Risk and the Organization of Bank Foreign Affiliates Giovanni DellAriccia (IMF and CEPR) Robert Marquez (Arizona State University) The views expressed in this presentation are those of the authors and do not necessarily represent those of the IMF.

Motivation Recent trend towards financial liberalization and increased cross-border activities for banks. Recent trend towards financial liberalization and increased cross-border activities for banks. Growing literature on merits/pitfalls of extensive foreign-bank presence in emerging markets. Growing literature on merits/pitfalls of extensive foreign-bank presence in emerging markets. Yet, little attention paid to how that presence is established: Yet, little attention paid to how that presence is established: Branches; Branches; Subsidiaries; Subsidiaries; Cross-border flows. Cross-border flows.

Differences across structures Subsidiaries: Subsidiaries: Locally incorporated, stand-alone entities; Locally incorporated, stand-alone entities; Separately capitalized; Separately capitalized; Protected by limited liability at affiliate level. Protected by limited liability at affiliate level. Branches: Branches: No independent legal personality; No independent legal personality; Capital for regulatory purposes can be supplied at the consolidated level; Capital for regulatory purposes can be supplied at the consolidated level; Liabilities of foreign branches represent real claims on parent bank. Liabilities of foreign branches represent real claims on parent bank.

Why this matters May affect competitive structure of local banking systems: May affect competitive structure of local banking systems: Threatening profits and market share of domestic banks; Threatening profits and market share of domestic banks; Affecting price and quality of bank services in host-country. Affecting price and quality of bank services in host-country. Involves different levels of parent bank responsibility and financial support with implications for: Involves different levels of parent bank responsibility and financial support with implications for: The parent banks, who care about their exposure; The parent banks, who care about their exposure; Local regulators, who care about domestic stability; Local regulators, who care about domestic stability; Local depositors, who care about safety of their savings. Local depositors, who care about safety of their savings.

We focus on risk We argue that risk structure is an important determinant of banks organizational choice: We argue that risk structure is an important determinant of banks organizational choice: Different limited liability structure; Different limited liability structure; Different jurisdictional location of bank capital. Different jurisdictional location of bank capital. We consider two sources of risk: We consider two sources of risk: Economic risk: macroeconomy, interest rates, credit risk, etc. Economic risk: macroeconomy, interest rates, credit risk, etc. Political risk: Expropriation of foreign banks, infringement of banks property rights. Political risk: Expropriation of foreign banks, infringement of banks property rights.

Main results Relative importance of economic and political risk determines preferred organizational structure: Relative importance of economic and political risk determines preferred organizational structure: Branches preferred when political risk is paramount; Branches preferred when political risk is paramount; Subsidiaries preferred when main concern is economic risk. Subsidiaries preferred when main concern is economic risk. Intuition: Intuition: Branch structure benefits from keeping capital at home and avoiding expropriation; Branch structure benefits from keeping capital at home and avoiding expropriation; Fragmented liability structure protects parent bank from losses due to economic risk at affiliate level. Fragmented liability structure protects parent bank from losses due to economic risk at affiliate level.

Related literature Growing empirical literature studying what drive banks abroad and what determines location choices: Growing empirical literature studying what drive banks abroad and what determines location choices: Claessens et al. (2000), Focarelli and Pozzolo (2001 and 2005), Buch (2000 and 2003), Cerutti et al. (2006). Claessens et al. (2000), Focarelli and Pozzolo (2001 and 2005), Buch (2000 and 2003), Cerutti et al. (2006). While theoretical work on this topic is still limited... : While theoretical work on this topic is still limited... : Kahn and Winton (2004); Kahn and Winton (2004);...a few papers have focused on how to regulate multinational banks:...a few papers have focused on how to regulate multinational banks: Calzolari and Loranth (2003), Dalen and Olsen (2003), and Harr and Ronde (2005). Calzolari and Loranth (2003), Dalen and Olsen (2003), and Harr and Ronde (2005).

Start with a simple model Bank has foreign affiliates in countries i = 1,…,n. Bank has foreign affiliates in countries i = 1,…,n. Revenue for each affiliate: L i P i = L i R i i, where Revenue for each affiliate: L i P i = L i R i i, where L i = loan quantity; L i = loan quantity; P i = realized return on loan; P i = realized return on loan; R i = average interest rate on loan; R i = average interest rate on loan; i = credit risk, iid with distribution F( ), over [0,1]. i = credit risk, iid with distribution F( ), over [0,1]. The bank is also subject to political risk: The bank is also subject to political risk: i = probability of expropriation in country i. i = probability of expropriation in country i. Bank has capital E used to satisfy capital requirement: Bank has capital E used to satisfy capital requirement: For branch structure: at the consolidated level; For branch structure: at the consolidated level; For subsidiary structure: at each affiliate. For subsidiary structure: at each affiliate.

