What drives banks’ geographic expansion? The role of locally non-diversifiable risk Reint Gropp, Felix Noth, Ulrich Schüwer

Motivation Why do some banks geographically expand after deregulation and others do not? The decision to expand is interrelated with the decision how much risk to take: Tricky identification problem –For example if banks with a higher tolerance for risk are more likely to expand geographically, it is difficult to ascertain the effect of geographic diversification on risk The literature has tried to deal with this problem in a myriad of ways with mixed results (see e.g. Loutskina and Strahan, 2011; Goetz et al., 2015) To understand the motivation for geographic expansion matters as –Banks may try to diversify in order reduce the risk they face –Banks may try to use their expertise in managing some types of risk and seek them out in other regions

Motivation Main contribution of this paper: We use variation in exogenous, locally non-diversifiable risk and combine it with the staggered deregulation process in the U.S. during the 1990s. Exogenous, locally non-diversifiable risk: Long run damages from natural disasters that banks face in their county.

Literature The theoretical literature on bank risk-taking emphasizes the role of (geographic) diversification for banks’ lending decisions and bank risk. e.g., Winton (1997, 2000), Acharya et al. (2006), and Loutskina (2011) –Diversification vs. Specialization Consequences of catastrophic risk. e.g., Garmaise and Moskowitz (2009), Cortes and Strahan (2014), Chavaz (2014), Klomp (2014), Lambert et al. (2015) Banking deregulation in the U.S. e.g. Gan (2004), Brook et al. (1998), Goetz et al. (2013), Rice and Strahan (2010)

Preview of results Banks facing higher locally non-diversifiable risk expand significantly more into other regions compared to banks less exposed to locally non-diversifiable risk. Only large banks are able to expand following deregulation, small banks are not Banks given they expand, expand to regions with similar (correlated) locally non-diversifiable risk Banks with more within state diversification opportunities expand less in response to deregulation Banks expand to take advantage of locally acquired risk management expertise, rather than to reduce risk exposure

Data We use bank level data (balance sheet and profit and loss data) for all U.S. banks from the FDIC The data cover the period Only banks with a headquarter in the 48 continental states of the United States Banks that change their headquarter from one state to another are dropped The dataset covers 12,095 banks and 159,247 bank-year observations

Data Data on natural disasters for each U.S. county come from the Spatial Hazard Events and Losses Database for the United States (SHELDUS) provided by the University of South Carolina We scale these numbers by a county’s yearly total personal income To identify how much individual banks operating in one or several counties may be affected by disaster damage, we use the summary of deposits

Data We are interested in the potential risk from natural disasters that banks face as of the year before the liberalization period of the 1990s (i.e., 1994) We weight the long term measure for each bank with the summary of deposits they had across counties in 1994 The variable DIS is thereby the long term disaster damage each bank face as of their geographic spread in 1994

Disaster damages over personal income: an overview

Expansion opportunities (OPP): staggered liberalization We are interested in the liberalization following the Riegle-Neal Act of 1994 We calculate the expansion opportunity index for each bank in each state for each year in two steps: 1. We check for each year whether a state allows de novo branching or acquisitions of single branches from out-of-state banks after We then weight this information with the distance between all states for each bank (gravity) This index is higher when more states at a close distance to the banks’ home state allowed for interstate branching

Expansion opportunities over time

Descriptive evidence The variable for geographic expansion of banks is EXP, which measures the bank’s share of deposits outside the bank’s home state (“out-of-state deposit share”) The calculation is based on yearly data since 1994 from the Summary of Deposits statistics of the FDIC

DD approach We explain out-of state expansion of bank i in state s in year t between 1994 and 2012 Main variables: EXP is a bank’s share of out-of-state deposits, OPP is an index of out-of-state expansion opportunities, DIS the long term property damage from natural disaster for each bank ν and τ capture bank and year fixed effects

DD approach We explain out-of state expansion of bank i in state s in year t between 1994 and 2012 Main variables: EXP is a bank’s share of out-of-state deposits, OPP is an index of out-of-state expansion opportunities, DIS the long term property damage from natural disaster for each bank ν and τ capture bank and year fixed effects

Baseline results: Banks that face higher locally non-diversifiable risks increase their out-of-state deposits when they were given the opportunity to expand out-of-state after 1994

Baseline results: Conditional marginal effect of DIS At OPP=0.5, the economic effect is around 0.5 → if DIS increases by one standard deviation (0.0033) → EXP increases by 17 basis points In terms of a mean value of EXP about 0.75%, this would mean a increase of about 23%

Bank and Regional Characteristics Effects are driven by banks that are a member of Bank holding companies and larger banks. –Small banks do not take advantage of deregulation Within state diversification opportunities (i.e. within state low correlation of natural disasters) result in a smaller response to deregulaton. Other regional variables have no additional effect

Where do banks expand to? Banks faced with locally non-diversifiable risk may expand –to regions where local risk exhibits a low correlation with the risks faced in their home state („diversification“) –to regions where local risk exhibits a high correlation with the risks faced in their home state („specialization“) The difference is crucial for understanding what drives the geographic expansion of banks and how this expansion affects their risk

Where do banks expand to? In order to address this question we calculate –The time series of damages from natural disasters over GDP that each bank would a faced when we consider only the counties the banks were active in –The times series of damages from natural disasters over GDP for all counties. –Then we calculate for each bank all correlations between the local time series of disaster damages and all other time series of disaster damages. –With this set of correlations we then calculate for each bank the average correlation (weighted by the inverse distance) with all counties outside each bank’s home region. DatumKurztitel19

Where do banks expand to? We call this the “benchmark correlation”, if the bank had expanded “randomly”, i.e. without any regard for the relationship between local and out of region locally non-diversifiable risk. We take the difference between the correlation in natural disasters between the home county and where the bank actually expanded to and this benchmark. If this is positive: banks expanded to regions with positively correlated local disaster risk, i.e. areas with “similar” disasters. If this is negative : banks expanded to regions with less (than average) correlated disaster risk, i.e. areas with “dissimilar” disasters DatumKurztitel20

Where do banks expand to? We calculate this difference for each bank and use this as the dependent variable in the DD regressions We find a positive and significant coefficient on OPP*DIS, i.e. given that banks expand they tend to expand to areas that exhibit a high correlation in locally non-diversifiable risk with their home region. Banks tend to seek out regions with similar risks, rather than dissimilar risks: evidence in favor of “specialization” and against “diversification” DatumKurztitel21

Conclusion In order to address the tricky identification problem when examining geographic expansion and risk taking by banks we use disaster risk as a measure of “locally non-diversifiable risk” that a bank faces We combine the data on local disasters with the staggered deregulation process in the US Permits to investigate: –The determinants of geographic expansion: why do some banks expand and others do not? –Do banks seek to diversify their risk exposure or do they use their expertise to similar risks elsewhere?

Conclusion Findings: –Banks facing more locally non-diversifiable risks in their home regions respond more strongly to deregulation and expand more into other states –Only large banks and banks that are part of BHC take advantage of deregulation –Banks first take advantage of local geographic expansion opportunities –Banks tend to “specialize” rather than “diversify”: They expand to areas where they face similar risks to those they face at home. DatumKurztitel23

Conclusion Results may explain mixed findings in the literature on geographic expansion of banks and risk taking: Banks do not tend to reduce the risks they face when expanding, but rather increase risks that they tend to have expertise in. DatumKurztitel24