Risk and the Risk and the Organization of Bank Organization of Bank

Foreign AffiliatesForeign Affiliates

Giovanni Giovanni Dell’AricciaDell’Ariccia

(IMF and CEPR)(IMF and CEPR)

Robert MarquezRobert Marquez

(Arizona State (Arizona State University)University)

The views expressed in this presentation are those of the authors and do not necessarily represent those of the IMF.

MotivationMotivation

Recent trend towards financial Recent trend towards financial liberalization and increased cross-border liberalization and increased cross-border activities for banks.activities for banks.

Growing literature on merits/pitfalls of Growing literature on merits/pitfalls of extensive foreign-bank presence in extensive foreign-bank presence in emerging markets.emerging markets.

Yet, little attention paid to how that Yet, little attention paid to how that presence is established:presence is established: Branches;Branches; Subsidiaries;Subsidiaries; Cross-border flows.Cross-border flows.

Differences across Differences across structuresstructures

Subsidiaries:Subsidiaries: Locally incorporated, stand-alone entities;Locally incorporated, stand-alone entities; Separately capitalized;Separately capitalized; Protected by limited liability at affiliate level.Protected by limited liability at affiliate level.

Branches:Branches: No independent legal personality;No independent legal personality; Capital for regulatory purposes can be Capital for regulatory purposes can be

supplied at the consolidated level;supplied at the consolidated level; Liabilities of foreign branches represent real Liabilities of foreign branches represent real

claims on parent bank.claims on parent bank.

Why this mattersWhy this matters

May affect competitive structure of local May affect competitive structure of local banking systems:banking systems:

Threatening profits and market share of domestic Threatening profits and market share of domestic banks;banks;

Affecting price and quality of bank services in host-Affecting price and quality of bank services in host-country.country.

Involves different levels of parent bank Involves different levels of parent bank responsibility and financial support with responsibility and financial support with implications for:implications for:

The parent banks, who care about their exposure;The parent banks, who care about their exposure; Local regulators, who care about domestic stability;Local regulators, who care about domestic stability; Local depositors, who care about safety of their Local depositors, who care about safety of their

savings.savings.

We focus on riskWe focus on risk

We argue that risk structure is an We argue that risk structure is an important determinant of banks’ important determinant of banks’ organizational choice: organizational choice:

Different limited liability structure; Different limited liability structure; Different jurisdictional location of bank Different jurisdictional location of bank

capital.capital.

We consider two sources of risk:We consider two sources of risk:

Economic risk: macroeconomy, interest rates, Economic risk: macroeconomy, interest rates, credit risk, etc.credit risk, etc.

Political risk: Expropriation of foreign banks, Political risk: Expropriation of foreign banks, infringement of banks’ property rights.infringement of banks’ property rights.

Main resultsMain results

Relative importance of economic and political Relative importance of economic and political risk determines preferred organizational risk determines preferred organizational structure:structure:

Branches preferred when political risk is paramount;Branches preferred when political risk is paramount; Subsidiaries preferred when main concern is Subsidiaries preferred when main concern is

economic risk.economic risk.

Intuition:Intuition:

Branch structure benefits from keeping capital at Branch structure benefits from keeping capital at home and avoiding expropriation;home and avoiding expropriation;

Fragmented liability structure protects parent bank Fragmented liability structure protects parent bank from losses due to economic risk at affiliate level.from losses due to economic risk at affiliate level.

Related literatureRelated literature

Growing empirical literature studying what Growing empirical literature studying what drive banks abroad and what determines drive banks abroad and what determines location choices:location choices:

Claessens et al. (2000), Focarelli and Pozzolo (2001 Claessens et al. (2000), Focarelli and Pozzolo (2001 and 2005), Buch (2000 and 2003), Cerutti et al. and 2005), Buch (2000 and 2003), Cerutti et al. (2006). (2006).

While theoretical work on this topic is still While theoretical work on this topic is still limited ... :limited ... :

Kahn and Winton (2004);Kahn and Winton (2004);

...a few papers have focused on how to ...a few papers have focused on how to regulate multinational banks: regulate multinational banks:

Calzolari and Loranth (2003), Dalen and Olsen Calzolari and Loranth (2003), Dalen and Olsen (2003), and Harr and Ronde (2005).(2003), and Harr and Ronde (2005).

Start with a simple modelStart with a simple model Bank has foreign affiliates in countries Bank has foreign affiliates in countries i = 1,…,n.i = 1,…,n.

Revenue for each affiliate: Revenue for each affiliate: LLiiPPii = L = LiiRRiiii, where , where LLii = loan quantity; = loan quantity; PPii = realized return on loan; = realized return on loan; RRii = average interest rate on loan; = average interest rate on loan; ii = credit risk, = credit risk, iidiid with distribution with distribution FF((), over [0,1].), over [0,1].

