Alberto Franco Pozzolo Universit à del Molise and Ente Luigi Einaudi Ancona September 22-23

1. Discussion of:Risk and Organization of Foreign Bank AffiliatesBy Giovanni Dell’Ariccia and Robert Marquez Alberto Franco Pozzolo Università del Molise and Ente Luigi Einaudi Ancona September 22-23 The Changing Geography of Banking

2. Outline • My reading of the paper: • research question • stylized facts • answer • Analytical framework • a simplified version • some stringent assumptions • extensions • Open issues and possible additional extensions

3. Research question • What determines banks’ mode of entry in foreign markets? • Limiting the choice to branches vs. subsidiaries, there is one major trade-off: • branches have unlimited liability, and therefore suffer more from credit risk and less from political risk • subsidiaries have limited liability, and therefore suffer less from credit risk and more from political risk

4. Stylized facts and answer • The model explains the choice between branches and subsidiaries focusing on the role of credit vs. political risk • The empirical evidence confirms that economic and political default risk matter: • subsidiaries are preferred when economic risk is high (limited liability) • branches are preferred when political risk is high (ring fencing)

5. A simplified analytical framework (1) • The model compares profits of banks organizing all foreign affiliates: • as branches • as subsidiaries • Focusing on entry in a single country, expected profits for a branch can be written as: since it is assumed that

6. A simplified analytical framework (2) • In the case of a subsidiary, excluding the option of defaulting, expected profits are: • Since it is assumed that: and it is possible to express expected profits as • The option to default would add an additional term to expected profits, increasing in the variance of ε

7. A simplified analytical framework (3) • Therefore, abstracting from the option’s value: • Therefore, opening a branch gives higher expected profits when: • political risk is high • cost of deposits relative to capital is low • capital requirements are high • the variance of credit risk is low

8. Stringent assumptions • The model fits perfectly the major stylized fact • However, it builds on a number of simplifying assumptions: • the size of foreign affiliates is given and it is symmetric for all countries • banks’ only activity abroad is to grant loans • the decision to enter a foreign country is given • there is no transfer of funds from the parent company to the affiliates, except for capital • No activity has decreasing marginal returns

9. Extensions • If credit risk is correlated across countries, the value of subsidiaries’ default option is lower making a branch structure becomes more appealing • It would be interesting to study this issue in conjunction with the decision to diversify, possibly making the number of foreign affiliates endogenous • This would also link the discussion to that on endogenizing the rate of return on loans across countries • It would be interesting to endogenize the rate of return on deposits allowing for cross-border transactions between parents and affiliates

10. Open issues • The empirical evidence also points to the role of other factors, such as: • organizational costs (set-up and running costs) • degree of control of foreign activities (parent companies could be unable to appropriate all profits generated by subsidiaries) • type of activities undertaken (there is evidence of specialization in the foreign activities undertaken through branches and subsidiaries) • regulatory restrictions • taxation