We investigate the optimal regulation of financial conglomerates which combine a bank and a non-bank financial institution. The conglomerateâ€™s risk-taking incentives depend upon the level of market discipline it faces, which in turn is determined by the conglomerateâ€™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 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.
We analyse a model of financial intermediation in which intermediaries are subject to moral hazard and they do not invest socially optimally, because they ignore the systemic costs of failure and, in the case of banks, because they fail to account for risks which are assumed by the deposit insurance fund. Capital adequacy requirements are designed to minimise the social costs of these effects. We show that banks should always have higher regulatory capital requirements than insurance companies. Contrary to received wisdom, when banks and insurance companies combine to form financial conglomerates we show that it is socially optimal to separate their balance sheets. Moreover, the practice of "regulatory arbitrage", or of transfering assets from one balance sheet to another, is welfare increasing.
Financial conglomerate, capital regulation, regulatory arbitrage
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