International Diversification Gains and Home Bias in Banking

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International Diversification Gains and Home Bias
in Banking

• by
• Alicia Garcia-Herrero and
• Francisco Vázquez
• Comments
• Kenneth D. Jones
• Federal Deposit Insurance Corporation
• Mergers and Acquisitions of Financial
  InstitutionsL. William Seidman Center -
  Arlington, VANovember 30 - December 1, 2007

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These deep thoughts are my own and not those of
the U.S. Government
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Objective

• Assess the potential gains of geographic
  diversification for the largest international
  banks in the G7 by analyzing the risk-return
  performance of these banks in their home country
  vis-à-vis their overseas subsidiaries.

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Findings

• Larger asset allocation to foreign subsidiaries
  improves the risk-adjusted returns of the
  consolidated financial group.
• Diversification gains originate from low return
  covariances across country groups.
• Gains are partially eroded by the concentration
  of foreign subsidiaries in specific geographical
  regions.
• Actual allocation of international bank assets
  displays a substantial home bias compared to an
  efficient international portfolio.

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Major Contributions

• Body of research on international diversification
  in banking is still somewhat thin
• New bank-level dataset that links each
  international bank with its foreign subsidiaries
• New approach uses financial statements of
  parent banks, foreign subsidiaries, and the
  combined financial group to drive the analysis
• Uses a mean-variance portfolio model to study the
  potential gains from geographic diversification

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Types of Diversification Portfolio (asset type,
revenue source) Geographic (domestic,
cross-border)

• Benefits of Diversification (cross-border)
• Reduce risk (lower volatility of returns or
  default probability)
• Reduce country-specific macro shocks
• Lower cost of capital
• More efficient internal capital markets
• Achieve scale and scope economies
• Increase market power
• Potential for tax benefits

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• Costs of Diversification (cross-border)
• Increased firm complexity
• Increased operating costs and risks
• Increased agency problems
• Tendency for diversified firms to take on riskier
  activities
• Increased currency risk
• Introduction of political risk

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Literature

• Behr, Kamp, Memmel, and Pfingsten (2007)
• Use data on the loan portfolio composition of
  German banks to examine performance and risk.
  They find that specialized banks have lower
  ratios of loan loss provisions and non-performing
  loans but have higher volatilities of these
  ratios exemplifying the typical risk-return
  trade-off.
• Odesanmi and Wolfe (2007)
• Examines the effect of revenue diversification on
  banking stability in emerging economies and find
  evidence of positive benefits across and within
  business lines on systemic risk. More
  specifically, the authors find that revenue
  diversification between and within traditional
  interest and non-interest income generating
  activities results in an increase in the distance
  to default across the banking sector.
• Choi, Hasan, and Kotrozo (2006)
• Examines the effects of both activity and
  geographic diversification on risk and
  performance of international banks and find that
  the benefits of diversification can be dependent
  on the specific type
• Activity diversification (asset type and income
  source) is likely to undermine performance
  (Tobins Q)
• Geographical diversification is likely to enhance
  performance (Tobins Q)

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Literature

• Hayden and Porath (2006)
• Finds no large performance benefits associated
  with diversification (portfolio lending or
  geographic)
• Stiroh and Rumble (2006)
• Find that revenue diversification benefits exist
  for FHC but are offset by increased exposure to
  more volatile non-interest activities.
• Deng and Elyasiani (2005)
• Find that in the U.S. banking industry,
  geographic diversification is associated with
  lower total, firm-specific, and market risk but
  has insignificant effects on stock returns and
  firm value (Tobins Q) also find that physical
  distance between subsidiaries and headquarters
  raises total and firm-specific risk while
  reducing firm value and leaving returns
  unaffected -- implying higher operational risk.
• Iskandar-Datta and McLaughlin (2005)
• Study U.S. corporate performance (pre-tax cash
  flows) for firms that choose to diversify
  globally and find that they outperform the
  benchmark firms in the years following a firms
  diversification event. Larger firms and firms
  with higher cost of goods sold are better able to
  benefit from diversification.

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Literature

• Lin, Wu, Penm, Terrell (2005)
• Finds a significant positive link between revenue
  diversification and financial performance in the
  banking industry in Taiwan, but a negative
  relationship between revenue diversification and
  risk.
• Morgan and Samolyk (2005)
• Find a U-shaped relationship between geographic
  diversification and bank holding companies
  risk-adjusted returns.
• Chionsinni, Foglia, and Reedtz (2003).
• Apply a portfolio approach to measuring credit
  risk in a MA framework and find that, as a
  consequence of a merger, credit risk is
  significantly reduced because of diversification
  of idiosyncratic risk (Italian banking industry).

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Discussion

• Literature
• Strongly suggest that the authors incorporate the
  ideas in these recent papers
• Make more clear how your paper differs from
  previous studies and where it makes a
  contribution
• Methodology
• Geographic diversification is defined by asset
  shares by country group
• Concern that this mixes the effect of activity
  diversification and pure geographic
  diversification
• Foreign subsidiaries can often engage in
  activities that are prohibited in home country
  is this a geographic effect?
• Dont control for portfolio differences
• Do subsidiaries have the same mix of assets?
• Do subsidiaries have same revenue sources?

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Discussion

• Methodology
• Is it important to control for
• Ownership share/degree of control?
• Age of subsidiary?
• Physical distance to subsidiary?
• What about alternative definitions of geographic
  diversification?
• Define in terms of revenues, deposits, or
  activities
• What about using additional measures of
  performance?
• Stock performance, firm value, etc.
• Use of financial statements creates some problems
  that should be considered/discussed in more depth
• Statements are subject to accounting manipulation
• Differences in taxation across countries
• Use EBIT as a performance measure
• Use cash flow/asset measure
• Controlled for off-balance sheet activities?

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