How banks go abroad: Branches or subsidiaries? Eugenio Cerutti a , Giovanni Dell’Ariccia a , Maria Soledad Martı ´nez Perı ´a b, * a International Monetary Fund, 700 19th Street, NW, Washington, DC 20431, United States b The World Bank, 1818 H Street, NW, Washington, DC 20433, United States Received 1 July 2005; accepted 14 November 2006 Available online 23 January 2007 Abstract We examine the factors influencing international banks’ organizational form, using an original database on the operations in Latin America and Eastern Europe of the world’s top 100 banks. We find that banks are more likely to operate as branches in countries that have higher taxes and lower regulatory restrictions on bank entry and on foreign branches. Subsidiary operations are pre- ferred by banks seeking to penetrate host markets by establishing large retail operations. Finally, economic and political risks have opposite effects, suggesting that legal differences in parent banks’ responsibilities associated with branches and subsidiaries are important determinants of banks’ orga- nizational form. Ó 2007 Elsevier B.V. All rights reserved. JEL classification: F23; G21 Keywords: Foreign banks; Organizational form; Branches; Subsidiaries 1. Introduction Over the last two decades, many countries liberalized bank activities that traditionally had been heavily regulated and protected from competition. As a result, foreign banks, which had previously played only a marginal role, established a substantial presence in 0378-4266/$ - see front matter Ó 2007 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2006.11.005 * Corresponding author. Tel.: +1 202 458 7341; fax: +1 202 522 1155. E-mail address: [email protected](M.S. Martı ´nez Perı ´a). Journal of Banking & Finance 31 (2007) 1669–1692 www.elsevier.com/locate/jbf
Transcript
Journal of Banking & Finance 31 (2007) 1669–1692
www.elsevier.com/locate/jbf
How banks go abroad: Branches or subsidiaries?
Eugenio Cerutti a, Giovanni Dell’Ariccia a,Maria Soledad Martınez Perıa b,*
a International Monetary Fund, 700 19th Street, NW, Washington, DC 20431, United Statesb The World Bank, 1818 H Street, NW, Washington, DC 20433, United States
Received 1 July 2005; accepted 14 November 2006Available online 23 January 2007
Abstract
We examine the factors influencing international banks’ organizational form, using an originaldatabase on the operations in Latin America and Eastern Europe of the world’s top 100 banks.We find that banks are more likely to operate as branches in countries that have higher taxes andlower regulatory restrictions on bank entry and on foreign branches. Subsidiary operations are pre-ferred by banks seeking to penetrate host markets by establishing large retail operations. Finally,economic and political risks have opposite effects, suggesting that legal differences in parent banks’responsibilities associated with branches and subsidiaries are important determinants of banks’ orga-nizational form.� 2007 Elsevier B.V. All rights reserved.
Over the last two decades, many countries liberalized bank activities that traditionallyhad been heavily regulated and protected from competition. As a result, foreign banks,which had previously played only a marginal role, established a substantial presence in
0378-4266/$ - see front matter � 2007 Elsevier B.V. All rights reserved.
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several middle-income and developing countries. That presence has taken a variety offorms, ranging from the acquisition of domestic institutions with extensive branch net-works to the establishment of isolated representative offices aimed at serving niche marketsegments. However, in contrast to the growing literature on the merits and pitfalls of for-eign bank participation in emerging markets, little attention has been paid to how thatpresence is established.1
This paper tries to fill this gap by examining what determines whether banks operate aslocally chartered and independently capitalized subsidiaries or as branches when goingabroad. In particular, we put together and analyze an original database focusing on theactivities of the world’s 100 largest banks in Latin America and Eastern Europe, thetwo regions with the greatest increase in foreign bank presence over the last decade.
There are at least two reasons why policy makers, bank users, and bankers should careabout how foreign banks operate in host markets. First, the organizational form of foreignbank operations may affect the competitive structure of the local banking systems, threat-ening the profits and market share of domestic banks and affecting the price and quality ofbanking services in the host country. For example, foreign subsidiaries with extensive net-works are in direct competition with local commercial banks for retail clients, while single-branch foreign banks or representative offices tend to concentrate, instead, on segmentssuch as wholesale and investment banking that tend to be underdeveloped in the hostcountries. Second, branches and subsidiaries typically involve different levels of parentbank responsibility and financial support. While subsidiaries are separate entities fromtheir parent banks, under most circumstances, parent banks are responsible for the liabil-ities of their branches.2 This can have implications not only for the parent bank but alsofor local regulators, who care about the stability of the host country, and for local depos-itors, who care about the safety of their savings.
We build an empirical model inspired by the Eclectic Theory of the multinational firm(Dunning, 1977) and its application to international banking (Gray and Gray, 1981;Williams, 1997), where banks’ organizational form depends on parent bank characteris-tics, home-country regulations, the desired level of penetration in the host market and hostcountry factors. Among the parent bank characteristics, we consider bank size, businessorientation (wholesale versus retail), degree of international presence, and expansion strat-egies in other countries. Among the host country factors, we consider the impact of legalrestrictions on foreign bank operations, entry requirements, and corporate taxes. In addi-tion, we examine the role of differences in the degree of legal responsibility by parent banksvis-a-vis the liabilities of their branches and subsidiaries, by looking at the impact of mea-sures of host country economic and political risks.
Whether and how differences in parent banks’ responsibilities with respect to branchesand subsidiaries matter is an interesting empirical question, given that the distinctionbetween branches and subsidiaries is much more blurred in practice than in theory. Onthe one hand, ring-fencing provisions may limit the responsibility of a parent bank to sup-
1 See Clarke et al. (2003) for a review of the literature on the impact of foreign bank participation.2 Recent crises demonstrate the heterogeneous behavior of branches and subsidiaries. Following the
Argentinean crisis of 2000–2001, Citibank announced an increase in the capital of its branch operations, butsold its subsidiary (Bansud). Also, in Argentina Credit Agricole cut its losses by letting the government take overits subsidiaries Bersa, Bisel and Suquia. In Eastern Europe, the Bayerische Landesbank gave up its subsidiary,Croatian Rijecka bank, after a trader at the subsidiary incurred huge foreign exchange losses.