Comparing the profit functions Expected profits of branch structure: Expected profits of branch structure: Expected profits of subsidiary structure: Expected profits of subsidiary structure:

Economic risk favors subsidiaries For i = 0, the banks expected profits are higher with a subsidiary structure than with a branch structure. For i = 0, the banks expected profits are higher with a subsidiary structure than with a branch structure. Intuition: When there is no political risk, there is no value to keeping capital at home. Intuition: When there is no political risk, there is no value to keeping capital at home. However, macroeconomic risk creates an incentive for bank to operate internationally via a subsidiaries: However, macroeconomic risk creates an incentive for bank to operate internationally via a subsidiaries: Limited liability at each affiliate prevents foreign losses from spilling over to parent bank. Limited liability at each affiliate prevents foreign losses from spilling over to parent bank.

Political risk favors branches There exists a value of i < 1 such that the banks overall expected profits are higher with a branch structure than with a subsidiary structure. There exists a value of i < 1 such that the banks overall expected profits are higher with a branch structure than with a subsidiary structure. Intuition: When political risk is very high, fear of expropriation dominates other risk factors: Intuition: When political risk is very high, fear of expropriation dominates other risk factors: Bank is better off keeping all capital at home and financing branch with foreign deposits. Bank is better off keeping all capital at home and financing branch with foreign deposits. It follows that there exists a value of such that: It follows that there exists a value of such that: for i < a subsidiary structure is preferred, and for i < a subsidiary structure is preferred, and for i > a branch structure is preferred. for i > a branch structure is preferred.

Cross-country risk correlation Suppose that economic risks at home and abroad are correlated: Suppose that economic risks at home and abroad are correlated: i.e. i are positively correlated. i.e. i are positively correlated. Then the threshold value is decreasing in the degree of cross-country correlation. Then the threshold value is decreasing in the degree of cross-country correlation. Intuition: when economic risk is correlated across countries: Intuition: when economic risk is correlated across countries: If affiliate makes losses, parent bank is likely making losses at home as well. If affiliate makes losses, parent bank is likely making losses at home as well. Hence, shielding effect from limited liability of subsidiaries reduced. Hence, shielding effect from limited liability of subsidiaries reduced.

Endogenous pricing of liabilities So far, cost of deposits and other liabilities exogenous So far, cost of deposits and other liabilities exogenous However, in practice this cost should reflect different risks associated with organizational structures. However, in practice this cost should reflect different risks associated with organizational structures. If investor/creditors are risk neutral and all liabilities are correctly priced at the margin: If investor/creditors are risk neutral and all liabilities are correctly priced at the margin: Organizational structures have identical expected profits. Organizational structures have identical expected profits. Application of Modigliani-Miller irrelevance result. Application of Modigliani-Miller irrelevance result. However, some liabilities are not or cannot be priced correctly (we are working on this... ): However, some liabilities are not or cannot be priced correctly (we are working on this... ): Deposit insurance; Deposit insurance; Asymmetric information. Asymmetric information.

Empirical fit Branch vs. Subsidiary: Cerutti et al. (2006) find that banks are more likely to set up branches when political risk is relatively high. Branch vs. Subsidiary: Cerutti et al. (2006) find that banks are more likely to set up branches when political risk is relatively high. Correlation: there is a sense that branches are more prevalent within country and subsidiaries across countries. However, need data confirmation. Correlation: there is a sense that branches are more prevalent within country and subsidiaries across countries. However, need data confirmation.

Much to do Partial pricing of liabilities. Partial pricing of liabilities. Edogenizing the rate of return on bank assets Edogenizing the rate of return on bank assets Rate of return should be a function of competitiveness of market; Rate of return should be a function of competitiveness of market; Required return to bank should also be risk-adjusted. Required return to bank should also be risk-adjusted. How the scale of entry and market structure help drive organizational form? How the scale of entry and market structure help drive organizational form? Banks tend to have both branches and subsidiaries: Banks tend to have both branches and subsidiaries: Model may need to be expanded to handle both. Model may need to be expanded to handle both.