Internal Capital Markets and Lending by Multinational Bank Subsidiaries

1. Internal Capital Markets and Lending by Multinational Bank Subsidiaries Iman van Lelyveld Joint work with Ralph de Haas (EBRD) Financial Integration and Stability in Europe Madrid, 30 November – 1 December 2006

2. Set up of presentation • Relevance / existing literature • Theoretical priors • Data • Preliminary results • Conclusions

3. Topic • Do multinational banks (MNBs) manage the lending growth of subsidiaries through an internal capital market? • If so, what is the influence of: • the home country business cycle; • the host country business cycle; • characteristics of the parent bank; • characteristics of the subsidiary; • characteristics of other subsidiaries? • PM: Focus on locally granted credit, not cross-border credit

4. Relevance of the paper (I) • Capital market integration has led to a more integrated international banking system • 1990s: M&A’s increased the number of MNBs, both of the global and of the regional variety (Latin-America and CEE) • Near future: Western-Europe, Russia, China…?

5. Relevance of the paper (II) • Lending by MNBs may differ from national/domestic banks’ credit supply because of internal capital markets • Countries that host many MNBs may be more exposed to external shocks (SE Asia) • Implications for macroeconomic stability and monetary transmission, also in many transition countries

6. Existing literature: theory • Related, but not a diversification benefit paper • In case of perfect external capital markets: • no need for internal capital markets; • each subsidiary finances all projects with NPV>0; • credit of various subsidiaries not correlated. • Theory on internal capital markets: • bright side versus dark side (Scharfstein & Stein, 2000) • Theory on internal capital markets in MNBs (Morgan et al., 2004): • support effect and substitution effect (± dark side/bright side) • result: shocks to bank capital dampened, but real- economic shocks amplified

7. Our main theoretical priors • Compare the behaviour of MNB subsidiaries in case of: • Existence of an internal capital market • No internal capital market (“independent” subs)

8. Our main theoretical priors • Compare the behaviour of MNB subsidiaries in case of: • Existence of an internal capital market • No internal capital market (“independent” subs) 1. Effect home-country business cycle: - 2. Effect host-country business cycle: ++ 3. Effect host-country financial crisis: 0 4. Effect parent bank “health”: +

9. Our main theoretical priors • Compare the behaviour of MNB subsidiaries in case of: • Existence of an internal capital market • No internal capital market (“independent” subs) 1. Effect home-country business cycle: -0 2. Effect host-country business cycle: +++ 3. Effect host-country financial crisis: 0- 4. Effect parent bank “health”: +0

10. Our main theoretical priors • Compare the behaviour of MNB subsidiaries in case of: • Existence of an internal capital market • No internal capital market (“independent” subs) 1. Effect home-country business cycle: -0 2. Effect host-country business cycle: +++ 3. Effect host-country financial crisis: 0- 4. Effect parent bank “health”: +0 • Difference within a particular MNB between greenfield subsidiaries and take-over subsidiaries?

11. Existing empirical literature • Loan growth of various subsidiaries in a MNB negatively correlated (Houston et al., 1997) • MNBs dampen host-country financial shocks and transmit home-country financial shocks (Dages et al., 2000; Peek and Rosengren, 2000; Martinez Peria et al., 2002, De Haas and Van Lelyveld, 2004/2006) • MNBs credit also dependent on home-country business cycle (Calvo et al., 1993; Jeanneau and Micu, 2002, Martinez Peria et al., 2002, De Haas and Van Lelyveld, 2006)

12. Limitations existing empirical literature • Focus on specific home region (US, Japan, EU) or host region (LA, CEE) only • Mostly based on aggregate bank-lending data, no bank-level information on intrabank linkages • Our paper: broader geographical scope and bank-level data (BankScope)

13. Data • Of the 150 largest banks in the world (The Banker, July 2004, asset rank), we take: • all banks that operated more than one significant foreign subsidiary • >≥ 0.5% of parent bank assets • >≥ 50% owned by parent bank • and that were not the result of a recent merger • Results in a set of 45 parent banks and >200 subsidiaries (1992-2004)

14. Solvency (in %) Liquidity (in %) Profitability (in %) Weakness (in %) Loan growth (in %) Total assets (mill. $) Efficiency (in %) Parent banks 5.3 16.9 2.4 13.9 17.4 11.3 281,456 Subsidiaries 7.7 16.2 2.8 11.7 18.2 12.5 30,518 Descriptives • Solvency: Equity / total assets • Liquidity: Liquid assets / total assets • Efficiency: Net interest margin • Profitability: Return on average equity • Weakness: Loan loss provisions / net interest revenue

15. Geographical distribution

16. 1 2 3 Estimation: Three models

18. Profitable subsidiaries expand their credit faster • Very liquid and solvent subsidiaries show lower rates of credit growth • Subsidiaries grow faster when economic growth is higher in the host country (procyclicality) • Subsidiaries do not reduce their credit supply when the host country is hit by a systemic banking crisis (support effect?)

19. Subsidiaries of parent banks that are highly liquid tend to grow slower • Subsidiaries of more efficient parent banks tend to growth faster

20. If other subsidiaries in the same group are relatively profitable, this positively influences the credit supply of a subsidiary • GDP growth in the home country has a negative influence on subsidiaries’ credit growth (substitution effect)

21. Further results • Ownership interaction terms (greenfields versus take-overs): • Confirms earlier results • Take-overs are more sensitive to weakness of own balance sheet than greenfields • Credit supply take-overs not procyclical • Parent-subsidiary distance • Influence parent on subsidiaries greatest for distant parents (cf. Carlin et al., 2006 for non-financial companies)

22. Sensitivity test • Control group of domestic banks: • Randomly linked to “foster parent” • Firm specific variables significant • Crisis dummy important • Link MNB subsidiaries to “surrogate” parent (cf. Carlin et al., 2006) • Internal capital market effects disappear • Macro linkage remains • Possible improvements • Improve efficiency measure (ie replace NIM with Cost / Income) • add “Market Share” as control • split sample between conglomerates with few and many subs

23. Conclusions • Subsidiary credit growth is influenced by bank conglomerate factors • Robust to sensitivity tests • Substitution effects: negative effect of home-country business cycle and positive effects host-country business cycle (latter greenfields only) • Support effects: subsidiaries grow faster if their parent banks are efficient and if other subsidiaries in the same group are relatively profitable. Also: (‘independent’) take-overs sensitive to own financial health, but (‘integrated’) greenfields are not