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International Diversification Gains and Home Bias in Banking

International Diversification Gains and Home Bias in Banking. Alicia García-Herrero (BIS) Francisco Vázquez (IMF). Conference on Mergers and Acquisitions of Financial Institutions L. William Seidman Center, Arlington November 30-December 1, 2007. Overview. Motivation Objectives

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International Diversification Gains and Home Bias in Banking

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  1. International Diversification Gains and Home Bias in Banking Alicia García-Herrero (BIS) Francisco Vázquez (IMF) Conference on Mergers and Acquisitions of Financial Institutions L. William Seidman Center, Arlington November 30-December 1, 2007

  2. Overview • Motivation • Objectives • Related literature • Overview of the sample • Methodological aspects and results • Econometric estimates • Portfolio model • Conclusions

  3. Motivation • Dramatic increase in FDI in the banking sector since the mid-nineties • International banks would likely obtain cross-country diversification benefits • International diversification in banking is barely understood • International diversification effects not taking into account in the Basel II standard approach

  4. Cross-Border M&As Targeting Banks in:

  5. Consolidated Foreign Claims of BIS-Reporting BanksRecipient: Emerging and Developing Countries1983-2004

  6. Synchronization of Macroeconomic ConditionsHigher Between Industrial Countries

  7. Growth Correlations, Cumulative Probabilities by Country Groups

  8. Objectives • Explore the risk-return effects of international diversification in banking • Are parent banks with a larger share of their assets allocated to foreign subsidiaries able to obtain larger risk-adjusted profits? • Is geographical concentration detrimental to the risk-adjusted profitability of international banks? • Use portfolio theory as a benchmark to analyze the international allocation of bank assets • How does the actual allocation of bank assets compare with the “optimal frontier”

  9. Related Literature • Portfolio theory: (Markovitz 1952, 1959) • International portfolio diversification: (Grubel, 1968; Levy and Sarnat, 1970; Lessard, 1973) • Geographical local diversification in banking: (Acharya, Hasan, and Saunders, 2002; Morgan and Samolyk, 2003) • International diversification in banking: (Griffith-Jones, Segoviano and Spratt, 2002; Buch, Discroll and Ostrgaard, 2005)

  10. Sample • Source: BankScope; Zephyr • Coverage: • 38 large international banks from G7 countries plus Spain • Their 399 subsidiaries overseas • Sample unbalanced 1995-2004, with over 2,000 observations

  11. Sample: Distribution of Assets by Country of Incorporation of Parent Banks and Location of Subsidiaries(unweighted averages, in percent)

  12. Summary Statistics of Risk and Return by Country Groups

  13. Methodology: 1) Econometric Estimation Alternative specification including a Herfindhal index of asset concentration

  14. Dependent: Risk-Normalized ROA of Parent Banks (Consolidated)

  15. Omitted variable bias • The dependent variable is computed from the consolidated financial statements of parent banks • Captures risk-return gains from local operations abroad plus those of cross border operations • If cross-border and local operations are complementary coefficients biased toward previous finding • The results could also be driven by unobserved differences across banks • Differences in business strategies, quality of risk management, etc. • We control by exploiting differences in information content between consolidated and unconsolidated financial statements

  16. Robustness Check: Controlling for Parent Bank Idiosyncrasies

  17. Dependent: Difference of Risk-Normalized ROA (Consol-Unconsol)

  18. Methodology: 2) Portfolio model • Use portfolio theory as a normative benchmark • Treat foreign subsidiaries as single components of the world portfolio of international banks • Caveats: • Transaction costs of entry/exit a given country • Bank subsidiaries may not be perfect substitutes • Time dimension is not balanced—difficult to compute variances and covariances of returns across subsidiaries • Treatment: • Focus on portfolio optimization within the observed set of subsidiaries of each international bank • Aggregate returns of subsidiaries by regions (industrial vs. emerging)

  19. Methodology: 2) Portfolio model Expected return: Expected variance:

  20. Example:

  21. Deviations of Actual Asset Allocations from the Efficient Frontier

  22. Selected Statistics of the Observed Asset Allocation(unweighted averages)

  23. Conclusions • On average, banks with a larger share of their assets in foreign subsidiaries, particularly in emerging economies, have been able to obtain larger risk-normalized returns • The regional concentration of international expansion is detrimental to diversification • Banks exhibit a home-bias in their international investment strategies—further international expansion beneficial from the pure risk-return perspective

  24. Conclusions (Cont.) • The estimates strongly underestimate international diversification benefits • Caveat: The data do not allow to disentangle cross-border investment by parent banks, which accounts for a large part of international exposures

  25. Thank you!

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