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port its branches. Such provisions, adopted by several banks in recent years, establish thata parent bank is not required to assist a foreign branch if it becomes illiquid due to extremecircumstances (such as war or civil conflict) or due to certain actions by the host govern-ment (e.g., exchange controls, expropriations, etc.).3 On the other hand, concerns aboutloss of reputation have sometimes led banks to support their subsidiaries, although theywere not legally bound to do so.4
The findings from this paper can be summarized as follows. First, regulations appear tohave a paramount effect on banks’ organizational form. Foreign banks are less likely tooperate as branches in countries that limit their activities and where regulation makes itdifficult to establish new banks. Second, taxation also influences banks’ organizationalform. Branches are more common in host countries with high corporate taxes – possiblybecause of the greater ease allowed by this structure in shifting profits across borders.Third, our results suggest that different organizational forms are associated with differentdegrees of penetration in the host market. Branches are more likely when foreign opera-tions are smaller in size and do not have a retail orientation. Fourth, foreign banks tendspecialize in one organizational form or the other, beyond what is explained by theirhome-country regulation.
Finally, host country risks matter. In particular, economic and political risks haveopposite effects on banks’ organizational form, suggesting that differences in parent banks’responsibilities vis-a-vis branches and subsidiaries play an important role in determiningbanks’ organizational form. Branches are less common in countries with highly risky mac-roeconomic environments, where parent banks seem to prefer the ‘‘hard’’ shield of limitedliability provided by subsidiaries to the ‘‘soft’’ protection of ring-fencing provisions. How-ever, faced with risks stemming from possible government intervention and other majorpolitical events, parent banks are more likely to operate as branches. This is not necessar-ily surprising given the provisions that shield parent banks from the liabilities of their for-eign branches in events such as wars, insurrections, or arbitrary actions by foreigngovernments. Under those circumstances, banks are actually more exposed as subsidiaries,which typically have higher capital and reserve requirements and larger investments inlocal fixed assets, relative to branches.
This paper builds on the existing literature on the overseas activities of internationalbanks. The closest studies to this paper examine the determinants of the size and presence(in terms of assets and number of offices) of the operations of US banks abroad and offoreign banks in the US during the 1980s (see Goldberg and Saunders, 1980, 1981a,b;
3 In the case of US bank branches section 25C of the Federal Reserve Act establishes that ‘‘a member bank shallnot be required to repay any deposit made at a foreign branch of the bank if the branch cannot repay the depositdue to an act of war, insurrection, or civil strife or (2) an action by a foreign government or instrumentality(whether de jure or de facto) in the country in which the branch is located, unless the member bank has expresslyagreed in writing to repay the deposit under those circumstances’’. Another example are the clauses included inthe International Swaps and Derivatives Association (ISDA) Master Agreement. These stipulate that theheadquarters will bear no responsibility for transactions made at overseas branches in the case of exchangecontrols or expropriation (see ISDA (2003), Section 10 (a) Ring-Fencing Agreements).
4 For example, HSCB injected over US $600 millions into its Argentine subsidiary after the crisis (EconomistIntelligence Unit Wire, 16 December 2003). Similarly, Portugal’s Banco Espiritu Santo injected capital into itsBrazilian subsidiary Banco Boavista Interatlantico, to cover for the losses sustained by its mutual funds followingthe Real’s devaluation of January 1999. ABN Amro and KBC promised to make good on any losses to clientsarising from an alleged fraud at their Hungarian subsidiary K&H equities (The Economist, September 2003).
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Goldberg and Johnson, 1990; Miller and Parkhe, 1998, among others). These studies arenot only US centered but also, with the exception of Miller and Parkhe (1998), they con-sider the activities of each type of organizational form in isolation.5
More recently, some studies have analyzed the factors driving the overseas operationsof international banks using data for US and non-US banks, covering the last two decades(see, for example, Claessens et al., 2000; Focarelli and Pozzolo, 2001; Moshirian, 2001;Buch, 2000; Galindo et al., 2003; Buch, 2003; Buch and Lipponer, 2004; Wezel, 2004;Focarelli and Pozzolo, 2005). However, these studies completely ignore the issue of orga-nizational form.
The remainder of the paper is organized as follows. Section 2 explains the dataset col-lected on the activities of the top 100 international banks and their operations in EasternEurope and Latin America. Section 3 presents the empirical methodology pursued in thepaper to examine the determinants of foreign banks’ type of organizational form. Section4 discusses the empirical results. Section 5 concludes.
2. Data
We assembled an original database on the operations of the world’s 100 largest banks,6
focusing on their presence in Latin America and Eastern Europe.7 Table 1 summarizes thisdatabase by country of origin (home country) of the parent banks. In particular, Table 1shows the number of banks within the top 100 banks from each home country, illustratestheir importance in terms of the share of assets that they represent, and specifies the aver-age number of countries worldwide and in Latin American and Eastern Europe wherethese banks operate. Finally, the table summarizes the type of operations – branch or sub-sidiary – that these banks have (if any) in Latin America and Eastern Europe. Subsidiariesrefer to locally incorporated banks with over 50 percent foreign ownership, while branchesare offices fully owned by a foreign parent bank.8
US, German, and Japanese banks are dominant both in terms of assets and number ofinstitutions. There are 20 US banks, 16 German banks, and 11 Japanese banks among thetop 100 banks. US banks account for 21% of the banking assets of the top 100 banks andboth German and Japanese banks account for 15% each. However, in terms of averagenumber of countries where banks operate, US, German, and Japanese banks, with oper-
5 While other studies consider the determinants of the number of offices of subsidiaries and branches separately,Miller and Parkhe (1998) also estimate an equation for the share of subsidiary offices to total offices. Using adataset of overseas branch and subsidiary offices of US banks in 32 countries for the period 1987–95, the authorsfind that the share of subsidiaries is positively related to restrictions on branches, the size of the local market, andwhether universal banking is allowed in the host country. On the other hand, regulatory restrictions onsubsidiaries and corporate taxes have a negative impact on the share of subsidiaries.
6 Banks were ranked according to their global assets as of December 2002. Banks owned (50% or more of theshares) by another Top 100 bank were excluded. The shareholder data structure was obtained from Bankscope.
7 Host countries in our sample include: Argentina, Bolivia, Brazil, Bulgaria, Chile, Croatia, Czech Republic,Ecuador, Estonia, Hungary, Latvia, Lithuania, Mexico, Peru, Poland, Slovak Republic, Slovenia, Turkey, andUruguay. Sample-selection biases are unlikely to be relevant, since we cover the large majority of foreign banks inthe countries considered. At the same time, focusing on Latin America and Eastern Europe is justified by the factthat foreign bank presence in other parts of the world (such as Asia) has been small until recently.
