This paper investigates whether the current minimum capital requirement regulation properly evaluates a group-wide risk exposed to financial firms when they are affiliates of conglomerates. Particularly, we check how each sectorial capital requirement regulation assesses the risks exposed to the regulated firms by holding the shares of the other affiliates in the same group. By comparing with the international standard of group-wide capital regulation suggested by Joint Forum (1999), we find that the capital regulation for insurance companies underestimates the risks associated with holding the shares of non-financial affiliates.
This paper further provides analysis for an optimal regulatory design on how to induce financial conglomerates to prudently manage the group-wide risks exposed to their financial affiliates. To this end, we present a model in which the group owner can expropriate the financial affiliate’s ability to raise funds to buying the shares of the other affiliates for the purpose of controlling. We find that an optimal regulatory response to the financial affiliate’s inefficient share purchase decision varies with the types of incomplete information. If the inefficiency arises from the owner’s private information on non-profitability of the affiliates, it will be optimal to separate financial entities from commercial entities. However, if the inefficiency arises from the controlling financial firm’s imprudent monitoring of the controlled affiliates, imposing additional required capital on the controlling financial affiliate can achieve the (constarined) efficiency.