Complex financial institutions and systemic risk

The objective of this paper is to identify the bank organizational structures that generate substantial systemic risk and to explain why banks have incentives for creating them. We seek the explanation in a bank’s incentive to exploit financial synergies by choosing an organizational structure that maximizes the benefits the bank can derive from an interest tax shield, reduced default cost and the possibility of a state bailout in the presence of limited liability for legally separate entities. In both a calibrated and some stressed scenarios, we show that subsidiaries generate the highest value and the highest systemic risk. Complexity exacerbates the incentive to lever up in subsidiary structures. It blows up expected losses without having a comparable effect on value. The main sources of complexity in this paper are differences in asset risk and size across bank affiliates in different countries or with different financial activities. We also provide a perspective on current reform efforts with respect to the organization of banks..