8 Branches operating in a country as a branch of a top 100 subsidiary incorporated in a developing country werecoded as subsidiaries. The parent bank is under no legal obligation to honor those branches’ liabilities in excess oftheir developing country subsidiary.
Table 1Summary of country of origin (home), relative importance, and operations of top 100 banks worldwide and in our host countries1
Countries Number ofbanks in top100 listaccording toassets in2002
Assets’shareamongtop 100banks (%)
Averagenumber ofcountrieswhere banksoperate
Number of top 100banks withoperations in hostcountries in EasternEurope and LatinAmerica
Number of hostcountries inEastern Europeand LatinAmerica wherebanks operate
Number ofsubsidiaries inhost countries inEastern Europeand LatinAmerica
Number ofbranches in hostcountries inEastern Europeand LatinAmerica
Source: Parent Countries’ Banking Sector Regulations, National Central Banks, Bankers Almanac, and Bankscope.1 The host countries in our sample include: Argentina, Bolivia, Brazil, Bulgaria, Chile, Croatia, Czech Republic, Ecuador, Estonia, Hungary, Latvia, Lithuania,
Mexico, Peru, Poland, Slovak Republic, Slovenia, Turkey, and Uruguay.2 The Home-Country Branch/Sub Regulation Dummy is equal to zero if the legal requirements for a branch are the same as for a subsidiary. Instead, it is equal to
one if there are more requirements for a branch than for a subsidiary. The references to each case with 1 can be found below. Note that none of the host countries inthe sample were EU members in 2002.
(continued on next page)
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Table 1 (continued)a No bank shall have any branch, other than a representative office, outside Canada, without the approva of the Minister, whose approval may be subject to such
terms and conditions as the Minister considers appropriate (Banking Act, art 422).b An institution shall report immediately to the Federal Banking Supervisory Office and the Deutsche Bu desbank, the establishment, relocation and closure of a
branch in a non-EEA state (Banking Act, art 24 (7)).c Overseas Branches should not rely substantially on borrowed funds for asset expansion above the tol ance level (Instruction of RBI for Banks and Banking
Operations: Chapter 17, paragraph 17.1 (viii)). Numerous ceilings to individual borrowers and the exposur f branches overseas (Instruction of RBI for Banks andBanking Operations: Chapter 17, paragraph 17.3). In depth and detailed ‘‘reviews’’ of the working of the ov seas branches in each country at reasonable intervals ofnot more than a year and put the reviews for the consideration of the Top management and the Board o Directors (Instruction of RBI for Banks and BankingOperations: Chapter 17, paragraph 17.11 (v)).
d Italian banks may establish branches in a non-member state, subject to authorization by the Bank of I y. Italian banks may establish branches in Italy and inother member states (Banking Act, art 15(2)).
e If it is intended to open the branch in a non-EU Member State, the Banco de Espana can refuse the app cation on the basis of, and in addition to the foregoingreasons, the fact that it considers that the activity of the branch is not going to be subject to effective control the supervisory authorities of the host country, or thatthere exists legal or some other kind of obstacles that prevent or hamper control and inspection of the bran by the Banco de Espana. (Real Decreto 1245/1995, art13).
* China Banking Regulatory Commission (CBRC) was officially launched on 28 April 2003. Before it wa regulated by the PBOC (People’s Bank of China). Themain banks are state banks. No legislation was found for that period.
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ations in 16, 13, and 10 countries, respectively, are not the most international. Instead,Dutch and Swiss banks, with operations in an average of 38 and 31 countries, respectively,operate in the largest number of countries.
Regarding our sample of host countries, we observe that US and German banks haveoperations in 15 out of the 19 host countries in Eastern Europe and Latin America thatmake up our sample. Italian and Dutch banks operate in 14 and 12 countries, respectively,while both British and French banks have operations in 11 countries. On the other hand,Japanese banks, which hold a dominant role in international banking, operate in only 5 ofthe host countries in our sample.
In terms of organizational form, with the exception of US, UK, and Japanese banks,which have a balanced portfolio of branches and subsidiaries, banks from most othercountries largely prefer to operate as subsidiaries. Home-country regulations governingthe activities of the affiliates of parent banks are likely to affect banks’ organizationalform. A dummy summarizing home-country regulations regarding the operations ofbanks’ affiliates overseas is shown in the last column of Table 1. A value of 1 is associatedwith countries that place additional restrictions on opening branches relative to subsidiar-ies. For example, Canadian and Italian banks cannot open a branch without the previousapproval of the home regulator.9 Also, Spanish regulators can refuse a bank’s applicationto open an overseas branch based on a wider set of criteria (e.g. legal or other type ofobstacles that prevent or hamper the control and inspection of the branch by the homeregulator) than in the case of a subsidiary.
Table 2 summarizes the extent of foreign bank participation in Latin America and East-ern Europe and illustrates the relative importance of the international banks considered inour sample Foreign-owned banks represent about 50% of all banks in Latin America andEastern and Central Europe. Banks in our sample (i.e., those within the world’s largest100) account for most of the foreign bank activity in these two regions: 247 out of 387 for-eign controlled institutions (about 65%), and more than 80% of the assets controlled by allforeign banks (Table 2).10 Hungary, Peru, and Bolivia are the exception, mainly becausethe biggest foreign banks in these countries are owned by banks from neighboring coun-tries that are not among the world’s top 100 banks.11
In terms of organizational form, subsidiaries prevail over branches.12 The formeraccount for 65% of the foreign affiliates in Latin America and for 82% of those in EasternEurope (Table 2). A summary of the regulatory treatment of branches versus subsidiariesby host regulators is shown in Table 3. Since there are more differences in host countryrequirements for foreign branches and subsidiaries than in home-country regulations,we distinguish between four categories of requirements that we later combine into theHost-Country Regulation Index. In particular, we take into account the following separaterequirements or restrictions: Written Statements, Restrictions on Activities, Responsibilities
9 Italian legislation does not include European Union Member States on this issue.10 Colombia is excluded from our sample as local legislation does not allow the entry of foreign bank branches.11 Peru’s low share is due to the importance of Banco de Credito del Peru and Interbank’s shareholders, which
are companies from Bermudas and Bahamas, respectively.12 There were only five cases in which a bank in the top 100 list had a foreign equity participation below 50%.
