DP7051 Bank Diversification and Incentives

Author(s): Gyöngyi Lóránth, Alan Morrison
Publication Date: November 2008
Keyword(s): Bank diversification, soft budget constraint, tying, universal banks
JEL(s): G20, G21, G34
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7051

This paper analyzes the consequences of bank diversification into fee-based businesses. Universal banks raise welfare by expanding the range of services available to entrepreneurs. However, because they may choose to rescue failed entrepreneurs in order to sell them fee-based financial services, universal banks provide weaker incentives. Adopting a holding company structure and devolving liquidation decisions to the lending division partially resolves this problem. We demonstrate a relationship between the welfare effects of diversification and competition for fee-based business, and we analyze the tying of lending and fee-based business. Our analysis yields several testable implications.