Risk and the Organization of Bank Foreign Affiliates

1. Risk and the Organization of Bank Foreign Affiliates Robert Marquez (Arizona State University) Giovanni Dell’Ariccia (IMF and CEPR) The views expressed in this presentation are those of the authors and do not necessarily represent those of the IMF.

2. Motivation • Recent trend towards financial liberalization and increased cross-border activities for banks. • Growing literature on merits/pitfalls of extensive foreign-bank presence in emerging markets. • Yet, little attention paid to how that presence is established: • Branches; • Subsidiaries; • Cross-border flows.

3. Differences across structures • Subsidiaries: • Locally incorporated, stand-alone entities; • Separately capitalized; • Protected by limited liability at affiliate level. • Branches: • No independent legal personality; • Capital for regulatory purposes can be supplied at the consolidated level; • Liabilities of foreign branches represent real claims on parent bank.

4. Why this matters • May affect competitive structure of local banking systems: • Threatening profits and market share of domestic banks; • Affecting price and quality of bank services in host-country. • Involves different levels of parent bank responsibility and financial support with implications for: • The parent banks, who care about their exposure; • Local regulators, who care about domestic stability; • Local depositors, who care about safety of their savings.

5. We focus on risk • We argue that risk structure is an important determinant of banks’ organizational choice: • Different limited liability structure; • Different jurisdictional location of bank capital. • We consider two sources of risk: • Economic risk: macroeconomy, interest rates, credit risk, etc. • Political risk: Expropriation of foreign banks, infringement of banks’ property rights.

6. Main results • Relative importance of economic and political risk determines preferred organizational structure: • Branches preferred when political risk is paramount; • Subsidiaries preferred when main concern is economic risk. • Intuition: • Branch structure benefits from keeping capital at home and avoiding expropriation; • Fragmented liability structure protects parent bank from losses due to economic risk at affiliate level.

7. Related literature • Growing empirical literature studying what drive banks abroad and what determines location choices: • Claessens et al. (2000), Focarelli and Pozzolo (2001 and 2005), Buch (2000 and 2003), Cerutti et al. (2006). • While theoretical work on this topic is still limited ... : • Kahn and Winton (2004); • ...a few papers have focused on how to regulate multinational banks: • Calzolari and Loranth (2003), Dalen and Olsen (2003), and Harr and Ronde (2005).

8. Start with a simple model • Bank has foreign affiliates in countries i = 1,…,n. • Revenue for each affiliate: LiPi = LiRiei, where • Li = loan quantity; • Pi = realized return on loan; • Ri = average interest rate on loan; • ei = credit risk, iid with distribution F(e,s), over [0,1]. • The bank is also subject to political risk: • i = probability of expropriation in country i. • Bank has capital E used to satisfy capital requirement: • For branch structure: at the consolidated level; • For subsidiary structure: at each affiliate.

9. Comparing the profit functions • Expected profits of branch structure: • Expected profits of subsidiary structure:

10. Economic risk favors subsidiaries • For i = 0, the bank’s expected profits are higher with a subsidiary structure than with a branch structure. • Intuition: When there is no political risk, there is no value to keeping capital at home. • However, macroeconomic risk creates an incentive for bank to operate internationally via a subsidiaries: • Limited liability at each affiliate prevents foreign losses from spilling over to parent bank.

11. Political risk favors branches • There exists a value of i < 1 such that the bank’s overall expected profits are higher with a branch structure than with a subsidiary structure. • Intuition: When political risk is very high, fear of expropriation dominates other risk factors: • Bank is better off keeping all capital at home and financing branch with foreign deposits. • It follows that there exists a value of such that: • for i < , a subsidiary structure is preferred, and • for i > , a branch structure is preferred.

12. Cross-country risk correlation • Suppose that economic risks at home and abroad are correlated: • i.e. ei are positively correlated. • Then the threshold value  is decreasing in the degree of cross-country correlation. • Intuition: when economic risk is correlated across countries: • If affiliate makes losses, parent bank is likely making losses at home as well. • Hence, shielding effect from limited liability of subsidiaries reduced.

13. Endogenous pricing of liabilities • So far, cost of deposits and other liabilities exogenous • However, in practice this cost should reflect different risks associated with organizational structures. • If investor/creditors are risk neutral and all liabilities are correctly priced at the margin: • Organizational structures have identical expected profits. • Application of Modigliani-Miller irrelevance result. • However, some liabilities are not or cannot be priced correctly (we are working on this ... ): • Deposit insurance; • Asymmetric information.

14. Empirical fit • Branch vs. Subsidiary: Cerutti et al. (2006) find that banks are more likely to set up branches when political risk is relatively high. • Correlation: there is a sense that branches are more prevalent within country and subsidiaries across countries. However, need data confirmation.

15. Much to do • Partial pricing of liabilities. • Edogenizing the rate of return on bank assets • Rate of return should be a function of competitiveness of market; • Required return to bank should also be risk-adjusted. • How the scale of entry and market structure help drive organizational form? • Banks tend to have both branches and subsidiaries: • Model may need to be expanded to handle both.