Thus, the 50% ownership rule when identifying subsidiaries is unlikely to bias our estimations. Branchesoperating in a country as a branch of a top 100 bank’s subsidiary incorporated in a different country are coded assubsidiaries, since the parent bank is under no legal obligation to provide direct support to these affiliates.
Table 2Foreign bank presence in Eastern Europe and Latin America
Countries Number ofbanks
Number of banksunder foreigncontrola
Number offoreignsubsidiaries
Number offoreignbranches
Number oftop 100subsidiariesb
Number oftop 100branchesc
Top 100 foreign banks’asset share withinforeign controlled banksd (%)
Sources: National Central Banks, Bankers Almanac, Bankscope, and others.a Foreign banks with at least 50% of the bank capital.b Number of subsidiaries under foreign banks’control whose parent banks are within the world’s top 100 banks, classified by assets as of 2002.c Number of foreign branches whose parent banks are within the world’s top 100 banks, classified by assets as of 2002 – four branches in the sample of Top 100
subsidiaries incorporated in a developing country were classified as subsidiaries.d Figures for Czech Republic, Estonia, Latvia, Poland, Slovak Republic and Uruguay underestimate the representativeness of the foreign banks in the sample due
to missing asset data. Bulgaria’s low foreign asset share is due to the important participation of banks from Greece and Hungary, which are not classified within thetop 100 banks. Peru’s low foreign asset share data is due to the importance of Banco de Credito del Peru and Interbank’s shareholders, which are companies fromBermuda and Bahamas respectively. Finally, Bolivia’s low asset share is due to the importance of Banco de Credito de Bolivia whose main shareholder is Banco deCredito del Peru.
e It does not include 605 cooperatives banks (they represent 6.5% of total assets).
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Table 3Host-country regulations on the organizational form of foreign banks: Branch vs. subsidiary index
Countries Written statements Restriction on activities Responsibilities undertaken Other restrictions Host-country regulation index
Argentina 0 0 0 0 0
Bolivia 1a 0 0 0 1
Brazil 0 0 0 0 0
Bulgaria 1b 0 0 0 1
Chile 0 0 0 0 0
Croatia 1c 1d 1e 0 3
Czech Republic 0 0 0 0 0
Ecuador 0 0 0 0 0
Estonia 0 0 0 0 0
Hungary 0 1f 0 1g 2
Latvia 0 0 0 0 0
Lithuania 0 0 0 0 0
Mexico 0 1h 0 0 1
Peru 0 0 0 0 0
Poland 0 0 1i 1j 2
Slovak Republic 0 1k 0 0 1
Slovenia 0 0 0 0 0
Turkey 0 0 0 0 0
Uruguay 0 0 0 0 0
Notes: This table explains how the Host-Country Regulation Index was constructed. The index was developed using four subcategories: Required Written State-ments, Restrictions on Activities, Responsibilities Undertaken and Other Restrictions. Each category is equal to zero if the legal requirements for a branch are thesame as for a subsidiary. They are equal to one if there are more requirements for a branch than for a subsidiary. An explanation when each subcomponent equals 1can be found below.Source: Host Countries’ Banking Sector Regulations.
a Written approval of bank supervisory body of country of domicile required to open a bank branch (Law of Financial Institutions, art 17 (1)).b Written approval of bank supervisory body of country of domicile required for opening a bank branch (Law of Banks, art 12). Also written statement of the
bank’s supervisory body agreeing exchange of information and prompt notification of news to the Bulgarian authorities (Regulation 2, Section 2).c (Among others) An opinion or approval of the supervisory authority of a bank of a Member State or the supervisory authority of a foreign bank on a bank that
intends to establish a bank in the Republic of Croatia (Banking Law, art 35).d A branch office of Foreign banks shall not perform the activities determined by the provisions of Articles 35, 36 and 37 of the Banking Act (e.g. receive deposits,
etc.). Special conditions for operating a branch office of foreign banks shall be regulated by Croatia National Bank (Banking Act, art 21).e A branch may conduct operations within the Republic of Croatia pursuant to the authorization of the founder bank and with the implicit responsibility of the
founder bank for all obligations undertaken in the Republic of Croatia in relation to the operations of the branch (Banking Law, art 51).(continued on next page)
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Table 3 (continued)f Unless otherwise provided for by an international agreement, the Government may, based on a law or an authorization granted by law, prescribe by decree that
only economic organizations with business offices registered in Hungary or organizations under full or majority ownership of domestic residents may be entitled toperform certain activities (Branch Act, Section 8).
g A branch office may be entered in the company registration records if an international agreement concluded with the country, or international organization, wherethe registered office, in which the foreign company is located, allows the foreign company to establish a branch office in Hungary (Branch Act, Section 5). From 1January 1998, The Branch Act recognizes and authorizes for the first time the ‘‘branch’’ as a legal form of establishment in Hungary.
h The Secretariat of Finance and Public Credit may authorize the establishment in the Republic of branches of pre-eminent foreign banks, whose borrowing andlending operations may be conducted only with residents outside Mexico (Law of Credit Institutions, art 7).
i The application shall have appended thereto an undertaking from the applicant foreign bank that it will satisfy all claims on the branch that may arise from itsrelations with other organizations (Banking act, art 40 (3)).
j The Commission for Banking Supervision stated in a debate that the most appropriate form of foreign organization in the baking business in Poland would be ajoint-stock bank (source: The Polish Banking System in the 1990s, National Bank of Poland, December 2001). The authorization of the Commission for BankingSupervision is a requirement for the establishment of a branch of a foreign bank (Banking Act, art 40).
k A branch of a foreign bank may only be permitted mortgage transactions if the foreign bank applying for the license has a license to perform mortgagetransactions in the home country (Banking Act, art 8(9)).
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Undertaken, and Other Restrictions. A value of one is associated with each category wherethe host country establishes more requirements for opening a foreign bank branch than fora foreign controlled subsidiary. The most common requirements are: the approval of thehome-country foreign bank regulator, restrictions on specific activities (e.g. mortgagetransactions) or on dealing with host country residents, and a statement of the applicantforeign bank that it will be responsible for all branch claims.
