Abstract
This paper explores the comparative advantage of multinational banking over cross-border financial services in terms of capitalizing on a global access to funding sources. We argue that this advantage depends on the benefit and the cost of multinational banks’ intimacy with local markets. The benefit is that it allows multinational banks to create more liquidity. The cost is that it causes inefficiencies in internal capital markets, on which a bank relies to allocate liquidity across countries. We analyze the conditions under which multinational banking is then likely to arise and show that capital requirements have an effect as they influence the degree of inefficiency in internal capital markets for alternative organization structures differently.
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Notes
Harr and Rønde (2006) and Lóránth and Morrison (2007) also argue that optimal capital regulation should differentiate between banks with different organizational structures. Acharya (2003), Holthausen and Rønde (2005), and Dell’Ariccia and Marquez (2006) further study the relationship between banking regulation and international banking activities.
Even in the Euro area, the degree of financial integration is still low (Baele et al. 2004).
Following Stein (2002), managing a legally independent, separately capitalized subsidiary also provides sufficient incentive to exploit informational advantages.
A natural question is who these newly born investors are and where they come from. Diamond and Rajan (2005) argue that new investors are those entrepreneurs who have already finished their projects at t = 1 and can thus reinvest their rents. Following this view, a regional liquidity shortage is a situation, where in one country the entrepreneurs with early projects have a common liquidity need. For example, they may face a profitable new investment opportunity, which promises higher returns than a banker can ever make. They are hence not willing to re-deposit their rents at the bank.
Since loans are no longer risky, this assumption is in line with Basel II (Basel Committee 2005). It also makes the analysis easier without changing our results.
If investors were also allowed to collect the transfer, they would be obliged to pay it back to the bank manager in country B at t = 2. Given that investors need to consume at t = 1, either the transfer has no value to them (when they store it for later repayment) or the supporting banker is unwilling to make the transfer (when investors do not store but consume).
Note that, although not explicitly modeled, it is the expectation of this rent that can be seen as an incentive device for building up tight lending relationships and to gather soft information in the first place.
See Diamond and Rajan (2000) for an in-depth analysis of a banker’s choice between safe and risky deposit contracts.
This is in line with the empirical findings of De Haas and Van Lelyveld (2006), who capture the importance of local expertise by dividing foreign subsidiaries into greenfields and take-overs. Take-overs of already existing local banks are typically associated with employing the former management and employees, which are better informed about local markets. In addition, the corporate governance links tend to be looser for take-overs than those between a parent bank and a greenfield affiliate.
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Acknowledgements
We like to thank Robert Marquez (the Editor), an anonymous referee, Jürg Blum, Hendrik Hakenes, Achim Hauck, Alexander Karmann, Tobias Knedlik, Niels Krap, and participants at conferences of Swiss Society for Financial Market Research (Zurich), European Financial Management Association (Vienna), Swiss Society of Economics and Statistics (St. Gallen), European Economic Association (Milan), Verein für Socialpolitik (Graz), CEPR-GIST (Milan), and the seminars at Hacettepe University Ankara, Deutsche Bundesbank, Kobe University, and IfW Kiel. All errors are ours.
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Appendix
Appendix
Proof of Lemma 1
To solve program (9) consider first the sum of rents
which has the following property
where \(\chi ^{crit}:=\frac{\beta_{mb}C-8T_{1}}{\beta_{mb}C}\). We proceed by distinguishing between four cases. □
Case 1
If deposits d 0 are too large while the transfer T 1 is too small, depositors will hold such a high claim on the banker that no liquidation rate smaller than 1 allows the banker to raise enough funds in order to deter investors from enforcing the liquidation of all late loans. Formally, there is no \(\hat{\chi}<1\) satisfying Eq. 6, i. e.
holds true. Rewriting this condition yields
Hence χ ∗ is equal to 1 for any combination of d 0 and T 1 satisfying Eq. 27.
Case 2
If χ crit is smaller than 0, i. e. if \(T_{1}>\frac{1}{4}\frac{\beta_{mb}C}{2} \) holds, it follows for all \(\hat{\chi}>0\) that \(\frac{d}{d\hat{\chi}}\left( R_{1}(\hat{\chi})+R_{2}(\hat{\chi})\right) >0\). It is thus optimal for the bank manager to set χ ∗ = 1, even though a \(\hat{\chi}\), which satisfies constraint (6) with equality, is smaller than 1. The reason here is that T 1 is too large, so the banker has an incentive to liquidate all late loans for strategic reasons: She simply pockets the high transfer T 1 at t = 1, but she is not inclined to repay it at t = 2.
For the remaining two cases, neither the condition for case 1 nor that for case 2 holds. Hence we finally consider those cases, where
holds.
