This paper investigates the effects of financial market consolidation on risk capital allocation in a financial institution and the implications for market liquidity in dealership markets. We show that an increase in financial market consolidation can have ambiguous effects on liquidity in foreign exchange and government securities markets. The framework employed assumes that financial institutions use risk-management tools (for example, value-at-risk) in the allocation of risk capital. Capital is determined at the firm level and allocated among separate business lines, or divisions. The ability of market-makers to supply liquidity is influenced by their risk-bearing capacity, which is directly related to the amount of risk capital allocated to this activity. A model of inter-dealer trading is developed that is similar to the framework of Volger (1997). However, we allow for heterogeneity among dealers with respect to their risk-bearing capacity.

The allocation of risk capital within financial institutions has implications for the types of mergers among financial institutions that can be beneficial for market quality. This effect depends on the correlation among cash flows from business activities that the newly merged financial institution will engage in. A negative correlation between market-making and the new activities of a merged firm suggests the possibility of increased market liquidity. Our results suggest that, when faced with a proposed merger between financial institutions, policy-makers and regulators would want to examine the correlations among division cash flows.

Published In:

Journal of Financial Research (0270-2592 (print); 1475-6803 (online))
Summer 2006. Vol. 29, Iss. 2, pp. 271-91