Among the sampled host countries, Croatia, Hungary, and Poland discriminate themost against foreign branches, with the first two countries placing restrictions on the activ-ities that branches can undertake relative to subsidiaries. With the exception of Mexico(where branches can only operate with non-residents), such restrictions appear to beuncommon in Latin America.
3. Empirical methodology
To study the type of organizational form international banks adopt when operatingoverseas, we build an empirical model loosely inspired by Dunning’s (1977) Eclectic The-ory of the non-financial multinational corporation and its application to banking as dis-cussed in Gray and Gray (1981) and Williams (1997). The Eclectic Theory identifiesthree categories of enabling factors or incentives that affect the creation of a multinational:ownership-specific advantages (derived from the size and established position of the parentcorporation), internalization incentive advantages (derived from the existence of imperfectmarkets for inputs and outputs) and location advantages. The latter encompass regula-tions, tax regimes, economic prospects, and political risks in host countries.
Our application of the Eclectic Theory is loose because the latter was mainly developedto explain the existence of multinational corporations and not their organizational form, asubject fairly unique to banking. Nevertheless, in building our empirical model, we focuson a similar set of factors considered by the Eclectic Theory and included in many of theprevious empirical studies on the overseas activities of international banks.
Organizational Formi;j;k ¼ a0 þ b1Parent Bank Characteristicsi;j
þ b2Affiliate Bank Characteristicsi;j;k
þ b3Home-Country Regulationsj
þ b4Host-Country Factorsk þ ei;j;k: ð1Þ
In our model, summarized by Eq. (1) above, Organizational Formi,j,k is a dummy equal to1 if parent bank i from home country j has a branch in host country k, and 0 if it operates asubsidiary in that country. Parent Bank and Affiliate Bank Characteristics refer to variablesthat capture ownership-specific factors, while Home-Country Regulations and Host-Country
Factors are variables that characterize internalization and location-specific advantages.Among the Parent Bank Characteristics we control for the size, business orientation, and
international strategy of each parent bank. Parent Bank Size refers to the log of the total par-ent bank assets. We expect this variable to affect a bank’s ability to operate in a foreign mar-ket (Focarelli and Pozzolo, 2001), and possibly to favor subsidiaries to the extent that theserequire a larger initial investment. This data come from Bankscope. Parent Bank Business
Orientation is a dummy that equals one if the bank has a retail orientation and zero if thebank is primarily engaged in wholesale or investment bank activities. Previous studies
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suggest that this variable will have a negative coefficient, since branches have been associatedprimarily with wholesale activities (Goldberg and Saunders, 1981b). The sources for thisclassification are Bankscope and the parent banks’ web pages. Parent Bank Internationaliza-
tion Strategy refers to the ratio of branches to total foreign operations that the parent bankowns. This variable helps determine whether the parent has a clear preference for and a com-parative advantage operating under one type of organizational form or the other. The Bank-ers’ Almanac is the source used to construct this variable.
We also control for several characteristics of the affiliate bank. Affiliate Bank Size refers tothe size of the local affiliate in the host country, as measured by the number of employees.13
This variable controls for the claim that branches have been typically associated with rela-tively smaller operations (Miller and Parkhe, 1998). This data come mainly from Bankscopeand Bankers’ Almanac. Affiliate Bank Business Orientation is a dummy equal to 1 if the affil-iate bank has a retail business orientation. The dummy is zero in the case of trade finance andcorporative and investment banks. This variable plays a similar role to Parent Bank Business
Orientation. This data come from Bankscope, Bankers’ Almanac and banks’ web pages.Two variables account for path-dependency in the organizational form of affiliates. The
first is a dummy (labeled Acquisition Dummy) for whether the bank is a greenfield opera-tion (0) or the result of an acquisition (1). The data suggests that acquired institutions arelikely to maintain their own charter and, hence, operate as subsidiaries. The second var-iable is the year in which the affiliate was established (Year-of-entry). This mainly controlsfor different factors affecting the organizational form at the time of entry. Information toconstruct both of these variables was obtained from central banks, banks’ web pages,Bankers’ Almanac and Bankscope.
Home-Country Regulations refers to restrictions placed by home regulators on the over-seas operations of banks from their country. Several studies have found such regulationsto affect the overseas activities of international banks (e.g., Goldberg and Saunders, 1980;Goldberg and Johnson, 1990). In our particular case, because we focus on the choice oforganizational form, our measure of home-country regulations captures restrictions onopening branches relative to subsidiaries (as opposed to restrictions on internationaliza-tion in general). This dummy was constructed on the basis of the information gatheredfrom laws and regulations in the parent bank countries, and it is expected to have a neg-ative sign. More details on this dummy can be found in Table 1.
Host-Country Factors include variables capturing banking regulations, corporate taxa-tion, country size, level of development and risk. Numerous studies have found these vari-ables to be significant factors driving the overseas operations of international banks.14
Here, we test the importance of these factors in determining banks’ organizational form.Among the host country banking regulations, Host-Country Bank Entry Requirements
is an index that takes values from 0 to 8, depending on the number of legal submissions
13 We measure size with the number of employees because data on assets for branches was lacking in many cases,given that balance sheets are typically consolidated at the parent level and no separate information is available forthe branch.14 See for example Miller and Parkhe (1998) on the impact of taxation; Buch (2000), Claessens et al. (2000),
Focarelli and Pozzolo (2005), Goldberg and Johnson (1990) on the role of per capita income; Buch (2000), Buchand Lipponer (2004), Focarelli and Pozzolo (2005), Moshirian (2001) on the effect of local market size; Buch(2000), Buch and Lipponer (2004), Focarelli and Pozzolo (2005), Galindo et al. (2003), Goldberg and Johnson(1990), Golberg and Saunders (1981a,b), Miller and Parkhe (1998) on the impact of host country regulations; andBuch (2000) and Buch and Lipponer (2004) on the impact of host country risk.
E. Cerutti et al. / Journal of Banking & Finance 31 (2007) 1669–1692 1681
required to obtain a license to operate as a bank in the host country. These requirementsmay include none, all or some of the following: (1) draft by laws, (2) intended organiza-tional chart, (3) first 3-year financial projections, (4) financial information on main poten-tial shareholders, (5) background/experience of future directors, (6) backgroundexperience of future managers, (7) sources of funds to capitalize new bank and (8) intendeddifferentiation of new bank from others. Restrictive entry regulation is likely to favor entryby acquisition and, hence, subsidiaries (see discussion above). This index is constructedusing the data collected and methodology proposed by Barth et al. (2001).
