On the Risk Situation of Financial Conglomerates: Does Diversification Matter?

In general, conglomeration leads to a diversification of risks (the diversification benefit) and to a decrease in shareholder value (the conglomerate discount). Diversification benefits in financial conglomerates are typically derived without accounting for reduced shareholder value, even though a comprehensive analysis requires competitive conditions within the conglomerate, i.e., shareholders and debtholders receive risk-adequate returns. In this paper, we extend the literature by comparing the diversification effect in conglomerates with and without accounting for the altered shareholder value. We compare results for a holding company, a parent-subsidiary structure, and an integrated model. In addition, we consider different types of capital and risk transfer instruments in the parent-subsidiary model, including intra-group retrocession and guarantees. We conclude that diversification does not matter to the extent frequently emphasized in the literature when diversification effects are studied under competitive conditions. Our analysis contributes to the ongoing discussion on group solvency regulation and enterprise risk management.