DP5036 Regulating Financial Conglomerates

Author(s): Xavier Freixas, Gyöngyi Lóránth, Alan Morrison
Publication Date: May 2005
Keyword(s): capital regulation, financial conglomerate, regulatory arbitrage
JEL(s): G21, G22, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5036

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.