THE IMPACT OF INTERNATIONALISATION ON THE PERFORMANCE AND RISKINESS OF BANKS

The benefits that banks can get from internationalisation in terms of increasing margins and reduced risk are rather small, according to researchby Cathérine Koch and colleagues, presented at the Royal Economic Society’s 2011 annual conference. Even for those banks that can achieve higher levels of market power through internationalisation, the marginal effects of going abroad are relatively small compared with the domestic determinants of market power.

At the same time, and perhaps contrary to conventional wisdom, the study finds that internationalisation has a rather limited impact on bank distress. Instead, the most important determinants of banks’ riskiness are their very market power and profitability as well as the size of their financial assets.

The research, which analyses detailed data on the cross-border positions and financial reports of German banks provided by the Deutsche Bundesbank, finds that:

  • Banks with higher shares of cross-border assets, either held directly by their domestic headquarters or by foreign branches, have higher market power in their home countries. Large banks that do not have a foreign presence have relatively less market power.
  • Banks benefit differently from their foreign presence. Commercial and savings banks tend to improve their risk-return trade-off; cooperative banks tend to worsen their risk-return trade-off.
  • Banks that maintain a foreign presence in many foreign countries are more likely to reveal above average probabilities of distress. One explanation for this finding is that maintaining a large international banking network is costly.

Understanding the trade-off between market power and risk for international banks is of key importance for policy-makers, particularly in light of the global financial crisis. But designing appropriate policy responses requires a better understanding of the links between a bank’s international activity and its riskiness.

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Recent developments in international financial markets have called the benefits of bank globalisation into question. Large, internationally active banks have acquired substantial market power, and international activities of banks have not necessarily reduced bank risk. Given these perceptions, surprisingly little is known about the actual link between bank internationalisation, bank risk and market power.

Analysing this link is the purpose of this paper. The researchers use a novel, very detailed bank-level dataset on external positions of German banks provided by the Deutsche Bundesbank. The data provide cross-border positions of all parent banks as well as reports submitted by branches and subsidiaries located abroad. Based on these data, the study develops indicators measuring the international activities of German banks.

The data paint a nuanced picture of banks’ internationalisation strategies. It is possible to distinguish the number of countries in which banks are active (the extensive margin) from the volume of foreign assets (the intensive margin), and the researchers compute these measures for different entry modes into foreign markets (cross-border asset holdings, foreign branches, foreign subsidiaries).

From the Bundesbank’s databases, they also obtain information on banks’ probabilities of distress, and estimate a Lerner index as a bank-specific measure of market power. They then analyse whether the internationalisation of banks affects their probability of distress and their domestic market power.

Understanding the risk-market power trade-off for internationally active banks is of key importance for policy-makers. The financial crisis has shown that diversification benefits have to be weighed against larger exposures to risks. Yet designing appropriate policy responses requires better insights into the link between bank risk and international activities of banks. These results inform this debate since they provide evidence on the impact of internationalisation on the performance of banks.

The analysis has four main findings:

  • First, there is a negative correlation between market power and the probability of experiencing a distress event for German banks. This finding is in line with theoretical models suggesting that higher market power increases profits and allows banks to build up buffers against loan losses.
  • Second, banks with higher shares of cross-border assets either held directly by their domestic headquarters or by foreign branches have higher market power at home. In addition, large banks in Germany do not necessarily enjoy higher market power. Instead, after controlling for other characteristics, market power and size are negatively correlated.
  • Third, banks that maintain a foreign presence in many foreign countries are more likely to reveal above average probabilities of distress. One explanation for this finding is that maintaining a large international banking network is costly.
  • Fourth, banks that differ in terms of size and banking group benefit differently from internationalisation. Commercial and savings banks tend to improve their risk-return trade-off; cooperative banks tend to worsen their risk-return trade-off. Also, bank size has an impact.

Perhaps the most important shortcoming of the data is that they do not include full information on off-balance sheet activities. Hence, an important channel of international activities is not included.

Overall though, the results suggest that the benefits ensuing from internationalisation in terms of increasing margins and reduced risk are rather small. Even for those banks that can achieve higher levels of market power through internationalisation, the marginal effects of going abroad are relatively small compared with the domestic determinants of market power.

At the same time, and perhaps contrary to conventional wisdom, internationalisation has a rather limited impact on bank distress. Instead, the most important determinants of bank risk are their very market power and profitability as well as their hidden reserves.

ENDS

‘Do banks benefit from internationalization? Revisiting the market power-risk nexus’ by Claudia Buch, Cathérine Koch and Michael Kötter