Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert...
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![Page 1: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/1.jpg)
Risk and the Organization of Bank Foreign Affiliates
Giovanni Dell’AricciaIMF and CEPR
Robert MarquezArizona State University
![Page 2: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/2.jpg)
Motivation• Recent trend towards financial liberalization and
increased cross-border activities for banks
• Growing literature on the merits and pitfalls of an extensive foreign bank presence in emerging markets
• Yet, little attention has been paid to how that presence is established:– Branches– Subsidiaries– Cross-border flows
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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
![Page 4: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/4.jpg)
Why this matters
1. 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
2. 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
![Page 5: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/5.jpg)
Our focus: Risk
• We argue that risk is an important determinant of banks’ organizational choice
• Two sources of risk:– Macroeconomic risk: Economic activity, interest
rates, credit risk, etc.– Political risk: Expropriation of foreign banks,
infringement of banks’ property rights
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Results• Branch structure preferred when:
– Political risk is primary source of uncertainty for bank• Bank benefits from keeping its capital at home and avoids being
expropriated
• Subsidiary structure preferred when:– Economic risk is of primary importance
• Fragmented liability structure protects parent bank from losses at affiliate
• Extensions to discuss cross-country correlation of risks, pricing of risk by investors, and competitive conditions of banking markets
![Page 7: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/7.jpg)
Related Literature
• There is a growing empirical literature studying what factors 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 examined the related issue of how to regulate multinational banks: Calzolari and Loranth (2003), Dalen and Olsen (2003), and Harr and Ronde (2005)
![Page 8: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/8.jpg)
Model
• Bank has foreign affiliates in countries i = 1,…,n
• Revenue for each affiliate: LiPi = LiRii, where – Li = loan quantity– Pi = realized return on loan– Ri = average interest rate on loan– i = credit risk
• The shock i is distributed iid across countries, takes a value in [0,1], and has distribution
![Page 9: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/9.jpg)
Political risk and capital
• Political risk: Probability i that host government appropriates foreign bank’s revenue and capital
• Capital: Bank has capital E that can be used to satisfy capital requirement– For branches, need
– For subsidiaries, need
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High political risk
• Result: There exists a value of i < 1 such that the bank’s overall profits are higher with a branch structure than with a subsidiary structure
• Intuition: When political risk is very high (i close to 1), parent bank is better off keeping all capital at home and financing branch with foreign deposits
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Low political risk
• Result: For i = 0, the bank’s profit is 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 the bank to operate internationally via a subsidiary network– Limited liability at each affiliate prevents losses from
spilling over to parent bank
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Comparison of organizational forms
• Main result: There is a value such that– A subsidiary structure is preferred for – A branch structure is preferred for
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Extension: Correlation of risks• Suppose that macroeconomic risks are correlated
across countries– Corresponds to i being positively correlated
• Result: The threshold value is decreasing in the degree of cross-country correlation
• Intuition: When economic risk is correlated across countries, the shielding effect from limited liability of subsidiaries is reduced
• Hence, the advantage of a branch structure is likely to be preferred
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Other extensions
• Have so far taken the cost of deposits and other liabilities as exogenous– However, in practice this cost should reflect the different
risks and organizational forms
• We also look at endogenizing 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
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Conclusion and implications
• Branch vs. Subsidiary: Cerutti et al. (2006) find that banks are more likely to set up branches when political risk is relatively high
• Correlation of risks: They also find that banks are more likely to use branches within-country, but subsidiaries for cross-border activities
![Page 16: Risk and the Organization of Bank Foreign Affiliates Giovanni Dell’Ariccia IMF and CEPR Robert Marquez Arizona State University.](https://reader036.fdocuments.in/reader036/viewer/2022083008/56649f565503460f94c7b27b/html5/thumbnails/16.jpg)
To do
• Much to do!
• For instance, need to understand how the scale of entry may help drive organizational form
• Banks tend to have both branches and subsidiaries– Model may need to be expanded to handle both