The bank is also subject to political risk: The bank is also subject to political risk: ii = probability of expropriation in country i. = probability of expropriation in country i.

Bank has capital Bank has capital EE used to satisfy capital used to satisfy capital requirement:requirement:

For branch structure: at the consolidated level; For branch structure: at the consolidated level; For subsidiary structure: at each affiliate.For subsidiary structure: at each affiliate.

Comparing the profit Comparing the profit functionsfunctions

Expected profits of branch structure:Expected profits of branch structure:

Expected profits of subsidiary structure:Expected profits of subsidiary structure:

Economic risk favors Economic risk favors subsidiariessubsidiaries

For For ii = 0, the bank’s expected profits are = 0, the bank’s expected profits are higher with a subsidiary structure than higher with a subsidiary structure than with a branch structure.with a branch structure.

Intuition: When there is no political risk, Intuition: When there is no political risk, there is no value to keeping capital at there is no value to keeping capital at home.home.

However, macroeconomic risk creates an However, macroeconomic risk creates an incentive for bank to operate incentive for bank to operate internationally via a subsidiaries:internationally via a subsidiaries:

Limited liability at each affiliate prevents Limited liability at each affiliate prevents foreign losses from spilling over to parent bank. foreign losses from spilling over to parent bank.

Political risk favors Political risk favors branchesbranches

There exists a value of There exists a value of ii < 1 such that the < 1 such that the bank’s overall expected profits are higher with bank’s overall expected profits are higher with a branch structure than with a subsidiary a branch structure than with a subsidiary structure.structure.

Intuition: When political risk is very high, fear Intuition: When political risk is very high, fear of expropriation dominates other risk factors:of expropriation dominates other risk factors:

Bank is better off keeping all capital at home and Bank is better off keeping all capital at home and financing branch with foreign deposits.financing branch with foreign deposits.

It follows that there exists a value of It follows that there exists a value of such such that:that:

for for ii < < a subsidiary structure is preferred, anda subsidiary structure is preferred, and

for for ii > > a branch structure is preferred.a branch structure is preferred.

Cross-country risk Cross-country risk correlationcorrelation

Suppose that economic risks at home and Suppose that economic risks at home and abroad are correlated:abroad are correlated:

i.e. i.e. ii are positively correlated. are positively correlated.

Then the threshold value Then the threshold value is decreasing in is decreasing in the degree of cross-country correlation.the degree of cross-country correlation.

Intuition: when economic risk is correlated Intuition: when economic risk is correlated across countries:across countries:

If affiliate makes losses, parent bank is likely If affiliate makes losses, parent bank is likely making losses at home as well. making losses at home as well.

Hence, shielding effect from limited liability of Hence, shielding effect from limited liability of subsidiaries reduced.subsidiaries reduced.

Endogenous pricing of Endogenous pricing of liabilitiesliabilities

So far, cost of deposits and other liabilities So far, cost of deposits and other liabilities exogenousexogenous

However, in practice this cost should reflect However, in practice this cost should reflect different risks associated with organizational different risks associated with organizational structures. structures.

If investor/creditors are risk neutral and all If investor/creditors are risk neutral and all liabilities are correctly priced at the margin:liabilities are correctly priced at the margin:

Organizational structures have identical expected Organizational structures have identical expected profits.profits.

Application of Modigliani-Miller irrelevance result.Application of Modigliani-Miller irrelevance result.

However, some liabilities are not or cannot be However, some liabilities are not or cannot be priced correctly (we are working on this ... ):priced correctly (we are working on this ... ):

Deposit insurance;Deposit insurance; Asymmetric information.Asymmetric information.

Empirical fitEmpirical fit

Branch vs. Subsidiary: Cerutti et al. Branch vs. Subsidiary: Cerutti et al. (2006) find that banks are more likely to (2006) find that banks are more likely to set up branches when political risk is set up branches when political risk is relatively high.relatively high.

Correlation: there is a sense that Correlation: there is a sense that branches are more prevalent within branches are more prevalent within country and subsidiaries across country and subsidiaries across countries. However, need data countries. However, need data confirmation.confirmation.

Much to doMuch to do

Partial pricing of liabilities.Partial pricing of liabilities.

Edogenizing the rate of return on bank Edogenizing the rate of return on bank assetsassets

Rate of return should be a function of Rate of return should be a function of competitiveness of market;competitiveness of market;

Required return to bank should also be risk-Required return to bank should also be risk-adjusted.adjusted.

How the scale of entry and market structure How the scale of entry and market structure help drive organizational form?help drive organizational form?

Banks tend to have both branches and Banks tend to have both branches and subsidiaries:subsidiaries:

Model may need to be expanded to handle both.Model may need to be expanded to handle both.