International Diversification Gains in Banking: Risk-Return Analysis of G7 Banks

1. International Diversification Gains and Home Bias in Banking by Alicia Garcia-Herrero and Francisco Vázquez Comments Kenneth D. Jones Federal Deposit Insurance Corporation Mergers and Acquisitions of Financial InstitutionsL. William Seidman Center - Arlington, VANovember 30 - December 1, 2007

2. These deep thoughts are my own and not those of the U.S. Government

3. Objective Assess the potential gains of geographic diversification for the largest international banks in the G7 by analyzing the risk-return performance of these banks in their home country vis-à-vis their overseas subsidiaries.

4. Findings • Larger asset allocation to foreign subsidiaries improves the risk-adjusted returns of the consolidated financial group. • Diversification gains originate from low return covariances across country groups. • Gains are partially eroded by the concentration of foreign subsidiaries in specific geographical regions. • Actual allocation of international bank assets displays a substantial home bias compared to an efficient international portfolio.

5. Major Contributions • Body of research on international diversification in banking is still somewhat thin • New bank-level dataset that links each international bank with its foreign subsidiaries • New approach – uses financial statements of parent banks, foreign subsidiaries, and the combined financial group to drive the analysis • Uses a mean-variance portfolio model to study the potential gains from geographic diversification

6. Types of Diversification Portfolio (asset type, revenue source) Geographic (domestic, cross-border) Benefits of Diversification (cross-border) • Reduce risk (lower volatility of returns or default probability) • Reduce country-specific macro shocks • Lower cost of capital • More efficient internal capital markets • Achieve scale and scope economies • Increase market power • Potential for tax benefits

7. Costs of Diversification (cross-border) • Increased firm complexity • Increased operating costs and risks • Increased agency problems • Tendency for diversified firms to take on riskier activities • Increased currency risk • Introduction of political risk

8. Literature • Behr, Kamp, Memmel, and Pfingsten (2007) • Use data on the loan portfolio composition of German banks to examine performance and risk. They find that specialized banks have lower ratios of loan loss provisions and non-performing loans but have higher volatilities of these ratios – exemplifying the typical risk-return trade-off. • Odesanmi and Wolfe (2007) • Examines the effect of revenue diversification on banking stability in emerging economies and find evidence of positive benefits across and within business lines on systemic risk. More specifically, the authors find that revenue diversification between and within traditional interest and non-interest income generating activities results in an increase in the distance to default across the banking sector. • Choi, Hasan, and Kotrozo (2006) • Examines the effects of both activity and geographic diversification on risk and performance of international banks and find that the benefits of diversification can be dependent on the specific type: • Activity diversification (asset type and income source) is likely to undermine performance (Tobin’s Q) • Geographical diversification is likely to enhance performance (Tobin’s Q)

9. Literature • Hayden and Porath (2006) • Finds no large performance benefits associated with diversification (portfolio lending or geographic) • Stiroh and Rumble (2006) • Find that revenue diversification benefits exist for FHC but are offset by increased exposure to more volatile non-interest activities. • Deng and Elyasiani (2005) • Find that in the U.S. banking industry, geographic diversification is associated with lower total, firm-specific, and market risk but has insignificant effects on stock returns and firm value (Tobin’s Q); also find that physical distance between subsidiaries and headquarters raises total and firm-specific risk while reducing firm value and leaving returns unaffected -- implying higher operational risk. • Iskandar-Datta and McLaughlin (2005) • Study U.S. corporate performance (pre-tax cash flows) for firms that choose to diversify globally and find that they outperform the benchmark firms in the years following a firm’s diversification event. Larger firms and firms with higher cost of goods sold are better able to benefit from diversification.

10. Literature • Lin, Wu, Penm, Terrell (2005) • Finds a significant positive link between revenue diversification and financial performance in the banking industry in Taiwan, but a negative relationship between revenue diversification and risk. • Morgan and Samolyk (2005) • Find a U-shaped relationship between geographic diversification and bank holding companies’ risk-adjusted returns. • Chionsinni, Foglia, and Reedtz (2003). • Apply a portfolio approach to measuring credit risk in a M&A framework and find that, as a consequence of a merger, credit risk is significantly reduced because of diversification of idiosyncratic risk (Italian banking industry).

11. Discussion Literature • Strongly suggest that the authors incorporate the ideas in these recent papers • Make more clear how your paper differs from previous studies and where it makes a contribution Methodology • Geographic diversification is defined by asset shares by country group; • Concern that this mixes the effect of activity diversification and pure geographic diversification • Foreign subsidiaries can often engage in activities that are prohibited in home country – is this a geographic effect? • Don’t control for portfolio differences • Do subsidiaries have the same mix of assets? • Do subsidiaries have same revenue sources?

12. Discussion Methodology • Is it important to control for: • Ownership share/degree of control? • Age of subsidiary? • Physical distance to subsidiary? • What about alternative definitions of geographic diversification? • Define in terms of revenues, deposits, or activities • What about using additional measures of performance? • Stock performance, firm value, etc. • Use of financial statements creates some problems that should be considered/discussed in more depth • Statements are subject to accounting manipulation • Differences in taxation across countries • Use EBIT as a performance measure • Use cash flow/asset measure • Controlled for off-balance sheet activities?