Market discipline and incentive problems in conglomerate banks

This paper analyzes the optimal conglomeration of bank activities. Weshow that the effectiveness of market discipline forstand-alone activities (divisions) is of crucial importance for thepotential benefits of conglomeration. We find thateffective market discipline reduces the potential benefits ofconglomeration. With ineffective market discipline of stand-alone activities conglomeration would further undermine marketdiscipline, but may nevertheless be beneficial. Inparticular, when rents are not too high the diversification benefitsof conglomeration may dominate the negative incentiveeffects. A more competitive environment therefore may induceconglomeration. We also show that introducing internalcost of allocation schemes may create 'internal' market disciplinethat complements the weak external market discipline ofthe conglomerate. In this context we show that these schemes shouldrespond to actual risk choices, rather than be limitedto anticipated risk choices.