Moral Hazard and Optimal Subsidiary Structure for Financial Institutions




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    • Charles Kahn is from the University of Illinois at Urbana-Champaign. Andrew Winton is from the University of Minnesota. This is a substantial revision of an earlier paper entitled “Project Choice, Moral Hazard, and Optimal Subsidiary Structure for Financial Intermediaries.” We are grateful to the late Herb Baer, Douglas Diamond, Paolo Fulghieri, Richard Green (the editor), Joseph Haubrich, Timothy Guinnane, John McMillan, Yossi Spiegel, Larry Wall, and an anonymous referee for their comments, and to Sen Li for research assistance. We also thank seminar participants at Bellcore, the Federal Reserve Bank of Chicago, the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of New York, the Federal Reserve Bank of Philadelphia, INSEAD, New York University, Stanford University, the Stockholm School of Economics, Tulane University, Yale University, the University of Chicago, and the University of Texas.


Banks and related financial institutions often have two separate subsidiaries that make loans of similar type but differing risk, for example, a bank and a finance company, or a “good bank/bad bank” structure. Such “bipartite” structures may prevent risk shifting, in which banks misuse their flexibility in choosing and monitoring loans to exploit their debt holders. By “insulating” safer loans from riskier loans, a bipartite structure reduces risk-shifting incentives in the safer subsidiary. Bipartite structures are more likely to dominate unitary structures as the downside from riskier loans is higher or as expected profits from the efficient loan mix are lower.