Financial synergies and the Organization of Bank Affiliates; A Theoretical Perspective on Risk and Efficiency

We analyze theoretically banks’ choice of organizational structures in branches or subsidiaries in the presence of government bailouts, default costs and - possibly - economies of scale as sources of financial synergies. We compare with stand-alone banks. Subsidiary and branch structures are characterized by different arrangements for internal insurance of affiliates against default risk. The cost of debt and leverage are endogenous. For moderate bailout probabilities, subsidiary structures, wherein the two entities provide mutual internal insurance under limited liability, have the highest private group value, but also the highest risk taking as measured by leverage, expected default costs and expected loss. The branch structure, wherein the two affiliates support each other until the whole bank fails, is generally burdened by greater default costs – in excess of bailout benefits – than the subsidiary structures. Stand-alone banks have the highest excess default costs. We explore also the impact on social values and policy implications of "ring-fencing" of affiliates.