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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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Citations

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Cited by:
  1. Lóránth, Gyöngyi & Morrison, Alan, 2008. "Bank Diversification and Incentives," CEPR Discussion Papers 7051, C.E.P.R. Discussion Papers.
  2. Dietrich, Diemo & Vollmer, Uwe, 2012. "Are universal banks bad for financial stability? Germany during the world financial crisis," The Quarterly Review of Economics and Finance, Elsevier, vol. 52(2), pages 123-134.
  3. De Jonghe, Olivier, 2010. "Back to the basics in banking? A micro-analysis of banking system stability," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 387-417, July.
  4. Bourjade, Sylvain & Schindele, Ibolya, 2011. "The role of agency costs in financial conglomeration," MPRA Paper 34815, University Library of Munich, Germany.
  5. Itai Agur, 2009. "Regulatory Competition and Bank Risk Taking," DNB Working Papers 213, Netherlands Central Bank, Research Department.
  6. Swamy, Vighneswara, 2012. "Financial Holding Company Structure for India," MPRA Paper 47515, University Library of Munich, Germany.
  7. Hamid Mehran & Alan Morrison & Joel Shapiro, 2011. "Corporate governance and banks: what have we learned from the financial crisis?," Staff Reports 502, Federal Reserve Bank of New York.
  8. Elisa Luciano & Clas Wihlborg, 2013. "The Organization of Bank Affiliates; A Theoretical Perspective on Risk and Efficiency," Carlo Alberto Notebooks 322, Collegio Carlo Alberto.
  9. Mälkönen, Ville, 2009. "Financial conglomeration and monitoring incentives," Journal of Financial Stability, Elsevier, vol. 5(2), pages 105-123, June.
  10. Krishnan, Karthik, 2013. "Commercial banks getting underwriting business: Tying or business building?," Journal of Economics and Business, Elsevier, vol. 66(C), pages 47-75.
  11. 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.
  12. Onji, Kazuki & Vera, David & Corbett, Jenny, 2012. "Capital injection, restructuring targets and personnel management: The case of Japanese regional banks," Journal of the Japanese and International Economies, Elsevier, vol. 26(4), pages 495-517.
  13. Olivier De Jonghe, 2008. "The impact of revenue diversity on banking system stability," EIEF Working Papers Series 0815, Einaudi Institute for Economics and Finance (EIEF), revised Jul 2008.
  14. Moreno, Diego & Takalo , Tuomas, 2012. "Optimal bank transparency," Research Discussion Papers 9/2012, Bank of Finland.

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