Host-Country Restrictions on Bank Activities is also an index developed by Barth et al.(2001). This index, ranging between 1 and 16, tries to capture the extent to which bankscan engage in (a) the business of securities underwriting, brokering, dealing, and all aspectsof the mutual fund industry, (b) insurance underwriting and selling, (c) real estate invest-ment, development and management, and (d) whether banks can own non-financial firms.For each of these subcategories, a value between 1 and 4 is assigned depending on whetherthe activity is unrestricted (1), permitted (2), restricted (3), or prohibited (4). Previous studiesindicate that branches tend to engage in a narrower range of activities, and hence are less sen-sitive to this kind of restrictions (Goldberg and Saunders, 1981b; Miller and Parkhe, 1998).
Host-Country Regulations on Foreign Bank Branches refers to an index that captures thedegree to which the host country restricts the operation of foreign banks as branches in thecountry, relative to its treatment of foreign subsidiaries. This variable was constructed onthe basis of 2002 bank regulations and legislation in each of the host countries. Details onthis index are shown in Table 3. We expect this variable to have a negative impact on thelikelihood that a bank will operate as a branch.
Host-Country Corporate Taxes refers to the top corporate tax rate in the host countryas reported by the Heritage Foundation. We expect high taxes to favor branches since theyallow for easier cross-border profit shifting (Miller and Parkhe, 1998).
Host-Country Size is measured by the log of constant dollar GDP in the host country.This variable is intended to capture the scope for scale economies in the country (e.g.,Buch, 2000; Buch and Lipponer, 2004). Host-Country GDP per capita, measured as thedollar GDP per capita, is included to capture the degree of economic development inthe host country. This variable may also help to measure business opportunities in the hostcountry (see Buch, 2000; Claessens et al., 2000; Focarelli and Pozzolo, 2005; Goldberg andJohnson, 1990). Data for both of these variables come from the World Development Indi-
cators produced by the World Bank.Given the different liability structures of branches and subsidiaries, we expect country
risk to affect banks’ organizational form. We use different measures to test for these effects.In particular, Host-Country Risk refers to four different types of host country risk indexesreported by the International Country Risk Guide (ICRG). These variables are Economic
Risk, Political Risk, Investment Profile Risk, and Country Risk (composite index). TheEconomic Risk rating assesses a country’s economic strength or weakness as a functionof variables such as the country’s GDP per capita, real GDP growth, annual inflation rate,budget balance, and current account balance.15 The Political Risk rating provides a sum-mary of the degree of political stability in each host country. Investment Profile Risk, a
15 Although the ICRG Economic Risk index includes the host country GDP per capita as a subcomponent, thecorrelation coefficient between the ICRG Economic Risk index and host country GDP per capita variables is verylow in our sample.
Table 4Probit estimations of the likelihood that a foreign bank operates as a branch
Independentvariables
Dependent variable: Branch = 1; Subsidiary = 0
Model (1) Model (2) Model (3) Model (4) Model (5) Model (6)
This table reports probit regressions with standard error adjusted for clustering on each parent bank. A constant is estimated but not reported. Robust standarderrors are in parentheses. *, **, *** denote significance at 10%, 5% and 1%, respectively.
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subcomponent of the Political Risk index, takes into account factors such as contract via-bility, profits repatriation, payments delays measurements, etc. that affect those who investin the host country. Finally, Country Risk is a composite index that includes both eco-nomic and political risk variables and other variables such as exchange rate stabilityand total foreign debt as percent of GDP. We change the sign on these variables fromhow ICRG reports them, so that higher values indicate greater potential risk.
The type of organizational form explained by Eq. (1) can only be observed for a givenhost country once the parent bank decides to establish operations in that country. Thus, inestimating Eq. (1) there might be a selection bias, unless we also consider how parentbanks make decisions on where to establish foreign operations. We take this into accountby estimating a Heckman probit model where the first stage or selection equation is mod-eled following Eq. (2) below and the second stage is equivalent to the model presented inEq. (1).16
Foreign Bank Presencei;j;k ¼ a0 þ b1Parent Bank Characteristicsi;j
þ b2Affiliate Bank Characteristicsi
þ b3Home-Country Regulationsj
þ b4Host-Country Factorsk
þ b5Home-Host Proximityj;k þ ei;j;k; ð2Þ
where Foreign Bank Presencei,j,k is a dummy equal to 1 if parent bank i from home countryj has any kind of operations in host country k, and 0 if it does not have a presence in thehost country. We base our empirical modeling of Foreign Bank Presence on the existingliterature on the factors that determine the location of international banks overseas.(see Buch, 2000 for a review of this literature). Most variables included in Eq. (2) havebeen defined above, with the following three exceptions. First, within the parent bankcharacteristics, Parent Bank Worldwide Activity takes into account the number of coun-tries worldwide where each parent bank has operations (data source: Bankers’ Almanac).Second, among the regulatory variables, Host-Country (inward) Foreign Investment Regu-
lation and Home-Country (outward) Foreign Investment Regulation capture governmentcontrols on inward and outward direct investment in banking, respectively. Both variablesare constructed as a 5 year average (2002–1998) from IMF data.17 Finally, Home-Host
Proximity is a matrix of variables that capture the degree of economic, cultural, andinstitutional affinity or proximity between the home and host countries. In particular, itincludes separate dummies for whether the host and home-country share a common lan-guage and a common legal origin. Also, the matrix includes the share of bilateral trade anda measure of geographical distance between home and host countries, expressed in miles.Finally, we include a dummy for whether the home and host were in a colonial relation-
16 An alternative approach would be to estimate a nested logit model where the first decision level is to enter acountry or not and the second is whether to operate as a branch or as a subsidiary. The problem with thisapproach is that we could not study the impact of affiliate characteristics on the second level decision becausethese factors are not observed for cases when a bank has no operations in a given host. Despite this limitation,results on the remaining variables, available upon request, yielded very similar findings to those reported here.17 The IMF data are dummies that equal 1 in those years when the countries had controls.