Case 3
Apparently, the bank manager will set χ ∗ = 0 if the constraint (6) is slack for \(\hat{\chi}=0\) and if
is additionally fulfilled. Constraint (6) will not be binding for \(\hat{\chi}=0\) if
which is equivalent to require
Condition (29) holds true if
Hence, it follows that χ ∗ = 0 if T 1 meets conditions (28), (31) and (32) simultaneously, i. e. if
where—owing to assumption (1)—we have \(\beta_{mb}C-L<\frac{\beta_{mb}C}{2}\). Hence, Eq. 33 further simplifies to
Case 4
Consider the case where \(T_{1}\leq \frac{1}{4}\frac{\beta_{mb}C}{2}\) holds true but constraint (6) is violated for χ = 0. Investors then require the banker to choose \(\chi \geq \hat{\chi}\) where \(\hat{\chi}\) is implicitly defined by Eq. 6, i. e.
Hence, as a consequence of the property (25) of R 1(χ) + R 2(χ), the banker will set \(\chi ^{\ast }=\hat{\chi}\) only if
holds and sets χ ∗ = 1 otherwise. Since \(\hat{\chi}\) is defined as that χ for which available liquidity at t = 1 exactly equals what is demanded by investors (i. e. for which condition (6) holds with equality), we have \(R_{1}(\hat{\chi})=0\) and condition (36) can be rewritten as
We know from Eq. 25 that \(R_{1}(\hat{\chi})+R_{2}(\hat{\chi})<R_{1}(1)+R_{2}(1)\) if \(\hat{\chi}\geq \chi ^{crit}\) or, equivalently, if
We therefore have χ ∗ = 1 if T 1 satisfies Eq. 38. But if this condition is violated, we have \(T_{1}\leq\frac{1}{4}\left( 1-\hat{\chi} \right) \frac{\beta_{mb}C}{2}\). In this case Eq. 37 reads as
Its RHS is even smaller than the expression on the RHS in Eq. 38.
We conclude
Comparing the parameter ranges in Eqs. 27, 28, 34 and 40 yields that Eq. 27 is redundant. Hence, three cases are left which yields Eq. 10.
Proof of Proposition 2
We have to distinguish two cases: □
Case 1
When \(\hat{k}\leq \alpha \), deposits \(d_{0}^{\ast }\) are equal to \(\frac{\beta_{mb}C+L}{4}\). Thus, according to Eq. 15, there will be no transfer and it follows from Lemma 1 that χ ∗ = 1.
Case 2
When \(\hat{k}>\alpha \), deposits are smaller than \(\frac{\beta _{mb}C+L}{4}\) and monotonically decreasing in \(\hat{k}\).
Since there are no deposits for \(\hat{k}=1\), and since
if \(d_{0}^{\ast }=0\), the intermediate value theorem implies that there is a critical capital-to-asset ratio, denoted by η, such that
holds for any \(\hat{k}\geq \eta \) and
for any \(\hat{k}<\eta \). There is thus no need to liquidate loans at all if \(\hat{k}\geq \eta \), i. e. χ ∗ = 0. For intermediate capital-to-asset ratios satisfying \(\hat{k}\in (\alpha ,\eta )\) we have χ ∗ ∈ (0,1). In this case, \(d_{0}^{\ast }\) decreases as \(\hat{k}\) increases, which allows for higher transfers. Both, lower deposits and higher transfers, lead to a lower χ ∗ as shown in Lemma 1.
Proof of Proposition 3
Expected repayments to initial investors depend on \(\hat{k}\) (Table 1). The proof will show that a necessary condition for repayments associated with cross-border financial services being higher than those associated with multinational banking is that \(\hat{k}\) is sufficiently small. Moreover, an increasing \(\hat{k}\) will make the provision of cross-border financial services less favorable. Once multinational banking dominates for some \(\hat{k}\), there will be no \(\hat{k}\) beyond that ratio where cross-border financial services will dominate again.
We distinguish two cases, depending on whether capital requirements are binding. □
Case 1
We start with capital adequacy ratios satisfying \(0<\hat{k}\leq \alpha \). Cross-border financial services are then associated with higher expected payments than multinational banking if
In what follows we show that Eq. 44 reaches its maximum at \(\hat{k}=0\) and that this maximum is strictly positive if and only if Eq. 23 is met. Differentiating Eq. 44 yields
For \(\hat{k}=0\), rearranging Eq. 44 yields that \(\Delta _{0\leq\hat{k}\leq \alpha }>0\) if Eq. 23 is satisfied. It can easily be checked that this condition holds for at least some parameters, for instance for β mb and β cfs being very close to each other.
Case 2
When \(\alpha <\hat{k}\leq 1\), cross-border financial services still dominate multinational banking if
that is if
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Dietrich, D., Vollmer, U. International Banking and Liquidity Allocation. J Financ Serv Res 37, 45–69 (2010). https://doi.org/10.1007/s10693-009-0074-7
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DOI: https://doi.org/10.1007/s10693-009-0074-7
Keywords
- Financial integration
- International banking
- Capital regulation
- Foreign direct investment
- Incomplete contracts