Financial Conglomerates: What we know and do not Gianni De Nicoló IMF Research Department 10/20/2019

Overview Some facts Potential drivers of conglomeration Evidence Policy Implications 10/20/2019

Some Facts Conglomerate: a financial firm active in at least 2 business lines (banking, insurance, asset management) Conglomeration is pervasive, especially in emerging markets and developing economies However, some “de-conglomeration” has occurred recently, especially in developed economies (focus versus diversification) 10/20/2019

Facts (cont.) Conglomeration among the largest 500 firms worldwide increased between 1995 and 2000 both in terms of number of firms and assets held About 87 percent of conglomerates are led by banks The trend in conglomeration appears global (industrialized and emerging market countries). 10/20/2019

What are the drivers of conglomeration? Exploit “synergies” and diversification Increase market power Managerial “hubris” and other agency costs Moral-hazard related expansion of safety net subsidies (e.g. To Big to-Fail, to-Discipline, to- Monitor-Effectively, etc.) 10/20/2019

Synergies Economies of scale/scope Information sharing Revenue economies of scope: cross-selling Cost economies of scope BUT, there may be managerial diseconomies of scale/scope, firms may become too large/complex to manage 10/20/2019

Evidence on “synergies” The evidence on economies of scope is at best mixed No clear cost or revenue advantages on average. Among the top global financial services providers as of end-2002, the largest firms were not necessarily those with the highest market value 10/20/2019

Conglomeration discount? The market value of the whole is lower than that of its components: the difference is the “discount” Studies that finds it and study that do not (mainly for the U.S.) Nobody seems to find a conglomeration premium. 10/20/2019

Market power? Difficult to measure Some business segments are highly concentrated (investment banking, asset management....) Evidence is scant Research needed 10/20/2019

Diversification and risk-taking incentives Conglomerates should attain lower variability of returns vs. specialized firms “Simulation” studies showed potential diversification benefits through mergers among different services (banking, insurance, asset management, etc.) Results: some mergers might reduce risk, some might not 10/20/2019

Financial Risk Product diversification and efficiency gains may allow firms to attain LOWER RISK PROFILES Extension of safety-net to non-bank activities may allow firms to choose HIGHER RISK PROFILES What are the NET EFFECTS? I carried out a simple regression analysis 10/20/2019

Questions Do large financial firms exhibit levels of failure risk lower than small firms? NO Does failure risk of conglomerate and non-conglomerate firms differ? YES, (LARGE) CONGLOMERATES APPEAR TO BE AT LEAST AS RISKY AS OR RISKIER THAN SPECIALIZED FIRMS 10/20/2019

Cross-sectional regressions Dependent variables: Z-score (a proxy measure of failure risk) Z components: ROA, E/A and ROA volatility Regressors: Conglomerate dummy Size of conglomerates and non-conglomerates Other controls 10/20/2019

Table 2: Regression Results on Risk, Size and Conglomeration 1/

Implication The incentives for firms to take on more risk appear to have offset the risk reductions allowed by either scale and scope economies or geographic and product diversification 10/20/2019

Other issues Conflict of interest? Large foreign intermediaries in (smaller) financial systems have beneficial effects BUT, are there risks of “over-dependence” (credit flows) ? Large conglomerate housed in “small” countries: could they be rescued? 10/20/2019

Summing up Benefits of synergies hard to detect on average Risk profiles do not appear smaller than those of specialized firms We do not know enough about market power effects of conglomerates More research needed, especially for emerging and developing economies 10/20/2019

Policy responses Choose the supervisory architecture that maximizes monitoring capacity Choose the regulatory architecture that minimizes regulatory arbitrage and the extension of safety net subsidies To what extent international conglomeration implies “conglomeration” of supervision? 10/20/2019

References Amel, D., Barnes, C., Panetta, F. and Salleo, C. , 2004, “Consolidation and Efficiency in the Financial Sector: A Review of the International Evidence,” Journal of Banking and Finance. Bank for International Settlements, 2001, The Banking Industry in the Emerging Market Economies: Competition, Consolidation, and Systemic Stability, BIS Papers, number 4, August. De Nicoló, G., P.Bartholomew, J. Zaman, and M.Zephirin, 2004, Bank consolidation, conglomeration and internationalization: Trends and implications for financial risk, Financial Markets, Institutions and Instruments. Group of Ten, 2001, Report on Consolidation in the Financial Sector, (January), Bank for International Settlements: Basel, Switzerland. Litan, R. and Herring, R. (Editors), 2003, Brookings-Wharton Papers on Financial Services, focusing on Financial Conglomerates. 10/20/2019