Moral Hazard and Optimal Subsidiary Structure for Financial Institutions

When a financial institution relies heavily on debt finance, it may be tempted to engage in risk-shifting, deviating from efficient asset choice. We show that such risk-shifting incentives can be dampened by creating a two-subsidiary structure, where one subsidiary holds lower-risk assets and the other holds higher-risk assets; intuitively, this “insulates” lower-risk assets from higher-risk assets, reducing incentives to engage in riskshifting in the safer subsidiary. This bipartite structure is most likely to dominate a unitary structure when risk differs greatly across assets and high-risk assets are relatively plentiful. If efficient high-risk assets are highly profitable and relatively few in number, however, the bipartite structure may lead to “cherry-picking.” Our analysis also suggests that institutions may opt for multiple subsidiaries even though this does not appear to take full advantage of gains from diversification. Our results help motivate a number of institutional arrangements, including the use of separate commercial bank and finance company subsidiaries, “good bank/bad bank” structures, securitization, and “swaps” subsidiaries. This is a substantial revision of an earlier paper entitled “Project Choice, Moral Hazard, and Optimal Subsidiary Structure for Financial Intermediaries.” We thank seminar participants at the University of Chicago, the University of Texas, Bellcore, and the Federal Reserve Banks of Cleveland and Chicago, and particularly Herb Baer, Doug Diamond, John McMillan, and Yossi Spiegel for their comments. Address all correspondence to Winton at Finance Department, University of Minnesota, 321 19th Avenue South, Minneapolis, MN 55455. Phone: (612) 624-0589. Fax: (612) 626-1335. Email: [email protected]. 1 For example, in the recent debate on banking reform (HR 10), one of the major points of contention was the question of whether the new lines of business to be permitted to banks were to be housed in wholly-owned subsidiaries or in separate firms within a holding company structure. While the realpolitik underlying this debate was actually a turf fight between regulators, the substantive issues in the debate included the relative merits of various structures for limiting risk taking behavior. 1