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 Banks Recipient: Emerging and Developing Countries

6. Synchronization of Macroeconomic Conditions Higher 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 , 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!