# Presentation: 719245

## 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
- Related literature
- Overview of the sample
- Methodological aspects and results
- Econometric estimates
- Portfolio model
- Conclusions

## 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

## Cross-Border M&As Targeting Banks in:

## Consolidated Foreign Claims of BIS-Reporting BanksRecipient: Emerging and Developing Countries1983-2004

## Synchronization of Macroeconomic ConditionsHigher Between Industrial Countries

## Growth Correlations, Cumulative Probabilities by Country Groups

## 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”

## 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)

## 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

## Sample: Distribution of Assets

*by Country of Incorporation of Parent Banks and Location of Subsidiaries**(unweighted averages, in percent)*

## Summary Statistics of Risk and Return by Country Groups

## Methodology: 1) Econometric Estimation

*Alternative specification including a Herfindhal index of asset concentration*

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

## 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

## Robustness Check: Controlling for Parent Bank Idiosyncrasies

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

## 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)

## Methodology: 2) Portfolio model

*Expected return:*

*Expected variance:*

## Example:

## Deviations of Actual Asset Allocations from the Efficient Frontier

**Deviations of Actual Asset Allocations from the Efficient Frontier**

## Selected Statistics of the Observed Asset Allocation(unweighted averages)

## 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

## 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

## 

Thank you!

- Thank you!