Market discipline and incentive problems in Conglomerate firms with applications to banking

This paper analyzes the optimality of conglomeration. We show that the Pote ntial benefits of conglomeration depend critically on the effectiveness of market discipline for stand-alone activities. Effective market discipline r educes the benefits of conglomeration. with ineffective market discipline o f stand-alone activities, conglomeration would further undermine market dis cipline, but may nevertheless be beneficial. In particular, when rents are not too high, the diversification benefits of conglomeration dominate the n egative incentive effects. A more competitive environment therefore induces conglomeration. We also show that introducing internal cost-of-capital all ocation schemes creates internal market discipline that complements the wea k external market discipline of a conglomerate. Our analysis sheds light on the Barings debacle and other recent developments in the banking sector, J ournal of Economic Literature Classification Numbers: G20, G21, G34. (C) 20 00 Academic Press.