Regulating Financial Conglomerates

Alan Morrison, Xavier Freixas, Universitat Pomeu Fabra and CEPRGyongyi Loranth, Judge Institute of Management and University of Cambridge and CEPR

No 2005-FE-03, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: We investigate the optimal regulation of financial conglomerates which 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 decentralised 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, decentralised 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 transfering 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.

Keywords: Financial Conglomerate; Capital Regulation; Regulatory Arbitrage (search for similar items in EconPapers)
JEL-codes: G21 G22 G28 (search for similar items in EconPapers)
Date: 2005-03-01
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Citations: View citations in EconPapers (1)

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