Market Discipline in Conglomerate Banks: Is an Internal Allocation of Cost of Capital Necessary as an Incentive Device?

This paper analyzes the optimal conglomeration of bank activities. We show that incentive problems in banking sometimes dictate integration of activities, but with perfect market discipline always push us away from integration/conglomeration. Ineffective market discipline could make conglomeration optimal, even if conglomeration further undermines market discipline. We also show that an internal allocation of the cost of capital could add effective `internal' discipline and improve on the outcome of conglomeration. The analysis is subsequently applied to the Barings debacle. This paper was presented at the Financial Institutions Center's October 1996 conference on "