E. Cerutti et al. / Journal of Banking & Finance 31 (2007) 1669–1692 1685
ship or colonized by the same country. All these variables come from the Central Intelli-gence Agency (CIA) World Factbook.18
4. Results
Table 4 reports the results for the probit estimation of Eq. (1).19 We present six alter-native specifications, including different proxies for political and economic risk. All regres-sions are estimated with robust standard errors, allowing for the possibility thatobservations for the same parent bank may not be independent (i.e., we allow for clusteredstandard errors for affiliates with the same parent bank). Most coefficients are significantand have the expected sign. Since results are robust across specifications, in what follows,we choose as our baseline the results for the regression labeled model (4).
The results can be summarized as follows. First, regulations affect bank’s organiza-tional form. The variables describing host- and home-country restrictions on foreignbranches both have the expected negative sign and are significant in all specifications(often at the 1% level), indicating that more restrictions on branches lower the probabilitythat banks adopt this organizational form. This result adds further support to the findingsof previous studies in the international banking literature that regulations affect the over-seas operations of multinational banks (see Buch, 2000; Buch and Lipponer, 2004; Focar-elli and Pozzolo, 2005; Galindo et al., 2003; Goldberg and Johnson, 1990; Goldberg andSaunders, 1981b; Miller and Parkhe, 1998). Host-country bank entry requirements, whichcapture the number of procedures required to license a bank, also have a negative,although less consistently significant, effect on the establishment of branches. One possibleexplanation for this result is that while branches are typically de-novo operations, bankscan circumvent entry requirements by setting up subsidiaries through the purchase ofdomestic institutions. Consistent with this interpretation, we find that the acquisitiondummy is always significant and has a negative sign.20 Host-country restrictions on bankactivities do not seem, however, to have a significant impact on the organizational formadopted by foreign banks. This is not necessarily surprising since these restrictions typi-cally apply to both locally- and foreign-incorporated banks.
Second, tax rates also influence banks’ organizational form. The coefficient on the hostcountry top corporate tax rate is positive and highly significant in all regressions. Thus,branches, which have an advantage in shifting profits across borders, are more likely incountries with relatively higher corporate taxes. This result is consistent with and extends
18 The variables included in the first stage equation (or Eq. (2) above) of the Heckman model that are notincluded in the equation for the organization form (Eq. (1)) are the exclusion restrictions which allowidentification of the Heckman probit model. We tried a number of variations on these, and results remainedlargely unchanged. Furthermore, in separate probit estimations, available upon request, we verified that thosevariables included in the selection equation did not affect the second stage equation (i.e., the type oforganizational form).19 Note the sample size, which captures the number of bank affiliates (both branches and subsidiaries), drops to
240 observations instead of 247 as shown in Table 2, because of missing data for five Brazilian banks (allinvestment banks), one Mexican bank, and one Polish bank.20 We also attempted to look at this hypothesis by adding an interaction term between entry restrictions and the
acquisition dummy but, due to multicollinearity with the individual variables that make up the interaction term,this interaction term had to be dropped. Nevertheless, we thank Alberto Pozzolo for the suggestion.
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the findings of Miller and Parkhe (1998), which had focused only on a sample of US inter-national banks.
Third, different organizational forms are associated with different degrees of penetra-tion in a foreign market on the part of the parent bank. Branches are more likely whenforeign operations are smaller in size. The link between the degree of penetration and alower probability of being a branch is reinforced by the negative and significant coefficientof the dummy indicating that the affiliate is a retail bank. These results are consistent with,and extend to more countries and to a large set of banks, the results of the 1980s US basedstudy by Goldberg and Saunders (1980). The coefficient of affiliate year-of-entry is positiveand significant, suggesting that there has been a recent trend by foreign banks to increas-ingly penetrate emerging markets by operating as subsidiaries.
A related finding is that branches are less likely in relatively richer countries: the hostcountry’s per capita income has a negative and significant coefficient. This may in partreflect the fact that subsidiaries are often the result of crisis-related acquisitions that aremore likely to occur in poorer countries. However, this cannot be the entire story as majorcrises have occurred also in relatively richer emerging market economies. One additionalexplanation may be that foreign banks enter as subsidiaries in markets where they believethere is ample room for expansion and these are typically poorer economies, where thelocal banks are less developed and capitalized, and hence easier to compete against.
Fourth, parent banks seem to specialize, in one organizational form or the other,beyond what is explained by their home-country regulation. Indeed, the worldwide ratioof branches-to-subsidiaries at the parent bank is positive and highly significant. One pos-sible explanation for this finding is that the two organizational forms require differentexpertise and corporate governance design at the parent level. However, the coefficientsof the dummy indicating that the parent institution is a retail bank and that of its sizeare not significant, suggesting that the business orientation and overall size of the parentbank itself are not important when it comes to the organizational form of its foreign oper-ations.21 Possibly, the reason why parent size seems not to matter can be ascribed to thefact that all parent banks in our sample are pretty large, with assets ranging from USD$1097 billions (Citigroup Inc.) to USD$ 94 billions (Bank of China, Hong Kong).
Finally, economic and political risk matter but have opposite effects, suggesting thatdifferences in parent banks’ responsibility for the liabilities of branches and subsidiariesplay an important role in the organizational form of international banks’ affiliates. Undernormal circumstances, parents face full responsibility vis-a-vis the liabilities of branches,but their exposure is limited to the loss of the equity invested in the case of subsidiaries.Consistent with these differences in the legal treatment, we find that banks are more likelyto operate as branches in host countries characterized by relatively low economic risk. Thecoefficient of the proxy for economic risk is negative and significant, suggesting that, incountries with a highly risky macroeconomic environment, parent banks prefer the shieldof the ‘‘hard’’ limited liability provided by subsidiaries to the ‘‘soft’’ protection of ring-fencing provisions. However, the coefficients on the political risk proxy and on the mea-sure of investment risk (capturing risk to the viability of contracts, risk of expropriation,and potential obstacles to the repatriation of profits), are positive and significant. This sug-
21 The lack of significance of the parent bank size is another reason why we think that limiting our sample to the100 top largest banks in the world is not likely to be introducing a bias in our estimations.
E. Cerutti et al. / Journal of Banking & Finance 31 (2007) 1669–1692 1687
gests that when it comes to risks stemming from possible government intervention andother major political events (such as civil unrest or wars), parent banks prefer to operateas branches, since the latter are often protected against such events by ring fencing provi-sions.22,23 In other words, in view of legal provisions that shield parent banks from the lia-bilities of their foreign branches in events such as wars, insurrections, or actions by foreigngovernments, banks are on such occasions less exposed as branches than as subsidiaries,which typically have higher capital and reserve requirements and larger investments inlocal fixed assets. This is a new and important finding not explored in previous studies.
