moral hazard and optimal subsidiary structure for financial.pdf

Moral Hazard and Optimal Subsidiary Structure for Financial Institutions Charles Kahn Finance Department University of Illinois at Champaign-Urbana and Andrew Winton Finance Department University of Minnesota This version: March 22, 2001 Abstract Because many financial institutions rely heavily on debt finance and have great flexibility in their choice of investments, they may be tempted to exploit debt holders by taking on inefficient but risky investments. By “insulating” low-risk assets from high-risk assets, a two-subsidiary (“bipartite”) structure where one subsidiary holds low-risk assets and the other holds high-risk assets reduces incentives to engage in risk- shifting in the safer subsidiary. Nevertheless, the risky subsidiary may engage in limited risk-shifting, and the institution may engage in “cherry-picking,” putting the most profitable high-risk assets in the safer subsidiary and replacing them with inefficient high-risk assets. A bipartite structure is most likely to dominate a unitary structure when risk differs greatly across assets. 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. These results help motivate a number of institutional arrangements, including the use of separate commercial bank and finance company subsidiaries, “good bank/bad bank” structure