," Insurance: Mathematics and Economics, Elsevier, vol. 45(1), pages 113-122, August.
  4. Schlütter, Sebastian & Gründl, Helmut, 2011. "Who benefits from building insurance groups? A welfare analysis of optimal group capital management," ICIR Working Paper Series 08/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.
  5. Agur, Itai, 2009. "Regulatory Competition and Bank Risk Taking," CEPR Discussion Papers 7524, C.E.P.R. Discussion Papers.
  6. Grégory de Walque, 2004. "Voting on pensions: a survey," Working Paper Research 62, National Bank of Belgium.
  7. Wagner, W.B., 2006. "The Broadening of Activities in the Financial System: Implications for Financial Stability and Regulation," Discussion Paper 2006-72, Tilburg University, Center for Economic Research.
  8. O. De Jonghe, 2009. "Back to the Basics in Banking? A Micro-Analysis of Banking System Stability," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 09/579, Ghent University, Faculty of Economics and Business Administration.
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  12. Lóránth, Gyöngyi & Morrison, Alan, 2008. "Bank Diversification and Incentives," CEPR Discussion Papers 7051, C.E.P.R. Discussion Papers.
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