Financial Conglomerates: What we know and do not Gianni De Nicoló IMF Research Department

1. Financial Conglomerates:What we know and do notGianni De NicolóIMF Research Department

2. Overview • Some facts • Potential drivers of conglomeration • Evidence • Policy Implications

3. 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)

4. 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).

5. 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.)

6. 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

7. 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

8. 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.

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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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?

17. 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

18. 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?

19. 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.