Working Paper Series 06/2007. Regulating financial conglomerates. Freixas, X., Loranth, G. and Morrison, A.D.

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1 Working Paper Series 06/2007 Regulating financial conglomerates Freixas, X., Loranth, G. and Morrison, A.D.

2 These papers are produced by Judge Business School, University of ambridge. They are circulated for discussion purposes only. Their contents should be considered preliminary and are not to be quoted without the authors permission. Author contact details are as follows: Xavier Freixas Dept of Economics and Business Universitat Pompeu Fabra Gyongyi Loranth Judge Business School University of ambridge Alan D Morrison Saïd Business School University of Oxford alan.morrison@sbs.ox.ac.uk This paper is also available from the entre for Economic Policy and Research, DP 5036, It is also under third review at the Journal of Financial Intermediation ( Please address enquiries about the series to: Research Support Manager Judge Business School Trumpington Street ambridge B2 1AG, UK Tel: Fax: research-support@jbs.cam.ac.uk

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7 Δ

8 κ ρ ζ ζ φ φ φ φ ζ

9 ρ Δ κ ζ φ time 0 time 1 time 2 time 3 time 4 Regulator announces capital requirement Nature reveals expected project return, R Intermediary decides whether to invest, and selects investment risk B {0,B} Fund-raising occurs Returns realise ρ

10 ρ ρ ρ ρ ρ ρ π ρ ρ κκ κ π ρ ζ κ κ ζ π π κ S

11 R R h S 1 () =1 κ R S + R l 0 π π ζ κ ζ κ ζ κ π π ζ

12 R h 1 ζ + B ( 1+ ζ) 1+ κ B 1+ κ 1+ ζ B 1 F S Welfare = R-1 Welfare = R-1-φ/2 R = B + 1 ζ ( ) R ( ) FIR : R = 1 + ζ B κ SIR : R = 1 + κ R l 0 B ζ 1+ κ F S κ ζ κ κ

13 φ φ φ φ φ ζ κ φ κ κ ζ κ κ κ φ κ ζ φ φ φ ζ κ ζ ζ

14 φ κ ζ φ φ φ φ φ φ φ φ φ φ φ φ ζ

15 Δ κ ζ φ ζ φ φ ζ

16 time 0 time 1 time 2 time 3 time 4 Regulator announces capital requirement Nature reveals expected project return, R D, R M Investment decision for each project, and selection of risk B D, B M {0,B} Possible opportunity for trade. Fund-raising occurs. Returns realise

17 π π κ ζ κ κ κ ζ φ φ φ

18 ζ κ φ φ φ

19 2R h R S Safe B 3 ζ F Diversified ( ) ( ) 1 R F 7 2 B ζ 8 κ 3 ( ) B ζ 1 R F 7 2 B + + ζ 8 κ 3 ( ) + 4 R = 7 1 = ( ) 3 2R l ( ) B 3ζ 8 1 ( + κ ) 2B ζ 8 1 ( + κ )

20 φ φ φ φ ζ φ φ φ

21 ζ ζ ζ φ ζ κ φ ζ κ ζ ζ κ

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24 φ

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26 F ζ F

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28 ζ ζ

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32 φ Δ ω ω ω φ ζ ζ Δ ζ κ φ Δ ζ κ κ Δ κ Δ R ζ κ F κ

33 φ φ Δ φ Δ κ ζ κ κ φ κ φ φ F F F F F F F ρ F ρ F ρ ρ F ρ ρ F F F F F F F F F F F π κ ζ

34 2R h R F 5 F 3 R = B = ( ) 2 ( ) 2 R = 2 B ( ) ( ) S R = = ( ) B ( ) B F 2 R = 1 = R 7 1 = ( ) 3 ( ) 3 F 4 F 1 2R l 0 1 3B 2 1 F F F F F π κ ζ π κ ζ π κ ζ π κ ζ F F

35 F F ρ F F 2R h R R = B ^ F 2 2( ( ) S ( ) R = B + 1 = 1( ) ^ F 1 2R l 0 1 F F F F π κ ζ π κ ζ ζ π

36 F F ζ F F ζ F F ζ F F ζ ζ F F ζ F F ζ ζ F F ζ ζ π π F ζ F F F F F F F F F F F F F F

37 ζ ζ F F F F F F F F F F F ζ ζ π π κ ζ ζ ζ κ ζ κ

38 2R h R V: Safe B 3 ζ 1 + ζ III: Diversified II: Undiversified B ζ 1 ζ IV: Diversified 2R l I: Diversified 7 1 ( ) B 2 1 π π ζ κ ζ κ ζ ζ κ ζ κ π ζ κ ζ π ζ ζ ζ ζ ζ

39 ζ κ ζ κ ζ κ π π π F F S