We investigate the optimal regulation of financial conglomerates which combine a bank and a non-bank financial institution. The conglomerate's risk-taking incentives depend upon the level of market discipline it faces, which in turn is determined by the conglomerate's liability strucure. We examine optimal capital requirements for standalone institutions, for integrated financial conglomerates, and for financial conglomerates that are structured as holding companies. For a given risk profile, integrated conglomerates have a lower probability of failure than either their standalone or decentralised equivalent. However, when risk profiles are endogenously selected conglomeration may extend the reach of the deposit insurance safety net and hence provide incentives for increased risk-taking. As a result, integrated conglomerates may optimally attract higher capital requirements. In contrast, decentralised conglomerates are able to hold assets in the socially most efficient place. Their optimal capital requirements encourage this. Hence, the practice of "regulatory arbitrage", or of transfering assets from one balance sheet to another, is welfare-increasing. We discuss the policy implications of our finding in the context not only of the present debate on the regulation of financial conglomerates but also in the light of existing US bank holding company regulation.

We analyze state-sponsored credit guarantees in a setting where entrepreneurs are capital-constrained and subject to moral hazard. In our model, guarantees can raise welfare because they reduce the cost of capital faced by entrepreneurs, and so potentially enhance entrepreneurial effort incentives.Overly generous guarantees have perverse incentive effects, however: they induce lenders to reduce lending standards and to lower their collateral requirements. Co-funding schemes do not suffer from the put option feature inherent in guarantees, but they may encourage entry by unproductive entrepreneurs who plan simply to consume subsidies, without investing. This limits the guarantee fund's ability to support productive entrepreneurs, and thereby destroys value. Based on these trade-offs, we show how the optimal design of state-sponsored loan subsidy schemes depends on the fund's technological expertise and the degree of creditor rights protection. We explore the dynamic efficiency effects of public subsidies, and show that they may impair the private sector's initiative to uncover cost savings in order to diminish future financial constraints.

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