Moral Hazard and Optimal Subsidiary Structure for Financial Institutions

43 Pages Posted: 26 Aug 2001

See all articles by Charles M. Kahn

Charles M. Kahn

University of Illinois, Urbana-Champaign; Feseral Reserve Bank of Saint Louis; Bank of Canada

Andrew Winton

University of Minnesota - Twin Cities - Carlson School of Management; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Date Written: July 1, 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. 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 bank and finance company subsidiaries, "good bank/bad bank" structures, securitization, and "swaps" subsidiaries.

Keywords: financial institutions, subsidiaries, securitization, risk-shifting, moral hazard, corporate structure

JEL Classification: G20, G21, G24, G32, L20

Suggested Citation

Kahn, Charles M. and Winton, Andrew, Moral Hazard and Optimal Subsidiary Structure for Financial Institutions (July 1, 2001). AFA 2002 Atlanta Meetings. Available at SSRN: https://ssrn.com/abstract=281037 or http://dx.doi.org/10.2139/ssrn.281037

Charles M. Kahn

University of Illinois, Urbana-Champaign ( email )

Department of Finance
340 Wohlers Hall
Champaign, IL 61820
United States

HOME PAGE: http://kahnfrance.com/cmk/

Feseral Reserve Bank of Saint Louis

411 Locust St
Saint Louis, MO 63011
United States

Bank of Canada

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

Andrew Winton (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

321 19th Avenue South
Department of Finance
Minneapolis, MN 55455
United States
612-624-0589 (Phone)
612-626-1335 (Fax)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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