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The Effects of Bank Consolidation on Risk Capital Allocation and Market Liquidity

  • Chris D'Souza
  • Alexandra Lai

We investigate the effects of financial market consolidation on the allocation of risk capital in a financial institution and the implications for market liquidity in dealership markets. An increase in financial market consolidation can increase liquidity in foreign exchange and government securities markets. We assume that financial institutions use risk-management tools in the allocation of risk capital and that capital is determined at the firm level and allocated among separate business lines or divisions. The ability of market makers to supply liquidity is influenced by their risk-bearing capacity, which is directly related to the amount of risk capital allocated to this activity. 2006 The Southern Finance Association and the Southwestern Finance Association.

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Paper provided by Bank of Canada in its series Working Papers with number 02-5.

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Length: 44 pages Abstract: This paper investigates the effects of financial market consolidation on risk capital allocation in a financial institution and the implications for market liquidity in dealership markets. We show that an increase in financial market consolidation can have ambiguous effects on liquidity in foreign exchange and government securities markets. The framework employed assumes that financial institutions use risk-management tools (for example, value-at-risk) in the allocation of risk capital. Capital is determined at the firm level and allocated among separate business lines, or divisions. The ability of market-makers to supply liquidity is influenced by their risk-bearing capacity, which is directly related to the amount of risk capital allocated to this activity. A model of inter-dealer trading is developed that is similar to the framework of Volger (1997). However, we allow for heterogeneity among dealers with respect to their risk-bearing capacity. The allocation of risk capital within financial institutions has implications for the types of mergers among financial institutions that can be beneficial for market quality. This effect depends on the correlation among cash flows from business activities that the newly merged financial institution will engage in. A negative correlation between market-making and the new activities of a merged firm suggests the possibility of increased market liquidity. Our results suggest that, when faced with a proposed merger between financial institutions, policy-makers and regulators would want to examine the correlations among division cash flows.
Date of creation: 2002
Date of revision:
Handle: RePEc:bca:bocawp:02-5
Contact details of provider: Postal: 234 Wellington Street, Ottawa, Ontario, K1A 0G9, Canada
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Web page: http://www.bank-banque-canada.ca/

References listed on IDEAS
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  1. S. Baranzoni & P. Bianchi & L. Lambertini, 2000. "Market Structure," Working Papers 368, Dipartimento Scienze Economiche, Universita' di Bologna.
  2. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
  3. Toni Gravelle, 1999. "Markets for Government of Canada Securities in the 1990s: Liquidity and Cross-CountryComparisons," Bank of Canada Review, Bank of Canada, vol. 1999(Autumn), pages 9-18.
  4. Stoughton, Neal & Zechner, Josef, 1999. "Optimal Capital Allocation Using RAROC And EVA," CEPR Discussion Papers 2344, C.E.P.R. Discussion Papers.
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