The Internal Organization of Banks and the Transmission of Lending Shocks across Borders

Project Start: 06/2013
Status: Completed
Researchers: Reint Gropp, Deyan Radev, Michael Schröder
Category: Financial Institutions, Systemic Risk Lab

Topic & Objectives

The links between parents and subsidiaries within international bank conglomerates lead to a reduction of information asymmetries and provide liquidity sources in cases when outside funding is scarce or unavailable. However, they can also be channels for the transmission of shocks both across a country's regions and internationally. So far, there is little knowledge of how the internal organization of these financial conglomerates is connected with their cross-border lending decisions. A major obstacle for such an analysis is the lack of information about the degree to which a parent bank affects the decisions of its foreign subsidiaries. Few studies have used confidential information about the activities of the internal capital markets in banking conglomerates, but such information is usually either not available to the general scientific community, or available only for a small number of countries, such as the U.S., which makes the results difficult to apply elsewhere.

In SAFE Working Paper No. 174, we introduce a novel approach to measure bank integration, based on the language in the financial reports of global banks. The Power Index that we introduce reflects the prevalence of a language of power, authority and control, which is identified by the management literature as an indication of a tighter integration within a global corporation.

In SAFE Working Paper No. 175, we analyze the transmission channels of negative shocks from parent banks to their foreign subsidiaries and try to find an explanation of why a negative shock transmission occurs in certain cases and not in others. In our analysis, we recognize that not only the negative shocks are important as such, but also is their type, because banks use different approaches to address different types of shocks. We use this observation to identify whether solvency and wholesale shocks to parent banks are systematically related to a reduction subsidiary lending.

SAFE Working Paper No. 174

Key Findings

  • A more authoritative culture within a global banking conglomerate is crucially determined by the social (de-)centralization of the home country of the parent: more ethnically dispersed societies nurture less centralized corporate banking structures. Linguistically decentralized societies, on the other hand, produce more centralized corporate structures, which may be explained by the need for clearly stated rules and orders in a multilingual environment.
  • Bank integration, as measured by the Power Index, plays a major role in the transmission of negative shocks across borders: If a solvency shock hits a parent, its subsidiaries reduce lending more if the banking conglomerate is more integrated. Wholesale shocks do not appear to be transmitted through this channel.
  • Past experience with solvency shocks reduces the integration between parents and subsidiaries.

Policy Implications

Our study has important policy implications and adds to our understanding of the transmission of negative shocks across borders and how it is affected by corporate and country culture. Our findings suggest that in analyzing and forecasting the impact of external shocks on a country's economy, host country supervisors and regulators should take into account the social and cultural structure in the home country of their foreign-owned banks.

SAFE Working Paper No. 175

Key Findings

  • Solvency shocks to parents generally have larger effect on subsidiary lending than wholesale shocks. Transmission of wholesale shock does occur and it affects foreign subsidiaries of parent banks that rely heavily on wholesale funding.

  • Further, the transmission of wholesale shocks depends on the relative importance of the subsidiary within the parent business strategy: subsidiaries in markets that are traditionally used as a funding source by the parent tend to be affected by solvency shocks, while subsidiaries that provide investment income appear to be protected by the parent. Cetorelli and Goldberg (2012b) find this effect for U.S. banks hit by liquidity shocks and call it a “locational pecking order”. We find evidence for this phenomenon on a global scale.
  • Liquidity regulation tends to exacerbate the effect of wholesale shocks on foreign subsidiaries.
  • The subdued effects of both types of shocks for undercapitalized banks and banks that rely on wholesale funding are primarily due to parents using their capital and liquidity buffers.
  • Solvency shocks have higher impact on big subsidiary banks with low growth opportunities in mature markets, which further reinforces the “locational pecking order” hypothesis, as the latter markets may be used as sources of funding for investments in high-growth developing markets.

Policy Implications

These results have important theoretical and policy implications and add to our understanding of the transmission of solvency and wholesale shocks across borders. As we find that shocks to parents have strong impact on subsidiaries abroad, and that parents try to address shocks by depleting their own capital and liquidity buffers first, we deduce that the current focus of banking regulation on requiring banks to hold sufficient buffers might be effective in reducing cross-border contagion. However, the liquidity rules currently in place globally aggravate the transmission of shocks across borders and further efforts are needed to find a more effective global regulatory framework.

Related Working Papers

No. Author/s Title Year Research Area Keywords
175 Deyan Radev International Banking Conglomerates and the Transmission of Lending Shocks Across Borders 2017 Financial Institutions, Systemic Risk Lab Commercial banks, global banks, wholesale shocks, solvency shocks, transmission, internal capital markets
174 Deyan Radev Social Centralization, Bank Integration and the Transmission of Lending Shocks 2017 Financial Institutions, Systemic Risk Lab Global banks, social centralization, bank integration, shocks, transmission

 

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