DP1949 Market Discipline and Incentive Problems in Conglomerate Banks

Author(s): Arnoud W A Boot, Anjolein Schmeits
Publication Date: August 1998
Keyword(s): Banks, internal organization, scope
JEL(s): G21, G31
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1949

This paper analyses 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.