In Table 5, we measure the economic impact of a change in our explanatory variablesby considering what happens to the predicted probability of the affiliate being a branchwhen each right hand side variable increases from its sample average by one standard devi-ation (for the dummy variables we consider a change from 0 to 1). Among the taxationand regulatory variables, corporate taxes have by far the largest impact: a one-stan-dard-deviation increase from the average in corporate taxes increases the likelihood thatthe foreign bank will operate as a branch by about 6.8% points. Home-country restrictionson overseas branches increase the probability of an affiliate being a subsidiary by about4%. The economic effect of the other regulatory variables is between 1% and 2% points.Among the bank-specific factors, the acquisition dummy has the largest impact withacquired affiliates being more likely to be subsidiaries by almost 10% points. The interna-tional specialization of the parent bank and the affiliate bank’s business orientation arealso important: a one-standard-deviation increase in the ratio of branches-to-subsidiariesat the parent bank level increases the likelihood of the affiliate being a branch by almost5% points; retail oriented affiliates are more likely to be subsidiaries by about 6% points.Year-of-entry and the affiliate bank size, and the acquisition dummy increase the proba-bility of branches by 2% points. Finally, the relative importance of host country risk iscomparable or exceeds to that of regulations. A one-standard-deviation increase in polit-ical risk raises the likelihood that the foreign affiliate operates as a branch by almost 10%points. A one-standard-deviation increase in economic risk, lowers this probability byabout 2% points.
Estimates of the Heckman probit model discussed in Section 3 are shown in Table 6.Results for the first stage of the Heckman estimation, explaining the presence of interna-tional banks in a given country, are consistent with many of the previous studies on thisissue and are not reported here.24 Results for the second stage of the Heckman probit arevery similar (and almost identical in terms of significance) to those for our simple probitmodel. Furthermore, the tests of independence of the first (selection) and second stage equa-tions, reported at the bottom of Table 6, cannot reject the null of independence. In otherwords, we can take the probit results to be consistent and not affected by selection bias.
22 The opposite sign associated with economic and political risk explains why the ICRG country composite riskindex in model (1) is not significant.23 We also tried looking at the interaction of affiliate size and political risk, but we could not add this variable
due to multicollinearity with the individual variables which make up this interaction term that are alreadyincluded in the regressions. This is due to the fact that while the variability in affiliate size is significant, the same isnot true for our measure of political risk, so that the interaction term is highly collinear with size.24 The results of the first stage can be found in the more extended version of this paper (Cerutti et al., 2005).
These results also provide new insights with the inclusion of variables such as political and economic risk.
Table 5Impact of the determinants of the likelihood of a foreign bank operating as a branch
Independentvariables
Coefficienta Variable mean Variable hangeb Impact on the likelihood of operating asa branch (in % terms)b
Parent bank internationalization strategy 3.24 0.54 0.17 4.9Parent bank size �0.31 19.86 0.59 �0.8Parent bank business orientation 0.45 0.94 1 1.5Home-country regulations on overseas branches �0.85 0.38 1 �3.8Affiliate bank size �0.31 1.58 3.88 �2.0Affiliate bank business orientation �0.96 0.59 1 �6.3Year of entry �0.04 1987 24.77 �1.9Acquisition dummy �1.93 0.38 1 �9.7Host-country regulations on foreign bank branches �0.72 0.72 0.95 �1.8Host-country bank entry requirements �0.34 7.37 0.92 �1.1Host-country restrictions on bank activities 0.13 9.38 1.96 1.7Host-country corporate taxes 0.09 27.06 7.68 6.8Host-country size �0.09 25.28 1.39 �0.6Host-country GDP per capita �0.3 4.66 1.72 �1.6Host-country political risk 0.12 71.49 6.97 9.9Host-country economic risk �0.22 33.96 2.88 �1.7Latin America dummy �0.58 0.48 1 �3.0
a Coefficients from model (4) in Table 4.b Effects are measured for a one standard deviation change in continuous regressors and a change from to 1 for discrete variables.
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Table 6Second stage Heckman probit estimations of the likelihood that a foreign bank operates as a branch
Independentvariables
Dependent variable: Branch = 1; Sudsidiary = 0
Model (1) Model (2) Model (3) Model (4) Model (5) Model (6)
This table reports the second stage of Heckman probit regressions with standard error adjusted for clustering on each parent bank. A constant is estimated but notreported. Robust standard errors are in parentheses. *, **, *** denote significance at 10%, 5% and 1%, respectively.
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E. Cerutti et al. / Journal of Banking & Finance 31 (2007) 1669–1692 1691
This also explains why the Heckman second stage results and the simple probit estimationsare almost identical.
5. Conclusions
Using an original database of the operations in Eastern Europe and Latin America ofthe world’s 100 largest banks, this paper studied the determinants of banks’ organizationalform. Our analysis indicated that the likelihood that a bank will establish a branch asopposed to a subsidiary is driven by a number of factors including: home-country regula-tions on how banks are allowed to operate overseas, entry restrictions and taxes in hostcountries, the desired degree of penetration in the host market, parent banks’ type of oper-ations elsewhere (i.e., their past expansion strategies), and the type of risks that banks facein the host markets.
From a policy perspective, our results lead to two main conclusions. First, since riskmatters, parent banks should be expected to behave differently vis-a-vis branches andsubsidiaries in times of economic and political crisis. Second, since regulatory variableshave non-marginal effects on the form of foreign bank entry, governments can design reg-ulations to favor one structure over another. Policy makers concerned with the behavior offoreign banks during periods of financial distress may want to favor branches to tap intothe deep pockets of their parents. However, the results indicate that subsidiaries are morelikely to enter retail markets and establish large local networks. Hence, a trade-offemerges. We leave the analysis of this trade-off to future research.
Acknowledgements
We thank Ugo Panizza and researchers at the Inter-American Development Bank forproviding us data. We are grateful for comments and suggestions received from AlbertoPozzolo and other participants at the World Bank and Journal of Banking and Financeconference on Globalization and Financial Services in Emerging Economies, as well asfor those provided by the editor of this volume, Fariborz Moshirian, and by an anony-mous referee. The findings, interpretations, and conclusions expressed in this paper are en-tirely those of the authors and do not necessarily represent the views of the World Bank orthe IMF.
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