Market Discipline in Conglomerate Banks: Is an Internal Allocation of Cost of Capital Necessary as Incentive Device
AbstractThis paper analyzes the optimal conglomeration of bank activities. We show that the effectiveness of market discipline for stand-alone activities (divisions) is of crucial importance for the potential benefits of conglomeration. We find that effective market discipline reduces the potential benefits of conglomeration. With ineffective market discipline of stand-alone activities conglomeration would further undermine market discipline, but may nevertheless be beneficial. In particular, when rents are not too high the diversification benefits of conglomeration may dominate the negative incentive effects. A more competitive environment therefore may induce conglomeration. We also show that introducing internal cost of allocation schemes may create 'internal' market discipline that complements the weak external market discipline of the conglomerate. In this context we show that these schemes should respond to actual risk choices, rather than be limited to anticipated risk choices.
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Bibliographic InfoPaper provided by William Davidson Institute at the University of Michigan in its series William Davidson Institute Working Papers Series with number 125.
Date of creation: 01 Nov 1997
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2002-04-03 (All new papers)
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