Moral Hazard and Optimal Subsidiary Structure for Financial Institutions

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. Consider a two-subsidiary (bipartite) structure in which one subsidiary is supposed to hold low-risk assets and the other is supposed to hold high-risk assets. By insulating low-risk assets from high-risk assets, this bipartite structure 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 and finance company subsidiaries, good bank/bad bank structures, securitization, and swaps subsidiaries.